Critically discuss the harmful consequences of insider dealing and the effectiveness of its legal control in the 21st

century. Insider dealing has long created great heated debate, with regulators stating it is a financial crime that is immoral, unethical and ultimately damages the integrity of the market; whilst opponents insist that it provides stability, allocative efficiency and is the best form of entrepreneurial compensation. This question requires a critical analysis of the harmful consequences of insider dealing and how effective the legal control mechanisms are in dealing with this offence. This will be concluded with possible suggestions and ideas for reforms. Insider dealing, also known as insider trading can briefly be defined as the dealing of price sensitive securities within a regulated market, by an individual who does so by using inside information;1 either directly or indirectly through the exercise or by virtue of his or her employment. This could be a director, investor, broker and even a shareholder. The objectives would be to profit from this activity or to avoid loss. Insider dealing was made unlawful after the 1980s and the issue of legality or illegality has lead to an abundance of academic debates, around the legal, social, economical, moral and ethical effects and consequences which must be considered. This essay will be limited to the most harmful consequences as perceived by the writer. Firstly, harm can be defined as to injure, to cause hurt or to cause damage to something. Insider dealing can be injurious to the companies, investors and shareholders. It causes a negative financial impression or as phrase suggests hurts their pockets and the damage caused has significant repercussions on the markets, which ultimately affects the economy and society. This can be detrimental to a country like the UK when considering we are one of the leading financial centres of the world. Manne, Macey and Cox, quite fancifully argue that insider dealing does quite the opposite. Firstly, unconvincingly suggesting that it is legally unenforceable; stating that it attaches a property right, giving the company the power of disposal as and when they consider; that exploiting information is the perfect means of compensation2 to entrepreneurs for their valiant efforts; that neither shareholders, investors, market makers or even corporations are hurt by using inside information; finally, that insider dealing actively promotes allocative efficiency3 and no conclusive empirical evidence in relation to the effect on public confidence in the market and insider dealing. On this basis it seems that it is not too detrimental for needing regulations to outlaw it.4 On the other hand, Scheppel, Schotland and Klock, insist that insider dealing jeopardises the existence and future of fair and orderly markets, leading to undermine investor confidence. In addition, it is immoral, harms shareholders, investors, corporations and impairs the allocative efficiency of the
1

118C Inside information (1)This section defines inside information for the purposes of this Part. (2)In relation to qualifying investments, or related investments, which are not commodity derivatives, inside information is information of a precise nature which (a)is not generally available, (b)relates, directly or indirectly, to one or more issuers of the qualifying investments or to one or more of the qualifying investments, and (c)would, if generally available, be likely to have a significant effect on the price of the qualifying investments or on the price of related investments. 2 Henry G Manne, Entrepreneurship, Compensation and Corporation (2011) 14 QJAE 3-24 3 Harry, McVea, What's wrong with insider dealing? (1995) 15 Legal Studies, Issue 3: 390, 391 http://onlinelibrary.wiley.com/doi/10.1111/j.1748-121X.1995.tb00527.x/abstract >accessed 01 February 2012 4 Ana Hajduka, The Enron collapse: justice and fairness as a theoretical background for ultimate market efficiency (2002) 9 UCL Juris Rev 30, 35-36

markets, which reduces liquidity; ultimately increasing the value of capital.5 It is submitted that it is cheating and harmful. In analysing, Mannes arguments of economic and business sense, concerned regulators feared that existing and potential investors would withdraw from the market on the assertion of probable harm, which would ultimately decrease the liquidity and overall effectiveness of the market. In respect of fairness, whilst reviewing Mannes book, (Trading and the Stock Market (1966)) Schotland expressed that any gains made could be overreached for the benefit of fairness and integrity. After all, we should not let Choi rob Abid purely because he may be able to put the stolen property to a better economic use.6 In explanation of these consequences, Margaret Cole from the Financial Services Authority (FSA)7 has mentioned the prices of shares in an efficient market should truly reflect the actual price based on the totality of information available, which is imperative for investors wishing to make valuable assessments or decisions on purchasing. If unreliable this reduces the confidence in investors, damaging the market place and potentially leading them to withdraw their investments. In respect of fairness and morality she explains is the unfair advantage and equality of access to this sensitive information.8 McVea incisively concludes that predominately it is a form of cheating or fraud against the investors, shareholders and outsiders. The primary objective is the protection of investors from harmful conduct or practices and the integrity of an honest market place. This is where all information is equally known and accessible by individuals, corporations, investment firms and brokers at the same time, promoting an open, transparent and effective market place to invest in.9 Subsequently, another harmful consequence is related to fiduciary duties. The word fiduciary refers to trust and confidence and using ones position against the interest of another whom he owes a duty. 10 A director must not directly or indirectly get into situations which may conflict with the companies interests;11 or the profits accumulated would belong to the company, unless agreed otherwise. 12 This duty is owned only to the company and not to the shareholders,13 but in limited circumstances there could be a principal and agent scenario.14 It has been argued that even though there have been cases on the accountability of fiduciaries using information that is privileged; there have been no European case law that a fiduciary duty is a real constraint on insider dealing.15 All employees within a company are committing the offence, directors, employees and the securities law is best suited to regulate insider dealing. The UK has sought to prevent insider dealing by means of criminal and civil penalties and sanctions. 16 This is now regulated and predominantly prosecuted by the Financial Services Authority (FSA).

5 6

n3 at 390, 391 n4 7 Regulator and Principal prosecutor since FSMA 2000 8 Margaret Cole, FSA Director of Enforcement, Insider dealing in the City(Speech at London School of Economics, 17 March 2007) < http://www.fsa.gov.uk/pages/Library/Communication /Speeches/2007 / 0317_mc.shtml > accessed 29 January 2012 9 n3 at 413-414 10 D French, S Mayson, C Ryan, Company Law (28th edn, OUP, Oxford 2011) at 371 11 s175 (1) Companies Act 2006 (CA 2006) 12 Walsh v Deloitte and Touche Inc [2001] UKPC 58, 59 13 Percival v Wright [1902] 2 Ch 421 14 Allen v Hyatt (1914) 30 TLR 444 15 Barry A.K. Rider, The control of insider trading - smoke and mirrors! (2000) JFC 7(3) 227, 228-9 16 Criminal Justice Act 1993; Financial Services and Markets Act 2000

Insider dealing was made unlawful after the 1980s and two subsequent legislations failed to tackle this taboo. It was not until a European Directive17 was adopted in 1989 by Member States; the UK implemented these measures in Part V of the Criminal Justice Act 1993 (CJA). This adopted the methodology of the directive, in that it treated insider dealing as a type of market abuse, rather than a breach of fiduciary duty which was owed to the company. This is the reason why this offence is regulated under securities law rather than company law. Under the act, an individual is classed as an insider if he knows that the information is inside info and it comes from an inside source. It includes both primary and secondary individuals.18 Here the UK law goes further than the directive intended to, as it makes it a criminal offence for secondary insiders (brokers or analysts) to deal, encourage or disclose rather than just banning. 19 But this is still restricted to individuals (natural persons) only, not to corporations (legal persons) or any other authority. In extension, there are specified jurisdictional issues under the act which express that the offence20 must be committed on a regulated market within the UK; or (e.g. a broker or investment firm) based within the UK.21 This approach is very constricted as it does not cover deals or any suspicious behaviour on unregulated markets outside the UK, or any harmful acts from outsiders which have an effect on the UK markets.22 Next, the standard of evidence for a conviction is the criminal standard which is proof beyond all reasonable doubt. This has clearly led to minimal convictions due to the level of evidence required and is the one of the main difficulties in making the CJA effective legally. This also expands to the defences which an individual could use if convicted of insider dealing, by emphasisng his or her lack of awareness that the information was inside information or that regardless of which he would have done it anyway. Here the FSA could be effective as it could access information from computers, assessing times, dates, telephone calls, email correspondence and further analyse the individuals previous transaction history in acquiring or disposing, in order to ascertain the facts. But even a simple insider could give an excuse for his actions by stating that it was for a car, holiday, childrens tuition fees or pensions. This could potentially suffice as a deterrent for the basic insider, but is this sufficiently effective against the sophisticated, savvy insiders, or insider rings, which are syndicates or consortiums of individuals. Therefore, the sentences and penalties for these different types of insiders should reflect this.23
17 18

EC Directive 89/592/EEC ss52, 57 CJA 1993 19 British Institute of International and Comparative Law, Comparative implementation of EU Directives (I) Insider Dealing and Market Abuse (Report) (December 2005) <http://www.biicl.org/news/view/-/id/20/ > accessed on 03 February 2012 20 ss52(1)-(2) CJA 1993 21 ss62 (1)-(2) 22 Kern, Alexander, Insider Dealing and Market Abuse: The Financial Services and Markets Act 2000 (2001) ESRC Centre for Business Research, University of Cambridge Working Paper No. 222 /2001 <http://www.cbr.cam.ac.uk/pdf/WP222.pdf> accessed on 3 February 2012 23 s53 CJA 1993: View outstanding changes status warnings53 Defences.(1)An individual is not guilty of insider dealing by virtue of dealing in securities if he shows (a)that he did not at the time expect the dealing to result in a profit attributable to the fact that the information in question was price-sensitive information in relation to the securities, or (b)that at the time he believed on reasonable grounds that the information had been disclosed widely enough to ensure that none of those taking part in the dealing would be prejudiced by not having the information, or (c)that he would have done what he did even if he had not had the information. (2)An individual is not guilty of insider dealing by virtue of encouraging another person to deal in securities if he shows (a)that he did not at the time expect the dealing to result in a profit attributable to the fact that the information in question was price-sensitive information in relation to the securities, or (b)that at the time he believed on reasonable grounds that the information had been or would be disclosed widely enough to ensure that none of those taking part in the dealing would be prejudiced by not having the information, or

The criminal penalties for insider dealing under CJA are a maximum of 7 years imprisonment, unlimited fine or both. An individual could also be disqualified from being the director of a company.24 In the last 10 years the harshest sentence given for insider dealing has been 3 years and 4 months.25 Considerably, short of the possible 7 years, but this sentence did take into account a guilty plea. Another recent case involved a management consultant being found guilty on 22 counts of insider dealing, but he only received 2 years imprisonment. 26 To put this in perspective, his co associate who pleaded guilty to one charge on conspiring received a 10 month suspended prison sentence for two years and received a 50,000 fine. However, the problem throughout Europe is that different Member States have dissimilar sentences and fines for insider dealing, making it opportune for an insider to cherry pick (potentially abuse) where he feels the penalties or sanctions are more favourable. Margaret Cole concisely stated that the FSA has recognised the minimal criminal prosecutions to date, but highlights that it is a highly challenging offence, which is extremely complex and time consuming in nature.27 The clear benefit she emphasised was that the FSA had now extended powers; a regulator and in most the principal prosecutor after the enactment of the Financial Services and Markets Act 2000 (FSMA) and subsequent Market Abuse Directive 2003/124/EC.28 The Market Abuse regime under FSAMA was brought in to provide a civil dimension to insider dealing and to remedy the difficulties associated with prosecuting under the CJA; namely, being applicable to corporations as well as individuals, extending jurisdictional powers in relation to conduct or practices which might have an effect on any UK securities or investments and ultimately, reducing the standard of proof required to the balance of probabilities.29 The various provisions related to market abuse are found under Part VIII of FSMA. It is broken down into three areas: namely, where an insider deals or attempts to deal in qualifying investments; improper disclosure by insider and behaviour based on information not generally available. The latter does not necessarily have to be an insider. 30 There are effectively a wider number of sanctions available from financial penalties,31 through to injunctions, restitution orders and public censure. At first glance it seems that the financial penalties are effective, considering a recent case where the owner of a leading US hedge fund was fined 7.2 million for avoiding a loss of over 5.8 million. This was due to receiving inside information obtained from a telephone conference with a corporate
(c)that he would have done what he did even if he had not had the information. (3)An individual is not guilty of insider dealing by virtue of a disclosure of information if he shows (a)that he did not at the time expect any person, because of the disclosure, to deal in securities in the circumstances mentioned in subsection (3) of section 52; or (b)that, although he had such an expectation at the time, he did not expect the dealing to result in a profit attributable to the fact that the information was price-sensitive information in relation to the securities. (4)Schedule 1 (special defences) shall have effect. (5)The Treasury may by order amend Schedule 1. (6)In this section references to a profit include references to the avoidance of a loss. 24 R v Goodman (1993) 97 Cr App R 210 25 Financial Services Authority, Investment banker, his wife and family friend sentenced for insider dealing (02 February 2011) FSA/PN/018/2011<http://www.fsa.gov.uk/library/communication /pr/2011/018.shtml >accessed on 31st January 2012 26 Financial Services Authority, Management consultant found guilty of insider dealing and sentenced to two years (15 December 2011) FSA/PN/114/2011<http://www.fsa.gov.uk/library/communication /pr/2011/114.shtml > accessed 30 January 2012 27 Margaret Cole, FSA Director of Enforcement, Insider dealing in the City(Speech at London School of Economics, 04 October 2007) <http://www.fsa.gov.uk/library/communication/speeches/2007/1004_mc.shtml> 28 OJ 2003 L339/70 29 n18 30 Mayson S, French D & Ryan C, Company Law (28th edn, OUP, Oxford 2011) 353-355 31 S123(1)(a) FSMA 2000

broker. He stated that it was unjust and a mistake, but would not argue about paying the fine. He was also censured by the FSA. 32 Tracey McDermott, a director within the FSA, stated that being a high profile personality within the financial community, he should have realised this was inside information and acted in an appropriate manner. Failure was clearly a severe breach and the high penalty highlighted this, due to the fact that instances like this harm market confidence.33 However, this does not seem effective enough to deter high profile individuals, considering the fine was only 1.4 million above the actual loss avoided. It should have been significantly higher considering the defendant was the owner/president of the company. The FSA should investigate all the transactions for this company retrospectively for the last 12 months. Next, a censure or public statement in relation to individuals who engage in market abuse by the FSA does damage the reputation and standing of the individual and or company. This will potentially alert investors and companies to deal with scepticism, investors may even withdraw existing or prospective investments and associations. To further strengthen this sanction, the various forms of media we have in the 21st century, thrust this information in front of every business man or woman on the planet, making them conscious that insider dealing or market abuse has been perpetrated. Another sanction available to FSA is an injunction and in certain circumstances this does not actually require an offence to have been committed, as long as the courts are satisfied that it was reasonably likely.34 It can be an injunction of restraining, apprehending or continuing market abuse. 35 To expand on this, in May 2011, the FSA apprehended seven individuals from various banks and hedge funds over insider deals. All of their assets were frozen while they were under investigation. The FSA confirmed that this was on suspicion of a sophisticated long running insider dealing ring, either directly or indirectly resulting in considerable profits.36 The FSA has also obtained High Court injunctions in respect of many companies and individuals continuing in market abuse or manipulating the market.37 This practice is effective legally and on par with the SEC in the US. It seems that injunctions are in fashion and are an efficient legal control device in halting market abuse, dealing directly or disposing of assets. On the other hand, it has received fair criticisms predominantly the freezing injunctions; as individuals requiring money for valid expenses have had to apply to the High Court to release amounts and have burdened the Legal Services Commission under Legal Aid.38 This is clearly not fair, just or reasonable and should at least be proportionate. The final sanction available is for the FSA to make a restitution order, or apply to the High Court against anyone who has committed, encouraged or required another to engage in market abuse. The

32

Financial Services Authority, David Einhorn and Greenlight Capital Inc fined 7.2m for trading on inside information in Punch Taverns Plc (25 January 2012) FSA/PN/005/2012 < http://www.fsa.gov.uk/library/communication/pr/ 2012/005.shtml >; J Russell and R Blackden, FSA fines hedge fund manager David Einhorn 7.2m for insider trading The Telegraph (25 January 2012) <http://www.telegraph.co.uk/finance/financial-crime/9039624/FSA-fines-hedge-fund-manager-David-Einhorn7.2m-for-insider-trading.html. accessed 02 February 2012 33 ibid 34 Alistair Alcock, Five years of market abuse (2007) 28(6) Comp Law 2007 163-171 35 ss381(1)-(4) FSMA 2000 36 J Russell, Seven City traders to be interviewed by FSA over 'insider deals' The Telegraph (31 May 2011) < http://www.telegraph.co.uk/finance/financial-crime/8546339/Seven-City-traders-to-be-interviewd-by-FSAover-insider-deals.html> accessed on 4 February 2012 37 Financial Service Authority, FSA obtains High Court injunction to stop market manipulation (01 September 2011) FSA/PN/077/2011<http://www.fsa.gov.uk/library/communication/pr/2011/077.shtml> accessed 03 February 2012 38 n21

monies would be for the benefit of individuals or organisations that have been adversely affected as a consequence of that abuse.39 The FSA has under the new five point penalty system; fined and obtained restitution orders against a Dubai based private investor to the tune of 4 million fine and 2 million restitution for Market abuse under FSMA. This is the highest fine handed out by FSA to any individual. 40 Tracey McDermott acknowledged swiftness and decisiveness in which the FSA protect the integrity of the market, especially where individuals seek to abuse them.41 In contrast, the US recently convicted a hedge fund owner for insider trading and sentenced him to 11years in prison, $10m fine and $53.8m in restitution. This clearly dwarfs any such sentence, fine or restitution order. The Judge in the case stated that the 11year prison sentence would be a likely deterrent, even though the state was aiming for a 19 year sentence. The FSA has a two pronged approach to Insider dealing: Enforcement and Prevention. They have sought to prevent any misuse of information by compiling the FSA Disclosure and Transparency Rules sourcebook (DTR). This puts a mandatory obligation for an issuer of shares to disclose inside information, within the set parameters and within the relevant timescales. Next, they must provide insider lists for all those who are privy to the sensitive information (defacto, shadow). Furthermore, notifications of transactions by persons discharging managerial responsibilities (PDMR) or others closely connected must be given within the requisite parameters. Also must supply suspicious transaction reports. Non compliance or delayed compliance, could lead to multiple civil penalties and sanctions as mentioned above.42 This seems to be an effective control mechanism that supports FSMA. In conclusion, it is clear that the harmful consequences overreach the potential benefits that Manne and others favour. It obviously damages not only the integrity of the market but the economy as a whole. However, the problem of quantifying the exact damage and the effect of insider dealing is unclear. The FSA has an effective two-pronged approach for prevention and enforcement allowing them to utilise various criminal and civil penalties and sanctions to tackle this problem. This seems effective for basic insider dealing that exists and seems to be working well, especially with 11 successful prosecutions at present and 15 awaiting trial. The problem is that when regulations change, the insiders mentality changes and for the sophisticated insiders or rings without any major convictions it is hard to state that current law is only adequately effective. The number and extent of imprisonments, fines and sanctions in the US dwarf the UK, especially considering that the value of securities listed in NYSE is over $12 trillion and LSE is $2.4 trillion (not that much different). Therefore, it is suggested that interdepartmental cohesion and coherence is requisite, starting with a harmonisation of insider dealing law across Europe. For example, setting a baseline of 4/5 years minimum, allowing countries to exceed if they desire and all having unlimited fines. This would prevent potential abuse of an insider who will deal from a MS which has lower fines or penalties. It is also highly likely that the insider rings in the US will be working with individuals within the UK market, so collaboration with SEC would be paramount, maybe incorporating some valuable tips on plea bargaining and witness protection for whistleblowers.

39 40

ss 383(1)-(10) FSMA 2000; Mayson, French and Ryan, Company Law (28th edn, OUP, Oxford 2011) Financial Services Authority, FSA fines Dubai based investor US$ 9.6 million for market abuse (09 November 2011) FSA/PN/094/2011 <http://www.fsa.gov.uk/library/communication/pr/2011/094.shtml >accessed on 05 February 2012 41 n32 42 DTR 1.41R- DTR 3.1.4R; Mayson S, French D & Ryan C, Company Law (28th edn, OUP, Oxford 2011) 361363

BIBLOGRAPHY Table of Cases Walsh v Deloitte and Touche Inc [2001] UKPC 58, 59 Allen V Hyatt (1914) 30 TLR 444 Percival v Wright [1902] 2 Ch 421 R v Goodman (1993) 97 Cr App R 210 Table of Books Bourne, Nicholas, Bourne on company Law (4th edn, Routhledge Cavendish, Oxon 2008) Dignam A & Lowry J, Company Law (6th edn, OUP, Oxford 2010) Mayson S, French D & Ryan C, Company Law (28th edn, OUP, Oxford 2011) Table of Legislation Insider Dealing Directive EC Directive 1989/592/EEC Market Abuse Directive 2003/124/EC Companies Act 2006 s175 (1) Criminal Justice Act 1993 ss 52 (1)-(2) s 57 ss 62 (1)-(2) Financial Services and Markets Act 2000 ss118A, B, C ss123 (1)(a) ss381 (1)-(4) Articles Alcock, Alistair, Five years of market abuse (2007) 28(6) Comp Law Hajduka, Ana, The Enron collapse: justice and fairness as a theoretical background for ultimate market efficiency (2002) 9 UCL Juris Rev 30, 35-36 Manne, Henry G, Entrepreneurship, Compensation and Corporation (2011) 14 QJAE 3-24 McVea, Harry, What's wrong with insider dealing? (1995) 15 Legal Studies, Issue 3 Rider, Barry A K, The control of insider trading - smoke and mirrors! (2000) JFC 7(3) 227, 228-9 Working Papers Kern, Alexander, Insider Dealing and Market Abuse: The Financial Services and Markets Act 2000 (2001) Research Papers & Reports British Institute of International and Comparative Law, Comparative implementation of EU Directives (I) Insider Dealing and Market Abuse (Report) (December 2005)

Websites British Institute of International and Comparative Law British Institute of International and Comparative Law, Comparative implementation of EU Directives (I) Insider Dealing and Market Abuse (Report) (December 2005) <http://www.biicl.org/news/view/-/id/20/ > accessed on 03 February 2012 ESRC Centre for Business Research Kern, Alexander, Insider Dealing and Market Abuse: The Financial Services and Markets Act 2000 (2001) ESRC Centre for Business Research, University of Cambridge Working Paper No. 222 /2001 <http://www.cbr.cam.ac.uk/pdf/WP222.pdf> accessed on 3 February 2012 Financial Services AuthorityMargaret Cole, FSA Director of Enforcement, Insider dealing in the City (Speech at London School of Economics, 17 March 2007) < http://www.fsa.gov.uk/pages/Library/Communication /Speeches/2007 /0317_mc.shtml > accessed 29 January 2012 Financial Services Authority, Management consultant found guilty of insider dealing and sentenced to two years (15 December 2011) FSA/PN/114/2011<http://www.fsa.gov.uk/library/communication /pr/2011/114.shtml > accessed 30 January 2012 Financial Services Authority, Investment banker, his wife and family friend sentenced for insider dealing (02 February 2011) FSA/PN/018/2011<http://www.fsa.gov.uk/library/communication /pr/2011/018.shtml >accessed on 31st January 2012 Financial Service Authority, FSA obtains High Court injunction to stop market manipulation (01 September 2011) FSA/PN/077/2011<http://www.fsa.gov.uk/library/communication/pr/2011/077.shtml> accessed 03 February 2012 Financial Services Authority, David Einhorn and Greenlight Capital Inc fined 7.2m for trading on inside information in Punch Taverns Plc (25 January 2012) FSA/PN/005/2012 < http://www.fsa.gov.uk/library/communication/pr/ 2012/005.shtml > accessed on 5 February 2012 Margaret Cole, FSA Director of Enforcement, Insider dealing in the City(Speech at London School of Economics, 04 October 2007) <http://www.fsa.gov.uk/library/communication/speeches/2007/1004_mc.shtml> accessed on 6 February 2012 The TelegraphJ Russell and R Blackden, FSA fines hedge fund manager David Einhorn 7.2m for insider trading The Telegraph (25 January 2012) <http://www.telegraph.co.uk/finance/financial-crime/9039624/FSAfines-hedge-fund-manager-David-Einhorn-7.2m-for-insider-trading.html>accessed on 2 February 2012 J Russell, Seven City traders to be interviewed by FSA over 'insider deals' The Telegraph (31 May 2011) < http://www.telegraph.co.uk/finance/financial-crime/8546339/Seven-City-traders-to-be-interviewd-byFSA-over-insider-deals.html> accessed on 4 February 2012

US Securities and Exchange Commission<www.sec.gov>accessed> between 05 January 2012 6th February 2012 Westlawhttp://web2.westlaw.com/signon/default.wl?rs=WLW11.01&vr=2.0&fn=_top&bhcp=1 <accessed on 05 January 07th February 2012 WileyHarry, McVea, What's wrong with insider dealing? (1995) 15 Legal Studies, Issue 3: 390, 391 http://onlinelibrary.wiley.com/doi/10.1111/j.1748-121X.1995.tb00527.x/abstract >accessed 01 February 2012