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Speech by Margaret Cole, Director of Enforcment, FSA
Securities House Compliance Officers Group
29 June 2007

I am delighted to have been asked to speak to you today, in this fantastic location away from the bright lights. My plan is to talk to you about the FSA's strategy for market abuse for about forty minutes and then open it up to questions, and hopefully ideas from you on how to overcome the challenges that we all face in ensuring clean UK markets.

So, why are the FSA (and the press and other commentators) so exercised about the cleanliness of our markets? Well, as you know, we are charged with the responsibility, through our statutory objectives, with maintaining confidence in the financial markets and exchanges. We are also tasked with the responsibility of reducing the extent to which is possible for a business to be used for a purpose connected with financial crime.

There are important synergies between our financial crime objective and our objective to maintain market confidence. We are concerned with three broad areas in financial crime – fraud, money laundering and market abuse – and we work closely with other agencies, particularly law enforcement and other regulators, towards those aims. Clean, fair and efficient markets will provide investors and potential investors with confidence in the integrity and orderly conduct of the market.

We take our responsibilities with respect to market integrity very seriously and we are determined to make inroads into changing behaviour in this difficult area. This subject will remain high on our agenda.

Partnership with industry to tackle market abuse

We believe that most effective strategy for ensuring the integrity of our markets is a partnership approach where both the regulator and market participants work together to help combat market abuse. When I talk about market abuse here, I include all aspects of market misconduct including market manipulation, insider dealing, misuse of information, improper disclosure, distortion and misleading behaviour.

The FSA’s strategy is two-fold. On the one hand we undertake proactive work, largely in conjunction with market participants, which has the aim of preventing market misconduct – and I will expand on this in a moment. On the other hand we use the enforcement tool in a targeted and effective way to deter poor market conduct. Enforcement is used to not just to punish individual wrong-doing but also to send a message to the market about behaviour that falls below the required standards. The aim of publishing enforcement outcomes is to bring about wider change for the better.

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Prevention

Turning first to the prevention element of our strategy. We undertake a number of proactive thematic activities that assess systems and controls in key areas in samples of firms. Our aim is to identify good practices and areas of weakness that we can share with the wider community. We want firms to review their practices against our findings and consider making positive changes to their controls. Our objective is to strengthen systems and controls across the industry and to increase the awareness of potential risks. Ultimately we want to reduce the leakage of inside information, thereby minimising the opportunities for insider dealing and other forms of market abuse, and increasing investor confidence in the UK markets.

The biggest single piece of thematic work undertaken by our Markets Division is a wide ranging review of the controls over inside information in relation to public takeovers. Clearly it is unrealistic to expect there to be no leakage ever, but nonetheless the level of price movements before takeover announcements, (as reported by our recent market cleanliness report), is clearly too high and gives rise to the concern that a significant number of price movements are caused by "informed" trading.

This thematic project was scoped widely, so that, in order to obtain the full picture of the movement of inside information, it went beyond the FSA regulated community to include Public Relation firms, financial printers and lawyers. We selected four deals to help focus our review: three where there had been an unusual degree of price volatility, indicating that there could have been a leak of information, and one where this was not the case before the deal was first announced.

The review had a number of objectives:

• Firstly to increase our understanding about the flow of information in a typical deal and the process by which firms decide who to make insiders. The number of "insiders" on some of these deals is very large – and thus perhaps it is not surprising that there are leaks. In one recent enforcement investigation, we were provided with an insider list of almost 1500 names!
• In common with other thematic reviews, we also want to identify good practices and potential areas of weakness and publish these in order that firms might benchmark themselves against these and look to strengthen their own controls.
• We also want to consider how best to influence controls at those firms who handle inside information but are not regulated by the FSA.
• And, finally, to inform our ongoing market abuse strategy.

More generally, we are taking a step back to consider the causes of leaks in order to reduce the opportunities for insider dealing and enhance investor confidence in the UK. You don’t have long to wait. Our findings from the review will be published next Monday 2 July.

Another area of work, and one which straddles both elements of our strategy, is the Suspicious Transaction Reporting (STR) regime. We have found this to be a very valuable source of information and the STRs play a key part in our market abuse monitoring regime. A review of all the STRs received twelve months into the new regime revealed a number of trends. These included:

• that the majority of the STRs came to us from small to medium sized brokers with only a small handful from the largest firms;
• that the majority were in relation to the equity markets with very few in relation to other products such as commodities or bonds; and
• most related to insider dealing matters with reporting in other areas, such as possible market manipulation, almost non existent.

On the back of this analysis, we undertook a piece of thematic work to assess controls and we published areas for good practice in December last year in the Marketwatch publication. I am pleased to say that we have now had over 400 STRs from 100 firms as compared to 260 from 50 firms at the time of our review. And it is encouraging that most of the STRs have also been of high quality. We have also been receiving more complex STRs in areas such as the credit markets and a greater flow of market intelligence generally where firms see activity by peers that they regard as suspicious. This is all excellent news in terms of the goal of the FSA to increase the partnership approach with the industry.

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Engagement by senior management

Now, you will not be surprised to learn we consider a key aspect of the prevention and enforcement arms of our strategy is the role and engagement of senior management. Especially in the move towards a more principles-based regime, we expect senior management to engage proactively in the risks they face, and the challenge of making regulation appropriate to their business and risk profile. Our Principles are deliberately focused on outcomes and behaviours rather than processes and procedures. We want the Principles to act as a starting point for our approach to regulation because they will help us engage with the industry in a less prescriptive way, underpinned by the theme of senior management responsibility.

This means that we expect senior management to take responsibility for ensuring that their business identifies and properly considers the risks that it faces, has due regard to the operation of financial markets as a whole and develops appropriate systems and controls to manage those risks. The move towards a more principles-based regime will make it easier for senior management to do this and its flexibility makes regulation more easily relevant to each of the many and varied types of institutions regulated by the FSA.

Through our direct interactions with firms and through publications like Marketwatch and speeches we have been particularly explicit in our expectations that market participants manage conflicts of interest properly. The inherent conflicts within the investment banking model mean that it is vital that firms are able to demonstrate that they are actively identifying their conflicts, assessing and managing them.

We also expect senior management to be aware of their people-risks and to have considered which pre-employment checks are appropriate for a particular role. These may include credit checks, references from previous employers and criminal records checks. I want to emphasise that the FSA's approval process for applicants for Approved Person status is in addition to, not as a substitute for, appropriate, risk-based checks by employers. Firms and individuals must understand the importance of establishing honest and open relationships with us from the outset. We consider each application on a case by case basis and take a very dim view of non-disclosure. So does the Tribunal.

Dealing appropriately with staff is important to us – firms must obviously ensure that staff receive appropriate training, that they are aware of their obligations, and, when things go wrong, that they receive and understand the lessons learned. It is also important that senior management deal appropriately with wrongdoers and self report if they suspect their own staff have been involved in misconduct. If you do this, and can also demonstrate that you have, and are complying with, robust systems and controls, then you have nothing to fear. Last year we published two significant enforcement cases where we chose only to pursue the individual following self reporting by a firm. Equally, its important to foster an open culture where staff feel that they can freely report suspected market abuse to compliance – even if it involves their own firm.

We expect senior management to engage in these challenges and we believe that the move to more principles based regulation will make it easier for you to secure the engagement and commitment of senior management.

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Cure?

Now turning to the second but integrated limb of our strategy – the use of enforcement as both a specific and general deterrent. There are many debates about achieving an effective "fear factor". The FT commented last week that "many still regard handcuffed dealers and harsh jail time as the best deterrent". On that, market misconduct remains one of our key priorities and it is absolutely our intention to investigate and, where we have the evidence, to pursue cases of market misconduct.

We will use all the options at our disposal, by which I mean administrative proceedings under section 118 of the Financial Services & Markets Act and breaches of our Principles, specifically Principle 5 which requires that a firm must observe proper standards of market conduct. We will also, where the appropriate tests are met, consider bringing criminal prosecutions under the Criminal Justice Act.

Law enforcement agencies across the world face a hard task in bringing criminal prosecutions for insider dealing – something that is equally acknowledged by our US counterparties at the SEC. Linda Thomsen, Director of the Enforcement Division at the SEC, commented that "it is important to understand how difficult it is to bring 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 well as considering the usual evidential and practical challenges faced by prosecuting bodies, we are studying the US experience in respect of plea bargaining. We are participating in a working group under the auspices of the Attorney General's office which is looking at plea bargaining as a way to deliver more efficient case management in complex fraud and white collar crime cases. The US experience suggests that plea bargaining and immunity agreements are likely to assist us in evidence gathering and enable more effective prosecutions in front of juries.

Having said that, we have come a long way since being given our powers in December 2001 and we have learnt many lessons which well equip us for taking forward these challenging investigations and prosecutions. Since 2001 we have issued Final Notices against 8 firms and 15 individuals for market conduct related offences. These cases involved breaches of section 118, the Principles for Businesses and the Statements of Principles and Code of Practice for Approved Persons. And in line with our published strategy, the more recent cases against individuals have involved higher financial penalties.

This week you may have read that GLG has reached an agreement with the SEC to settle charges of illegal trading and has agreed to pay a fine which is the equivalent of £250,000 (plus another £250,000 in interest). You may also know that the FSA fined GLG £750,000 for market abuse last year. The SEC has also required GLG to pay another £1.1million to disgorge the profits from the trades. That is also a feature of our penalty policy. It is crucial that firms should have robust systems and controls in place to mitigate against potential market abuse and this is why we will continue to investigate and, where appropriate, bring systems and controls cases. The absence of actual market abuse is no defence to such cases.

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Investigation techniques

We have developed our investigatory techniques and through our powers and enhanced cooperation with overseas regulators and law enforcement agencies now have access to a phenomenal variety of sources (and volume!) of information. We are in the process of a major upgrade of our 'Sabre' transactions monitoring system which will make it easier for us to identify unusual transactions. This system stores all the transaction reports received from firms executing transactions reportable to the FSA and we use this post trade information to undertake market surveillance and identify situations of potential market abuse. We look at all suspicious price movements and then consider which merit formal investigation by Enforcement. Part of the Sabre upgrade will involve turning Sabre from a purely passive database to one which will proactively alert us to transactions or market events to follow up.

Enforcement investigations are not pleasant – no one would choose to spend time dealing with enquiries from our enforcement investigation teams and explaining what they did and this of itself is part of the deterrent effect. However, during an investigation – or even during the referral stage – there are a number of things that you can do in order to make the process smoother. One of the most important of these is to ensure that you get the right people together – and by this I mean staff of the appropriate level of seniority and business knowledge. Again, engagement by senior management is key.

Where the issue relates to the conduct of a firm, that firm can usually expect to be invited to attend a scoping meeting at the outset of the investigation. At this meeting we will typically tell you why the matter has been referred to enforcement, the nature of our concerns and what you can expect to happen during the investigation stage. We will explain the powers under which the investigators have been appointed and you will have the opportunity to meet the manager of the investigation and some team members. You will also have the opportunity to ask questions and provide the team with any information that you consider may be helpful.

The importance of preservation of evidence, whether that be electronic data or what someone recalls in respect of particular trade, means that you will notice that at the outset of the investigation things may move very quickly. There will, of course, be times during the investigation stage when you may not hear from us perhaps because we are conducting an evidential review or obtaining information from third parties. We need to get better at keeping firms and individuals informed but if you feel a little out of the loop then I would encourage any firm or individual proactively to contact the investigation team for an update.

I think it is worth emphasising that the objective of the investigation team is to investigate the facts of a matter or incident. We conduct investigations to discover whether there have been any breaches of our rules or Principles and commencement of an investigation is only the start of that process of fact finding and consideration. Disciplinary, civil or criminal action is not an inevitable consequence of an FSA investigation. To illustrate, I think it might be helpful if I provide you with some figures. In the last financial year we closed 219 enforcement investigations and of these, 109 cases were concluded without the use of powers. This means in 109 of the 219 closed cases, the FSA did not take any disciplinary action. In 10 of those closed we gave private warnings.

At scoping, and sometimes later meetings, investigations teams will often comprise, or be accompanied by, an investigation IT specialist to ensure that we act to prevent crucial electronic data being destroyed. This can happen inadvertently through, for example, the recording over of back-up tapes. Sometimes, regrettably, it is deliberate. On these occasions, it will be important to have someone from your firm who is capable of providing the necessary information about your systems, so that you are able to fulfil your data retention obligations.

Going back to my point that half of our investigations close without the use of powers, we recognise the value of evidence. Evidence is not just of an incriminating nature – it can equally go towards proving that a subject has not committed a criminal offence or is not in breach of our Principles or rules. Depending on the scope of the investigation, we may seek and obtain evidence from a variety of sources including computer hard drives, mobiles, taped lines, emails and instant messaging.

Depending upon the nature of the case and the powers under which investigators are appointed we are also able to require third parties to provide us with information. We have an extensive international network and use our powers through Mutual Legal Assistance requests for investigations conducted on a criminal footing and MoUs to obtain information from third parties located overseas.

Some of our other investigative techniques are more immediate than the standard documentary and information requirements and these may be things that you don't know much about as we don't tend to publicise them. Last year several of our market misconduct cases involved search and seizures. Historically we have not made extensive use of this method of gathering evidence but we have now concluded that we should, where necessary, take this approach to better ensure the preservation of evidence. These operations are carried out with the assistance of the police and we have developed excellent relations with a number of police forces throughout the country.

Last year we also used our civil powers and 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 the trading may have been on the basis of inside information improperly disclosed to him. The individuals concerned made a substantial profit. This was the first time that we obtained an asset freezing injunction under FSMA in respect of the proceeds of suspected market abuse. We expect there to be more such orders.

Enforcement outcomes contribute towards both the prevention and cure elements of our market abuse strategy. Published Final Notices are a useful tool for industry to understand better the types of behaviour we consider unacceptable. Last year supervisors observed that the publication of an enforcement action often led firms to consider whether the enforcement action had implications for their business, systems and controls. We also heard that the publication of the cases against Sean Pignatelli and Roberto Casoni resulted in compliance teams receiving lots of questions from traders about what they could and could not reasonably do. This is great news!

You will be interested to know that both cases arose as a result of self reporting by the firms concerned and in both cases, our activity focused upon the individuals not the firms.

I hope that I have managed to provide you with an overview of our strategy for market abuse and if you were only to take away one thing from what I have said today is that we want to work closely with you on both the prevention and cure elements of our strategy. We are not seeking to catch you out but rather looking for ways to provide you with the information you need to be able take strategic decisions about your regulatory approach. We are sure that proactive monitoring, thematic reviews, engagement with market participants and appropriately targeted enforcement action using all the options available to us will help us achieve that aim.

Yes, we have challenges and we are working hard on many fronts to overcome these for the good for the UK markets – we want London to remain a world leader. Our strategy is set within the context of the move towards more principles based regulation and last year we took many cases on the basis of Principles alone. And we will continue to do so.

We believe that less prescription and a more principles based approach is a huge opportunity for the industry. The approach has received overwhelming support because it makes it easier for senior management to engage and its flexibility makes regulation more easily relevant to each of the many and varied types of institution regulated by the FSA. But we acknowledge that there are some challenges for both the industry and the FSA in making this shift. Industry will have to adjust to the fact that the corollary to less prescription is fewer certainties. It will be crucial that Boards, Chief Executives and senior management teams engage, work with us in a constructive way and exercise sound judgement and that they are supported appropriately by compliance, risk management and audit functions. But this is a two way street, and we recognise that we also need to make changes to our behaviour. There is a huge programme of work underway to invest in the required technology and in our staff in order to improve their capabilities.

I hope that my talk will stimulate some debate for today and I am very interested in hearing your thoughts on our approach and any questions you may have.

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