Insider trading rules vs. the real world

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Some people like to spend Labour Day up at the cottage watching the sun set on summer or watching the air show at the CNE. Personally, I enjoy spending my Labour Day reading the epic 119 page Ontario Securities Commission insider trading decision In the Matter of Jowdat Waheed and Bruce Walter, but I realize this may be atypical.

What's nice about the OSC's decision is that it has a happy-ish ending – the OSC found that Mr. Waheed and Mr. Walter didn't illegally insider trade. This is good, because the OSC's analysis reveals troubling issues with how securities commissions analyze illegal insider trading.

The bare facts of the case are surprisingly simple for a 119 page decision. Between February and April 2010, Baffinland Iron Mines Corporation engaged the services of Mr. Waheed as a consultant. As one does when one is a consultant, Mr. Waheed obtained undisclosed information about Baffinland – including information about its negotiations with European mining giant ArcelorMittal regarding a potential joint venture. In April, Mr. Waheed's consultancy was terminated. On September 9th, Nunavut Iron Ore Acquisition Inc., a company owned by Mr. Waheed and Mr. Walter, bought a block of shares in Baffinland – known as a "toehold" in M&A jargon – and proceeded to launch a hostile bid for Baffinland, mere weeks before ArcelorMittal and Baffinland announced a friendly deal.

The OSC staff's theory was that Nunavut bought the toehold because Mr. Waheed had obtained an undisclosed material fact about Baffinland while in a special relationship with the company. In other words, the complaint alleged, he had engaged in illegal insider trading. The information was, of course, the negotiations with ArcelorMittal, and the special relationship was either Mr. Waheed's employment relationship with Baffinland or subsequent facts about the negotiations he found out from persons in an employment relationship with Baffinland after his employment was terminated.

In the end, the OSC found that any undisclosed material information that Mr. Waheed obtained while he was employed by Baffinland had gone stale and that any information he obtained subsequently was the product of good deduction, not misappropriation.

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As a matter of sheer practicality, this would have been an odd insider trading strategy on the part of Nunavut. After all, it's much easier to just buy the stock and wait for the price to rise, as opposed to going through the trouble and expense of hiring lawyers and financial advisors to put together a takeover bid for the company. It's also kind of a very public way to "insider trade," which seems like a counter-intuitive way to go about that sort of business. And then, presumably, if the goal was insider trading, you wouldn't actually end up buying the company as Nunavut, in partnership with ArcelorMittal, did.

Of course, those speculations are not law. What is law – or, more accurately, law-like – is the reasoning in the decision. The decision's 119 pages of exhaustive factual analysis do a very good job of explaining what Mr. Waheed knew and when. What they don't do a good job with is grappling with the core insider trading concepts of "materiality" and "disclosure."

To understand why, it's worth taking a moment to figure out why "materiality" and "disclosure" are so important to insider trading law. Without materiality, there can be no harm. Merely trading on an undisclosed fact – like, for example, that the CEO of a company takes three sugars in her coffee – is harmless because that fact has no effect on the company's price. Without an effect on price, the person trading on that fact receives no benefit nor does that person do any harm to the integrity of capital markets. That's why a "material fact" is one, per the OSC's definition, that could be expected to have a "material effect on market price."

Similarly, we operate on the somewhat stylized fact that markets are generally efficient. Our laws reflect the idea that markets do a pretty good job of incorporating new information about a company into its share price. So, if material information is generally disclosed, there can be no benefit to trading on that information; it should already be incorporated into the price.

Therefore, the question of the effect of information on price is a fundamental question of insider trading analysis. Immateriality and public disclosure both dampen the price impact of information and, therefore, make insider trading impossible.

In its "common sense" analysis of materiality, the OSC determined that the fact that Mr. Waheed knew at the time of the toehold purchase on September 9, 2010 was that ArcelorMittal and Baffinland had engaged in serious discussions, that term sheets had been disseminated, but that the companies had failed to reach an agreement. Asking whether the probability that a contingent event of such magnitude would come to pass and applying a sprawling, ambiguous balancing test suggested in prior cases, the OSC concluded that Mr. Waheed knew things that were once material but that had been rendered immaterial by the passage of time.

In addition, the OSC found that Baffinland had not publicly disseminated information about its negotiations. While Baffinland did disclose that it was engaged in strategic talks with European steelmakers, of which ArcelorMittal was one of the very few with the resources to develop Baffinland's project, it did so on August 31, 2010 in Mining Weekly, a magazine read mostly by industry specialists and sophisticated investors and was therefore not a venue that one could reasonably expect would distribute information to the investing public.

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Now, much of the OSC's analysis was dictated by precedent and legislation, but that doesn't make it any less post-modern. Materiality and disclosure are, in theory, objective situations. So, one question the OSC could ask, in its effort to determine the objective state of the world, is: was the information at issue disclosed prior to the impugned purchase and, if so, did it move the market price? If disclosure needs to a movement in the market price, we know both that the information was material, because material information is information that moves the market price, and that it was publicly disclosed, because public information is incorporated into the market price.

Given that, it comes as somewhat of a surprise that the OSC didn't ask: What happened to Baffinland's share price when it disclosed the information in Mining Weekly, a week before the toehold purchase? If it had, it would have discovered that the price of Baffinland shares immediately rose 5 per cent after the disclosure, from 47 cents to 52, and continued to rise almost 50 per cent over the course of the next few days. In other words, the market price of the securities suggests the exact opposite of the OSC's analysis: information about the negotiations was material; it was just widely disclosed before the Nunavut purchase. The price may have moved for other reasons, but studying them is a critical part of any insider trading analysis.

In his recent book Reflections on Judging, the eminent U.S. appellate judge Richard Posner criticizes unweighted multi-factor tests and formalistic analysis as being muddy and imprecise. He advocates for a more direct approach to legal analysis that involves asking clear, practical questions. While I think the OSC reached the correct decision in this case, its reasoning provides a clear demonstration of why Judge Posner's critique is so powerful. Legal tests are interrogative because they are supposed to guide a court to analyze the relevant facts in making its legal conclusion.

If our tests are telling us that the real world is the opposite of what it is – that facts that affect the market price of a security on disclosure are neither material nor disclosed – it's probably time that we think about a new series of tests.