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Insider Dealing and the Chinese Wall: a Legal, Economic INSIDER DEALING AND THE CHINESE WALL: A LEGAL, ECONOMIC, AND POLICY ANALYSIS by Harold McVea LL.B This thesis is submitted in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY HERIOT-WATr UNWERS1TY, EDINBURGH, SCOTLAND (DEPARTMENT OF ACCOUNTANCY AND FINANCE) October 1989 This copy of the dissertation has been supplied on condition that anyone who consults it is understood to recognise that the copyright rests with its author and that no quotation from the dissertation and no information derived form it may be published without the prior consent of the author or the University as may be applicable. ( ) THESIS TITLE: INSIDER DEALING AND THE CHINESE WALL - A LEGAL, ECONOMIC, AND POLICY ANALYSIS TABLE OF CONTENTS Acknowledgements Table of Cases Table of statutes INTRODUCTION CHAPTER ONE: SETTING THE SCENE 1 Deregulation and Re-regulation: The International Enviroiiment I What is Financial Dere gulation? 2 Why is Deregulation Takin g Place? 3 The Re gulatory Paradox: The Trend Towards New Regulatory Measures 4 The Resultant Effects of Both Deregulation and Re-regulation 7 One As pect of Deregulation - Financial Con glomerates 7 One As pect of Re-re gulation - Conflicts of Interest and Duty and the Chinese Wall 10 Methodology 11 Law and Economics 11 The Tentative Application of Economics to Law 13 The Tentative Approach: Problems, Terminology and Definitions 14 The Tentative Approach: An Application 19 The Tentative Approach: A Conclusion 20 Comparative Legal Analysis 21 Summary 24 CHAPTER TWO CONFLICT ABUSE iN THE U.K. 25 Deregulation in the U.K. 25 Pressures for Structural Change 26 The New Regulatory Framework 29 The Need for Re gulatory Change 30 Financial Services Act 1986 and the SIB Rulebook 32 Conflicts of Interest 35 Are Conflicts of Interest Important? 37 Types of Conflicts of Interest in Bankin g and Securities Business 41 ( ; ) Conflicts of Interest Distin guished from other Forms of Market Abuse 45 Conflicts of Duty 48 What Duties Do Financial Con glomerates Owe? 48 Summary 50 CHAPTER THREE: INSIDER DEALING - THE NATURE OF THE PROBLEM 51 Introduction 51 What is Insider Dealin g and Who is an Insider? 51 The Traditional View of Insider Dealing 51 The Unorthodox View of Insider Dealing 53 Economics v. Law: Different In puts = Different Outcomes 54 Those Who Argue Against Prohibition: The Deregulators 56 Positive Aspects Of Insider Dealing Rewarding Entrepreneurs; Stock Market Efficiency; Benefits Firm. Polic y of Enforcement is Misguided 64 Enforcement Problems Insider Dealin g Does Not Cause Harm 67 Victimless crime; 'Victim' Receives Better Price Arguments In Favour of Prohibiting Insider Dealing: The Regulators 70 Unfair and Damages the Inte grity of the Market 70 A False Economic Logic; Fairness and Inequality of Bargaining Power; Fairness: Congressional Concern about the Intergrity of the Market and Confidence in the Market; Fairness and Cost Moral and Ethical Arguments 76 Insider Dealing is not a Victimless Crime 78 Efficienc y Arguments 81 Incentive to delay the disclosure of valuable information; cost of collecting inside information; not a good compensatory device; allows managers to profit on bad news as well as on good Other Arguments 85 Summary 86 CHAPTER FOIJR: DETAILED LEGLSLATIYE APPROACH TO THE PROBLEM OF INSIDER DEALING IN BOTH THE UK AND THE US 88 Introduction 88 Formal Regulation at Law 88 Self-Regulation 89 Self-Regulation Within a Statutor y Framework 90 ( tI ) The Regulation Of Insider Dealing in the U.K. 91 The Companies Act - Disclosure 93 ComDan y Securities (Insider Dealin g ) Act 1985 - Prohibition 93 Who is a Primary Insider? 94 95 What is Inside Information? 98 Dealing in the Securities of Any Other Company 99 Secondary Insider Dealing R v. Fisher 101 103 Fisher in the Court of Appeal 107 Takeovers Failing to Sell on the Basis of Inside Information 108 108 Defences 110 Penalties The Financial Services Act 1986 - Enhanced Enforcement Powers 111 Civil Liability for Insider Dealin g: Is There a Remedy? 113 114 The General Principle of Percival v. Wright 115 The Special Circumstances Doctrine Unexplored Remedies Under Existing Case Law 117 Section 61 and 62 of the Financial Service Act 1986 125 The Regulation of The Insider Trading in the U.S. 131 132 Tradin g By CorDorate Insiders The Misapøropriation Theory 139 143 Tender Offers: Rule 14e-3 144 Tradin g b y Secondary Insiders or Tiees Penalties 146 Summary 154 CHAFFER 5: THE CHINESE WALL - AN INTRODUCTION 156 Regulating Insider Dealing and other Conflicts in Financial Conglomerates 156 The Chinese Walt A Description 157 Procedural and Structural Measures Used in Constructing a Chinese Wall 159 A Practical Viewpoint 166 Some Reservations 167 Summary 168 CHAPTER SDC AN EXAMINATION OF THE LEGAL STATUS OF THE CHINESE WALL 169 Introduction 169 The Law Relating To Fiduciaries 172 (iv') The Fiduciary Acting For both Sides Per Se 172 The Fiduciary Who Self-Deals 178 The Fiduciary Who Erects a Chinese Wall 180 Full and Frank Disclosure of the Conflict of Interest 181 Do Conglomerates Owe Fiduciary Duties? 181 The Chinese Wall: Market Usa ge or Custom? 184 U.S. Case Law Relating to the Chinese Wall 187 Other Relevant Case Law 195 Summary 201 CHAPTER SEVEN: LEGISLATIVE AND REGULATORY APPROVAL OF THE CHINESE WALL IN THE U.S. AND THE U.K. 203 The U.S.: An Introduction 203 Recent SEC and Legislative Approval of the Chinese Wall 204 204 Insider Trading Sanctions Bill 1984 205 Recent SEC Rule Changes The First Boston Case 210 Insider Trading Bill 1987 212 The Insider Trading and Securities Fraud Enforcement Act 1988 214 Comment on the SEC's use of the Chinese Wall 215 The U.K.: Legislative and Regulatory Approval of the Chinese Wall. 216 216 Developments Pre Bi g Bang Big Bang and the Formation of Financial Conglomerates 218 Official Treatment of the Chinese Wall 218 222 Regulatory Approval of the Chinese Wall 222 SIB Use of the Chinese Wall Mechanism Takeover Panel and the Chinese Wall: post-Big Bang 238 Summary 250 CHAPTER EIGHT: THE CHINESE WALL - A POLICY APPRAISAL 253 The Dilemmna: Benefits of Conglomeration v. The Costs of Conflict Abuse 254 What are the Economic Benefits of Conglomeration? 255 (i) Benefits from enhanced competition 255 (ii') Diversification 256 (iii) Economies of sco pe or synergies 257 (V) Conflict Resolution and The Regulatory Dilemma: 261 The Nature of the Problem 261 Resolvin g the Problem 264 Reliance on Market Forces 266 The 'Naked' Chinese Wall 272 Full Disclosure 293 The Reinforced Chinese Wall 296 Deconglomeration 298 Summary 301 CHAPTER NINE SUMMARY AND CONCLUSION 303 Summary 303 Conclusion 311 An Assessment of the Le gal Validity of the Chinese Wall 311 A Ouestion For the Courts to Decide 314 What Factors Would Influence the Courts to Acce pt a Chinese Wall? 316 Final Remarks 324 APPENDICES 328 APPENDIX I : Schedule Eight 328 APPENDIX II: Merrill Lynch's Statement of Policy 329 APPENDIX III : Sydney Stock Exchange 330 APPENDIX IV: Take-over Panel Annual Report 1970 (p.12) 338 BIBLIOGRAPHY 341 (Vi) TABLE OF CASES Aaron v. S 446 U.S. 680. Aberdeen Railway Co. v. Blakie Bros. (1854) 1 Macq. 461, (H.L.) Allen v. Hyatt [1922] 30 TLR 444. American Mendicor p . Inc.. v. Continental Illinois National Bank No.77 C 3865 (N.D. III. 1977). Anglo-African Merchants v. Bayley [1970] 1 Q.B. 311. Attorney-General's Reference (No.1 of 1988) [1988] 2 W.L.R. 195. Belmont Finance Cor ps v. Williams Furniture Ltd [No.21 1980 1 All 393 at 405. Black v. Shearson. Hammill & Co. 266 Cal. App. 2d 362, 72 Cal. Rptr. 157 (1968). Boardman v. Phi pps - [1967] A.C. 46 Bolton (Engineering') Co. Ltd. v. T.J. Graham and Sons Ltd., [1957] 1 Q.B. 159. jy v. Ford [1896] AC 44. Brophy v. Cities Serv. Co. 31 Del. Ch. 241, 70 A. 2d 5 (1949). Cady. Roberts & Co. Re 40 S.E.C. 907 (1961) Canadian Dred ge & Dock Co. Ltd. et al v. The Oueen (1985), 19 D.L.R. (4th) 314, 19 C.C.C. (3d) 1, 45 C.R. (3d) 289. Carpenters et al., v. United States, 108 S. Ct. 316 (1987). Chiarella v. LLS 445 U.S. 222 (1980). Coco v. A N Clark (En g) Ltd [1967] RPC 41. Colmen v. M yers, [1977] 2 NZLR 225. Comeau and Comeau v. Canada Permanent Trust Co. and Arsenault (1979), 27 N.B.R. (2d) 126 (Q.B.). Connell v. Chase Manhattan Bank N.A. NYU (Jan. 15, 1981), p.7, col.1. Diamond v. Oreamuno 24 N.Y.2d 494, 301 N.Y.S.2d 78, 248 N.E.2d 910 (1969). Dirk v. , 463 U.S. 646 (1983). pjj v. Ottewell [1968], 52 CAR 679. Dunford & Elliot Ltd. v. Johnson & Firth Brown Ltd. [1977] 1 Lloyd's Reports 505 (C.A.) Dunne v. En glish (1874) L.R. 18 Eq. 524. Elkind v. Liggett & Myers. Inc., 635 F.2d 156 (2d Cir. 1980) Ernst & Ernst v. Hochfelder 425 U.S. 185. Fischman v. Ra ytheon Mfg. Co. 188 F.2d 783 (2d Cir. 1951). Fisher v. Raven [1964] A.C. 210, (H.L.'s). v. Harbpttle (1843) 2 Ha 461. Freeman v. Decip 584 F.2d 186 (7th Cir. 1978). Fridrich v. Bradford, 542 F.2d 307 (6th Cir. 1976), cert. denied, 429 U.S. 1053 (1977). Fuliwood v. Hurley [1928] 1 K.B. 498. Gethin g v. Kilner [1972] 1 WLR 337. Goodwin v. A gazziz, 283 Mass. 358, 186 N.E. 659 (1933). Harnischferger Corp. v. Paccar. Inc., 474 F.Supp. 1151, 1153& n.1 (E.D. Wis.), afrd mem., 624 F.2d 1103 (7th Cir.
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