Insider trading: how effective is a Chinese wall defence?

A recent Australian case involving the ASIC's action against the Australian arm of Citigroup Inc., provides some insight into how New Zealand courts may assess the effectiveness of a Chinese wall defence to an allegation of insider trading. It also confirms how important it is for investment banks, acting as advisers, to explicitly exclude fiduciary duties in their terms of engagement and ensure that appropriate systems are in place to manage conflicts of interest between their dealing and advisory functions.

In a case that was followed closely by the media and investment banks around the world, the Federal Court of Australia¹ has found that Citigroup Global Markets Australia Pty Ltd (Citigroup) was not involved in insider trading, while acting as the investment advisers for transport group Toll Holding's (Toll) takeover bid for Patrick Stevedoring (Patrick) in 2005. It also found that the terms of Citigroup's engagement letter with Toll were sufficient to prevent any conflict of interest based claims from succeeding.

The decision is considered to be important for investment banks in so far as it relates to thier existing business practices of providing advisory services to corporate clients alongside their proprietary trading desks.

Background facts

The case arose after the ASX's surveillance division notified ASIC that Citygroup had acquired a significant parcel of shares on its own account on the last business day prior to Toll making its takeover announcement for Patrick. ASX had observed that there may have been a possible breach in Citigroup's Chinese wall between its corporate advisory division (the private side of Citigroup's business which was acting as investment advisers in Toll's takeover bid) and its proprietary trading division (the public side of Citigroup's business trading in Patrick shares).

On the day the trading took place, Citigroup's advisory division had noted that its proprietary desk had been acquiring Patrick shares and had discussed the possibility that this might be perceived by the ASIC as insider trading by Citigroup. This eventually led to a conversation between two advisory and proprietary division heads in which no details were given, but it was made known that Citigroup "may have a problem" with Citigroup's trading in Patrick shares. Later on the same day, while on a cigarette break, the proprietary trader who had been responsible for purchasing the Patrick shares was told by his supervisor not to buy any more Patrick shares (again with no reasons given to him). Following this direction, the trader went on to sell a portion of the Patrick shares he had acquired earlier that day.

ASIC's claims

A number of the ASIC's claims against Citigroup were based on establishing that Citigroup owed a fiduciary duty to Toll which, in turn, gave rise to a series of conflicts of interest on the facts and statutory contraventions.² In particular, by trading in Patrick shares on its own account, ASIC argued that:

• Citigroup required Toll's express informed consent to trade and this had not been given.

• Citigroup could no longer provide disinterested advice to Toll as it may conflict with a desire by Citigroup to ensure that Toll did not think that Citigroup's Chinese walls had failed.

• Citigroup had placed itself in a position where its duty of loyalty to Toll conflicted with its own interests, since it was in Toll's interests for Patrick's shares to remain as low as possible whereas Citigroup's purchasing of the shares, contrary to Toll's interests, had the possible effect of driving the price of Patrick shares up.

The ASIC also argued that there were two separate insider trading claims arising from the purchase and subsequent sale by Citigroup's proprietary trading desk of a portion of the parcel of Patrick's shares.

The Federal Court's decision

CONFLICTS-BASED CLAIMS

The Federal Court found that, although it was possible for a financial adviser and client relationship to give rise to fiduciary obligations, in this case Citigroup's relationship with Toll was determined by the specific terms of an engagement letter which stated Citigroup was engaged as Toll's adviser for the takeover bid "as an independent contractor and not in any other capacity including as a fiduciary". The letter was held to override any fiduciary obligations on their relationship that might have otherwise arisen and also overrode any requirement (identified by the ASIC) for Citigroup to obtain the express "informed" consent of Toll before trading in Patrick shares.

Accordingly, having found that there was no fiduciary relationship between Toll and Citigroup, all of the ASIC's conflicts-based claims were dismissed.

INSIDER TRADING CLAIMS

The insider trading claims also failed. First, in relation to the trader being told by his supervisor not to acquire further Patrick shares, the court found, on the evidence presented, that the individual trader had not traded on the basis of inside information.³ In reaching this conclusion, the court noted that his selling off of Patrick shares after being told not to acquire any further shares was consistent with his explanation that he had taken the comment from his supervisor to mean that he was over-exposed rather than that Citigroup was acting for Toll in the rumoured takeover of Patrick. This particular claim also failed because under the Australian insider trading provisions Citigroup's liability for the trader's actions was premised on the trader being an "officer" of Citigroup.

Second, the claim that Citigroup's trading in Patrick shares constituted insider trading because other Citigroup officers and employees from the corporate advisory division had knowledge of the imminent takeover also failed because Citigroup was able to show that it had satisfied the requirements of the statutory Chinese wall defence against insider trading.

CHINESE WALL DEFENCE

Chinese walls are a means of restricting the flow of information between different departments of the same organisation and are a favoured technique for dealing with conflicts of interest which arise from carrying on business by large financial institutions as well as many legal and accounting firms.

The court noted an English authority which drew upon the observations of a UK Law Commission consultation paper to illustrate the type of organisational arrangements which would ordinarily constitute an effective Chinese wall. These are:

• the physical separation of departments to insulate them from each other;

• an educational programme, normally recurring, to emphasise the importance of not improperly or inadvertently divulging confidential information;

• strict and carefully defined procedures for dealing with situations where it is thought the wall should be crossed and the maintaining of proper records where this occurs;

• monitoring by compliance officers of the effectiveness of the Chinese wall; and

• disciplinary sanctions where there has been a breach of the wall.

The question of whether Citigroup's Chinese wall arrangements were adequate as a defence for insider trading depended on whether they met the requirements of the Chinese wall defence in s1043F of the Corporations Act 2001. This section is similar to the wording of New Zealand's proposed Chinese wall defence for insider trading (new section 10D of the Securities Markets Act 1988⁴) which is expected to come into force later this year.

One of the requirements of both the Australian and the new New Zealand Chinese wall defence is to be able to show that "arrangements existed that could reasonably be expected to ensure" that the inside information was not communicated to the individual who made the decision to act.

The ASIC contended that there were two reasons why the Chinese walls defence must fail. The first was that Citigroup had no mechanism to bring proprietary traders, such as the one involved in these facts, across the Chinese wall. The second was that Citigroup had no effective arrangements to prevent the duty of loyalty conflict (noted above) from arising.

The court disagreed. It considered that Citigroup's arrangements satisfied the test in s1043F. The judge noted that the Citigroup's Chinese wall measures appeared to follow accepted international practice and included all of the requirements stated by the UK Law Commission listed above.

The court also noted that the test in s1043F was an objective one and did not require a standard of "absolute perfection".

On the question of whether there should have been procedures in place to bring proprietary traders across the wall, the court acknowledged that Citigroup's written policies did not in express terms anticipate the situation which arose. However it found that they did set out "general procedures which could reasonably be expected to ensure that legal or compliance officers of Citigroup vetted any communication of potentially price sensitive information to prevent it crossing the Chinese wall." The court did not agree that a further step was required in order to put in place appropriate arrangements for proprietary traders and noted that to bring a trader across a wall, on these facts, risked "sending a signal to the market that confidential investment banking activities" were in progress.

Further, it noted that underlying the ASIC's attack on the adequacy of Citigroup's Chinese walls was its contention that Citigroup required Toll's informed consent to carry out trading on its own account. A finding in favour of ASIC on this point in the court's opinion would have been contrary to the express recognition of the statutory Chinese wall defence.

CAUTION ON USE OF CHINESE WALLS

Citigroup may have passed the test in this case, but the judgment includes several cautions on the use of Chinese walls. The court acknowledged that, as illustrated by the facts of this case, there is an inherent risk of leakage through Chinese walls and that it is not always realistic to place reliance on Chinese wall arrangements. It was also stressed by the court that:

"Adequate arrangements require more than a raft of written policies and procedures. They require a thorough understanding of the procedures by all employees and a willingness and ability to apply them to a host of possible conflicts."

Practical implications

Clearly this case highlights the effect when an adviser's terms of engagement explicitly exclude fiduciary duties. In this case many of the ASIC's claims failed on the basis that, due to effective restrictions in Citigroup's engagement letter with Toll, a fiduciary relationship did not arise between the parties.

The case also highlights the types of organisational arrangements required for effective Chinese walls. Although it may not be necessary to demonstrate "absolute perfection" in order to take advantage of a Chinese wall defence under New Zealand's new insider trading regime, it will be critical to be able to show that reasonable arrangements have been put in place and that the arrangements have been applied consistently.

This will require more than written polices and procedures. As noted in this judgment adequate Chinese wall arrangements include the requirement for physical separation, wall crossing procedures and records, monitoring by compliance, and sanctions for breach. In addition, employees should have a thorough understanding of the procedures and be able to demonstrate a willingness and ability to apply them in a variety of possible conflict situations. In this regard, it would be advisable to put in place regular education and training exercises.

¹ Australian Securities and Investments Commission (ASIC) v Citigroup Global Markets Australia Pty Ltd. (No 4) [2007] FCA 963

² The main statutory contravention was based on s912A(1)(aa) of the Corporations Act 2001 which requires Australia's financial service providers to have in place adequate arrangements to manage conflicts of interest. New Zealand does not have an equivalent statutory requirement, but like Australia, most financial providers are bound by common law obligations affecting their management of conflicts of interest.

³ The court did, however, agree that the inference or supposition made by the trader following his conversation with his supervisor could constitute information based on the Australian statutory definition of "information", rejecting Citigroup's submission that the trader's own internal thought processes were incapable of constituting information.

⁴ This section is part of the new insider trading regime introduced by the Securities Markets Amendment Act 2006. This Act is subject to Orders in Council being issued to bring its provisions into force.

To view ASIC's comments on the decision visit the ASIC website - www.asic.gov.au A copy of the Federal Court's decision can be viewed online at www.austlii.edu.au/au/cases/cth/federal_ct/2007/963.html

Enquiries and information

For more information on any of the cases, articles and features in Commercial Quarterly, please email Diane Graham or call her on 64 9 916 8849.