Donald Lai ACG ACS, Solicitor, CPA, reviews the first unsuccessful attempt to apply the ‘mosaic theory’ defence in an insider dealing case in Hong Kong.

The decision of the Market Misconduct Tribunal (MMT) in the insider dealing case relating to Meadville Holdings Ltd (Meadville) in February 2021 should prompt governance professionals to strengthen internal controls relating to insider dealing. The case marked the first unsuccessful attempt to apply mosaic theory (see ‘Mosaic theory’ section below) to defend an insider dealing case in Hong Kong.  

Case background

The former Chairman and Executive Director of Meadville, Tang Chung Yen Tom (Tang), was in an intimate relationship with Li Yik Shuen (Li) at the material time. In July 2009, Meadville planned to sell its principal business to a US-listed company. The negotiations continued until October 2009. Based on the agreement, the shareholders of Meadville would receive a dividend of HK$3.40 per share. On 23 October 2009, the agreement was passed at a Meadville board meeting chaired by Tang.

From 23 to 28 October 2009, Li spent HK$5.95 million to acquire about 2 million shares in Meadville at a price range of HK$2.57 to HK$2.79. Trading in Meadville shares was suspended from 30 October to 16 November 2009, pending an inside information announcement about the business sale and the dividend. The trading resumed on 17 November 2009 after Meadville announced the inside information. Li sold all her shares at the price range of HK$3 to HK$3.13 and earned about HK$550,000.

Knowledge of inside information

Li came to possess inside information by piecing together information she received from Tang. After accidentally spotting Tang on the news in the Mainland, she looked into his background. Tang mentioned to her that he was busy at work and had meetings with foreigners. He also said that he had to visit a factory in Dongguan and visit the US for business meetings. Li collated the information and concluded that a possible acquisition of Meadville by a US-listed company was imminent. She bought Meadville’s shares before the details of the acquisition were announced.  

The MMT found that there was no direct evidence of Li possessing inside information. Tang did not directly communicate the details of the acquisition to her, but she had been able to collate the information from incidental disclosures he made. The MMT ruled that Tang was the only source of Li’s inside information and, as such, it ruled that Li had committed insider dealing. 

Concerning Tang, the MMT held that he did not commit any market misconduct as he did not know, and did not have a reasonable cause to believe, that Li was dealing in Meadville shares. The MMT found that Tang was unaware that Li had purchased Meadville shares after a boyfriend in the Mainland had remitted about HK$5 million to finance her share purchase.     

Mosaic theory

Mosaic theory permits financial analysts to draw significant conclusions from the analysis of public and non-material, non-public information even if those conclusions would have been material inside information had they been communicated directly to the analyst by a company. 

Free flow of information is essential for financial analysts to form an independent, informed investment decision. The US Supreme Court acknowledges the US Securities and Exchange Commission (SEC) view that analysts’ initiatives to ‘ferret out and analyse information’ significantly enhances market efficiency, thus benefiting all investors (Dirks v. SEC (1983) 463 U.S. 646, 658). Moreover, the CFA Institute, the professional body of financial analysts, recognises mosaic theory as a valid method of analysis in its Standards of Practice Handbook. On this basis, analysts can expect to escape prosecution for insider dealing if they only make ‘informed guesses’ of inside information based on non-material, non-public information.  

Nevertheless, the application of mosaic theory as a defence in insider dealing cases has been at best uncertain. Before the Meadville case, Hong Kong had no precedent in applying mosaic theory to insider dealing, but the US case law may be a helpful reference. In the Galleon Group case in 2011, Raj Rajaratnam, a hedge fund manager, tapped into his network of friends and close business associates to obtain insider tips and confidential information. Mr Rajaratnam tried to use the mosaic theory defence and claimed that the fragments of information he received did not affect his trading decision, but he was found guilty and sentenced to 11 years of imprisonment (United States v Rajaratnam, 09 Cr.1184 (RJH) (SDNY 29 November 2010). 

A different outcome resulted in the Steffes case in 2014. Steffes and other defendants were employees of a railway company that was about to be sold. Before the acquisition, the employees noticed sudden visits to their office by people in business suits, unusual information requests from management and surprising numbers of railway tours. On the basis of these observations, they surmised that an acquisition was imminent. They purchased the company’s shares and call options and sold all securities after the acquisition was finalised, realising a profit of about US$1.6 million. The SEC charged the employees with insider dealing, but they were acquitted after a jury trial (SEC v. Steffes, Case No. 1:10-cv-06266 (N.D. Ill. Verdict 27 January, 2014)). 

The Meadville case leaned more on the Galleon Group case than the Steffes case. Li pieced together public information, such as Tang’s identity and position in Meadville, and non-material, non-public information, such as Tang’s business schedules, to arrive at the inside information. Unlike the Steffes case, Li was never an insider of Meadville. She was not justified to gather the information in the first place. She obtained confidential information from Tang through an extramarital relationship, just as Mr Rajaratnam had acquired inside information from his network. Moreover, Li was not a business analyst. Her trading was purely for personal gain and did not enhance market efficiency. All these factors invalidated mosaic theory as a defence to her insider dealing charge, but the MMT did not enter into a detailed discussion of the validity of mosaic theory in Hong Kong. 

The implications

The Meadville case demonstrates that the circulation of inside information is not exclusively about what goes on in the office during office hours. An insider might not obtain the full details of the inside information from senior executives, but may instead exploit inadvertent disclosures of senior executives’ scheduled meetings and whereabouts to deduce the inside information. 

Moreover, while senior executives like Tang may not breach insider dealing provisions for the lack of mens rea, they will expose their corporations to high legal costs, and stress to handle the ongoing investigation and legal proceedings. When senior executives’ private lives are exposed and intertwined with insider dealing, they also attract reputational risks to themselves and their corporations. 

In this context, governance professionals should remind senior executives to be mindful of the potential damage their private lives may cause in scenarios like the Meadville case. While it is unrealistic to require senior executives to live a Puritan life, they should be careful not to divulge business matters, no matter how trivial, to anyone outside the corporation. In addition, governance professionals should arrange training sessions to enhance senior executives’ awareness of inside information disclosure risks. The corporation should also set a clear policy and procedures on public disclosure of corporate actions. 

Donald Lai ACG ACS

Solicitor, CPA

Donald Lai is a securities law specialist and a CSj contributor. His previous article – Working from home? – was published in the September 2020 edition of this journal.