The business of crime: insider dealing

Hannah Langworth asks what it is, how it works, and how it affects the economy and our everyday lives

One in five corporate announcements about a takeover or other significant activity is preceded by suspicious activity. That's City regulator the Financial Services Authority (FSA)'s official estimate regarding the current level of financial crime surrounding big deals in the Square Mile.

"Suspicious activity" in this context means trading conducted to take advantage of inside information about a company or a big deal before this information is released to the market in general. For example, a company will usually see its share price rocket if it's put up for sale, so if you know before the rest of the market that its owners intend to sell it, you can invest in its shares while their price is low and then benefit from their subsequent significant rise in value. Given the scale of the City's equity and equity derivatives markets, this kind of trading can be hugely profitable - and is also illegal.

Insider dealing is a civil offence under the Financial Services and Markets Act 2000, one of the key pieces of legislation regulating the financial services industry. It states that dealing on the basis of inside information, disclosing insider information to people not authorised to have that information, and a number of other related activities, should be classified as market abuse, and are punishable in law. Insider dealing is also a crime under the Criminal Justice Act 1993, which describes insider dealing as where individuals use, or encourage others to use, information about a company which is not generally available to deal for their own financial advantage. Because of the financial complexities of this offence, insider dealing is one of the few financial offences dealt with by the FSA rather than the Serious Fraud Office or the police.

What does insider dealing look like on the ground? Chris Hamilton of the FSA explains: "Typically, the insider will be a financial services professional. But the insider will not be the person that's making the money. It can be someone many times removed. We've had the wives of investment bankers prosecuted, and a dentist who was the father of an insider."

One of the FSA's most high-profile recent insider dealing cases of recent years was its prosecution this summer of six men for committing insider dealing offences in relation to a number of publicly listed companies, including news agency Reuters and oil company Premier Oil. Two of these men were employed in the print rooms of leading investment banks and, thanks to their positions, were able to pass confidential information about potential takeover bids onto the other four defendants. These members of the insider dealing ring then made lucrative spread bets on the basis of this information before it became public, netting themselves a total profit of £732,044.59 over a two year period.

Nowhere to hide

Bringing the perpetrators of crimes like these to justice is tricky. Chris describes insider dealing as "an extremely difficult offence to investigate and prosecute - it's very hard to join up the dots between the insider within the financial services institution and the person that's trading." However, he explains that the FSA has two main tools at its disposal to track down incidences of insider dealing.

First, as in many fields, technology has made regulators more powerful: "We have market monitoring systems that can look at data on price movements and identify when someone is trading ahead of an announcement in a way that needs to be investigated."

Second, they rely on those within the industry to help them. There's a legal requirement on financial services institutions to submit what's known as a "suspicious transaction report", or STR, if they have concerns about any trading activity, and the matter will then be investigated by the FSA. Not submitting such a report in such circumstances is an offence, and the FSA has prosecuted a number of firms in recent years for not doing so.

Commenting on the six-man insider dealing ring prosecution this summer, Tracey McDermott, director of the Enforcement and Financial Crime Division at the FSA, said: "Our success in bringing these individuals to justice is the result of innovative and determined work done across our markets, intelligence and enforcement teams over several years. We will continue to use all of the tools at our disposal to ensure those who seek to abuse the system have nowhere to hide."

As this statement indicates, insider dealing and efforts to combat it are certainly taken very seriously by the FSA and the criminal justice system. This is because of the impact that these activities can have on the economy. As McDermott said of the activities of the six-man ring: "This sort of behaviour poses a significant risk to the integrity of markets and cheats honest investors." Insider dealing distorts trading activity in a market unfairly and also weakens the market as a whole, as participants start to avoid trading there once they've lost trust in it.

Furthermore, while insider dealing may seems like a victimless and remote crime, it can in fact have a tangible impact on our everyday lives. Every time one party makes money through trading, someone else loses out, and it could be your bank or insurance company on the other side when someone profits illegally from insider information. Their loss could contribute to a reduction in the interest you get on your savings, an increase in the amount your bank charges you when you go overdrawn, or a rise in your insurance premiums.

Tough times

The FSA attitude towards insider dealing has hardened significantly in recent years. 2005 saw the arrival of lawyer Margaret Cole as Director of Enforcement, who restructured the FSA's enforcement division, roughly doubling it in size and bringing in considerable new expertise in the form of forensic accountants, data analysts, lawyers and investigators from other law enforcement agencies. The increased scrutiny of the financial services industry, arising from the financial crisis, spurred the FSA crackdown. It placed the regulator, which will be replaced by new bodies the Financial Conduct Authority and the Prudential Regulation Authority in 2013, firmly under the spotlight. "One of the big changes of the last three years," said one City insider we spoke to, "is the determination on the part of the authorities to make the stock markets a cleaner place. And part of that is punishing insider dealing." The replacement of Cole as the regulator's enforcement figurehead with the equally tough Tracey McDermott means that there's likely to be no let-up in the FSA's revitalised campaign against financial crime.

A key element of this change in the FSA's attitude has been a shift from simply imposing civil fines on those convicted of insider dealing to prosecuting them in court. McDermott says: "Insider dealers are criminals, no more and no less, and we are committed to using all the tools at our disposal to bring them to justice."

This cultural shift towards tarring what are sometimes known as "white collar" - that is, by implication, somehow lesser - criminals with the same brush as those who commit any other crime seems a deliberate step designed to deter those working in the financial services industry who would never dream of committing any other offence, from being tempted to take part in insider dealing. Chris explains: "We're trying to stop the people who probably wouldn't break the law in any other area of their life, [who might say] 'no-one's going to catch me and it's harmless, so I'll pass on this insider information'. When these people read in the papers that an investment banker has been locked up for three-and-a-half years, they think twice about insider dealing." A recent high-profile case in point is this year's prosecution of highly-respected J.P. Morgan banker Ian Hamman, widely regarded in the City as a signal to the market of the FSA's determination to name and shame breakers of the rules, regardless of their reputation or seniority.

The results of the FSA's efforts have been good. The FSA has made a long string of successful prosecutions over the past few years (see box) and has managed to reduce the proportion of market announcements estimated to be preceded by insider dealing from a staggering 30 per cent before Cole's arrival to today's figure of around 20 per cent.

However, it's worth bearing in mind that this reduction in insider dealing activity is likely, to a certain extent, to simply be the result of reduced deal flow over the past few years - the City insider we spoke to said that, in his view, the reduction had occurred "purely because the level of bid activity has fallen dramatically". It would seem then, regardless of what regulators are doing, financial criminals, like everyone else, find it harder to make money in a downturn.

Inside view

The prosecutor

**Chris Hamilton **The Financial Services Authority

Why did the FSA decided to pursue and punish insider dealing and other financial crime more rigorously?

It's what we call the "credible deterrence" strategy. Where's the deterrent to an individual committing a crime if it's just a cost of doing business? If someone's just going to get a fine for potentially making millions, then they'll just think, 'I'll pay the fine and so what?' There needed to be meaningful punishments to stop people [from committing insider dealing].

Do you think the FSA will ever eliminate insider dealing in the City?

No. There are complex insider dealing rings which, regardless of what laws there are or how tough a regulator is, will still do it. We think the lowest figure we'll get down to is somewhere between 10 and 15 per cent [of market announcements being affected].

Are there any other kinds of financial crime that can affect the lives of students in particular?

We're currently seeing quite a lot of students becoming cold callers on boiler room scams. Boiler rooms are essentially share fraud. Typically what will happen is that investors will get an unsolicited phone call from someone telling them that they can get them the latest and best shares in a company. Sometimes it's a legitimate company and sometimes it's completely fictitious. It's essentially a scam to get people to part with their money to buy shares that are worthless, or even non-existent.

The people [running these] tell students that they'll offer them hundreds or even thousands of pounds for opening a certain number of accounts. The students think it's a legitimate business, get given a sheet with telephone numbers on it, and start ringing up and pitching to people, with no idea that it's illegal.

We rely on intelligence to combat [these kinds of scams]. So if students have people contacting them [with these kinds of proposals], we'd encourage them to get in touch with us.

The financial services institution employee

**Senior figure at a leading City firm **who asked to remain anonymous

How do measures to combat insider dealing affect the working lives of City employees?

All your fixed line and mobile calls, including the line we're on now, are recorded by your firm's compliance department, so if there's ever any doubt about what you've said to a client, it can be played back. It's also so that compliance can check up on what you're saying in the course of business. I've also heard of rules stating that people are required to go on holiday for two weeks at a stretch so that anything dodgy they're doing will be revealed.

How has an increased focus on tackling financial crime in the banking industry affected the way you work?

There's a far greater air of sobriety about business practices. Compliance departments have got bigger and there's a greater level of scrutiny. The FSA is now much tougher on the internal procedures of individual firms. It now has the ability to turn up announced at any member firm and go round and ask employees questions. This means that as an employee you have to be much more aware of the different FSA requirements as they can come and quiz you on a whole series of different aspects of compliance. So when you go into HR reviews now, part of the process is to ask you about your awareness of compliance procedures. This never happened before.

Do you think the FSA's crackdown on insider dealing has been too harsh in any way?

No, I don't. I think the system got very, very lax, and it's vital that the integrity of the system is seen to matter above everything else.

And I'd be loathe to give the impression that the increased regulation of the industry is going down the way of crushing entrepreneurialism. Because I think that if there's any industry where entrepreneurialism is still allowed to flourish, it's finance.