In Securities and Futures Commission v Yiu Hoi Ying Charles and Others  [1]  , the Court of Final Appeal (CFA) curtailed the ambit of the “innocent purpose defence” to insider dealing under s.271(3) of the Securities and Futures Ordinance (SFO). That defence states that a person will not be guilty of insider trading if their purpose for trading was not to profit or avoid a loss by using the inside information (the “relevant information”).

The CFA held, by a 4-1 majority, that for the purpose of the defence “using relevant information” simply means making one’s decision to buy or sell at the market price while knowing that price to be either artificially high or low because the relevant information is not known to the public.  Unfortunately the CFA did not take the opportunity to clarify (obiter) the application of the defence in a margin loan enforcement context.

Background

Asia Telemedia Limited (ATML) is a company listed on the Hong Kong stock exchange.

On 26 April 2007, ATML was served with a statutory demand by a company named Goodpine, seeking payment of $70,270,491 and stating that if within 21 days ATML failed to pay the full amount, a petition for winding-up would be presented.  ATML made no public announcement nor was consideration given to suspending trading in ATML’s shares. On 6 June 2007, six weeks after serving the statutory demand, Goodpine presented a winding-up petition.  Trading in ATML shares was suspended.  They had been trading at $0.83.  When trading resumed on 18 October 2007, the share price fell by 62% to close at $0.315.

Following receipt of the statutory demand but prior to the presentation of the winding-up petition, Charles Yiu (Yiu), Director of Finance and Executive Director at ATML, and Marian Wong (Wong), Company Secretary of ATML, both of whom were aware of the statutory demand, sold shares in ATML, via share options granted to them as employees. They did so to take advantage of a surge in ATML’s share price. Proceedings were brought by the SFC before the MMT alleging that this amounted to insider trading.

Both relied upon the innocent purpose defence provided in s.271(3) of the SFO.

The MMT found that prima facie, each had committed insider dealing under s. 270 of the SFO but that they were able to rely on the innocent purpose defence, having chosen to exercise their options and sell their shares to take advantage of the sudden and unexpected surge in the price of ATML shares while believing that the statutory demand would be resolved “behind closed doors”.

The SFC appealed to the Court of Appeal and subsequently the CFA.

An “innocent purpose”

Section 271(3) of the SFO provides that:

“A person shall not be regarded as having engaged in market misconduct by reason of an insider dealing taking place through his dealing in ... listed securities ... if he establishes that the purpose for which he dealt in ... the listed securities ... was not, or, where there was more than one purpose, the purposes for which he dealt in ... the listed securities … did not include, the purpose of securing or increasing a profit ..., by using relevant information.”

The burden of establishing the defence is on the connected person, the insider-dealer, who seeks to rely on it, on the balance of probabilities.

The defence

The innocent purpose defence looks to the purpose for which the specified person dealt in the listed securities, with the focus of the inquiry being on whether or not it was for, or included, the prohibited purpose, namely “the purpose of securing or increasing a profit or avoiding or reducing a loss, whether for himself or another, by using relevant information” (emphasis added).

The alleged offender must establish that the purpose for which he or she dealt with the securities was not and (if there was more than one purpose) did not include, the prohibited purpose. That is a question of fact in every case.

The CFA noted that the defence might arise, for instance, where he or she dealt in the securities pursuant to a prior contractual obligation and had to sell whether or not it entailed realising a profit or a loss or where a person sells shares in compliance with an order of the Court.

As noted by the majority in the CFA, the defence is not easy to establish. 

To discharge that burden, the defendant may give direct evidence of his or her subjective purpose to show that he or she was motivated by an “innocent purpose”.  If such direct evidence is not given, they must be able to point to evidence which demonstrates that he or she acted for a purpose or purposes which entirely excluded the prohibited purpose.

The CFA also noted that the purpose that the specified person relies upon in support of the defence is that which exists at the time of his or her dealing in the relevant listed securities.

The decision of the majority of the CFA

Curtailing the ambit – “using relevant information”

The meaning of “by using relevant information” was the critical issue in the SFC’s appeal. 

It was the case of the SFC that “using relevant information” simply meant dealing in the listed securities when in possession of undisclosed price sensitive information which one knew, if disclosed, would be likely to affect the share price.  For their part, the respondents contended that “using relevant information” must mean something other than mere possession or knowledge of the relevant information.

The CFA held that construing the provision purposively and in context, “using relevant information” simply means making one’s decision to buy or sell the listed securities because of the quoted market price, knowing that price to be either artificially high or artificially low because the relevant information is not generally known to those accustomed or likely to deal in the securities.  By doing so, one is employing the price sensitive information to one’s own advantage in order to steal a march on the rest of the market since, were that information generally known, it “would … be likely to materially affect the price of the listed securities”.

In the opinion of the majority, it is the turning of the possession of price-sensitive information into action which constitutes the use of the relevant information.

The majority noted that this conclusion was also consistent with EU law where, for a person to have used inside information within the meaning of article 2(1) of European Council Directive 2003/6, which prohibits insider dealing, the information must “have played a role in his decision-making.”

 Curtailing the ambit – subjective belief

The majority held that subjective belief as regards whatever might happen in the future to resolve the listed company’s financial affairs was irrelevant, since at the time the dealing took place, being the critical time for assessing whether insider trading took place, the matter, namely the threat of insolvency proceedings, remained unresolved.

In the words of the majority: “It would be surprising if the law were to permit an insider to escape culpability by reliance on his or her own subjective belief, saying: ‘Yes, I traded shares knowing that their price would be affected by undisclosed price sensitive information which I had, but that is okay because I believed that the market would never find out’.”

Accordingly, Yiu’s and Wong’s belief that the information regarding the statutory demand would not pass into the public domain and the company’s problems would be resolved 'behind closed doors' was legally irrelevant.  That belief did not mean that the respondents did not use the information.  Moreover, “Deciding to sell – to “seize that chance of a lifetime” – with the benefit of price sensitive information, did involve stealing a march by using the relevant information at the material time, that is, at the point in time they dealt in the shares.”

Conclusions of the majority

Accordingly, the Tribunal fell into error in holding that the respondents had succeeded in establishing the section 271(3) defence.

In so holding, the majority stressed that their analysis did not involve any challenge to the findings of the MMT. The respondents were found, “no doubt correctly,” to have genuinely believed that the threat would be resolved and the information would not get out from behind closed doors.  However, such a belief is legally irrelevant and did not demonstrate that they did not use the price sensitive information they possessed.  It did not help establish the section 271(3) defence.

A dissenting view

Mr Justice Tang PJ was unable to agree with the majority.

In his view, the defence is not confined to the insider dealer establishing that the purpose(s) of his dealing did not include the purpose of securing a profit or avoiding a loss, for that would render the words “by using relevant information” otiose. Nor is it limited to situations where the dealer was under compulsion to deal. 

Rather, if the insider can prove on a balance of probabilities that the inside information had not in any way, influenced, motivated or been a factor, in his dealing, he should not be regarded as having engaged in market misconduct by reason of an insider dealing. 

Moreover, the motivation of the sale was a question of fact for the Tribunal, which finding was not disturbed by the Court of Appeal.

Accordingly, Mr Tang PJ did not believe he was entitled to interfere: “I agree [insider dealing] is a species of dishonest misconduct.  That being the case, it is only right that innocent dealing should not be covered.  I would not regard any person who has satisfied the Market Misconduct Tribunal that he dealt without being in any way influenced by the inside information as dishonest.”

Comment

The decision of the CFA will not be welcome to those active in the securities market who wish to rely on the innocent purpose defence.

Simply making one’s decision to buy or sell the listed securities because of the quoted market price, knowing that price to be either artificially high or artificially low because the relevant information is not generally known to those accustomed or likely to deal in the securities, will amount to the use of relevant information. 

Moreover, prospective defendants will be required to give direct evidence of his or her subjective purpose to show that he or she was acting for what might be called an “innocent purpose”, or be able to point to evidence which demonstrates that he or she acted for a purpose or purposes which entirely excluded the proscribed purpose when dealing with the securities.

A subjective belief will not be sufficient.

As noted in our bulletin regarding the earlier Court of Appeal decision[2], the innocent purpose defence is often considered by financial institutions in the context of enforcement of security over Hong Kong listed shares following a default by the borrower under a margin loan facility.  This situation commonly arises where the director of a listed company obtains a personal loan and provides a charge over his shares in the company by way of security.  If the director defaults on the loan, the lender may be considered as having possession of inside information.  Establishing an innocent purpose defence would require the lender to show that its sole purpose in enforcing security in this scenario was to recover the underlying debt and not to make a profit or avoid a loss, and that the possession of the inside information did not turn into (or was not a factor in) the action of enforcing the security.  This could be challenging.  The CFA's decision represented an opportunity to provided clarity on the application of the defence in this important context.  It is unfortunate that the CFA did not take that opportunity.