INSIDER TRADING - psst ... wanna buy some shares?

Insider trading has hit the headlines as Compaq faces legal action from shareholders. What redress can victims expect in the UK?

When it comes to buying or selling shares, it's what you know that from shareholders. What redress can victims expect in the UK? counts, rather than who you know. Having a good understanding of a company, its structure and the dynamics of the market in which it operates can make you extremely rich.

On the other hand, relying on who you know, what they know and what they divulge to you is called insider trading and is illegal. Having a director disclose confidential information that is yet to hit the public domain can land you - and them - in prison.

Analysts and brokers aside, the primary source of investor information is from the companies themselves. It is, after all, the source of information on which the analysts and brokers base their opinions and set their expectations.

A stock can swing significantly on the back of a set of positive results or pessimistic prediction from a chief executive, adding or wiping millions of pounds respectively off the value of a firm in an instant - just ask Compaq.

Following one such pessimistic prediction from Compaq's now former chief executive Eckhard Pfeiffer that it would post net profit and dividends in the first quarter significantly below analyst expectations, the vendor's share price crashed (PC Dealer, 7 April). From a high just shy of dollars 50 in late January and early February, Compaq shares are now hovering at the dollars 24 mark.

For the vast majority of its shareholders it was a big hit. For those who sold their shares in February it was a lucrative stroke of genius.

The only problem for Compaq was that the visionaries who cashed in while the going was good just happened to be high-ranking executives within the company.

According to documents from the US Security and Exchange Commission (SEC), 11 people, including the recently departed chief financial officer Earl Mason, shifted almost a million shares between them before the profit warning became public knowledge. Mason alone netted more than dollars 12 million.

Today, those shares are worth only half that.

While shareholders would have ordinarily taken the losses on the chin, the spectre of senior staff alighting at the stop before the gravy train plunged over the cliff was a difficult one for many to swallow. In retaliation, Compaq was hit by a raft of shareholder lawsuits accusing it of issuing misleading statements to inflate its stock price. Pfeiffer and Mason have now departed, but the lawsuits - four in total, and counting - remain.

Unfortunately for investors, Compaq is not the first, and certainly won't be the last, to feel the heat from 'cheated' shareholders. In June 1997, Informix was accused of insider trading after board members sold shares before issuing a profit warning. Documents filed at the US District Court of the Northern District of California cited 'unusual' sales one month before the developer closed its first quarter. Informix's chief executive, chief financial officer and chief technology officer were all singled out for special shareholder scrutiny.

In another incident, US citizen Robert Kowalskie confessed he had inside information about IBM's acquisition of Lotus in 1995, allowing him and others to buy shares at a price that doubled after the deal was concluded.

It seems the lure of making a quick buck is often hard to resist.

In the UK, share ownership, whether direct or indirect through pension policies and other savings vehicles, is spreading. Employee incentives through share option schemes and the allocation of a proportion of privatisation issues to private investors are now commonplace. This trend has meant an increasing number of people are interested in the way in which companies are run - particularly if it seems that management is using its position for personal gain.

Directors owe many duties to the company they serve. But where wrongdoing in a firm is alleged, what can shareholders do about it? In the US, they may sometimes take action against the directors personally through the courts. In the case of Compaq, shareholders have issued a writ against both the company and some of its officers.

If a similar situation were to arise in the UK, there might be an investigation to ascertain whether the criminal offence of insider dealing under the Criminal Justice Act 1993 had been committed. Inside information as defined in law is any undisclosed information which is specific and relates to particular shares and which, if made public, would affect the price of them. This arises if an individual in possession of price-sensitive data encourages others to deal, or passes information to a third party about a company listed on a regulated securities market.

Individuals who believe they have been financially injured as a result of insider dealing can go to the Department of Trade and Industry (DTI), which investigates and decides whether or not to prosecute. Many referrals to the DTI come from the Stock Exchange itself, supervised by the Financial Services Authority (FSA), which investigates all transactions where sharp movements in share prices occur.

A director found guilty of the offence can be subject to an unlimited fine and/or imprisonment of up to seven years. Although seeing a director go to jail or, more likely, pay a fine may be satisfying, the shareholder who has suffered loss cannot claim damages under the Criminal Justice Act.

Although a Financial Services Bill giving regulatory powers to the FSA is at the consultation stage, it is unlikely to gain Royal Assent until next year. Until it becomes law, a claim for compensation as the victim of a criminal offence under the Criminal Courts Act 1973 could be one of the only avenues open for an investor seeking financial recompense.

Companies listed on the London Stock Exchange must require their directors to comply with minimum standards for share dealings, known as the model code, a set of rules for when directors may and may not deal in shares of their company. Directors cannot buy or sell shares in closed periods - the two months before the announcement of its annual, half-yearly and quarterly financial results. Nor may they, or any employee, deal at any time when in possession of price-sensitive information. The prohibition on dealing also applies to dealings by persons connected to the director, such as family members, trusts and other companies in which the director has an interest.

If a company breaches the model code, the Quotations Committee of the London Stock Exchange can censure the directors, publicly state that if they remain in office it would be prejudicial to the interests of investors, and even suspend or cancel the listing of the company's shares. Shareholders cannot, however, seek damages.

Under common law, a director owes duties to his company, including the obligation not to use inside information relating to it for his own profit and a duty always to act in the best interests of the company. The law imposes a trust on profit derived from the misuse of inside information and the wrongdoer can be ordered to repay all such profit back to the company.

This applies to all confidential information that a director obtains by virtue of his position as a director. This would certainly cover the undisclosed Compaq information where presumably only the top management would have known about the slowdown in sales.

Minority shareholders can sue the directors on behalf of the company, alleging the directors have breached their common law and fiduciary duties to the business. Any remedies awarded are for the benefit of the company.

But an individual victim of insider dealing is unable to claim damages directly from the director, except in wholly exceptional circumstances.

Under English law, a director does not owe a duty of good faith and fair disclosure to an individual shareholder. He does not, therefore, owe such duties to an individual with whom he happens to deal, but who is not a shareholder. The director must not deliberately mislead the purchaser of his shares, but silence does not constitute a misrepresentation.

Shareholders have no power to force the DTI or the Stock Exchange to take action, but they can take matters into their own hands. Shareholders holding more than 50 per cent of the issued share capital are always able to remove one or more board members, although the procedure may be lengthy if the directors refuse to go quietly.

Another option is to bring an action under Section 459 of the Companies Act 1985. Any member of a company can allege that the affairs of the company are being conducted in a manner which is unfairly prejudicial to the interests of its members generally, or to some of its members in particular.

Section 459 actions cover a wide variety of wrongdoings, including past actions of directors - but they can be costly and are seldom successful.

If such an action does succeed, the courts have very wide discretion as to the remedies they can grant, including the purchase of the minority shareholder's shares by the wrongdoer.

Shareholders may also petition the court under the Insolvency Act 1986 to wind up the company on the grounds that it is just and equitable to do so, although the circumstances would have to be exceptional to justify such a course.

But shareholders have to actually know about a wrongdoing before they can take any action in respect of it. Directors have a duty to disclose their interest in shares under the Companies Act 1985. This covers interests held by their family, businesses in which they are interested, or trusts of which they or their family are beneficiaries.

A record of these interests must be kept in the register of directors' interests, which is part of the statutory books of the business and which all shareholders are entitled to inspect. So get checking.

Managing directors

It is fair to say that most directors, at least of listed companies, strive to uphold the highest ethical standards in relation to the affairs of their companies. In respect of the small minority for whom this cannot be said, it is evident that, under the law as it presently stands, prevention is better than cure.

Although there is no absolute defence against a rogue director, as shareholders begin to shake off their traditional apathy and begin to question the actions of their directors, directors will begin to realise that the boundaries of what they are able to get away with are shrinking rapidly.

But until that Utopia arrives, there are bound to be more headlines detailing dubious dealings. It is up to the government to ensure that those it is encouraging to invest in shares are adequately protected by the law.