What is the function of Chinese walls in preventing insider dealing?

Since their creation, capital markets have suffered insider dealings. It has become a more serious threat as the amount of capital transfers largely increased during the 20th century. The Securities Exchange Commission (SEC) on behalf of the US government has been the first agency to challenge this market abuse. In 1968, the SEC settled litigation with Merrill Lynch provided that the latter establishes a Chinese wall within its organisation. Many other cases in the USA were settled at this condition. Insider dealing was widespread in the western economies partly because of the fixed brokerage commission model in the trading system. Broker-dealers had to use inside information to be competitive on the financial markets. The transition to negotiable brokerage commissions resolved this issue but increased the need for Chinese walls as the multi-service bank model became prominent. In the UK, the Financial Service Act in 1986 promoted Chinese walls in the broker-sale situation but also in the commercial banks.

Insider dealing is the illegal trading in shares by someone or at the instigation of someone with knowledge of unpublished business information that would affect the price of shares being bought or sold (e.g. FCA glossary definition for a extensive definition). Usually, the investment-banking department obtains information through its relationship with corporate clients. The investment banker then shares this information with the firm’s brokers who make trade recommendations to their customers based on this information.

To prevent this market abuse, many financial markets participants use Chinese walls. According to the UK Financial Conduct Authority (FCA), a Chinese wall is an arrangement that requires information held by a person in the course of carrying on one part of its business to be withheld from, or not to be used for, persons with or for whom it acts in the course of carrying on another part of its business. In a bank, a Chinese wall separates the M&A advisory division which will often learn of inside information from its work for corporate clients on acquisitions and its trading division which is restricted from trading if it knows such information.

Initially, insider dealings were only covered by the Criminal Justice Act 1993 but it was difficult to prove the abuse under criminal law.  The Financial Services and Market Act (FSMA) came into force in 2000 to provide an extensive measure against insider dealing. Then, the EU Market Abuse Directive (2003) harmonized the EU member’s legislation on this matter. The Market Abuse Regulation and the Market Abuse Directive have been adopted in 2014. The Market Abuse Regulation shall enter into application in July 2016 and will repeal the Market Abuse Directive. Member States have two years to transpose the Directive into their national law.  The FCA can impose fines based on the FSMA. Besides, the FCA edited the Code of Market Conduct (The Code), which represents the FCA’s views on market abuses. The Code also provides provisions regarding Chinese walls.

Chinese walls are used to prevent insider dealings and conflicts of interests. This paper focuses on the Chinese walls in preventing insider dealings. Then, this essay puts forward alternatives to overcome the Chinese walls disadvantages.

I. Goals and characteristics of Chinese walls

Chinese walls prevent insider dealing by preventing the flow of non public information. Chinese walls usually include:

–       Physical separation of departments in different wings or floors of a building

–       Maintenance of separate accounting systems, records, support staff

–       Restrictions on sensitive documents

 

According to the Market Abuse Regulation[1], effective arrangements, systems and procedures aimed at preventing and detecting insider dealing (i.e. Chinese walls) shall be established. They can contribute to market integrity and combat market abuse provided they are enforced with determination and dutifully controlled.

Chinese walls are not only forbidding market participants to act but are also protecting them. If the information is held behind a Chinese wall, that evidences that the organisation did not deal on the basis of inside information[2]. For example, the broker-dealer can continue to engage in trading activities without any fear of being guilty of insider trading.

The Market Abuse Regulation[3] also provides a safe harbour for some share buy back programmes. This safe harbour is subject to important restrictions. These restrictions are also subject to exceptions for some firms if there is a Chinese wall implemented within the company.

II. Disadvantages of Chinese walls

However, Chinese walls appear to be more successful in preventing the accidental flow of inside information than they are in preventing purposeful misconduct and conspiracies to share inside information[4].

More importantly, Chinese walls won’t be able to prevent insider trading by classic insiders of the corporation and their tippees. These instances of insider trading are more common than insider trading resulting from the breach of a Chinese wall particularly with the emergence of discount brokers.

As evidenced by the news, numerous allegations of insider trading continue to arise. In 2014, the FCA charged former Morrisons treasurer and head of tax with insider trading.

The customer’s interest in being fully informed about all material facts affecting the transaction is also put in jeopardy. Is it fair to hold information if a firm is restating its earnings because of accounting fraud?

Chinese walls also prevent companies from cost saving, opportunities for collective thinking and other synergies of combining and integrating various departments. Finally, they are not designed for hedge funds that are flexible organization with low administrative costs.

For all these reasons, Chinese walls are ineffective to put an end to insider dealings. They are not sufficient to prevent most of these market abuses.

III. Alternatives to the inefficient Chinese walls

This is why firms use lists to prevent insider dealings by adding these lists to their Chinese wall:

–       Restricted lists provide that no employee at the firm would be allowed to make recommendations or solicit trades for a security on this list. But this is equivalent to revealing the adverse information itself if the firm previously recommended the security!

–       Watch lists provide a list of securities whose trading is monitored by the firm’s compliance department but there are no formal trading restrictions placed on them. However, it only detects insider trading after it has already occurred.

Given the difficulties encountered by these regulation policies, some academics and economists recommended a complete segregation of the different activities. Nevertheless, this solution prevents firms from making economies of scale and it does not prevent an investment banker at one firm from calling a friend who is a retail broker for another firm and share inside information.

The most balanced solution might be –as recommended by Nicholas Wolfson – the full and immediate disclosure of all corporate information by the client or by the investment banker on the behalf of his client. The Market Abuse Regulation implements provisions regarding public disclosure of inside information[5]. Does this loss of confidentiality balance with the benefit of such a rule?

 

Jean-Marie Pédron

 

Pour en savoir plus :

REGULATION (EU) No 596/2014 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 16 April 2014

Directive 2003/6/EC of the European Parliament and of the Council of 28 January 2003 on insider dealing and market manipulation (market abuse)

Insider trading, Chinese walls, and brokerage commissions: The origins of modern regulation of information flows in securities markets by Stanislav Dolgopolov

Are Chinese walls the best solution to the problems of insider trading and conflicts of interest in broker-dealers? By Christopher M. Gorman

With the spotlight on the financial crisis, regulatory loopholes, and hedge funds, how whould hedge funds comply with the insider trading laws? By Ted Kamman and Rory T. Hood

The EU/UK Market Abuse Regime – Overview by Slaughter and May (2011)