The Regulator: Insider trading - Knowing where to draw the line

30 March 2012

SPRING 2012

The Financial Services Authority (FSA) is alive and kicking. Since bringing its first criminal prosecution for insider trading in 2008, it has secured 11 convictions with 15 defendants awaiting trials in the wings. This new muscularity has not been brought about by new law, but in the FSA’s change in attitude since the censure of its role in the 2008 crisis. Civil regulation is also experiencing a transition: while fines spiral ever upwards, clarity on how to avoid them is enjoying less of a boom.

Although much of this aggression is modelled on the US approach, it is ironically American market participants who have often been left most bemused by the FSA’s attacks. When David Einhorn, the American hedge fund Titan who famously shorted Lehman brothers, sat down to explain his £7m FSA fine to clients of his $7bn hedge fund, he said, “This is as much like insider trading as football is like soccer”.

And he was right. The finding centred on Einhorn’s decision to sell shares in Punch Taverns Plc, shortly before Punch announced fundraising, thereby avoiding losses of about £5.8 million.

The fine was levied on the following basis. On 8 June 2009, Greenlight (Einhorn’s fund) had been contacted by Merrill Lynch, broker for Punch Taverns Plc. Punch was intending to fundraise so the broker wanted to “wall-cross” Greenlight, as a major shareholder, to discuss the matter. Greenlight responded by unambiguously refusing to be wallcrossed. A telephone conference was arranged for the next day on the strict understanding that Greenlight had refused to be wall-crossed, had not signed a non-disclosure agreement and therefore should have no confidential information disclosed to it. During the course of that telephone conference, items of information were relayed to Greenlight, none of which in isolation constituted inside information. However, interpreted together, the FSA found that they did. No party to the telephone conference at the time suggested that any inside information had been disclosed. Mr Einhorn himself honestly believed that no inside information had been disclosed.

However, this requirement for a preestablished fiduciary duty does not exist in the UK’s regulatory regime. That is why Einhorn could be fined for trading when in possession of price-sensitive, non-public information, despite declaring that he did not want it and believing that he did not have it.

The case is a salutary reminder of the important gulf between the enforcement regimes on either side of the Atlantic. The top two positions for the highest civil fines in FSA history are now occupied by foreigners punished for ignorance: both Rameshkumar Goenka ($6.5m) and Mr Einhorn (£3.6m) believed they were acting lawfully. Grey areas, real or perceived, erode the integrity of both market participants and regulators and therefore require attention. The FSA might consider issuing some guidance to guard against significant shareholders being hamstrung by a well-placed wall-crossing.

However, a perhaps more significant development to come from the Einhorn
case is the FSA’s move to prosecute where the alchemy of expert interpretation turned multiple pieces of “outside” information into “inside” information. It has long been held as a staunch defence to insider trading, at least in America, where the wise eyes of an experienced trader can work out what is going on the other side of the wall by putting together snippets of information which on their own say little. Is the “mosaic” defence now shattered? It would have been interesting to have seen the point properly tested by Mr Einhorn.

For the fine tuning of what is meant by insider trading has proved confusing not only to market participants but also to the tribunal which judges them.

In late 2007, David Massey, a corporate financial advisor, traded in the shares of Eicom, an AIM-listed company (see FSA v Massey [2011] UKUT 49 (TCC)). It was well known in the market that Eicom was in need of a cash injection of about £2.7m. One of their investors went spectacularly bankrupt and Eicom was forced to scramble for a replacement.

Eicom made many approaches in a bid to fill the hole in their funding, including to Mr Massey. On 25 October 2007, Eicom offered to sell to or through Mr Massey three million shares at 3.5p. That offer was good until 02 November. On 01 November, without yet having taken up that offer to buy the Eicom shares, Mr Massey agreed to sell 2.5 million of them at 8p to Allianz. Having agreed that naked short sale, Mr Massey went back to Eicom and offered to buy 2.6 million shares at 3.5p. Eicom accepted and the sale went through.

In considering whether Mr Massey had committed insider trading (market
abuse), the Tribunal had to answer a series of problematic questions. The first was whether the offer made by Eicom to Mr Massey was information which was “not generally available”.01 Mr Massey had argued that the specific details were irrelevant if the general thrust of the information is well known to the market: it was known to all that Eicom desperately needed at least £800,000 and was actively trying to sell shares discounted by more than 45%. The Tribunal distinguished the offer to Mr Massey as “in line with but not the same as” the publicly available information. This means that knowing more of the same type of information which is publicly available could make it “inside”.

The Tribunal also found that the precise details of the offers made by Eicom to the various companies to raise funds were “not generally available”, although the population of brokers and others who would have been privy to them was by no means tiny. It will therefore not avail a defence to identify a number of other individuals who know the same information as the accused, particularly if issues of confidentiality are bound into that knowledge. But where does the point come when so many individuals know information that the line into the public sphere is crossed?

Was the information “precise” under s118C(5)(b)? The Tribunal found that it was: while “it was uncertain whether the issue of at least 2.5million discounted shares at 3.5p when announced would have an effect on the price [as in a particular direction], an effect was possible” (emphasis added). The Tribunal candidly admitted that, “we have not found the statutory wording easy to understand” and noted, with demure exasperation, the lack of guidance on the point.

One pities the trader in the field grappling with these issues when the Tribunal itself was at sea after days of calm contemplation. It seems that traders must get used to attuning their minds to the consideration of remote, although reasonable, possibilities.

This knocks onto the issue of whether the information was price sensitive (s118C(2)(c) and (6)). Mr Massey was criticised for relying on his own feeling that the information was not likely to have a significant effect on the price of the shares, a view with which even the Tribunal had “considerable sympathy”.

What else could Mr Massey do? The Tribunal found not only that Mr Massey “genuinely believed” that he was not committing insider trading, but that he was even “concerned about whether he was entitled to do as he did” (emphasis added). After all, Mr Massey had consulted his compliance officer and been given the all-clear by her. Where Mr Massey fell short was in failing to consider the matter “dispassionately and objectively”. That criticism might amuse compliance officers used to listening to traders’ justifications of their actions. When decisions are taken in a fast paced market by intelligent players bearing huge responsibilities for high stakes (including their own livelihoods) the last place to locate the passionless flow of objectivity is the mouth of the trader. In particular, the Tribunal criticised Mr Massey for being “liable to persuade himself of a distorted version of the facts when he feels that his interests are at stake”. That is a trait Mr Massey shares with the vast majority of
human kind.

Before Massey there was the case of Morton and Parry,02 a yet more extreme example of proceedings against traders who have, at worst, equivocal culpability. The FSA prosecuted Morton and Parry despite accepting that the traders genuinely believed that they had done nothing wrong, there was no guidance to tell them otherwise and a significant body of their fellow professionals would have deemed their actions acceptable.

If the FSA wants a sea change in the way things are done, why not start with issuing guidance rather than spiking heads onto poles? The case is significant in that it eviscerates the common sense comfort gained from watching honest and experienced players openly doing for years and years the very thing with which you are accused, and concluding that they cannot all be wrong. Now, they can.

The dark days of 2008 still cast their shadow. That the FSA has turned on its powerful searchlights is to be welcomed. Blinking market participants must quickly adjust.

JONATHAN BARNARD

Jonathan Barnard is a barrister at Cloth Fair Chambers. He specialises in Professional Discipline, Criminal Fraud, Crime, Environmental Crime and Health & Safety.

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