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      • 2007

Speech by Margaret Cole, Director of Enforcment, FSA
London School of Economics
17 March 2007

I was delighted to accept the invitation to lead a discussion this evening about insider dealing and the regulatory response, including the FSA's expectations of market participants and the challenges we face in taking action for insider dealing offences. I have been told that the intention for this evening is that it will follow a fairly 'cerebral' format. Academic debate on this subject is important and I am hoping that tonight's discussion will throw up a lot of interesting ideas. However, I must warn you from the off that I am a practitioner at heart and you will notice that I favour real life practicalities and outcomes.

This discussion is very timely given the occasional paper that the FSA published last week, reporting on the FSA's work to develop a measure of market cleanliness.

That, of course, attracted a lot of press attention. Here are a few headlines:

"FSA needs big scalps to stop insider dealing"

"Sadly we can do sweet FSA about insider dealing"

"Fear of firm enforcement will help clean the City"

It was heartening to note that some of the media analysis went a little further than the headlines and recognised some of the challenges that we face in bringing criminal prosecutions for insider trading. A question for discussion tonight – what more practical steps can we take to enhance the "fear factor"?

The prevalence of insider dealing puts two of the FSA's statutory objectives at risk. First, the reduction of financial crime; reducing the extent to which it is possible for a business to be used for a purpose connected with financial crime. Second, market confidence; maintaining confidence in the financial system.

Not surprisingly, the FSA's – and indeed the UK's – record in bringing successful criminal prosecutions in this area is often compared to that of the United States. And I am sure that we have many things that we can learn from our American counterparts, but they too acknowledge the monumental task that law enforcement agencies face in bringing criminal prosecutions. Last year Linda Thomsen, Director of the Enforcement Division at the US Securities & Exchange Commission, commented that "it is important to understand how difficult it is to build an insider trading case. They are, unquestionably, amongst the most difficult cases we are called upon to prove, and despite careful and time-consuming investigations, we may not be able to establish all of the facts necessary to support an insider trading charge."

As both the SEC and we know "piecing together an insider trading case can be a complex, painstaking process. It is rare to find a "smoking gun;" virtually all insider trading cases hinge on circumstantial evidence. It is quite common for insider traders to come up with alternative rationales for their trading strategies that the staff must refute with inferences drawn from the timing of trades, the movement of funds and other facts and circumstances."

I hope that we can use this evening to discuss some of the challenges that we face when bringing criminal proceedings but it is important that we have this debate in context. The FSA has wide powers and the options open to us for dealing with poor market conduct by institutions and individuals are not limited to criminal sanctions – we also have punitive and extensive civil and regulatory powers which we aim to use strategically to achieve effective deterrence.

Those who have heard me speak before or have read some of the FSA's literature know that the FSA's aim in the markets is to deter wrongful behaviour. Appropriate enforcement activity that sends out strong messages is an important part of our strategy. But we also put significant emphasis on non-enforcement options, such as pro-active surveillance of likely 'hot spots', up to date transaction analysis systems and industry cooperation to ensure a steady flow of information. We take the view that prevention is better than cure.

Our view is that although the majority of individuals and institutions using the financial markets adhere to high standards, there are some who do not. This raises the costs for all market participants – unfair markets are inefficient ones.

There is a significant volume of academic material on the rationale for prohibiting insider dealing. The key points are that insider dealing:

• impairs the allocative efficiency of the financial markets; reduces market liquidity and increases the cost of capital. If a stock market is functioning efficiently, the share prices should reflect all available information and so provide reliable signals upon which investment decisions are based;
• it jeopardises the development of fair and orderly markets and in doing so it undermines investor confidence. It can threaten to harm confidence by undermining investors' beliefs that the market is fair, leading them to withdraw their investment;
• it is immoral by being inherently unfair on the basis of inequality of access to information;
• it is contrary to good business ethics;
• it damages companies and their shareholders/investors; and
• more recent US cases have emphasised the breach of fiduciary duty by employees using privileged information that belongs to a firm.

It has taken a while to reach this agreed view.

Insider dealing has only been a criminal offence in the UK since 1980. Prior to the FSA assuming its responsibilities in 2001, bodies such as the SFO and DTI had lead responsibility for pursuing insider dealing in the UK. It achieved particular notoriety in the 1980's with the arrest and prosecution of several leading bankers, arbitrageurs, brokers and lawyers in the Ivan Boesky affair in the United States.

Steps to introduce legislation took a number of years – up to the end of the World War II the buying and selling of stocks and shares in a company on the basis of information known only to the company or its directors, officers and advisors was considered legitimate and widespread. Between the end of the World War II and the late 1950's it began to be considered unethical to make private profits at the expense of the main body of shareholders but in the 1960's and early 1970's the practice became widespread once more, often using knowledge of a take over. Insider dealing was even described by the Financial Editor of the Sunday Times in 1973 as the "crime of being something in the City".

In 1973 The Stock Exchange and the Takeover Panel issued a joint statement calling for criminal sanctions. A number of subsequent attempts to pass legislation through Parliament were aborted, but on 23 June 1980, sections 69-73, Part V of the Companies Act 1980 came into force and made insider dealing a criminal offence in certain specified circumstances. These provisions were subsequently consolidated as the Company Securities (Insider Dealing) Act 1985, and amended by the Financial Services Act 1986.

The impetus for further reform came from within the European Community when in 1989, the Council of the EC agreed on a Directive to co-ordinate regulations on insider dealing. Implementation of the Directive in the UK resulted in Part V of the Criminal Justice Act 1993 being brought into force on 1 March 1994.

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History has shown that it has been extremely difficult to prosecute cases of insider dealing successfully under the criminal law. In addition, pre-2001 activities that fell short of criminal behaviour but still comprised poor market conduct punishable by regulatory authorities, extended only to authorised persons and, in some cases, key employees. The Financial Services & Markets Act 2000 (FSMA) provided the opportunity to establish a single regulator, overhaul and consolidate the UK's financial services law and provide the regulator with enhanced regulatory powers.

FSMA gave the FSA a wide range of rule making, investigatory and enforcement powers and certain important responsibilities, including the ability to take action to prevent market abuse and to prosecute offenders for insider dealing. The FSA was provided with the power to take action for market misconduct under section 118 of FSMA against the backdrop of very few successful criminal prosecutions. It was anticipated that a civil process with the accompanying benefits like a civil burden of proof, a jury not being required, the ability to settle, a quicker process with non-custodial outcomes and the ability to have a specialist Tribunal for difficult issues of fact and law would result in more successful actions against insider dealing. The FSA was also provided with the ability to take action for breaches of the FSA's Principles for Business , particularly Principle 3 – management and control – and Principle 5 – market conduct. Breaches of section 118 and the FSA's Principles permits the FSA to impose a wide range of sanctions like financial penalties, banning individuals from the industry and removing or restricting authorised activities.

The Market Abuse Directive came into force, largely, in July 2005. The MAD provisions were similar to those in the existing market abuse regime. The FSA's Code of Market Conduct – which was published in its original form nearly five years ago – sets out in detail the standards that should be observed by everyone who uses the UK's key financial markets, whether they are trading in the UK or from overseas. In particular it makes clear the standards we expect to see maintained through its descriptions of what is and is not market abuse. The Code brings transparency to all market users and lets everyone know what standards can be expected when dealing on UK markets.

The FSA is not an enforcement led regulator, but aims to maintain clean markets and deter abuse through a combination of enforcement action and preventative measures. We have invested heavily in upgrading the FSA's securities transactions monitoring system, which will improve our ability to detect and pursue market abuse. We also have a programme of thematic work and have stepped up our interactions with industry to encourage them to engage with the FSA.

Last year we conducted several thematic reviews – as part of our overall strategy to combat market abuse – focussing on institutions and visited participants in the debt, loan and credit markets. We now have a better understanding of these markets and have enhanced our approach to monitoring them, which is now on a more proactive basis. For example, following a significant regulatory news announcements by companies, we will review for potential suspicious credit default swap trades. With the ever increasing activity in the credit markets, we have been encouraging firms to report as much detail as possible when they report a suspicious credit default swap transaction.

Now, to return to my contribution to the more academic side of the debate – and the headlines that our recent market cleanliness report has generated. This work was motivated by the FSA's commitment to evaluate its overall performance – we want to be able to assess the impact of regulatory requirements on market practice. As I mentioned above, the regulatory response, whether that be using the enforcement tool or not, is about achieving changes in behaviour.

The methodology measures market cleanliness by looking at the extent to which share prices move ahead of significant, potentially price sensitive, regulatory announcements that companies are required to make to the market. This analysis was conducted for two types of statements – trading statements made by FTSE 350 issuers and Public take-over announcements related to UK companies.

The figures for FTSE 350 show a marked improvement in the level of untoward activity down from 19.6% in the period 1998-2000, to 11.1% in 2002/03 to only 2.0% in 2004/05. However, although the figures show that there is an improving trend there is still a lot of work to be done on mergers and acquisitions activity – for takeover announcements the figures were 32.4% in 2004 to 24% in 2000. The latest figures for 2005 are 23.7%.

Such activity is currently the focus of intensive work by the FSA's Markets Division in consultation with the Panel on Takeovers & Mergers – whilst I am sure that it would be difficult to argue that any level of leakage is acceptable, we consider that this apparent prevalence of leakage of insider information is too high for comfort. We are considering how to tackle this problem by examining the chain of inside information during a takeover, speaking to both regulated and non-regulated parties. We intend to feedback to the industry later this year but it is already clear that the risk of leakage is heightened by the way transactions are conducted and the number of people involved in the process. For example, in a recent investigation we were provided with an insiders list of over two thousand names. Lists, and indeed the transactions to which they relate, often include multiple parties and numerous advisors; this inevitably increases the risk of information leakage.

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Before I come onto the role of targeted enforcement activity in maintaining the integrity of the markets, I want to pause on another important point. It is not just the FSA's responsibility to ensure clean markets. We all benefit from having clean, efficient and fair markets, therefore all market participants need to play their part. Last year we were explicit in our expectations of market participants:

1. firms need to manage conflicts of interest properly. The investment banking model contains inherent conflicts of interests and we have made it clear that the industry should recognise the need to address the concerns of the regulators and the public. Of course, having a conflict is not the same as abusing it but the onus is on firms to demonstrate that they are actively identifying their conflicts and that they are being managed. We also have an eye to proprietary trading. If investment banks continue to make money from buying and selling securities for their own account rather than from traditional investment banking activities, there is a higher potential for conflicts of interest to arise.
2. Firms need to comply with their obligation under the Market Abuse Directive to provide us with suspicious transactions reports. A big change that came about as a result of MAD, was the introduction of the requirement to report transactions suspected of constituting market abuse to the relevant authority. Suspicious Transactions Reports (STRs) now play a key part in the FSA's market abuse monitoring regime: we had 336 from July 2005 to February 2007. Over 95% of the STRs we receive relate to insider dealing and are primarily in equity markets.
3. We have also stressed the need for firms to self report if they uncover wrongdoing by their employees. If a firm has good systems and controls and can demonstrate that it is complying with them, we will not pursue the firm in an enforcement action if an employee recklessly circumvents them. Instead we will pursue the individual. We also urge firms to bring to our attention any examples of significant misbehaviour by other market participants they come across. We believe that the firms, as participants in the markets day-in-day-out are in a good position to identify suspicions. It is important that tackling market abuse should not be seen as the job of the FSA alone – the full engagement of the industry is essential if we are to be successful in this task.

Having said all that, we recognise that enforcement activity can change behaviour and we will not shy away from taking enforcement action to support our strategic priorities. Since 2001, the FSA has issued Final Notices against 8 firms and 15 individuals for market conduct related offences. As I mentioned earlier, these include cases where we have found breaches of the FSA's Principles for Businesses. In line with our strategy, the most recent cases are ones involving institutions and their employees – such as GLG and Deutsche Bank – and have involved higher financial penalties.

Where Enforcement is the right tool, we will continue to use all the options at our disposal, by which I mean the administrative route under section 118 of FSMA, criminal prosecutions under the CJA, and the use of the FSA's Principles for Business.

We have already used our criminal powers for offences on our markets – that was in 2005 when we successfully prosecuted Directors of the AIT Group, for 'criminal market abuse' (making false and misleading statements in violation of section 397 of FSMA).

We have also been successful in the use of our other powers. Recently we obtained an injunction against two individuals to restrain the proceeds of suspected market abuse. One of the individuals concerned was an insider to an impending takeover announcement. The other, traded ahead of the announcement and it appears that trading may have been on the basis of inside information improperly disclosed to him. The individuals concerned made a substantial profit. This is the first time the FSA has obtained an asset freezing injunction under FSMA in respect of the proceeds of suspected market abuse.

We are making a real impact in punishing the types of market conduct which are not acceptable and serving notice to the market. We may not yet have initiated any proceedings for insider dealing under the Criminal Justice Act but, as I mentioned, we have taken action under section 118 and the FSA's Principles for Business. I would like to mention a couple of them here.

The FSA's case against GLG and Philippe Jabre was a highly publicised one and important for a number of reasons. It concerned a large institution – and is therefore in line with our strategic priorities. In this case the Financial Services & Markets Tribunal also made some important decisions about their jurisdiction and scope of market misconduct. The Tribunal concluded that it was open to it to impose a different and greater sanction than that imposed by the FSA's Regulatory Decisions Committee in its original decision. It was also made clear that it is not possible for someone with confidential information on a UK traded stock to circumvent the market abuse regime by trading in that stock on an overseas exchange. Both GLG and Jabre were fined £750,000 each for market abuse under section 118 of FSMA and breaches of the FSA's Principles.

In November we fined Sean Pignatelli for breaching Principles 2 and 3 for failing to exercise due skill, care and diligence and failing to observe proper standards of market misconduct when carrying out his role. Mr Pignatelli, an equity salesman at CSFB, had received an analyst's email which was worded in such a way as to appear as though it might have contained inside information. Despite the warning signals, Mr Pignatelli did not discuss the email with his senior manager or Compliance and in fact, he then proceeded to embark on a series of calls to clients passing on the information and giving the impression that it was inside information, when in fact it was not. A number of clients traded on receipt of the information.

This was the first reported case of something termed by the media as “outsider dealing” and had a big market impact. It emphasised the care and attention that Approved Persons must give to the information they disseminate to the market. Feedback from firms suggests that this case has really hit home with traders who are asking compliance lots of questions about what is or is not acceptable. We are pursuing a number of similar offences in current investigations.

There are a variety of reasons for regulatory cases making up such a large majority of our cases, but I consider that the main reasons are the greater scope they offer for establishing breaches, the on-the-face-of-it lower evidential standards that apply and the consequent lower (but definitely not low) litigation risk they involve and the greater prospect of settlement they hold out. Achieving early settlement is in the public interest and allows the FSA to facilitate prompt redress and achieve swift and effective outcomes so that we can utilise our resource more efficiently and move on to the next important issue.

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Whilst it was intended that the civil process would facilitate more outcomes, a number of concessions were made to the Financial Services and Markets Bill as it passed through Parliament in order to accommodated ECHR concerns. For example, not being able to use compelled evidence against subjects. The Tribunal has also made it clear that it expects the standard of proof in such cases to be very high and as a result there are, arguably, very few practical differences between the standard of proof expected in civil and criminal market misconduct cases.

There are many differences between the civil/administrative and criminal regimes. I thought it might be helpful if I briefly outlined the key challenges that we face in prosecuting insider dealing under the Criminal Justice Act.

The nature of the legislation creates a number of particular challenges to presenting a case of insider dealing before a jury. The experience of the past suggests that the difficulties in insider dealing prosecutions lie in establishing that someone did indeed possess inside information , establishing that the person knew it was inside information and traded on that basis.

In the Consultative document preceding the legislation, the Government stated it would be inappropriate to impose criminal penalties if the individual did not realise that the information he had was inside information. This is something which can be very difficult to establish, for example in the face of a defendant who states that he was simply fortunate in the timing of his dealing.

For example in R v Holyoak, Hill and Morl the prosecution failed to establish that the three accused knew the information to be unpublished price-sensitive information when they dealt in a take-over target's shares seven minutes before a take-over deal was announced. They sold the shares the next day making a profit of £13,000. They were the employees of the accountancy firm who were advisors to the bidders. They said that they thought the take-over was public knowledge when they dealt.

In the majority of cases the prosecution will be unable to obtain direct evidence that a person possessed inside information and knew that it was information of that nature. The best that the prosecution can expect is to be able to invite the jury to infer proof of these elements from the circumstances: the fortuitousness of the timing, an unusually large purchase (or short-selling), the fact that the defendant had never traded in that stock or even market sector before, perhaps even some timely contact with a person who may have been in a position to pass-on price sensitive information.

However, persuading a jury that they can be satisfied to the criminal standard that they are clear beyond a reasonable doubt of such guilty knowledge, even on the strongest circumstantial evidence, is likely to be extremely difficult (as in Holyoak above).

Besides the difficulty of proving the elements of insider dealing, the practical challenges of presenting complex insider dealing cases to a jury are immense.

Insider dealing may have been conducted by a number of defendants, involved multiple trades over a number of months and have been of a sophisticated nature. The trading may have been conducted through a number of accounts and attempts made to obfuscate the distribution of proceeds. The investigation into such activities increasingly involves a number of foreign jurisdictions.

Also, we are obliged to prove that the information was price sensitive which involves expert testimony. It can be difficult to obtain experts willing to testify and there is the risk of losing the jury as the evidence becomes more technical. It is also open to the defendant to claim that they would have traded anyway i.e. that their trade was not dependent on the information.

The result is that jurors may be faced with lengthy trials, involving complex and often tedious evidence against a background of financial markets and practices where their understanding is dependent upon expert testimony. A real risk in such cases is that what may be obvious to the relatively sophisticated observer will become lost or obscured to a less sophisticated panel of jurors in the course of a long trial dealing with technical and often tedious detail.

It is when these considerations are added to the particular evidential challenges unique to insider dealing that the true extent of the challenges of prosecuting such cases becomes fully apparent.

I mentioned earlier that we are often compared with the US experience. How do they do things differently? Probably the single biggest difference is the ability to plea bargain. This, without a doubt, enables more effective prosecutions in front of juries. Historically we have not thought it is appropriate in the UK but it is an area that is very much under consideration.

Having said that, these difficulties will not prevent us from bringing criminal cases. I have already said that we intend to use all the options at our disposal to fight market abuse. However, we do intend to be appropriately considered in our decision making about when and how we pursue cases, whether by the criminal or the administrative route.

It is important to remember that fighting market abuse is not just about making headlines by getting big scalps and imposing big fines – it has to be a collaborative effort with the market and we are keen to be on the front foot when it comes to monitoring the markets, conducting thematic visits and setting standards for the level of conduct we expect in the markets.

The FSA has very wide responsibilities and limited resources and we take a risk-based and strategic approach to applying our resources in enforcement cases. We will continue to use enforcement to support our market abuse strategy by focussing on market misconduct by institutions and senior management. We will continue to seek increased financial penalties in market misconduct cases – as demonstrated in our recent cases – in order to deter poor market conduct and improve market cleanliness.

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