The Emperor of All Evils

Scene 1: 1 Blue Horseshoe loves Blue Star Airlines.

Scene 2: The handcuffed Bud Fox (Charlie Sheen) is taken by policemen through the trading room at Jackson Steinme’s brokerage house.

The scenes above are from the movie Wall Street (1987). Their emotional impact is undeniable. The “good contravener” leaves the office burst into tears, probably thinking that his dreams and professional career have just started to dismantle as a result of his illegal acts. His colleagues show dismay and also the perception that, in fact, the crime does not pay.

A recent article published by The Economist magazine brings a number of studies showing the main factors that account for reduced criminal levels: the relationship among the advantages offered by criminal acts and their risks (that is, a cost/benefit analysis) and the probability of being caught. These studies provide a reflection about one of the most serious threats to the capital market’s credibility: the insider trading practice.

Considered a crime in Brazil since 2001, insider trading is defined as the use of relevant information yet unpublished in the market to create undue advantages through the trading of securities. The sentence goes from one to five years of imprisonment.

The perception by market’s players about the insider trading is that it is an actual problem that has never been regarded as a priority, however. For better or worse, everybody is aware of the fact that some players use relevant information and make money from that. But because of the idea that a single player is not able do something illegal by himself/herself (a false idea, as you will see), the difficulty of identifying the problem or even because people are often unwilling to discuss such a thorny topic, we do not see people mobilizing themselves as to this problem as they do when it comes to other malpractices in our capital market.

An example: do you know that two people have been convicted and sentenced to prison because of an insider trading event in Brazil? Yes, in the case of Perdigão’s offer for Sadia in 2006, two Sadia’s executives were accused and convicted for the use of privileged information. The first conviction, which took place in 2009, led to a one year and nine month conviction, in addition to a fine. The Brazilian Securities and Exchange Commission (CVM) and the Department of Justice appealed to the decision and the sentences have been brought up to two years and six months. It’s curious that many of the market’s players have not been aware of such an important fact.

First of all, because it is a relatively new law. Up to 2001, the maximum punishment to be applied to an insider was administrative or pecuniary penalties. In addition to that, due to our complex legislative process, our law is highly restrictive to who can be actually arrested because of insider trading events. For a person to be convicted, he/she needs to be subject to the duty of confidentiality – as in the case of Sadia’s two executives. An ordinary trader who eventually has access to privileged information and make use of it to trade securities can be committing an immoral or illegal act, feasible to be punished by the CVM. But he/she will not go to the jail because of that.

Additionally, the Sadia/Perdigão case showed the power of a partnership between the CVM and the Public Prossecutor’s Office, which must be expanded. The capital market’s confidence is a diffuse and collective right and, therefore, must be defended by the Department of Justice. This is particularly true in the case of capital market’s crimes (including the insider trading), but also in other situations that harm the perception about our market. Unfortunately, we still lack a culture about the importance of this public domain in the Judicial Branch. The above-mentioned case leads us expect changes in this aspect, and the involvement of the Department of Justice must be applauded and encouraged.

Another important precedent was the case regarding the sale of Grupo Ipiranga’s control. CVM detected inappropriate negotiations and managed to freeze the funds earned with the transactions before their financial settlement. Some of the defendants were obliged to pay fines. Other ones managed to avoid their punishment based on “instruments of commitment.”

Here, it is important to note that the need of punishment must obviously be inserted in the rule of law. And to prove the insider trading crime is not an easy task. Offenders are eventually acquitted due to “lack of evidence.” Additionally, many times a “lucky” transaction can be mistaken for the use of privileged information. It’s important that the regulating agency and the Judicial Branch are able to distinguish one from the other.

Yet, the perception that it’s easy “to get rid of” punishments still persists. Maybe, because of certain exaggerated formality in our legal tradition, it may seem that punishments will only take place if and when the proverbial lipstick on one’s collar is found. And it’s very unlikely that it is found. By definition, the inside trading is a result of information. And most of the times, information is fluid and leaves no physical traces. Nobody is going to sign a paper saying “buy this stock because the company is going to be sold next week.”

We are talking about admitting evidences as the elements that show that a crime took place. In a seminal article wrote in 1978, available at CVM site, the agency’s then-current attorney, Norma Parente, argues that evidences can and must be used by the Judge to check insider trading events. To require physical and concrete evidences that relate the piece of information to the illegal gain would be the same as making the ascertainment of the crime almost impossible. Unfortunately, some decisions seem to be far away from this reality, sheltering themselves under the formalism umbrella (or, as it’s fashionable to say today, under the “guaranteeism” umbrella). CVM has precedents of using evidences in its judging processes, but in many cases they have proven to be insufficient to assure a conviction.

The strongest evidence about the dimension of this problem took place during the roadshow promoted by Amec last April. When foreign investors were asked about the major governance problem in the Brazilian market, some 25% of the respondents were sharp in their answers: inside trading. Some of them even said that Brazil was facing the risk of undergoing a “russification,” that is, to become a market perceived – correctly or incorrectly – by foreigners as a country that does not follow the market rules and that lacks a fair play environment.

No doubt this turns on a yellow light – maybe a red one – in our market. Is the problem actually greater than we think? Opinions like that suggest that inside trading can in fact be compared to a tumor that has been slowly growing – and that is going through a metastasis.

It’s time to think about it. Insider trading is nothing but a robbery – money being stolen from minority shareholders. In the words of CVM’s Chief Assistant Attorney, Julya Wellisch, “insiders’ disloyal behavior does not only offend the rights of the remaining investors, but also the market itself, damaging the confidence and honesty of its relations, aspects that are the basis for its existence and development.”

CVM has been trying to progress, but it faces obstacles of all kinds. The implementation of the SIA-Eagle system, which monitors unusual transactions in the market, was adjourned for several months because of expense restrictions – a clear perversion to CVM’s financial and budgetary autonomy (Law 6.385/76, Article 5). This delay has been affecting the process until now and hinders the monitoring by the regulating agency. It’s essential that market’s players rebel against situations like this.

It calls to attention, the attempt to both mitigate the classification and reduce the punishment applied to financial crimes, which today is part of the project to renew the Criminal Code.

Considering the above-mentioned, investors must be attentive and aware of the seriousness of the problem. The partnership between CVM and the Department of Justice must be encouraged. It’s also essential to create structures to indemnify the losses resulting from the use of privileged information – which, today, do not exist.

Maybe CVM should create a “Disque Denúncia” (“Accusation Hotline”) through which transactions based on privileged information can be reported by the market’s players who eventually become aware of them. To report this kind of crime is already possible today, but few people know how to do that. If the process is consolidated, assuring the anonymity of those who call, no doubt we would have tools that would help regulating bodies punish this type of crime.

Anyway, it’s time to recognize that insider trading events are a cancer in our capital market – the reason for this article’s title – and that the fact that they have been more and more present can eventually thwart all the progress we have made for the last years.