The financial market

In the financial market, information is King. Rumours and speculation exchanged over a quick coffee or pint in the local can be used to make a quick buck on the stock exchange. Specific information about companies is a key determinant in the value of company shares. Certain individuals within a company are well placed to obtain this valuable, confidential and price sensitive information, giving them an unfair opportunity to deal in the shares before the information becomes public knowledge. According to White, “the abuse of privy knowledge has long been recognised as highly profitable in the marketplaces of the City.”

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This essay will look at the legislation that has been implemented to try and curb the practice of insider dealing and discuss the policy considerations behind these regulations. It will show that it is far from clean cut and an area of law that has generated debate and controversy over the years. At the outset, it is important to identify what we understand by the term insider dealing. Griffin defines it as, “The misuse of unpublished ‘inside information’ relating to a company for the purpose of gaining an unfair advantage in transactions involving company shares or other company securities.”

In summary, Part V of the Criminal Justice Act 1993 provides that a person is guilty of an offence if: a) he is an insider; b) he is aware of specific and precise information which relates to the shares themselves or the state of the company which issued them; and c) the information has not yet been made public; d) the information is of the sort which, if it had been made public, would be likely to have had significant effect on the share price; and e) he has the intention that the dealing is to make a profit or prevent a loss.

An insider includes directors, employees and shareholders (primary insiders) who by virtue of their employment are in a position to obtain this information. According to Welch et al, “a person can only be an insider if he knows that the information is inside information and that it has come from an inside source”.3 This will include tippees (secondary insiders) acting on information received, directly or indirectly, from an insider.

The offence of insider dealing takes three basic forms, a) that of acquiring and/or disposing of securities (CJA 1993 Section 52(1)); b) that of encouraging another to do so (CJA 1993 Section 52(2)(a)); c) that of disclosing information to another (CJA 1993 Section 52(2)(b)) Dignam and Lowry state, “Every country in the world with a major stock exchange has made this practice illegal because of its potential to destroy public confidence in the stock exchange.”4 It has been expressly illegal, punishable by fine or imprisonment, in the United Kingdom since the enactment of the Companies Act 1980, which remains in force today.

Prior to 1980, the practice of insider dealing was rampant. Up to the end of the World War II the trading of stocks and shares in a company on the basis of information known only to the company or its agents was considered legitimate and widespread. Between the end of the World War II and the late 1950’s it began to be regarded as unethical for agents of a company to make profits at the expense of the shareholders but in the 1960’s and early 1970’s the practice became commonplace once more.

In 1973, The Stock Exchange and the Takeover Panel issued a joint statement calling for criminal sanctions outlawing the practice. After several aborted attempts to pass legislation, Part V of the Criminal Justice Act 1980 came into force making it, “an offence for certain persons to deal in securities when they had “unpublished price sensitive information”. Further reform came from within the European Community with the introduction of the EC Directive on Insider Dealing (IDD) (EEC/89/592).

Before the adoption of the IDD, the approach taken by relevant Member States to prohibit the practice varied widely. The implementation of the Directive attempted to harmonize minimum standards for insider dealing laws throughout the Community. According to Ashe, “co-ordinated rules have the advantage of making it possible through co-operation to combat transfrontier insider dealing more effectively.” Frustration at the inability of the criminal regime to achieve conviction resulted in the Government introducing a civil offence of market abuse.

According to Welch et al, “the Financial Services and Markets Act 2000 (FSMA) provided the opportunity, both to reform the regulatory structure with the transfer of enhanced regulatory powers to the Financial Services Authority (FSA) and also to overhaul the substantive law.”7 The FSA was provided with the power to take action for market misconduct under section 118 of FSMA. It was expected that a civil process with the accompanying lower burden of proof and the non requirement of a jury would result in more actions against insider dealing being successfully brought. Unfortunately, this does appear to be the case.

According to Ringshaw, “since 2001, the FSA has successfully brought just eight cases of misuse of information.”8 This is almost embarrassing in comparison with its US counterpart regulator the Securities and Exchanges Commission’s success; in contrast it imposes millions of dollars in fines and initiates criminal proceedings against dozens of people every year. In its defence the FSA is a relatively new kid on the block and lacks the ability to plea bargain and to enter into immunity agreements with witnesses in return for hard evidence, which the SEC has used to great effect. According to Margaret Cole, FSA Director of Enforcement, these are areas which are under active consideration.

Pursuing insider dealer cases is notoriously complex and challenging. There is rarely a smoking gun and dealings are multifaceted and not easily understood by juries made up of lay persons. A real risk is that what may be evident to the sophisticated observer will become lost or hidden to a less sophisticated panel of jurors in the course of a long trial dealing with technical and often monotonous detail. Investigators face hurdles both in finding the beneficial owners behind overseas nominees and in identifying the links between people privy to information and the trading accomplices to whom they pass that information.

The trading may have been conducted through a number of accounts and attempts made to conceal the distribution of proceeds. The investigation into such activities increasingly involves a number of foreign jurisdictions. In the majority of cases, the prosecution will be unable to obtain direct evidence that a person possessed inside information and knew that it was information of that nature; proving that the information was in fact price sensitive will involve expert testimony evidence.

Alcock comments, “Rogues know that unless they carelessly leave a trail of paper to follow it will virtually be impossible to prove beyond reasonable doubt that they have dealt on inside information.” So why is there a need for regulation in this area? According to McVea, “Regulators claim that legislation is justified on the basis of a range of different arguments, the most consistently cited of which is that insider dealing jeopardises the development of fair and orderly markets and by doing so undermines investor confidence.” Other rationalizations include assertions that it is morally reprehensible and against good business ethics; it impairs the efficiency of the market and reduces market liquidity.

If a securities market is to be efficient, it must be properly able to ensure that the price of securities correctly reflects their true value. It could be said that in order to do this the market must have the means of preventing individuals taking advantage of superior knowledge gained through their informed positions, thus maintaining a level playing field for all. According to McVea, the theory of market egalitarianism promotes the idea that, “all individuals in the market should be placed on an equal footing, insofar as that is possible.

The implication is that anyone acting on superior information that is not available to all traders at that time is technically ‘stealing’ from the other market members. McVea goes further to say that, “carried to its logical extreme [market egalitarianism] would eliminate the use of all ‘informational advantages’, and remove the incentive to produce valuable information.”14 In other words rather than have a positive affect on the efficiency of the securities market it could have the reverse. Brazier comments, “The idea that the market should operate on the basis of complete equality….is too idealistic to be workable in practice….a requirement as to the immediate disclosure of all information would be too all-embracing. The market would be swamped with trivial material.”