THE KGB INTERROGATION: Eric Mayne
Chief supervision officer for the ASX, Eric Mayne, unravels some of the intricacies of aggressive short selling, insider trading and whether the ASX can legitimately police the market it operates.
Eric Mayne: Yep.
AK: Do you agree with that?
EM: In appropriate circumstances, yes. I would say the continuous disclosure laws as they are currently structured would certainly require the company to have regard for whatever margin loan positions directors might have... especially those directors who have large single holdings that would be potentially disclosable under our 3.1 laws. You’d have to have regard to factors such as the size of the holding, the relevant event, the trigger events under the margin loan and the circumstances surrounding the relevant market. In fact, we’ll be issuing a notice or an announcement later today with ASIC confirming that.
AK: So just to be clear about it, the existence of the margin loan needs to be reported or merely…
EM: No, I think... we’re not actually saying the existence of it [needs reporting] – really it will depend upon the circumstances of the case. What’s the size of the stock holdings that they’re having? What’s the percentage that they would probably have in relation to the whole issued stock? What are the trigger events under the margin loan? Are those trigger events, for example, somehow linked back into having an impact on the materiality of the price or volume of the stock.
AK: Are you going to issue guidelines so that companies can know what is reportable and what’s not? I mean how do we know what to report.
EM: Well I think you’ve got to look at what they think is going to have a material impact on the price. We’ll be looking to say that they’ve got to have regard to the trigger events, to things like the size of the stockholdings they might have. But if we start to say that if anything is more than 5 per cent then we would expect it to be disclosed, then we’ve got concepts of materiality in there in terms of profit recording, and as you know that could be somewhere between 5 and 10 per cent, or up to 15 per cent, say. I think the danger for us is to start putting down positions or being quite specific about it as to where that might end up in terms of people getting under the bar.
AK: But would you agree that any margin call against a chief executive is price sensitive information and needs to be reported?
EM: It depends on the volume. I mean if a chief executive’s got a margin call on 1,000 shares, it's not material. If a chief executive’s got a margin call over 90 per cent of the stock and he holds over 5 per cent of the stock, that's likely to be regarded as a reasonably material event and may well, in those circumstances, require the company to make a disclosure. I think that’s why you can’t be definite.
AK: I’ll throw to Robert Gottliebsen at this point.
Robert Gottliebsen: Just changing a little, do you believe that superannuation funds and index funds should loan scrip owned by clients to hedge funds so they can conduct a bear raid on a company to the detriment of the fund’s clients?
EM: I guess, Bob, the short answer to that would be no. I would have thought that if a trustee [of a super fund] allows the custodian to then on-lend the shares knowing that the shares are going to be used to cover a short sale position by, say, a hedge fund – who is then going to do a raid on a stock that’s held by the fund – if the trustee has knowledge of that, it’s hard to imagine how it’s complying with its fiduciary obligations as trustee.
RG: What about index funds?
EM: Index funds? That's maybe a little bit more difficult because it will be right across a portfolio of stocks rather than individual stocks. Again, it may be an issue for the trustee from a fiduciary point of view, but…
RG: Do you think in the light of ABC Learning that the regulator should take action here?
EM: What, for the super fund or the margin loan issues generally?
RG: No, the superannuation funds and the index funds lending stock.
EM: It’s a difficult question to answer, Bob. If, in the circumstance you’ve described to me, people do that knowingly then there’s a question whether or not they’ve actually engaged in market manipulation – in which case yes, the regulators should take action. If, in the circumstances that you’ve outlined, people do that with the intention essentially of manipulating the price to allow the hedge funds to come back in and make a profit, I would have thought that would fit squarely into a potential market manipulation action.
AK: Okay. What about the question of short selling via stock lending or borrowing which is then unreported. Is the ASX going to do something about that?
EM: What we’re talking about here is the under reporting of [a situation] where you had an interview with a hedge fund or somebody who’s borrowed stock to effect a sale that’s not reportable even under the Corporations Act – as currently defined – so the clients are under no obligation to tell the market participant that it has effected a short sale because it’s not a short sale as defined. In our market rules we then have jurisdiction over a market participant and our market rules require the market participant to disclose to us both naked short sales – that’s where they’ve not got any borrowings beforehand – plus also covered short sales. We then say that the market participant needs to get that information from the client. If the client’s not telling the market participant that they’ve got a covered transaction, and they do that because they’re saying we are under no obligation under the Corporations Act to make that disclosure, then that’s where there’s the potential under-reporting of what everyone says is a short sale – but in reality it's not a short sale as defined – but I suppose that’s what people are saying that hedge funds are exploiting. They’re going out, borrowing transactions, shorting stock and then driving down the price and then coming back later with a profit.
AK: Sounds a bit like you’re throwing up your arms and saying oh well, you know, we’ve done our bit, nothing we can do about it.
EM: No, no, no. During...a market rules overlap review project last year, we pointed out [to ASIC] that part of that needs to be a review of the short selling provision in relation to the reporting obligation of the Corporations Act. More recently that was brought to the attention of ASIC and Treasury in our response to their consultation paper on competition for market services. So we’re not throwing our hands up – we’re actually pointing out the problem and pointing to the problem and saying that the problem can’t be resolved until such time as... the definitional ambiguity that sits in the legislation is fixed up because people are exploiting… those provisions.
AK: Over to Steve Bartholomeusz.
Stephen Bartholomeusz: Eric before we leave this theme, a little earlier you referred to the potential for market manipulation.
SB: In several of these more high-profile instances of corporate crises associated with margin calls on the senior execs, there has been very strong anecdotal evidence in the market of heavy short selling by the hedge funds that appears to have been deliberately designed to force a stock through the margin call trigger points. That does smack to me of clear market manipulation. Do you have a view on that, and is the Exchange looking at specific instances.
EM: Yes I would agree with you Stephen...At the ASX profit release and the media interviews on that afternoon, the same proposition was put to me – that there was anecdotal evidence that hedge funds were essentially driving prices down as part of a strategy...I’ve had that said to me on a number of occasions and prior to that briefing I had instructed our surveillance people to go back and look at various stocks where, following profit releases, the price has been trashed...We’re doing an investigation at the moment to see who is behind those transactions and we’re working with ASIC in relation to those investigations, and if it transpires that there is market manipulation, whether it’s by hedge funds or other people, if we believe there’s a case to be had, we will refer that matter to ASIC for them to take prosecution action. If it’s a market participant, we have the ability to take our own disciplinary action before our own Disciplinary Tribunal.
SB: There also seems to have been quite a clear knowledge in the market of the various margin call trigger points in some of these more recent share price collapses. Is there potential for insider trading associated with that?
EM: Yes... I mean I saw... there was an article in today’s press. There seems to be a suggestion in some of that commentary in the press that directors are okay as long as.. [stock] has been sold as a result of the margin call. Well I wouldn’t agree with that. I mean, the legislation under the Corporations Act talks about whether or not someone’s disposed of shares at a time when they’ve had knowledge or information that’s not otherwise generally available. Whether or not the directors had to sell the shares or had been directed [to do so], it’s not in the legislation that that’s an excuse...so in the...cases where a director has disposed of shares [because of] margin lending arrangements, and subsequent to that, in a very reasonable period of time, there’s then an announcement by the company which is in effect more bad news, we would look at that closely to then decide whether...it may well require further investigation by ASIC for insider trading and we’re in fact looking at doing that, as we speak.
AK: You mean in some specific situations?
AK: But the margin.. where there’s a margin call, the director or executive doesn’t actually do the selling.
EM: No, I know that, but the legislation talks about where there’s been a disposal of the shares.
RG: Eric, what you’re really saying is that these margin arrangements have potential to cause people to breach the Act.
EM: I’m not saying that. The question there…
RG: But they’re forced to sell and therefore they’re in possession of insider knowledge.
EM: No. I think that if what the director in the company has...at that point in time...is access to information that's going to be price sensitive, they can clearly then call a trading halt and release that information...to allow the company to come out of the trading halt and let trading continue. The market’s fully informed.
AK: Okay. Well, are you investigating the situation with Allco Finance Group where Allco principal investors were sold up by the margin lender at $3 and subsequent to that the stock was suspended for two weeks and then came on at $1.
EM: Alan, I get asked this question every time about specifics and unfortunately I don’t entertain the discussion on specific cases for Allco, ABC, Centro, MFS, or whatever it is. What I can do is talk in a generic sense as to what we do in circumstances like this. In circumstances of the kind that you were describing, we do exactly what we do in every case and that is, if we think that it’s inappropriate insider trading, market manipulation, or a continuous disclosure matter that requires investigation, we do it and we refer it on to ASIC. You will have seen in today’s Australian there is a suggestion that we are referring Allco to ASIC. That’s speculation. I can’t confirm or deny that. We have an obligation with ASIC under a Memorandum of Understanding that we don’t talk about current matters, but we do talk in a generic way.
AK: On the subject of insider trading, Peter Hunt at Caliburn recently said to the ASIC Summer School that he believed insider trading is rampant at the moment. Do you agree with that?
EM: Look, I agree that insider trading occurs and the reason I say that of course is that we make referrals to ASIC and have continued to do so, and those referrals have been increasing each year for the last three years. As at the end of January we had made 14 referrals on insider trading. We made 23 for the whole financial year the year before and so I have to agree with Peter that insider trading occurs...whether that translates into 'rampant' is just a matter of subjective judgement, but certainly insider trading is a phenomenon that does occur and I suspect will continue to occur.
RG: Eric, in some of the stocks you just mentioned, there has been clear heavy selling well before any announcements. Do you have any idea where these sort of leaks are coming from? The market is actually trying to work out where it’s coming from, and thinks it might be the young auditors that come early into an audit and see this stuff even before the directors, and talk about it in their entertainment over the weekend.
EM: Bob that’s another category of source of rumour that you’ve introduced me to. I hadn’t appreciated it had gone down to that level. We get told that the class of source is really quite broad. It can be from people that are involved in advising the company in relation to a potential deal. There would be rating agencies or financiers that are involved in the deal. You’ve got fund managers that may [see it as in] their interest even to institute a rumour because they may want to get out of a particular stock. I’ve had that suggested to me – that that’s what’s triggered off a movement in the stock and obviously in this interview you’ve talked about the activities of hedge funds and it’s been suggested again to me that the rumours around are that hedge funds spread a rumour, and that they try to spread a rumour on bad news either leading up to or straight after the release of a profit announcement. You’ve got people within companies themselves and executives of companies who spread rumours and they all feed those rumours into the media and the media in turn feeds off that and provides that exposure to the market. We are in one sense grateful for that, because every morning before the market opens we read the newspapers and we see what comments are contained in the media and a lot of those are speculation or rumours that have been fed into the media and they rightly report it in the press, and we then use that article as a basis on which to make contact with the company and say, 'will you confirm or deny the rumour? Have you put out an announcement about it?' and in a lot of cases there are announcements put out. In the last six months there was something like 900 price queries issued and about 600 announcements followed on top of those price queries.
SB: Eric, the continuous disclosure regime – in light of what we’ve learned over the last couple of months – do they require any revisiting? Where does the line fall for disclosure for instance of prejudicial information in this kind of environment?
EM: I generally think the continuous disclosure laws are okay and they are flexible enough to move with the current environment and the trends and we’ll be saying that in the announcement we put out today about reminding companies of their obligations to disclose financial positions or movement or change in their financial position and the existence of margin loans, because the obligations change and move in accordance with the time and circumstances of the market and there’s nothing in the continuous disclosure laws that seems to suggest that there’s any problem. There’s been confusion about continuous disclosure laws as to...when something...loses its confidentiality – when it’s something to do with the preliminary stages of negotiation and companies no doubt get advice from external parties as to how they would or should interpret that. What we would say is, at the time, to get that advice, but you then as a company need to assess and make the decision as to whether you will still not disclose something to the market because at the end of the day, if you don’t disclose it and it turns out you should have disclosed it, then you will then face the rigours of any action either by us or by ASIC. The other issue that we reckon that we have is in and around 31B which talks about a false market, so that when we do see media articles or speculation that something is occurring and the company denies that, and there’s still continued trading based on that rumour, ASX has the power and does exercise the power to say to the company you are required to issue an announcement to the market because we’ve formed a view that we now have a false market. That’s a more recent change to the continuous disclosure laws and I think we’ve got laws which are reasonably broad. They’re flexible. They’ve got exceptions to them, so people have got some opportunity not to disclose them if they feel like it. But at the end of the day, if we form the view that we think confidentiality has been lost or we think there’s a false market, that’s the end of the discussion. We then say you are required to make an announcement and if you don’t, we will suspend you.
AK: Eric, more broadly, doesn’t the fact that the ASX profits from securities activity mean that you have a conflict of interest as a regulator?
EM: Look Alan, the statement you’ve made is correct as a matter of fact – that [when a company is] operating a business and generating a profit and they’re also regulating the people out of which they’re making business, there’s potentially a conflict of interest. We at ASX have addressed that by setting up the supervision function in a separate subsidiary under which I do not report at all to the CEO. Now before that subsidiary company was set up, I reported to the CEO and the suggestion from the press and everyone was that the mere fact that I reported to the CEO was a massive conflict and we should separate that. We did that, and put it into a separate subsidiary company. I now report to a separate board. I can put hand on heart and say that there is not decision I have ever made where I’ve had regard to the business interests of ASX or that I’ve had any influence within ASX to have regard to the business interests of ASX. People say 'well look because of that conflict of interest you shouldn’t have the regulatory role'. But people don’t also suggest to me what’s the alternative model. Everyone says that ASX shouldn’t be both operator and regulator, but they don’t go on to say 'a better system or an alternative system would be this', and it would be better because of A, B, C and D. I say that it’s better to stay where it is, because we are closer to the market. We have the expertise that’s contemporaneous with market activity and we’ve got the experience...of how you regulate the market. The best example of the ability or the need to have the supervision function close to the business, I would have thought, is more recent – when we looked at the matter involving Tricom. That was a matter that was initially an operational issue around trading and settlement, the clearing and settlement activities for the participants. It’s not a supervision issue that I look at or supervise. That’s an operational function. Yet when the issue arose, we had to get together and we got together inside 10 minutes to form a committee to oversee the events of that day to decide what action we would take. Now, if you don’t have that closeness and you don’t have that expertise at your fingertips as a supervisor, you can’t make decisions in real time, in a timely way, and I’m quite happy and confident that what we did in relation to the Tricom matter was appropriate and was effective...
AK: Yes, but by separating the business, separating regulatory functions away and ensuring that you don’t report to the CEO, you’re actually acknowledging that there’s a conflict of interest.
EM: No, we don’t acknowledge it. What we’re doing is addressing the perception that there was a conflict. It was because of suggestions – and you were one of those making them Alan – that people were very hot to trot on [the issue of ASX] having both functions. So what Tony D’Aloisio directed me to do when I first came here was to do a review of the supervision function. What we did was look at what happened internationally and what structures were being put in place. We saw that supervision divisions were still within the listed entity but they reported to a separate oversight board which in turn then reported to the main board. The only organisation that was thinking about putting in into a separate company was the New York Stock Exchange, which we looked at, and as a consequence of really trawling through structures in place overseas I made a recommendation back to D’Aloisio, and ultimately the board, that we should set ourselves up into a subsidiary company to further address the perception of conflict of interest. We didn’t say it was in recognition that there is a conflict of interest. It was really done to address people’s perceptions that there is one.
SB: Eric, at the moment the ASX is a monopoly. That’s unlikely to remain the case much longer. Does the advent of competition for the ASX have implications for market integrity or for your role in regulation?
EM: Yes to both questions Stephen. Let’s carve them up. In terms of market integrity, again where you’ve looked at different market operators involved in selling the same stocks on the ASX market, there’s issues about how the different market operators operate and supervise their particular activities that go on in that market. You can have regulation arbitrage which would be an issue. [With competition] you might have a race to the bottom here in terms of regulation, so I think it’s potentially a bad thing in terms of having that. That then raises the question of who should regulate the markets. If there’s another market operator comes into play... they’ll set up their regulator, their self regulatory organisation of their market. There will be issues that will arise for them purely from a conflict of interest point of view to start with, because it would be difficult to see how they could regulate a market that they are the owner of. ASIC oversees what we do on our market...so that raises the question of whether ASIC should be the overseer...And the other issue for a competitor is that we are... we currently would regulate a competitor who may well be the operator of the other market. Now, at the moment, every time we disciplined those other operators or equity participants...we would then potentially be accused of having a massive conflict of interest because there’ll be accusations that we said or did that because of our competitive role. Now that can be addressed in a couple of ways. There are currently conflict of interest rules and regulations that exist under the Corporations Act or under our licence requirement, that ASIC would oversee. So we could say to ASIC that we’ve put in existing conflict of interest arrangements and you can still therefore feel comfortable that we can monitor and discipline those other participants. That may not hold water across the market generally, so the next step would be to say we’ll regulate the market participants in the same way we regulate listed entities – that is to look at the compliance of other market participants who also operate other markets and their level of compliance against our market rules. If we discover a potential breach of those rules or potential misconduct by those market participants, we would then refer that matter to ASIC for its disciplinary action. So you could foresee, at least so far as those other market participants are concerned, that we might monitor and detect any potential breaches, but that ASIC would then be the organisation that disciplines those breaches. Under that structure you could still see ASX essentially as the regulator of the market.
SB: The situation you’re describing is one of another layer of potential conflicts for the ASX, and if you get competition to the ASX from other trading platforms, is that the beginning of the end for the ASX’s role as a self regulator?
EM: I don’t think so. I think in this… if there are different market operators you still could have ASX as the market regulator.
AK: You seem to be saying that everyone else has a conflict but….
EM: What I’m saying is that in a multi-market operator environment the question will be: do we need or should we have more than one regulator of those markets? The answer is most likely you shouldn’t have more than one. You should only essentially have one in this market... but with the size of this market, it seems a little bit strange that we could have three market operators equivalent to the ASX market supervision division trying to work together under a memorandum of understanding. So the question has to be should we have one single regulator and who should that regulator be. Should it be attached to ASX? Should it be separated from ASX and if it’s separated from ASX should development market operators have some interest in that regulator? When you look at other models overseas, you can see in Canada, for example, that there is an "independent” market regulator that is essentially the people who are… the shareholders are the relevant market operators and the relevant industry association and that market operator operates and supervises all of those markets and charges a fee to each of the relevant participants to essentially fund the operation of that market. The other question you would ask is whether we need to have any independent regulator at all. Let’s give it to ASIC. Now I guess that’s the question. That’s the elephant in the room here because that’s the issue that’s never addressed when people say the role should be taken off ASX. They don’t go on and say 'oh and actually the best alternative is to give it to ASIC'. Every general counsel, every CEO of a market participant – and they’re the people we regulate – they never say to me, we want the role taken off you. They say the opposite. They say we don’t want the role taken off you because we think you do a pretty good job at what you’re doing. And why? Because we’re closest to the market. We understand the market and we understand what they do. That gets back to my earlier point – in the discussion around who should have the role, there doesn’t seem to be in my view an appropriate level of debate as to what’s the best alternative.
AK: Any further questions?
SB: A little bit offbeat Eric – the ASX has been cracking down on disclosure by the junior miners.
SB: Can you explain why? Can you also say whether the Exchange is going to do something about the use of these so called hypothetical resources by that end of the sector?
EM: Yeah, I guess it’s been an area of focus especially since I’ve been here largely because of the volume of listings that have come out of the resources sector. We have 2,200-odd listed companies. Over 750 of them come out of Perth. Of that 750, about 500 of them are resource companies which are in the exploration sector and when I also look at the amount of... the number of referrals that we’re giving to ASIC in terms of potential market breaches around insider trading, market regulation and continuous disclosure, half of them are coming out of the resources sector in Perth. So they might represent one third of our total market, but they represent 50 per cent of the enforcement action at the serious end that we send on to ASIC. They don’t have the resources available and infrastructure available for support that the other end of town has in terms of making sure that they have processes and procedures and are addressing their regulatory obligations in the same way, so those factors and the fact that they’ve got to comply with a quite complex code called the JORC Code, there’s a confluence of those three things that suggest to us that we need to pay attention to that sector and we have certainly increased our focus around JORC Code disclosure. And we’ve issued some updates and we’ve run a number of education programmes for the market…for company secretaries, lawyers, geologists. We've also run seminars that focus on their obligations under the JORC Code and there is a major seminar coming up on 26th March in Perth where we will devote half the day again to JORC Code disclosure. The first half of the day will be devoted to obligations of directors of the SME sector and this resources sector for continuous disclosure and corporate governance. That’s an initiative following on from last year when we did a seminar in May of last year focused entirely on the JORC Code, so I guess Stephen, it’s a consequence of it being a significant sector of the market. It’s a small sector of the market. It’s a sector that doesn’t have resources available to it. It’s got compliance in quite a difficult area in terms of JORC Code disclosure, and the track record suggests that mistakes are being made probably mostly inadvertently or through ignorance and I guess that’s our role as a regulator – to focus on that and to educate that sector of the market more so than perhaps we’re doing with other sectors of the market.
SB: And the use of the hypothetical resource estimates?
EM: I’m not quite sure what you’re talking about there Stephen. Are you suggesting that a company’s listing and making up estimates or…
SB: I think if you look at a lot of the disclosures at that junior end, particularly in relation to takeovers, they go beyond the JORC estimates and talk about hypothetical resources.
EM: If it’s a prospectus matter, that’s a matter that ASIC looks at in terms of compliance in and around the JORC Code. If it’s an announcement they’re making after it’s been listed, we’re reasonably focused on the level of puffery there. We would focus on making sure the company makes appropriate disclosure so I guess if there are circumstances where you think that disclosure on an ongoing basis is hypothetical and rampant I’d alert my people in Perth to make sure that’s not the case, but if you’ve got examples of that being the case, I certainly would like to hear from you.
SB: I’ll send you a message Eric.
AK: OK, well we’ll have to leave it there I think. That’s been great. Thanks very much Eric.
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