Insider Dealing For Hedge Fund And Private Equity Managers

Although the objectives of laws governing insider dealing are clear in theory, namely to prohibit profiteering from access to material non-public price sensitive information (“MNPI”), in practice, these laws are surprisingly difficult to apply. Take for example a hedge fund trader who receives a call from a broker. The broker wishes to gauge interest in a proposed but not yet announced share transaction concerning a company listed on the Hong Kong Stock Exchange (“HKSE”). When do insider dealing laws restrict the hedge fund trader from dealing in those shares? Or, take for example, a private equity firm engaged in a potential private investment public equity (“PIPE”) transaction. The firm conducts due diligence and as a result, is privy to non-public information. When do insider dealing laws restrict the funds managed by the firm from taking a share position in that company?

Overview of Insider Dealing Laws

In Hong Kong, insider dealing is both a civil wrong and a criminal offence. On a criminal indictment, insider dealing is punishable by up to 10 years imprisonment.

Broadly, insider dealing restrictions arise from both fiduciary restraints and a statutory regime specifically governing insider dealing. The latter are set out in the market misconduct provisions of the SFO in sections 270 and 291 and are the more important in Hong Kong. The former originate in duties of confidentiality and may be enforceable under the SFO through the anti-fraud provisions in section 300.

Under the SFO’s statutory regime governing insider dealing, there are 3 separate categories of prohibitions, one for connected persons, one for takeover bidders and one for tippees. Each category, as it would normally apply to a hedge fund or a private equity manager, is described below.

Prohibition on Insider Dealing by Connected Person

Simplistically, under the SFO statutory regime for insider dealing, a "connected person" is an insider. Naturally therefore, directors and employees of a listed company are connected persons. However, the term also includes:

• Substantial shareholders (i.e. persons holding 5 per cent. or more of the nominal value of the share capital of the company).
• Professional and business counterparties (i.e. persons occupying a position which may reasonably be expected to give them access to inside information of the company by reason of a professional or business relationship).
• Transaction counterparties (i.e. persons having access to inside information relating to a transaction, actual or contemplated, involving the company or its securities).

A connected person who has information which he knows is inside information of a company may not deal in securities of that company and may not counsel or procure another person to deal in them knowing or having reasonable cause to believe that the other person will deal in them.

Prohibition on Insider Dealing by Takeover Bidder

Under the SFO’s statutory regime for insider dealing, a person who is contemplating or has contemplated making a takeover offer of a listed company and who knows that the information that the offer is contemplated or no longer contemplated is inside information:

• may not deal in securities of the company, and
• may not counsel or procure another person to deal in them otherwise than for the purpose of the takeover.

The takeover prohibition, as with the other prohibitions, is co-extensive, meaning, for example, that a person may be subject to both the takeover prohibition and the connected person prohibition at the same time.

Prohibition on Insider Dealing by Tippee

Tippee prohibitions include 2 types of persons. First, the prohibitions include a person who has information about a company which he or she knows is inside information and which he or she received from a person whom he or she knows is a connected person and whom he or she knows or has reasonable cause to believe held the information as a result of being a connected person. Secondly, the prohibitions include a person who receives from a person whom he or she knows or has reasonable cause to believe is a takeover bidder information that a takeover bid is contemplated or is no longer contemplated for a company and who knows that the information is inside information. In each case, the person may not deal in securities of that company and may not counsel or procure another person to deal in them.

Meaning of Inside Information

Broadly, under the SFO, inside information is specific information about a listed company, its securities or its officers which is not generally known to persons who are accustomed or would be likely to deal in such securities but which would, if it were so generally known, be likely to materially affect the price of such securities.

Inside Information Must be Specific Information

Under the SFC Guidelines on Inside Information, the SFC observes that prior authorities suggest that for information to be specific information, it must meet 3 criteria:

• The information must be capable of being identified, defined and unequivocally expressed. Information concerning a company’s affairs is sufficiently specific if it carries with it such particulars as to a transaction, event or matter so as to allow the transaction, event or matter to be identified and its nature to be coherently described and understood.
• The information need not be precise. It is not necessary that all particular or details of the transaction, event or matter be precisely known. Information may still be specific even though it has a vague quality and may be broad, allowing even substantial room for further particulars.
• Vague hopes and wishful thinking may not be specific information. The fact that a transaction is only contemplated or under negotiation and has yet to be subject to formal or informal documentation does not necessarily preclude information about the transaction from being specific information. However, a vague hope or wishful thinking that a transaction will occur is likely to be insufficient to qualify as specific information.

Inside Information Must Not be Generally Known

The SFC Guidelines on Inside Information note that by its nature, inside information in relation to an HKSE listed company is information which is known only to a few and not generally known to the market. In this regard, the market is those persons who are accustomed or would be likely to deal in the securities of that HKSE listed company.

Press speculation, reports and rumours in the market cannot be automatically taken to be information generally known to the market, even though in some cases the media reports might have a wide circulation.

Inside Information is Information Likely to Have a Material Effect on Price

A particular point of difficulty in determining whether information is inside information is determining whether the information would, if it were generally known to persons accustomed to dealing in certain securities, be likely to materially affect the price of those securities. The SFC Guidelines on Inside Information suggest that information is unlikley to meet the test of “likely to have a material price effect” if the information is likely to cause a mere fluctuation or slight change in price. Thus, to qualify as inside information, the information must be likely to cause a change in the price of sufficient degree to amount to a material change.

Unsolicited Hedge Fund Participations in Transactions

It is not uncommon for a hedge fund manager to receive telephone calls from other financial intermediaries to gauge interest in a transaction relating to shares of an HKSE listed company. In this case, the caller may be a connected person, such as where a broker is acting as a placement agent. If so, unless the participants to the call appropriately limit the telephone discussion or the fund manager agrees to accept tippee prohibitions (i.e., to be wall-crossed), insider dealing restrictions may prevent the fund manager from dealing in the shares of the company. This would be so even if the fund manager had plans to do so before the telephone call.

Limit Content of Discussions with Connected Persons

As alluded to, a measure to avoid the application of the SFO statutory insider dealing restrictions is to limit the content of the discussion between the caller and the fund manager. This approach aims to ensure that the information relayed never reaches the level where it may be properly regarded as inside information unless the fund manager agrees to be wall-crossed. This means generally that the information must not be specific. As a basic measure, the name of the company may remain undisclosed but this can only be effective where other information does not allow the fund manager to specifically identify the company. What information might specifically identify a company will depend on individual cases.

A problem here for the fund manager is that the content of the telephone call is not under its full control. Indiscretion on the part of the caller or, more simply, differing views between the caller and the fund manager as to whether the content constitutes inside information, could therefore place the fund manager in a difficult position.

Chinese Wall Exemption from Insider Dealing

Where the identity of the company has been inadvertently disclosed without the fund manager's active agreement to cross the wall, the fund manager may still be able to continue to deal in the securities of the company if conditions under the SFO insider dealing regime for exemption are satisfied. One exemption permits dealing where the dealing is done by a person at the fund manager who, as a result of a Chinese Wall, was not tainted by the unsolicited information.

However, the extent to which an ad hoc Chinese Wall may be established within the fund manager to contain unsolicited inside information is unclear. This is particularly so where portfolio managers and traders sit in the same area and are privy to telephone discussions of other team members and where there is no existing protocol for immediate and systematic containment.

Due Diligence in Private Equity Investments

It is routine for private equity managers to conduct due diligence on companies, including HKSE listed companies, before investing in them. At times, the due diligence may be agreed upon by a private equity manager and the controlling shareholder of a target company or the target company itself. In this case, the due diligence afforded may be far more extensive than that available from public sources. This due diligence is, of course, good practice but raises a sometimes overlooked issue as to whether or not such due diligence might cause the private equity manager to become subject to a connected person prohibition on insider dealing.

Whether Due Diligence Findings Qualify as Inside Information

A threshold issue is whether or not information acquired in the course of due diligence qualifies as inside information. At first glance, one might assume that it does but this is not necessarily so. Assuming that the listed company has made timely disclosures of all material information as it is required to do under the HKSE Listing Rules, it is arguable that all information which is likely to materially affect the price of the company's securities is already generally known to persons who are accustomed or would be likely to deal in such securities. Indeed, if it were otherwise, connected persons of the company, such as its directors and officers, would never be in a position to deal in the shares of the company.

Managing Inside Information to Avoid Breaching Insider Dealing Laws

Uncertainty arises, however, if the private equity manager's due diligence uncovers material information that was not previously disclosed. If the information is adverse and the private equity manager elects not to proceed with the investment, no issue of insider dealing will arise on the basis that the private equity manager does not deal. This though, assumes that the private equity manager does not have an existing share position which must be unwound. If there is such a position, it is possible that any attempt to close that position on the HKSE before the announcement of the information may constitute insider dealing.

Structuring Transaction to Avoid Breaching Insider Dealing Laws

On the other hand, if the information is positive, there is a risk that if the private equity manager proceeds with the investment, it will be dealing whilst in possession of inside information or counselling the private equity fund managed by it to do so.   The extent of risk will, in part, depend upon the structure of the investment.

Under the SFO inside dealing regime, an off-market transaction between 2 counterparties, each of whom is in possession of the same inside information, is exempt from the insider dealing prohibitions. Thus, for example, where the investment will take the form of an off-market acquisition of a minority position and will not require an offer to acquire shares of the company from members of the public, the investment may be exempt on the basis that the selling shareholder and the private equity manager both possess the inside information.

Equally, under the SFO, the insider dealing prohibitions only extend to dealing in securities of an HKSE listed company. Thus, for example, if the investment were to take place as an asset purchase rather than a share purchase, there would be no dealing in the securities of the listed company and hence, the investment may be exempt from insider dealing prohibitions.

Disclosure or Containment of Inside Information

If however, tax, regulatory or other considerations do not allow for the investment to be exempt from the SFO insider dealing regime through an appropriate structure, in some circumstances the solution may lie in appropriate public disclosure of the private equity manager's and fund's connected person statuses.

If however, tax, regulatory or other considerations do not allow for the investment to be exempt from the SFO insider dealing regime through an appropriate structure, in some circumstances the solution may lie in appropriate public disclosure of the private equity manager's and fund's connected person statuses.

Conclusion

Few funds or their managers set out deliberately to breach the insider dealing laws. They are more likely to end up on the wrong side of an investigation by mishap than by malice. For this reason, hedge funds and private equity managers should consult with legal counsel with a strong background in insider dealing issues to ensure that they have adequate compliance measures in place, specific to their commercial practice, to contain the risks posed by insider dealing. Of equal importance, hedge funds and private equity managers engaged in potential acquisitions or other deals should not overlook the pitfalls that may arise when an acquisition snares inside information on the target company.