Using financial incentives and income contingent penalties to detect and punish collusion and insider trading.

• Jurisdiction: Australia
• Date: 01 April 2005
• Author: Chapman, Bruce,Denniss, Richard
• Published date: 01 April 2005
• Author: Chapman, Bruce

Collusion and insider trading, being white collar crimes, are often characterised as being victimless crimes. The absence of identifiable victims makes the detection of these crimes particularly difficult. This paper proposes that, in order to increase the flow of information about collusion and insider trading, parties engaged in these crimes should be offered financial incentives to provide evidence against their co-conspirators. In order to provide greater certainty that rewards will be paid, and also to increase the probability that any fines are paid, it is also proposed that an income-contingent fine collection mechanism be utilised. The paper presents two case studies to illustrate how the fine collection mechanism could be used.

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Collusion and insider trading, being white collar crimes, are often characterised as victimless crimes. However, despite what the name suggests, such victimless crimes impose large costs on individuals and the economy. They are only victimless to the extent that those harmed by crimes such as collusion and insider trading are often unaware that they have been victimised. The absence of identifiable victims makes the detection of collusion and insider trading much more difficult. As the Australian Competition and Consumer Commission (ACCC) has stated, 'Collusion is extremely harmful to both businesses customers and consumers. The gains can be large and difficult to detect. The incentives for collusion are high in important areas of the modem economy' (ACCC, 2002, p.8). Similarly, the US Securities and Exchange Commission has stated that '[b]ecause insider trading undermines investor confidence in the fairness and integrity of the securities markets, the Commission has treated the detection and prosecution of insider-trading violations as one of its enforcement priorities' (USSEC, 2003).

This paper outlines a new approach to both detecting and punishing the crimes of insider trading and collusion. The paper proposes that financial incentives be offered to individuals or firms participating in illegal activity in return for the provision of evidence against other participants. In order to ensure that large incentives can be offered, and large fines levied, it is also proposed that a revenue-contingent payment mechanism be utilised to extract both incentive payments and fines from firms and individuals convicted of these offences. The use of a revenue-contingent penalty payment increases the certainty of collecting penalties while reducing the incentive for recourse to bankruptcy.

The paper is structured as follows. Section 2 outlines the dimensions of the problems of collusion and insider trading. Sections 3 and 4 provide more detail on the nature of collusion and insider trading. Section 5 provides a discussion of the reform proposal and Section 6 provides a more detailed discussion of the income-contingent collection mechanism. Section 7 provides an overview of the role of incentives to report criminal conduct. Sections 8 and 9 provide worked examples of how the scheme might work in practice, while Section 10 provides some concluding remarks.

The Dimensions of the Problem

Collusion and insider trading impose a wide range of costs on both society and the economy. Both forms of criminal conduct deliver an inequitable distribution of gains and impose a range of negative externalities, such as reduced economic efficiency, reduced faith in the structure of markets and financial costs to governments.

For regulators, a major problem associated with collusion and insider trading is the lack of information available to investigators. Without evidence from participants, the tasks of detecting criminal activity and achieving successful prosecutions are made particularly difficult.

While it is difficult to determine accurately the extent of collusion and insider trading, some estimates are available. In recent years it has been argued that reductions in trade barriers and increased globalisation have resulted in increased collusive activity (ACCC, 2002), with the OECD estimating that the value of commerce affected by collusive conduct in 16 large cartel cases that had been examined was greater than $55 billion (OECD, 2002).

Recent examples of collusion include the following:

* Hoffman La-Roche was fined 462 million € for participation in an international vitamin cartel in 2001.

* Lafarge was fined 250 million € for participating in a cartel in the plasterboard industry in 2002.

* TNT, Mayne Nickless and Ansett Freight express were fined more than A$11 million for cartel behaviour in the Australian freight industry.

* Six UK drug companies engaged in price-fixing of antibiotics are estimated to have cost the public health system 400 million £.

While there have been relatively few prosecutions for insider trading in Australia some researchers have suggested that between 5% and 10% of all trades involve insider information (Richards, 2000). Similarly, a study of Australian executives found that 52% of respondents would be willing to buy shares before their own company made a favourable announcement (Richards, 2000). It would therefore appear that the detection and prosecution of insider trading lags well behind its prevalence.

What is Collusion?

Collusion is defined as an agreement 'between different firms to cooperate by raising prices, dividing markets, or otherwise restraining competition' (Samuelson & Nordhaus, 1987, p. 900). Collusion imposes large, though difficult to quantify, costs on consumers and businesses not involved in the collusive conduct. The result is a mal-distribution of resources and income and a reduction in the allocative efficiency of the economy. Estimates of the impact of collusion on market prices range from 10% in the US (ACCC, 2002, p. 23) to between 15% and 50% (OECD, 2002a, p. 9). The OECD has referred to collusive practices as the most 'egregious violations of competition law' (OECD, 2002, p. 5).

While examples of successful prosecutions for cartel activity can be found it is widely considered that most collusion is undetected. The OECD has stated that:

The challenge in attacking hard-core cartels is to penetrate their cloak of secrecy. To encourage a member of a cartel to confess and implicate its co-conspirators with first hand, direct, 'insider' evidence about their clandestine meetings and communications, an enforcement agency may promise a smaller fine, shorter sentence, less restrictive order, or complete amnesty (OECD, 2002b, p. 7). Detection of collusion is made more difficult because of the absence of an apparent victim. This is further complicated by the difficulty of proving, without access to insider information, that firms suspected of colluding are doing so. In 2001-02 the ACCC received 442 complaints of cartel and price-fixing, of which 61 were investigated. On average, between three and five cases are taken to court each year (ACCC, 2002, p. 24).

The Chairman of the ACCC, Graeme Samuels, has recently described cartels as the 'very worst form of violation of corporation law' and plans to use a leniency policy to encourage executives to 'squeal on their fellow offenders' (cited in Dodd, 2003). The potential for the provision of financial incentives to remove the 'cloak of secrecy' that surrounds collusive conduct is discussed in below.

A Case Study in Collusion

In 1994 TNT Australia Pty Ltd, Ansett Transport Industries (Operations) Pty Ltd, and Mayne Nickless Ltd, as well as a number of individuals, admitted to contravening sections 45 and 45A (1) of the Trade Practices Act 1974 (Cth). They were fined $4,100,000, $900,000 and $6,000,000 respectively.

In summarising the nature of the collusive conduct of the cartel, Justice Burchett stated:

What was alleged, supported by voluminous evidence, and is now admitted, is that at five primary meetings attended by representatives of the three companies, which took place between 1987 and 1990, a series of agreements were reached, as follows: 1. That the companies would not 'poach' each other's customers, by which the admissions of Mayne Nickless Limited specified, and 1 understand the other respondents to have meant, that if one was requested to quote by a customer of another, it would either fail to do so or would submit a quotation above the price charged by the other company, the existing supplier, a practice described as 'giving cover'; 2. That if one received the custom of customers of another, compensation would be made by returning customers of the same value by the process of up-rating them or driving them away by the provision of poor service; 3. That there would be a balancing of accounts of customers lost and gained and payment of compensation; 4. That no quotes would be given to customers of another firm over the telephone; and 5. That uniform prices would be charged for what were referred to as 'air satchels'. Effect was given to these agreements by each of the companies on many occasions. A great number of instances was specified in documents filed in the proceedings.

As a result, between 1987 and mid-1991, the market shares of the companies were systematically protected from the effects of competition, and in particular their ability to set prices in the relevant market, the express freight market, was freed from the constraints of competition. Not only were the arrangements and their objects and consequences in flagrant breach of the obligations imposed on the companies, in the public interest, by law; the means for effecting the intended illegal results were themselves damaging to the public interest in a healthy economy, and were in direct conflict with the fundamental purposes of the Trade Practices Act 1974 (Cth). From the point of view of those purposes, an arrangement to maintain a cartel by deliberately providing poor service in order to compel customers to turn to or return to a supplier with whom they might be dissatisfied must be particularly pernicious...