Financial Services: Trading flaw
12 November 2007
The perception held by some in the 1970s that insider dealing was nothing more than 'being something in the City' appears astonishing in today's terms. Indeed, even in the 1970s when insider dealing was not yet a statutory offence, that view was on the losing side of the argument. The Companies Act 1980, the predecessor to the current provisions in Part V of the Criminal Justice Act 1993, eventually criminalised insider dealing.
Almost a quarter of a century on, how many insider dealers really think they are committing a crime at all? And of that small number, what tiny fraction fear prosecution? Also, how are insider dealing and other market abuses being pursued by the Financial Services Authority (FSA)?
Civil market abuse
The FSA can pursue market abuse cases in three ways: through its civil market abuse regime, administrative action (against regulated persons only) and prosecution for criminal market abuse.
The civil market abuse regime was brought into effect by Financial Services and Markets Act 2000 (FSMA). It was amended by the UK's implementation of the Market Abuse Directive (MAD), which (largely) took effect on 1 July 2005.
Section 118 of the FSMA sets out the various 'limbs' of behaviour considered market abuse. This includes insider dealing, improper disclosure, the misuse of information, manipulating transactions, manipulating devices, the dissemination of information that gives or is likely to give a false or misleading impression, and misleading behaviour.
Section 118(2) of the FSMA defines insider dealing as behaviour where an insider deals or attempts to deal in a qualifying investment or related investment on the basis of insider information relating to the investment in question.
Sanctions for market abuse include financial penalties, which have ranged from £1,000 to £17m, and public censure. Recent changes to the FSA Handbook, including the replacement of the Enforcement Manual by a Decision, Procedure and Penalties Manual and a new Enforcement Guide, attempt to clarify how the process works. It sets out the process by which a firm or individual may come to a settlement with the FSA.
There are those who have criticised the FSA for using the expediencies of the civil regime to navigate around the risks associated with a high-profile prosecution.
Individuals who are not regulated persons under the FSMA can be pursued. In 2004, the FSA fined oil giant Shell £17m for making misleading statements in relation to its proved reserves of oil. The civil regime, as such, sits neatly between the criminal and purely administrative processes also available to the FSA.
Administrative action is limited to action against regulated individuals for a breach of the FSA's rules, including breaches of the FSA's High Level Standards. Such actions often go hand in hand with civil market abuse cases: both go through the FSA's decision procedure and the penalties are the same. More principle-based regulation has seen an increasing number of cases based on breaches of the FSA's Statement of Principles for Approved Persons and its Principles for Businesses.
One case in point is Jabre v FSA (2006). Philippe Jabre, a senior trader at the hedge fund manager GLG Partners, was 'well crossed' as part of the pre-marketing for a new issue of convertible preference shares by a bank. He was given confidential information and was restricted from dealing in that bank's securities until the new issue was announced. Jabre ignored this restriction by short-selling $16m (£7.68m) of the bank's ordinary shares.
When the new issue was announced Jabre made a substantial profit for a GLG fund. Jabre and GLG were fined £750,000 each. Jabre was found to have committed market abuse for the purposes of Section 118 of the FSMA and also breached Principle 2 (Due Skill, Care and Diligence) and Principle 3 (Market Conduct) of the FSA's Statement of Principles.
Criminal market abuse
It is an offence for an individual who has information as an insider to deal in securities on a regulated market that are price-sensitive in relation to that information. It is also an offence to encourage another person to deal in such securities or disclose the inside information. The FSMA criminalises misleading statements and practices. The offences carry a maximum of seven years' imprisonment and unlimited fines.
Criminal and civil market abuse share broadly the same elements. It is also notable that there is little practical difference in the standard of proof between civil and criminal market abuse. In Parker v FSA (2006) the Financial Services and Markets Tribunal confirmed that in cases where the charge is a grave one, such as insider dealing, "it is difficult to draw a meaningful distinction" between the civil and criminal standard that the FSA must meet.
The FSA inherited its criminal powers of sanction on its inception in 2000. Only one case has ever been prosecuted by the FSA. In R v Rigby, Bailey and Rowley (2005) the first two defendants, both directors of call-centre software firm AIT, had issued a statement to the market saying that the turnover and profit of the company were in line with expectations. The turnover and profit took account of contracts that did not exist.
Both were found guilty of recklessly making a misleading statement to the market under the FSMA, and received custodial sentences of 18 months and nine months respectively (reduced on appeal). It is notable that the jury did not convict the defendants of the more serious charge of knowingly making misleading statements.
How is the hit rate in the criminal court so low? Why has the FSA not pursued more criminal market abuse cases? The problem predates the FSA. Between 1986 and 1997, just 30 prosecutions resulted in only 13 successful convictions. Howard Davies, former chairman of the FSA, said in 1999: "Perhaps London's markets have been perfectly clean throughout this period. I beg leave to doubt it."
The systemic risks of trying to prosecute such cases have been often cited. Piecing together an insider trading case can be complex and it is rare to find a 'smoking gun'. The prosecution must rely on circumstantial evidence to satisfy the burden of proof. It is quite common, for example, for traders to come up with a not implausible alternative rationale for their trading patterns. Persuading a lay jury of the elements of insider dealing is fraught with difficulty.
The FSA has also bemoaned its lack of powers in comparison with its US counterpart, the Securities and Exchange Commission (SEC). The SEC and Department of Justice can plea bargain with key witnesses and offer immunity from prosecution with the benefit of clear statutory guidelines. It is therefore perhaps of little surprise that the FSA has pursued all but one market abuse matter under the civil and administrative processes. The risk of failure has, perhaps, been too great. But that may be changing.
Time for action
Recent thematic work by the FSA on market cleanliness (Occasional Paper 25, 2007) looked at the extent to which share prices move ahead of significant regulatory announcements.
The 'informed price movement' ahead of such announcements was present in 42 of 177 takeovers in 2005 (23.7 per cent). In 2004 it was as high as 32 per cent. In light of such findings it is apparent that the FSA is looking increasingly to the Enforcement Division, and its director Margaret Cole, to apply the 'fear factor'.
There is every reason to believe that there has been a sea change in the regulator's approach to holding insider dealers and others to account through the criminal courts: it may yet prove a crime to be something in the City.
Richard Lissack QC and Farhaz Khan are barristers at Outer Temple Chambers