Directors need to be aware that their share buying and selling activities may arouse suspicions of insider trading. But as Domini Stuart found, directors of growing companies often find themselves with few ‘windows of opportunity’ to either buy or sell shares.
Buying your way into trouble
There is increasing pressure for directors to have a financial interest in the company they’re helping to run. As executive director of Guerdon Associates, consultants in executive and director remuneration, Michael Robinson has seen the trend developing over the past three years to the point where many companies are now making share ownership mandatory.
“Around 20 per cent of ASX 300 directors receive part of their remuneration as shares,” he says. “And, as with many trends, this one is being driven by the larger companies. Of the top 10 ASX companies, eight have a shares remuneration component. The other two are more international and this is probably why they don’t – variations in law from country to country would make this very complex. Of those who do, around six have mandatory requirements.”
Robinson is concerned that companies keen to follow suit may be failing to give the matter appropriate consideration. “Many directors sit on only one board and are likely to be financially independent,” he says. “Typically, cash would be a much more flexible option – and it would also be a safer option. While it may not be easy to prosecute successfully for insider trading, a mere whiff can be all it takes to damage a reputation irreparably.
“At the same time, directors are so bound by insider knowledge that it is difficult to find times when they can trade. Even during trading windows, after the announcement of results you could be accused of having material knowledge.”
At arm’s length
As president of the Australian Employee Ownership Association (AEOA), Gary Fitton sees some benefit in directors owning shares. He also acknowledges the dangers of such exposure.
“One option is an independent employee share trust where the director has no direct input into the decision-making,” he says. “We’re quite comfortable with a buying program which is put in place over a period of time – say a year – when shares are just progressively acquired. This is assuming, of course, that nothing was known at the commencement of that period which should have been disclosed. I would only have a problem if someone with undisclosed insider information stopped the program midway because they thought share prices would fall. That’s as much insider trading as buying if you anticipate a hike.”
In her role as director of Alinta, Tina McMeckan does not have that choice. “Alinta has a deferred employee share plan (DESP) which gives you just one opportunity a year to decide whether you want to participate,” she says. “From then on, everything happens automatically. You sign an agreement that a certain amount of money will go to shares on an incremental basis over 12 months. The shares are then purchased at a time nominated in advance at whatever the share price happens to be on that day. The director has no control – there’s no opportunity to chop and change.”
McMeckan has a sense that shareholders would like her to have a financial stake in the company. “A DESP allows me to do that and have a clear conscience,” she says.
While a DESP can keep the purchase of shares at arm’s length, it does not provide the same protection for a director wanting to sell. McMeckan says that, while Alinta’s plan would not necessarily place restrictions on selling, the company’s insider trading policy would.
“Like most public companies, we have a six week window for trading after the half yearly and yearly results come out,” says McMeckan. “This is then overlaid with the understanding that, if you or the company secretary or chairman identify any price-sensitive information within the company that the public is not aware of, you do not trade.”
This makes life particularly difficult for directors of companies in a strong growth phase. “Over the last three years, Alinta has been involved in the kind of acquisitions behaviour which places great restrictions on trading,” McMeckan continues. “If I wanted to sell, I would in the first instance discuss this with the company secretary. If I felt I had to sell for other pressing financial purposes, there would need to be a wider dialogue – with the chairman and maybe the board. After all, their reputations are also in jeopardy.”
“When any company is considering merger and acquisition activities it is a naïve view that there will still be appropriate windows for trade,” says Malcolm McPherson, former managing director and chief executive officer of Iluka Resources Limited. “Personally I believe that, while you’re a director, you should acquire but not dispose of shares except under exceptional circumstances. That way you’re fully aligned with shareholders – to sell can send the wrong message.
“Yes, events can occur when you will need to liquidate your assets – but then the size of the problem comes down to the quantity of shares you have accumulated. I think this should be relatively modest – say, building up to around twice your annual fee over a five year period. I don’t believe the role of an independent director is to build up a significant shareholding in a company. That adds a dimension to the role that shouldn’t be there.”
Time to sell
Some countries have mechanisms in place to manage sales as well as acquisitions. Robinson cites the USA’s SEC Rule 10b5-1 as the best form of legislation he’s seen. Introduced in October 2000, SEC Rule 10b5-1 allows officers, directors and other insiders of publicly traded companies to transact in their company shares any time, not just during open trading windows. The constraints are that all trading must take place through a trading trust, and that the specifics must be put in place well in advance.
While these trading plans vary in terms of complexity, each one must specify the amount, price and date of the purchase or sale, or alternatively provide a written formula that can be used to determine this information. Individuals entering into the plan must do so at a time when they are not in possession of any material, non-public information. “I think this does a good job of recognising the problems associated with owning shares and providing a fair way of dealing with them,” says Robinson.
However, there is still the issue of how share ownership may influence behaviour. “A few years ago, there was a furore over taking service-related retirement benefits as part of your remuneration package,” continues Robinson. “If your retirement benefits were expected to increase with service, you may not have wanted to pursue a merger or acquisition that could cut short your service period, even though that might be in the best interests of shareholders.There could be a similar problem with shares. Some companies have a policy that you must hold on to your shares until you resign or retire. In this case, if you wanted to sell, you might decide to move on when it would be in the best interests of the company for you to stay.”
Robinson also points out that not all shareholders will identify with directors who are forced to hold on to their shares for the long term. “The reality these days is that there are many types of shareholders,” he says. “Almost all of them have the choice to trade shares actively at any time, and some have very short term perspectives.”
There is even a question as to whether having directors with a financial stake in the company really does contribute to performance. “In recent research we found that the extent of shareholding by non-executive chairmen makes no difference to shareholder returns,” says Robinson. “If that applies to all non-executive directors, perhaps energies could be better devoted to other governance issues, rather than dictating that fees be delivered in the form of equity.”
The issue of margin lending
Recently, some investment banks have started actively encouraging directors to take out a margin loan against the value of the shares they hold in their company. As long as things are going well, this isn’t a problem. But, if the share price falls below a certain level it will trigger a margin call. Unless the borrower injects enough cash to bring the loan back to the agreed level, some or all of the shares will be sold.
This isn’t an insider trading issue – the director has no say in the timing of the sale. But it could prove embarrassing for the company. The sale is public information – it could be picked up by the media and reported as a ‘director dumps shares as price falls’ story. As far as shareholders are concerned, the director is failing to show confidence in the stock when confidence is most needed.
So why take the risk? “It is common for a managing director to have a base salary and then both long and short term incentives with shares as a component,” says Linda Nicholls, chairman Australia Post. “The managing director may not have his cash commitments wholly met by the base salary.
“He might want to buy a property or a hobby farm but be constrained by the fact that he is asset rich but cash poor. He can only buy or sell shares during trading windows and, in a growing company, these can be hard to find – and he knows it doesn’t look good when an MD starts selling shares. He may not even want to sell – he may want to participate in the growth of a company he really believes in. In this situation, margin lending could seem a reasonable choice.
“The problem is that rapidly-growing companies often have volatile patches – and margin lending is a day by day situation.”
Nicholls believes that nominations and remunerations committees should discuss this scenario and consider whether the managing director’s remuneration package could be structured to provide the cash he needs.
“They need to talk about what might happen on the worst day of the company’s life,” she says. “Share prices are in freefall and there’s a margin call on the MD’s loan. How will this look? How will you handle it?
“Of course, we all hope we won’t be faced with this kind of situation but, after 14 bull years on the sharemarket, we are now seeing more volatility in equity markets and that’s making the subject more topical. The board needs to have a view. That might be as simple as ‘we don’t have a problem with margin lending but please don’t do it if the only way you could meet a margin call is by selling’.
“Generally, major problems only arise where a lot of shares are involved,” Nicholls continues. “It can also occur where the director is not particularly well off and can’t meet the margin call because he doesn’t have the cash to cover the shortfall. The idea of disclosure again raises privacy issues – but the reality is you’re making a personal choice that could have ramifications for your company, and for your fellow directors.”
Domini Stuart has been a writer for over 25 years. As an award-winning advertising copywriter she worked with companies across all industry segments including finance, communications, travel and non-for-profit. As a journalist, she has a regular monthly column in My Business magazine and writes feature articles for a range of publications including export magazine and The Sunday Telegraph.
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