Insiders and Their Trading Games in China: Law, Enforcement Data, and a Puzzling Question.

• Author: Lin, Chien-Chung

1. INTRODUCTION: INSIDER TRADING IN A CONTROLLER-DOMINATED ENVIRONMENT 718 II. INSIDER TRADING LAW IN CHINA 719 A. Substantive Law 719 1. The Definition of Insider and Inside Information 720 2. Types of Proscribed Activities 721 3. Legal Consequences of Violation 722 4. Supplementary Explanation and Guidance 723 B. Comments From Legal Academia 725 III. WHAT HAPPENED IN THE REAL WORLD: CRIMINAL INSIDER TRADING CASES, 1997-2019 726 A. Empirical Literature Review 726 B. Our Data and Method 728 1. Descriptive Data 728 2. Beyond Those Being Detected: The Cumulative Abnormal Returns and Event Study 730 3. Sample 731 C. Result: Cumulative Abnormal Returns and Pre-Announcement Run-ups 733 D. Comparison Group: M&A Events in China from 2007 to 2017 and the Puzzle the Results Create 734 IV. CASE STUDY AND REFLECTIONS 736 A. Qualitative Analysis of Notable Cases 737 1. Nantong People's Procuratorate of Jiangsu Province v. Liu Baochun 737 2. Chengde People's Procuratorate of Hebei Province v. Liu Zhiqiang 737 3. Taiyuan People's Procuratorate of Shanxi Province v. Zhou Haijun 738 4. The Second Branch of Beijing People's Procuratorate v. Huang Guangyu 739 5. Wuxi People's Procuratorate of Jiangsu Province v. Du Lanku 740 6. Questions Remained 742 B. Reflections: Empirical Research and Its Limitations, Methodology of Comparison, and Implications of the Contradicting Data 743 1. Limitations of Traditional Approach and Quantitative Approach 743 2. Methodology Enhanced: Multi-Layer Comparison 744 3. Summary of Observations and Takeaways 744 V. CONCLUSION 746 I. INTRODUCTION: INSIDER TRADING IN A CONTROLLER-DOMINATED

   ENVIRONMENT

   This Article delves into two components of corporate law and securities law-concentrated ownership structure and insider trading--and studies their interaction. Specifically, we analyze how insider trading is carried out or prevented in the Chinese context, where concentrated ownership of businesses is prevalent. In theory, controlling shareholders could conduct insider trading (as they enjoy an informational advantage from which benefits can be gleaned if legal enforcement is weak) or not (as they may choose instead to maintain their reputation by treating minority shareholders or trading parties fairly). This dynamic is compounded if adding the existence of professional managers is taken into calculation. Therefore, the question is, do controlling shareholders have an incentive to stop their managers from misappropriating undisclosed corporate information for profit? Or should controlling shareholders allow some use of inside information as a form of bonus compensation, as suggested by a prominent academic? (1)

   To answer these questions, we gathered empirical data from China to see how insiders trade in an environment where corporate controllers dominate. We survey court decisions of insider trading criminal cases since the prohibition of insider trading (1997-2019) to gather details about trading activities. We use a technique developed by two of the authors to gauge the potential gap between spotted insider trading (cases tried) and those that remained undetected. We calculated a cumulative abnormal return (CAR), or the price movement for a company before a major announcement adjusted to the market situation, to measure the magnitude of insider trading across the board. We used this method to estimate the overall amount of insider trading in China.

   To check the validity of our findings, we compiled another randomly selected sample of companies that experienced merger and acquisition (M&A) events from 2007 to 2017. These two samples provide contradictory findings that pose a conundrum when considering the interplay of concentrated ownership, insider trading, and the enforcement of insider trading law in China.

   This Article proceeds as follows. In Part II, we trace the twenty-plus-year history of Chinese insider trading law to the present. In Part III, we use CAR to estimate informational leakage and after-announcement price movement to gauge market reaction. We then test our first and second samples. In Part IV, we survey the characteristics of individual criminal cases of insider trading. We examine how inside information is used (or not) in a controller-dominated corporate environment and then reflect on the implications of this for the existing theoretical discourse. Part V concludes.

2. INSIDER TRADING LAW IN CHINA

   1. Substantive Law

      China's first comprehensive regulation prohibiting insider trading was the Interim Provisions on the Management of the Issuing and Trading of Stocks, promulgated in 1993 by the State Council Securities Commission (predecessor to the China Securities Regulatory Commission, or CSRC). (2) It stipulated that insider trading is an illegal activity (3) and provided a set of definitions for enforcement, such as the definition of "insiders" (4) and the information prohibited. (5) Furthermore, it provided statutory grounds for the administrative agency to enforce a prohibition against insider trading.

      However, the actual effect of the interim provisions was questionable. In 1997, an amendment to the Criminal Code attached criminal sanctions to insider trading. (6) At that time, insider trading was rampant, and one commentator remarked, "In the [Chinese] stock market, about 80 percent of all securities cases are connected with insider trading, and about 80 percent of the amount of money in all securities cases are connected with inside trading." (7) Nevertheless, the 1997 Criminal Code did not stipulate the range and the components of insider trading but instead delegated its substance to administrative lawmaking, such as defining the scope of "inside information" and the definition of "insiders." (8)

      In 1999, China's first non-interim securities law, Securities Law of the People's Republic of China, filled the gap. (9) The law proscribed insider trading, along with general securities fraud and market manipulation, as one of three types of fraudulent acts in the securities market. (10) The statute's substantive content mainly includes (a) a long list of who is subject to insider trading restrictions and what constitutes proscribed information; (b) three types of insider trading violations; and (c) the civil penalty and liability for insider trading.

      1. The Definition of Insider and Inside Information

         Article 51 of the Securities Law set out nine types of persons (zhiqingren, meaning persons holding inside information) whose trading would constitute violation: (11)

         (1) the issuer and its directors, supervisors, and senior executives;

         (2) shareholders holding 5% or more of shares of the company and their directors, supervisors, and senior executives, and the actual controller of the company and its directors, supervisors, and senior executives;

         (3) the company that holds controlling shares or that is actually controlled by the issuer and its directors, supervisors, and senior executives;

         (4) the personnel who have access to the inside information of the company by virtue of their positions held in the company or their business exchange with the company;

         (5) the acquirer of a listed company or parties to material asset transactions, and their controlling shareholders, actual controllers, directors, supervisors, and senior executives;

         (6) the relevant personnel of stock exchanges, securities companies, securities depository, and clearing institutions and securities service institutions who may have access to inside information by virtue of their positions or work;

         (7) staff members of securities regulatory authorities who may have access to inside information by virtue of their duties or work;

         (8) staff members of competent departments and regulatory authorities who may have access to inside information in their performance of statutory duties of administering securities offerings and trading or listed companies and their acquisitions and material asset transactions; and

         (9) other personnel who may have access to inside information as provided for by the securities regulatory authority of the State Council.

         In Section 1 of Article 52, China's Securities Law defines inside information as any undisclosed information that may have a material impact on the issuer's business, financial condition, or stock price. (12) In section two of the same article, it refers to Articles 80 and 81 for all 23 itemized incidences considered to be proscribed information, including information about significant changes to the business strategy and scope of business, any investments, sales of assets, or mortgages exceeding 30% of a company's total assets, or major personnel changes or litigation. (13)

      2. Types of Proscribed Activities

         Three types of activities are proscribed by the Securities Law. The first is traditional insider trading: that is, company insiders cannot trade an issuer's securities while possessing undisclosed material information. (14) The second is trading by those who obtain inside information through illegal means. (15) This enjoins trading by anyone who breaches the duty owed to any party by using material non-public information for personal gain; this proscription is an outgrowth of "misappropriation" theory originated in the United States. (16)

         The third type of insider trading is identified in Article 53, which prohibits anyone, either an insider or someone who illegally obtains inside information, from passing on this information or recommending, implicitly or explicitly, purchasing or selling relevant securities. (17) This provision covers what is generally referred to as "tipper" or "tipping" liability. In such a situation, a tipper-defendant can be liable for insider trading even when the defendant has not engaged directly in securities trading. (18)

      3. Legal Consequences of Violation

         A violation of insider trading law incurs three sets of liabilities. Civil and administrative liability are based, respectively, on Articles 54 and 191 of China's Securities Law...