Some Thoughts on Tort of Insider Trading Based on the First Judgment Issued by the Shanghai Second Intermediate People’s Court For the “Fat-Finger Error” Case
By Yueyue Zhang
On September 30, 2015, Shanghai Second Intermediate People’s Court ruled in favor of six investors in Eight Investors v. Everbright Securities, a trial concerning a dispute over liability for the insider trading of securities and futures triggered by the “fat-finger error” incident on Everbright Securities on August 16, 2013. This is the first judgment that the court has issued in the dispute through trial instead of by settlement or mediation. Following is an analysis of the incident based on the trial judgment.
I. A Dispute over Insider Trading Liability is Categorized as a General Tort Action
Regardless of whether an act consists of insider trading, misrepresentation, market manipulation or fraud, it is essentially a tort involving securities, and as such, any courtroom dispute will be characterized as a tort lawsuit. Before we move on to the constituent elements of a tort, we must identify the appropriate principle for the allocation of liability with respect to securities torts.
China currently uses a tripartite liability allocation system in which the principle of fault-based liability, the doctrine of presumed liability and the principle of no-fault liability co-exist simultaneously. In particular, the scope of application of the no-fault liability principle is set forth in Article 122 and Article 123 of the P.R.C. General Rules on Civil Law and Article 7 of the P.R.C. Tort Law. With respect to the securities tort liability allocation principle, it would be inappropriate to broaden the scope of application of the no-fault liability principle, because securities torts have not been expressly applied to the principle by the relevant laws. On the other hand, the no-fault principle does apply to tort disputes involving the protection of personal interests such as injuries caused by defective products or hazardous operations. This is because the legislature’s purpose in enacting no-fault liability is to limit it to cases where a dangerous act threatens the life or safety of a person. Accordingly, there is no legal basis for directly applying this principle to securities torts -- it is the investors’ property rights and interests, not their personal interests, that are at stake. Consequently, the no-fault liability principle must be excluded from the principles applicable to disputes over securities. In summary, the four elements of a securities tort are (i) fault, (ii) violation of the law, (iii) causation and (iv) actual damages.
II. Everbright Securities was Engaged in Illegal Insider Trading.
The Shanghai Second Intermediate People’s Court held that the Administrative Penalty Decision (Zheng Jian Hui  No. 59) issued by the China Securities Regulatory Commission (the “CSRC”) and the effective verdicts in the relevant administrative lawsuits confirmed that Everbright Securities conversion of its shares to ETF and the sale thereof, as well as the sale of index futures short contracts, prior to the disclosure of insider information, constituted insider trading and could be used as the basis for the case findings. Even without considering the foregoing administrative analysis, it is easy to reach the same conclusion through analysis of the following facts:
Disclosed information shows that Everbright Securities’ lawyer used a “transaction of mistaken orders” defense to justify the hedging operation on that day, rather than characterizing Everbright Securities’ conduct as "insider trading”. We must admit that the incident was indeed caused by enormous unexpected orders due to defects in the order generation and execution system within the arbitrage strategies system adopted by Everbright Securities’ Strategic Investment Department. These unexpected orders were indeed so-called “mistaken orders”.
Normally, a hedging operation makes perfect sense as a countermeasure for a mistaken order. However, a hedging operation must be executed in accordance with applicable rules and regulations, because if a transaction is itself a violation of supervisory regulations, any further operation carried out prior to the disclosure of the same will be suspected of constituting insider trading. According to relevant regulations of the China Securities Regulatory Commission (CSRC), a securities company approved by the CSRC may use its own funds or funds collected in accordance with the law to open a securities transaction account and obtain profit by lawfully buying or selling publically offered securities and or other securities approved by the CSRC, provided that the total value of equity securities and derivative products (including stock index futures) executed by the securities company on its own does not exceed 100% of its net capital.
We can infer from a statement released by Everbright Securities after the incident that the company’s operations on that day constituted overbuying. As a listed securities company, Everbright Securities should have disclosed the “mistaken orders” to the public immediately after it became aware of the incident; in other words, if it had issued an announcement regarding the “mistaken orders” while suspending the trading of its stocks and taking further remedial measures, its act would have been characterized as a mere “mistaken orders transaction” and would not have triggered an insider trading investigation.
In order to determine whether or not Everbright Securities’ act constituted insider trading, we must first define the term "insider information”. According to Article 75.1 of the Securities Law of the People's Republic of China and Article 82.2.11 of the Administrative Regulations on Futures Trading, the major characteristics of “insider information” are that the information (i) is very important and (ii) has not been disclosed. Based on a later statement by Everbright Securities, the limit for Strategic Investment Department’s spot trading on the day was RMB 80 million, while the actual trading volume was RMB 7.27 billion. Consequently, the CSI 300, 180ETF, 50ETF and stock index futures contract prices were all severely affected. In the meantime, the extremely large number of purchase orders and deals could have also exerted a great influence on investors’ judgment of the market situation. Hence, the foregoing facts fit the definition of “very important”.
Moreover, since the foregoing information was kept confidential until it was disclosed at 2:22pm on the day, the condition of non-disclosure was satisfied. It’s worth noting that according to the applicable provisions of the Administrative Measures for the Information Disclosure of Listed Companies, a listed company must strictly follow the applicable procedures to disclose information; in addition, the information to be disclosed must be published in a newspaper or on a website designated by the CSRC. Even if rumors about the "fat finger" trading incident were known to the market on the morning of the day it happened, and even if these rumors turned out to be completely accurate, the information was non-public information by law until Everbright Securities officially released the information in accordance with statutory procedures,. Accordingly, this information was “insider information” from 11:05am August 16, 2013 until it was released by Everbright Securities at 2:22 p.m. the same day.
In addition, Everbright Securities was the origin of the insider information, and it had knowledge of the securities and futures information involved in the case. According to Article 202 of the Securities Law and Article 70 of the Administrative Regulations on Futures Trading, this case involved two types of acts of insider trading: (i) any insider who has access to inside information on securities trading or any person who has obtained inside information who trades any of the relevant securities, divulges relevant information or advises any other person to trade any of the relevant securities before the release into the public domain of information regarding the issuance or trading of securities or any other information that may have a significant impact on the market price of the securities; and (ii) where an insider with insider information on futures trading or any person unlawfully obtaining insider information on futures trading conducts futures trading by taking advantage of such insider information or discloses such insider information to any other person for futures trading before such insider information is published.
Before making its statement at 2:22 pm on the day of the incident, Everbright Securities sold the stocks after converting them to ETF, and also sold index futures contracts. These transactions were completed based on an information asymmetry between the securities company and the public, and they were hedging operations undertaken by taking advantage of the insider information that Everbright Securities possessed, rather than a routine transaction designed to hedge normal risks. Consequently, Everbright Securities committed the offense of insider trading.
III. Everbright Securities’ Insider Trading Caused Damages
The property losses suffered by investors are the most direct and manifest evidence of damages. According to pertinent provisions of the Securities Law and the Several Provisions of the Supreme People's Court on the Trial of Cases of Civil Compensation Arising Out of False Statements in Securities Markets (hereinafter referred to as the “Judicial Interpretations”), the scope of damages in a securities trading market must be limited to the losses actually caused to investors, including (i) losses arising from the investment balance; (ii) the commission and stamp tax on the losses; and (iii) interest on the funds listed in the preceding two items.
The most difficult point here is the calculation method for “losses arising from the investment balance”. Article 31 and 32 of the Judicial Interpretations further specify the method for calculation of the investor’s actual losses due to false representation,“Where an investor sells the securities on or before the base date, his losses arising from the investment balance shall be the product of the difference between the average price of the securities purchased and the average price of the securities actually sold, and the quantity of the securities he held.
Where an investor sells or holds the securities after the base date, his losses arising from the investment balance shall be the product of the difference between the average price of the securities purchased and the average of closing prices on the trading days between the disclosure or correction date of the false statement and the base date, and the quantity of the securities he held.”
Unfortunately however, since the calculation method for the “average price of the securities purchased” is not clear, the method described above remains controversial in practice. The author would like to propose a potential solution: First, define the three critical time points -- Point A, the time the insider information is generated (Point A in this case is 11:05am); Point B, the time that the insider information is disclosed (Point B in this case is 2:22pm on the same day); and Point C, the base time for insider pricing, that is, the date that the cumulated turnover rate reaches 100% of the tradable shares of the securities (Point C, in this case, depends on the specific stock involved in the incident). During the incident in question, between Point A and Point B the index and multiple heavyweight stocks all increased, while between Point B and Point C their prices simultaneously tumbled. Investors who suffered losses all purchased at a high price and sold at a low price.
Some investors purchased a stock at a price higher than the then benchmark price between Point A and Point B, and then sold the stock at a price lower than the purchase price between Point B and Point C. The difference between the purchase price and the selling price represents a relatively objective loss. If an investor sold the stock after Point C, in line with the aforementioned judicial interpretations, it is appropriate to determine his selling price based on the average closing price between Point B and Point C.
IV. The Causal Relationship between Everbright Securities’ Insider Trading and the Investors’ Damages
The Shanghai Second Intermediate People’s Court held, regarding causality, that in the course of Everbright Securities’ insider trading practices, if the plaintiff’s investors were engaged in 50ETF, 180ETF and the component stocks thereof, IF1309 and IF1312 transactions (which, in respect of Everbright Securities’ insider trading, are reverse trading) then a cause and effect relationship would be deemed to have been established.
The essence of the foregoing standard for identification is based on equity products. The holding clearly noted that if an investor did not purchase any equity product in connection with the incident, the investor would be excluded from the scope of the cause and effect relationship. The author, however, has reservations about this conclusion.
In essence, causality emphasizes the relationship between "cause" and "caused." In the Everbright Securities case, the so-called "cause" is the insider trading implemented by Everbright Securities, and what is “caused” is the investment loss. In order to determine whether the investment loss is limited to the Shanghai Stock Exchange 180 index-related stocks and other equity products, we must accurately identify the in-depth reasons for the investors’ losses that hid behind the tort of insider trading. One of the fundamental features of “insider trading” is that non-disclosure and the information asymmetry arising therefrom is the biggest risk for the market and for other investors.
We must admit that despite the fact that the capital market has been committed to “fair transactions”, complete openness and information transparency in securities transactions remains an ideal, not a reality. Consequently, information asymmetry is a common and normal risk that an investor must bear in an ordinary investment environment.
In this particular case, due to the fact that the investors were unable to learn the true reasons for the unusual index fluctuations in a timely manner and the fact that a misleading statement was issued by the Board Secretary of Everbright Securities, the investors made bad investment decisions. Consequently, the risk of information asymmetry borne by investors went far beyond the normal scope of risk. The author is of the opinion that the definition of ‘investors’ in this case should be based on whether or not they acquired insider information rather than whether or not they purchased the corresponding equity products. In other words, investors who did not learn the insider information within the sensitive time period were subject to abnormal information asymmetry in this incident.
Moreover, the primary legislative purpose for the prohibition against insider trading is to protect investors’ legal interest in fair trade on the basis of “information symmetry”. If insider information is improperly used by anyone for decision-making, the investors’ legal interests in fair trade on the basis of “information symmetry” will inevitably be undermined. Although the legal interests have yet to be identified as statutory rights, they tend to line up with the purpose and spirit of the legislation of the securities law.
As far as the Everbright Securities’ incident is concerned, before we can start discussing the specific damage to property interests suffered by investors, we must emphasize that the investors’ interest in fair trade were impaired and that the scope of investors who were impacted by the unusual information asymmetry was extensive. Consequently, whether or not these investors purchased certain equity products should not be used as a standard to classify investors.
Moreover, according to other provisions of the Judicial Interpretations, for causality to apply to the incident, the following conditions must be present: (i) an investor buys securities or futures products during the insider information-sensitive time period and; (ii) an investor incurs losses due to selling or holding the products after the insider information is made public. Nevertheless, a simple and rigid treatment of the foregoing elements is insufficient to prove a cause and effect relationship.
According to publicly available resources, the counsel for Everbright Securities asserted that the investors had acted recklessly in following suit, thereby bearing responsibility for their own losses. To be objective, there are two possible reasons for the losses: (i) bad decisions by investors; and (ii) insider trading. Although either of these reasons could result in losses, in most cases both of these factors could contribute to the damages. Hence, as a practical matter it is even more difficult to clearly discern the two factors in different cases.
We must admit that the securities market is characterized by constant change and that stock prices fluctuate continuously; therefore, even the shrewdest and most experienced investor is speculating to a certain degree. If an investor wanted to prove that the losses were all attributable to insider trading by Everbright Securities and that he/she was not at fault at all, he/she must bear an extremely heavy burden of proof. Consequently, it is advisable for investors to produce evidence of their practice habits, their purpose for holding stocks, and their anticipation of profits in order to minimize their own culpability. Nevertheless, in judicial practice, the identification of the weightiness of the foregoing two factors is largely subject to judicial discretion.
V. Everbright Securities’ Culpability
Fault refers to the mens rea element or the intentional or negligent mental state of the defendant. It is not difficult to prove fault in this incident. On one hand, Everbright Securities’ decision-makers, with full knowledge of the significance of the incident, secretly arranged the unusual hedging transaction by taking advantage of the insider information without disclosing their prior transactions to the public; consequently, its intention to conduct insider trading is evident. On the other hand, Everbright Securities should have anticipated the market disorder caused by abnormal fluctuations in the relevant index due to its own insider trading; further, it should have been fully aware that the unusual hedging transactions conducted that afternoon would greatly impact the prices and indexes of the market, and that operations carried out by investors who had no knowledge of what had happened would inevitably lead to economic damages. Consequently, since Everbright Securities should have been able to foresee the damages but did nothing to prevent them, Everbright should be held liable.
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