Why insider trading is hard to prove
LAST month, the FBI smashed an alleged $20m insider trading scheme centring on the New York hedge fund Galleon, when they raided its offices and arrested billionaire financier Raj Rajaratnam and five accused accomplices. In the wake of criticism of the Financial Services Authority (FSA) in this country over its percveived toothlessness, the regulator is similarly on the hunt for insider trading.
The FSA’s annual report 2008/09 includes measures of market cleanliness, and in 2008 it identified 53 abnormal pre-announcement price movements before takeovers, suggesting suspicious trades before 29.3 per cent of announcements. This has increased from a low of 13.8 per cent in 2003, though the report points out that factors other than insider trading can cause an abnormal price movement ahead of a takeover announcement, such as media speculation.
In March this year, the FSA successfully prosecuted its first insider dealing case against Christopher McQuoid, a solicitor, and his father-in-law James Melbourne. A jury found that McQuoid had passed inside information to his father-in-law and that Melbourne had traded, making a profit from that information.
It might seem incredible that the FSA only made its first conviction this year, but Graham More, a consultant in the corporate crime practice at Herbert Smith and until recently an Assistant Director at the Serious Fraud Office, says that cracking down on insider dealing is never going to be easy. “The defendant has to have information as an insider, and he has to know that it’s inside information and not public information coming from a confidential source,” he says.
“He must then go on and deal in the shares, and the information that he’s got must be proven to be price sensitive, so capable of having a significant influence on the price. So we are not just talking about rumours, but things that are specific and not public, and that would have a significant impact on the price were they made public.”
The first problem for prosecutors is finding evidence of the trading in the first place, as many tip-offs will take place in brief phone calls or face-to-face. The Galleon case is the biggest alleged insider-dealing scandal ever uncovered at a hedge fund, and the case was the result of months of painstaking phone tapping by federal investigators who persuaded one of the defendants, Roomy Khan, to record her conversations with Rajaratnam in return for leniency. But in England the use of telephone tap evidence is prohibited in court, making the FSA’s job even tougher. “The fact that you can’t use telephone tap evidence is one of the difficulties in prosecuting these cases,” says More.
NUMEROUS DEFENCES
There are a number of defences open to those accused of insider dealing that show the extent of the FSA’s problem with its clean-up operation. Firstly, defendants can claim that they were going to buy the shares in any event, and the fact that they were told price-sensitive information had no bearing on their decision. Secondly, there is always an argument that the defendants believed that the information they were told was in the public domain, or at least widely known.
Such was the case in the most recent insider-trading furore in London. A month ago two bond managers at Dresdner Kleinwort, Darren Morton and Christopher Parry, were censured by the FSA for market abuse after they sold $65m of Barclays bonds despite having inside information that more favourably priced bonds were about to be issued. In March 2007 Morton was told of a new issue coming up, so sold the bonds to counterparties who were unaware of the new issue, and who subsequently lost $66,000 when the new issue was announced later that day. (Morton and Parry did not personally profit from the trade.)
The FSA did not fine the pair or prohibit them from working in the City. Instead, Parry and Morton successfully argued that practices in the debt markets meant that they believed it was okay to trade after being “sounded out” on a new issue. Margaret Cole, the FSA’s director of enforcement, said: “This is not the case. Market participants must always be alert to the possibility that inside information is being passed, and where it is they must not trade.” The FSA has subsequently issued new guidance on market abuse in the debt capital markets.
Wilson Thorburn, a partner in the litigation department at law firm Ashurst, says: “The FSA analyses trading patterns before announcements, and where people who don’t buy shares regularly suddenly make large moves, that’s fairly easy for the FSA to spot. But if you are a trader buying and selling shares all day long and one of your mates tells you to get into this or out of that, you can come up with all sorts of reasons why you made that decision should the FSA pick up on it.”
Still, the FSA’s crackdown is real and the sanctions potentially hefty. Both McQuoid and Melbourne were given eight-month jail terms, and while Rajaratnam says he is “entirely innocent” of the 13 criminal charges against him, prosecutors believe they have a compelling case against him that could bring a lengthy spell behind bars. In the past, watchdogs were accused of being toothless. That, it seems, is no longer the case.