Enforcement of insider trading: empirical results and one practical case

1. Enforcement of insider trading: empirical results and one practical case Guillermo Larrain Superintendente Superintendencia de Valores y Seguros, Chile Presidente, Comité de Mercados Emergentes, IOSCO Conferencia “Foro sobre Modelos de Supervisión” Organizada por la CNMV y el IIMV Madrid, September, 2008

2. Insider trading : old phenomena, adult regulation, young enforcement Countries in the world Countries with Stock Markets Source: UtpalBhattacharya (2008): “When No Law is Better than a Good Law”

3. Insider trading : old phenomena, adult regulation, young enforcement Countries in the world Countries with Stock Markets … with Insider Trading regulation … which enforce IT regulations • Increasingly countries consider IT a bad practice, but few of them do something about it. • As no law could be preferable to a law not enforced regulators must take actions

4. How much IT takes place? • From the perspective of the announcement date, there is clearly an anomaly. • Anomalies can be or cannot be due to insider trading activities. • Alternative explanations include • issuers keep a good flow of information to markets so market participants can foresee price movements, • research by brokers is good enough so as to anticipate official announcement effects Pricet Time Announcement

5. How much IT takes place? Juan J. Cruces: “Anticipation and Impact of Corporate Announcements in the Americas”, SVS Research report

6. How much IT takes place?

7. Results from the Abnormal returns model

8. Results from the Abnormal volatility model

9. Results from the Total returns model

10. Conclusion: IT exists, it is significant and we are far away from tackling it properly • Enforcement of IT is still a process in the making: • Locally, regulators must learn how to face it and market participants must realize the damage they cause on markets • Internationally, regulators must improve their coordination and cooperation • LA countries, Chile among them, do not appear particularly bad, but • poor previous enforcement compared with the US, • better information from issuers available in the US • better research available in the US suggest that anomalies in prices in LA and Chile are more probably linked to IT activities

11. The approach taken by the SVS to enforce insider trading regulation • Regulation concerning IT dates back to 1981 • First case enforced in 1988. Since then, until 2006, there were 19 cases. • Enforcement division created in 2001 • From 2 to 12 • Material improvement: software, databases, knowledge [critical exchange of experiences: IIMV, SEC, CFTC, AMF, CVM…] • Investigation of price anomalies: exchanges, issuers, attorneys • Monitoring division created in 2007 • Continuum supervision of transactions. Daily report. • Updated follow up of national and international financial affairs • Transaction analysis to detect price anomalies • In 2007-08, 17 cases • Reform of the SVS into a real Commission : the CVS

12. There had been rumors concerning this merger (or other ones in this area) for long time. The merger would have been created one of the largest retailers in Latin America (lately refused by Tribunal de Defensa de la Libre Competencia) The D&S – Falabella merger case

13. Early april 2007. First warnings. The issuer answered SVS requirements officially saying (through an essential fact) that they had business plans concerning their credit card business (association with a bank) May 9th prices started abnormal behaviour. Monitoring division warned the respective areas at SVS. Press versions mentioned this particular merger. May 14th, both companies announced the merger May 14th, SVS asked both issuers to describe the merger process: timing, people involved (over time, insiders and outsiders,…) Simultaneously, Abnormal price movements of both companies started to be analyzed SVS defined the critical period of privileged information based on issuers description Databases were constructed (data from companies, brokers, civil register, 585 circ) Suspicious transactions identified: abnormal previous investment behaviour (around 600 cases) plus eventual links with potential sources of privileged information Formal administrative procedures were open under reserve One year later the SVS announced several sanctions Critical role of assumptions: according to Chilean law, only one assumption can be used to establish a case. Three general cases were sanctioned. The D&S – Falabella merger case

14. Breach of duty of confidentiality Use of privileged information The D&S – Falabella merger case Board member of firm 1 (recognized a telephone conversation to justify not to attend board in a third company) Fellowboardmembers of a thirdfirm(aftercommunication: massivedebt, portfolio concentration, opportunisticacquisition of firm 1 shares) Member of controllinggroup of firm 2 (askedtosign final agreement in themorning) Recognizedcoupleforseveralyears (acquisition of shares of firm 1 hourslater, benefitinghim and alsoher) Advisortothemergerprocess (informedtwodaysbeforeannouncement) Husband (acquisition of shares of firm 1 thedayafter)

15. The role of assumptions FACT 1 FACT 2 Someone provenly has a given knowledge that can be considered “privileged information” if made public Someone provenly acquired shares of a company and does so in a suspicious way: increasing indebtedness, changing portfolios, buying only after some critical decision was taken… Assumption This person breached the confidentiality duty This person used priveleged information

16. Thought 1: to prevent or not to prevent, what is the optimal? Sanction based regulator: the regulator believes that maket intervention may harm liquidity and therefore inhibits itself to act. This regulator acts expost, once the damage has been done. Preventive regulator: in order to prevent abuses and to avoid undesired and unfair wealth transfers,rules are set so as to induce insiders to behave properly. This may however reduce liquidity if a significant proportion of liquidity is provided by insiders. Sanction-based regulator Preventive regulator: Optimal request information, set rules, transparency … (sanctions are preventive…) avoids black out type of regulation, excessive info disclosures,

17. Meulbroek (1992): El mercado detecta insider trading y el efecto se ve rápidamente reflejado en los precios. Si esta hipótesis es correcta, la prohibición de insider trading sólo afectaría la liquidez del mercado y haría los precios menos informativos. La no intervención del regulador permitiría alcanzar mayor eficiencia de mercado pero el costo sería el no evitar la redistribución de riqueza no equitativa (se entiendo equitativo como “en igualdad de condiciones”). Thought 2: Trade-off between efficiency, liquidity and enforcement?

18. Thought 2: Trade-off between efficiency, liquidity and enforcement?

19. Hay quienes confunden flexibilidad del mercado con laxitud del regulador. El enforcement reduce el costo de capital del emisor, mejora la liquidez del mercado y aclara las “reglas del juego”. Se atribuye lo contrario a la ausencia de enforcement. No hay literatura que demuestre claramente que la “ausencia de enforcement” pueda ser percibida como beneficiosa, especialmente a nivel de bienestar social. Thought 3: Do participants prefer markets where enforcement is stronger?

20. Guillermo Larrain Superintendente Superintendencia de Valores y Seguros, Chile Presidente, Comité de Mercados Emergentes, IOSCO Enforcement of insider trading: empirical results and one practical case Conferencia “Foro sobre Modelos de Supervisión” Organizada por la CNMV y el IIMV Madrid, September, 2008