Directors of companies have a legal obligation to report all their share trading activity in that company’s shares. But, as Domini Stuart reports, there appears to be considerable non-compliance with these disclosure requirements.
Trading away disclosure responsibilities
The law could hardly be simpler. Directors of listed companies are required to disclose changes to relevant interests, no matter how small, in securities of the company of which they are a director. Notification must be made within five business days under the Australian Stock Exchange (ASX) Listing Rules and within 14 days under the Corporations Act.
Yet a review of ASX referrals to the Australian Securities and Investments Commission (ASIC) over the past 18 months, along with work done by the BT Governance Advisory Service, indicates that compliance with these obligations is far from adequate. In fact, the BT report shows that 60 per cent of Australia’s largest 200 listed companies have failed to meet basic disclosure rules on directors’ share trading. The research also found that directors of 10 per cent of companies traded during the ‘blackout’ between the end of a company’s reporting period and the announcement of results, while directors of 23 companies traded shortly before the announcement of an earnings upgrade or takeover bid.
Some of the breaches are likely to have occurred inadvertently through distribution reinvestment plans (DRP) or passive trades. To help clarify this situation, the Australian Institute of Company Directors (AICD) is putting pressure on the ASX to report passive and active trading separately. While passive trades might have increased the apparent incidence of late disclosure, there are those who argue that the research is merely highlighting the tip of an iceberg.
Head of the BT Governance Advisory Service and co-author of the report, Erik Mather, believes that non-compliance is likely to be under-represented. “The study used conservative methodology and only assessed director trades resulting from active decisions to purchase or sell securities,” he says. “Also, multiple late changes are counted as one late notification.”
“We were quite shocked by the BT research because it only identified trades that were subsequently disclosed,” says Fiona Balzer, corporate information officer at the Australian Shareholders’ Association (ASA). “Anyone who specifically wanted to hide trades and never did disclose them is still hidden.”
Maintaining shareholder confidence
“The obligation to notify directors’ interests is a central aspect of corporations law and, together with the insider trading prohibition and the continuous disclosure requirements, helps to maintain an informed market,” says Jennifer O’Donnell, ASIC’s executive director of compliance.
Martin Codina, senior policy manager investments, at the Investment and Financial Services Association (IFSA), emphasises that disclosure is critical to market integrity and confidence. “Without it, suspicions could be raised of insider trading and/or inappropriate profit-taking at ordinary shareholders’ expense,” he says.
IFSA believes that the ‘tone at the top’ – how a company is run – is of critical importance. “IFSA members are required to adhere to our standards, which we believe promote industry best practice,” says Codina. “Importantly, an IFSA member’s board is required to adopt a resolution each year stating that they are satisfied that the member has complied with mandatory IFSA standards for the year just completed. Otherwise, they must indicate any exemptions which may have been granted to the member by IFSA in this regard. This is an additional governance mechanism that overlays the specific legal requirements in the Corporations Act and elsewhere.
“IFSA members are encouraged to maintain direct contact with companies as a means of influencing corporate governance outcomes, and the ASX could or should also undertake follow-up reviews to put companies on notice,” he continues. “There is no reasonable excuse for non-compliance in this area and companies should have well-established trading policies in place on these matters. Institutional investors tend to take a dim view when such information is delayed in reaching the market and may look more closely at other aspects of a company’s operations.”
“Most companies do impose their own strict internal policies regarding employees and directors trading in the shares of the company, and we applaud that,” says Gary Fitton, president of the Australian Employee Ownership Association (AEOA).
Fitton believes that windows and blackouts are a reasonable response to the problem – but, again, they must be used in conjunction with a proper disclosure. “That just doesn’t seem to be happening,” he says. “Somebody’s trading in those periods. You can impose as many laws as you like but, if people trade in a window or blackout period and the appropriate disclosures aren’t occurring, it’s all a bit of a farce.”
Balzer believes that the problem is underpinned by a failure to tease out the ethics of the board. “Given that disclosure is the law, and it’s such a simple thing, it’s reasonable to assume that the chairman is not expecting anyone on the board to muck it up,” she says. “As a board, you don’t expect people to be dabbling in the shares of their own company. It seems so obvious. If you’re about to trade in shares and you’re on the board, it’s hard to imagine you wouldn’t think to drop an email to the company secretary, or to ask whether an announcement is imminent that might make the trade look suspicious.
“CSL CEO Brian McNamee sells a portion of his shareholding every year,” she continues. “Some time ago he came out and explained that his portfolio was heavily overweight in CSL shares and that he would be having regular sell-downs to keep more balance in his portfolio. He was letting shareholders know that he wasn’t dumping shares because he knew something they didn’t, and he was also emphasising the fact that directors follow similar financial strategies as anyone else – he didn’t want all of his eggs in one basket, however sound the basket happened to be. His disclosure makes it clear that the move is neither opportunistic nor a cause for concern.”
The question of compulsion
As a professional independent director, Duncan Schultz understands why shareholders might be anxious for non-executive directors (NEDs) to hold shares in their company.
“I can see that they might think ‘What’s their care factor? They get a nice remuneration, but what’s in it
for them beyond the money? Let’s make share participation compulsory!”
That’s not to say he agrees with the concept. Schultz sits on nine very active and two advisory boards, but the only company he has shares in is his own. “NEDs with no shareholding still have the same fiduciary responsibilities, and I strongly believe that a NED can perform as required without equity,” he says. “As a professional non-executive director, the whole of my working life is spent sitting on boards. I always give the best I can professionally and in execution of diligence – owning shares wouldn’t have any impact on that. You could even argue that, sometimes, it might be good for NEDs not to have shares in their companies. Short term gain might not be in the shareholders’ long term interest.”
Fitton remembers a debate around 10 years ago about whether NEDs should be allowed to participate in a company’s share ownership plan at all. “At the time, there was just about an even split between those in favour and those against,” he says. “Today things have changed substantially – few are opposed. While we don’t support compulsory share participation for NEDs, AEOA policy is that NEDs participating in share plans is a good idea because it links the visions and views of the directors with the shareholders – but only as long as the terms and conditions are appropriate and approved by shareholders and, naturally, any activity is fully disclosed.”
Fitton’s caution underlines the fact that, even in the unlikely event of participation being made compulsory, shareholders might still not be able to rest easy. Recently, financial products developed by a number of investment banks have been tempting executive directors to hedge their returns by cashing in shares that are meant to be at risk. By hedging, executives are not only protecting themselves from a fall in share price, they are also cutting themselves off from the benefits that normally come with a rise in the share price. They have lost their incentive to improve performance,” says Fitton. “They can work as hard or take it as easy as they like – they already have the money. Meanwhile, the shareholders are assuming they still have skin in the game.”
Is this significant? Macquarie Bank appears to think so. A market leader in selling hedging to directors, the bank refuses to let its own executives use its own hedging product, or anything like it. “My view on these schemes is they must be disclosed,” says Schultz. “I believe that the purpose of the ‘at risk’ components of remuneration is to link incentive to performance. Hedging can circumvent this relationship and, as such, I see it as something that demands transparency.”
“At the moment there’s no obligation to disclose, and there’s been an absolute lack of disclosure,” says Fitton. “Many companies have not even been aware that their own executives were hedging.”
In search of a level playing field
“When directors and companies do not meet basic disclosure requirements there will always be the risk that investors suspect insider trading,” says Steve Gibbs, CEO of the Public and Commonwealth Super Schemes. “If investors think the market is tilted in favour of insiders, they may be tempted to take their capital elsewhere.”
But a level playing field could be something of a pipe dream even when all of the legalities are in place. Last year, Goldman Sachs JBWere analyst Rob Pinnuck took a close look at lawfully-disclosed directors’ trades. Not surprisingly, they had occurred when directors were not in possession of undisclosed information which might affect share prices. What was surprising was the impact of perfectly legal insider knowledge.
“Both our own and academic research has found that company insiders make excess returns when trading in their own company’s securities,” says Pinnuck. “Implicit in the insider trading signal is that there is information asymmetry. That is, company insiders can benefit from their superior knowledge to make excess returns when buying or selling shares.”
Late last year, ASIC and the ASX announced their response to the incidence of non-disclosure – a joint campaign to increase awareness among listed public company directors of their obligations under the Listing Rules and the Corporations Act, and to ensure a high level of compliance. “Transparency of directors’ interests is all about sustaining confidence in our financial market and strengthening the integrity of Australian corporations,” says Eric Mayne, group executive market supervision at the ASX. Fitton puts it even more succinctly. “Whatever the situation, exposure to the sunlight usually brings about proper behaviour.”
AICD’s view on executive option hedging
- It is prudent for companies to have a written and published policy for the hedging of executive options.
- The hedging of options should be prohibited during the pre-vesting period, particularly where the company has informed the market that a portion of remuneration is ‘at risk’.
- Companies need to consider their individual circumstances in relation to securities that have already been vested. Some of the more conservative views indicate companies should disclose hedging arrangements in respect of executive options.
- Companies should consider a mechanism by which executives are required to report hedging of executive options.
- Any current or emerging breaches of policy should be treated seriously, and where appropriate, disclosed to the market.
Hedging – a snapshot
The remuneration of top executives typically includes a performance-based component of options or performance rights which can be vested once certain performance criteria are met. These aspects of executive pay are considered ‘at risk’ and are designed to reward executives in line with corporate performance and shareholder return.
A number of investment banks are selling sophisticated derivative products to enable executives to minimise the risk of price fluctuations of these ‘at risk’ securities and to ensure executives profit from the performance-based components of their remuneration packages regardless of whether or not they have met the performance criteria.
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.
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