Struggling listed companies’ senior management and insider dealing: the Asia TeleMedia paradox

I accept that [the Court of Final Appeal’s conclusion in this case] places people in the position of the respondents in this case at a disadvantage to other people, in that they may be unable to sell or buy shares in the company concerned when they would do so even if they had not got the information. From the insider’s perspective that is the price of being an insider; from the public perception, that is the price of ensuring a perceptibly fair and undistorted market.”

In the eyes of many, working as senior management in a listed company is glamorous and financially rewarding. Being a listed company “insider” appears to be an infinitely attractive proposition.

That may be true in relation to some listed companies. But there are also listed companies where the reality could not be more different. Such listed companies are in fact struggling businesses, often lurching from one crisis to another, surviving only in the hope that the latest crisis would somehow be resolved.

It is not easy to attract talented individuals to serve as such listed companies’ senior management. These companies often struggle to afford cash-attractive remuneration packages. They rely instead on offering copious amounts of share options, but with the exercise price being significantly higher than the prevailing (and typically struggling) market price.

Those agreeing to join the senior management of such companies in such circumstances take the risk of ultimately being poorly rewarded (or even left unpaid if the company teeters on insolvency). However, if one does a good job at turning the company around or is otherwise just plain lucky such that the share prices rise significantly, then one becomes (relatively speaking) fabulously rewarded.

This kind of scenario was played out within the listed company Asia TeleMedia Limited (ATML). It led to allegations of insider dealing against certain of its senior management members, which culminated in the recent Hong Kong Court of Final Appeal’s (CFA) ruling in Securities and Futures Commission v. Yiu Hoi Ying Charles. The CFA held in favour of the Securities and Futures Commission’s (SFC) contention that certain ATML senior management committed insider dealing.

Background

AMTL was a company in constant financial difficulties. It owed Madam Liu Lien Lien (Madam Liu) sums totalling around HK$83.39 million since July 2002. Various defaults over the years in repayment led Madam Liu to serve several statutory demands on ATML. Nonetheless, no winding-up petitions ensued in those instances.

In February 2007, Madam Liu assigned the balance of ATML’s debt to Goodpine Limited (Goodpine). On 26 April 2007, Goodpine served a statutory demand on ATML stating that it would issue a petition to wind-up ATML if it failed to settle the debt in full within 21 days.

ATML’s senior management suspected that Goodpine was merely Madam Liu in another guise. Thus, like all previous occasions when Madam Liu made repayment demands, it was believed that Goodpine’s statutory demand would be resolved “behind closed doors”. Against this background, Goodpine’s statutory demand was not publicly announced.

In the meantime, there was a surge of speculative interest in ATML shares which sharply drove up their price and trading volumes. Between 28 February and 5 June 2007, both Mr Charles Yiu (ATML’s Director of Finance and Executive Director)(Charles) and Ms Marian Wong (ATML’s Company Secretary)(Marian) exercised their share options (which had exercise prices that were much higher than ATML’s historical share price levels) and then sold their shares. They each made net profits of over HK$5 million.

On 6 June 2007, Goodpine presented a winding-up petition and trading of ATML’s shares was suspended. When trading was resumed in October 2007, the share price of ATML fell by 62%.

The SFC then instituted Market Misconduct Tribunal (MMT) proceedings against Charles and Marian for alleged insider dealing. In short, the MMT found that the various elements of insider dealing were made out. Charles and Marian raised a defence available to them under section 271(3) of the Securities and Futures Ordinance (SFO), namely:

A person shall not be regarded as having engaged in market misconduct by reason of an insider dealing taking place through his dealing in ... listed securities ... if he establishes that the purpose for which he dealt in ... the listed securities ... was not, or, where there was more than one purpose, the purposes for which he dealt in ... the listed securities … did not include, the purpose of securing or increasing a profit ..., by using relevant information.” (Innocent Purpose Defence)

Based on the Innocent Purpose Defence, Charles and Marian argued in essence that their sole motivation for exercising the stock options and then selling the ATML shares was to take advantage of the sudden speculative rise in the ATML share price. Thus, they did not use the “relevant information” (the SFO has, since the time of the alleged events in this case, amended this term to “inside information”) of Goodpine’s statutory demand, which they believed would be resolved behind closed doors (Behind Closed Doors Justification) as on other previous occasions involving Madam Liu, when dealing in ATML shares.

Seven members of various tribunals and courts, including three members of the Market Misconduct Tribunal (MMT), three members of the Court of Appeal, as well as Tang PJ in his Lordship’s dissenting judgment in the CFA, agreed with Charles and Marian. Four justices of the CFA did not and upheld the SFC’s appeal.

Judgment

The central question before the CFA was whether it was correct as a matter of law to hold that Charles and Marian were entitled to rely on the Innocent Purpose Defence. In particular, much of the debate turned on what constitutes the use of inside information.

The CFA’s majority noted that in selling their shares at the material time, Charles and Marian knew about the Goodpine statutory demand. This meant that the ATML share prices at which they sold their shares would not have been achievable had the Goodpine statutory demand been disclosed to the market. As for the Behind Closed Doors Justification, the CFA held that Charles’s and Marian’s assertions that they subjectively believed that the Goodpine statutory demand would be resolved “behind closed doors” and chose not to announce it publicly was legally irrelevant, as such news constituted inside information in any event.

The CFA concluded therefore that at least one of the purposes of their dealing in the shares included making gains by using inside information. The Innocent Purpose Defence was not made out and the SFC’s allegation of insider dealing was upheld.

Paradox

As noted at the start of this e-bulletin, the CFA’s position in this case is essentially that any listed company senior management that has inside information cannot trade in the company’s shares before such information is made public. This is so even if senior management would have traded on the shares regardless of his/her possession of inside information. The examples given in the CFA’s majority judgments as to what would satisfy the Innocent Purpose Defence suggest that it can now in essence only be used where an insider (like listed company senior management) is compelled by pre-existing contract or otherwise by law to trade in the shares.

Leaving aside narrow arguments about whether, the wording of section 271(3) of the SFO allowed for a narrow interpretation of the Innocent Purpose Defence as found by the CFA, from a policy perspective, the CFA’s conclusions would appear to be hard to argue against. Listed companies’ senior management are, by virtue of their intimate knowledge of most good news and bad about the company, the ultimate insiders. With this knowledge rightly comes extra responsibility, including facing additional restrictions on their trading of the company’s shares.

Evidentially speaking, it is also true that it may typically not be easy to discern the extent to which senior management’s subjective non-inside information based trading intentions are consciously or sub-consciously tainted by knowledge of inside information. It may indeed be more straightforward for a Court to conclude that, short of clear legal compulsion, any trading of shares whilst in possession of inside information would objectively be tainted by it.

These conclusions are applicable even in cases involving struggling listed companies, where being their senior management would by no means be as glamorous and highly rewarded as is often imagined. It cannot be the case that one rule applies for those working in successful companies and a more lenient rule applies for those working in struggling companies.

From this perspective, it may be said that the MMT’s and the Court of Appeal’s approach to applying section 271(3) of the SFO appeared to be more “human” by taking into account the realities of working in a struggling listed company. However, it risks opening the floodgates to all manners of subjective justifications for share trading while in possession of inside information, to the detriment of the investing public.

By contrast, the CFA’s more stringent approach would appear to provide stronger protections for the investing public. However, it could also make it difficult for struggling listed companies to attract talented senior management through share options with relatively high exercise prices (which the CFA’s ruling has now arguably made much harder to exercise and then to trade on the shares so gained profitably), when such are often the only incentives they can afford to offer. This in turn creates the risk of less talented individuals becoming listed companies’ senior management, which is also unlikely to be good news for the investing public.

The CFA’s ruling thus potentially creates a paradox. Its principled stance on protecting the investing public on market misconduct may have inadvertently created other risks for the investing public on the quality of non-market misconduct aspects of listed companies’ corporate governance and management. Nonetheless, given the alternatives available to the CFA (such as affirming the MMT’s and Court of Appeal’s rulings, which as noted above were also problematic), the paradox appears necessarily and reasonably to be unavoidable.