Business Financial Crime: Financial Markets Abuse

1. Business Financial Crime: Financial Markets Abuse

2. “Knowledge is power. Advance knowledge is profit.” Attributed to the Rothschild Family. Almost 200 years ago the Rothschild Family secured their fortune by accumulating British Government securities on the basis of advance knowledge of Wellington’s victory over Napoleon at Waterloo. Although would not today be defined as illegal trading as would have been public knowledge

3. Conflicts Between Market Participants • Information asymmetry occurs when one party to a transaction has information that the other party doesn’t. • Superior information creates a situation where one party can use that information for their own benefit at the expense of the other. • So one party wins one loses

4. Insider Trading • A City banker nicknamed The Walrus has been jailed for five years for making a fortune through insider-trading. • Asif Butt, 35, was supposed to block information leaks at Credit Suisse First Boston (CSFB), but instead he used his knowledge to make money. • He used old school friends to place bets of up to £600,000 often minutes before major financial announcements. • Mr Butt has been convicted of making at least £265,000, though the police think the figure is closer to £2m. • Mr Butt, was fired by CSFB in January 2002 when evidence of his activities first came to light, and is thought to be the first City compliance officer to be found guilty of insider trading.

5. Insider Trading • Judge Ewen also made it clear that this type of criminal activity was not victimless. • "If investors, large and small, come to the view that they cannot trust the market and that people are habitually stealing a market on them, the health of the financial services industry.....will suffer severely."

6. Insider Trading • Almost a third of large UK takeover deals show signs of possible insider trading, the Financial Services Authority (FSA) has warned. • The UK's financial regulator analysed takeover bids in 2000 and 2004 and said it had found unusual share price movements before about 29% of them. • Such movements "suggest some informed trading was going on", said an FSA spokesman. • The FSA added that the situation appeared to be getting worse. • Its study also found signs of informed trading before 21.7% of potentially market-moving announcements by companies listed on the FTSE 350 index between 1998 and 2003. • The study researched a total of 1,500 announcements by FTSE 350 members.

7. Insider Trading • A Goldman Sachs analyst, a Merrill Lynch banker and a printer have been arrested charged with insider trading. • According to court documents the three, along with another worker at Goldman Sachs, took part in an insider trading plot that made more than $6.7m (£3.8m). • The Goldman workers are alleged to have bribed staff at a printing plant to get early copies of Business Week magazine. • The pair are also believed to have paid the Merrill analyst for inside information on takeovers.

8. Insider Trading • Barclays Settles SEC Insider Trading Case • Insider trading can happen in lots of different ways, and Barclays Bank PLC chose an interesting one: using information from the creditors committees of bankrupt companies to trade in their debt securities.  • Steven Landzberg, a defendant in the case along with Barclays, was the bank's representative on the creditors committees for six different companies, and as a member received private information about the financial condition of the debtors.  • Landzberg's more important job at Barclays was as head of its U.S. Distressed Debt Desk, which traded the bonds of companies in bankruptcy, making it very hard to resist the opportunity to trade.  • SEC took action against Barclays • Barclays settled the case by agreeing to pay over $10.9 million: $3,971,736 in disgorgement plus prejudgment interest of $971,825, and a civil penalty of $6 million.

9. Insider Trading SEC Files Civil Insider Trading Charges Against Former Countrywide Exec • October 29, 2007 • LOS ANGELES (AP) - A former executive at mortgage lender Countrywide Financial Corp. was charged Monday with insider trading after he sold stock before the company announced negative earning results three years ago, regulators said. • The Securities and Exchange Commission filed a civil complaint against Quan Zhu, 43, in Los Angeles federal court. Zhu has agreed to settle the charges, without admitting or denying the allegations, by paying nearly $109,000, officials said. • Regulators say Zhu was tipped to nonpublic information about the company's negative earning results in 2004.

10. Insider Trading • Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, • While in possession of material, nonpublic information about the security. • Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.

11. SEC Define Insiders • Examples of insider trading cases that have been brought by the SEC are cases against: • Corporate officers, directors, and employees who traded the corporation's securities after learning of significant, confidential corporate developments; • Friends, business associates, family members, and other "tippees" of such officers, directors, and employees, who traded the securities after receiving such information; • Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded; • Government employees who learned of such information because of their employment by the government; and • Other persons who misappropriated, and took advantage of, confidential information from their employers.

12. WHO ARE INSIDERS? • A broad range of individuals; • A partner in a law firm representing the acquiring company in a hostile takeover bid who traded in target company stock. • A Wall Street Journal columnist who traded prior to publication of his column in the stock of companies he wrote about. • A psychiatrist who traded on the basis of information learned from a patient. • A financial printer who traded in the stock of companies about which he was preparing disclosure documents.

13. REASONS FOR REGULATING INSIDER TRADING • Unfair practice to public investors • Prohibiting it promotes efficiency of markets • Property of material information belongs to the corporation for business purposes. • Enforce rules of the game • Protect the weak from exploitation by cynical operators.

14. Securities and Exchange Commission • 1920s were period of much fraud, manipulation. • SEC part of Roosevelt’s New Deal, 1934. • Initially viewed by business as a radical, almost socialist, institution. Peculiar that it started in US, imitated by other countries. • Motive was repeated examples of exploitation of minority or unobservant shareholders.

15. US REGULATION OF INSIDER TRADING • Section 16 of the 1934 Securities Exchange Act • SEC Rule 10b-5 • Misappropriation Theory • SEC Rule 14e-3

16. Rule 10b-5 • Promulgated in 1942 under §10(b) of the Securities Exchange Act of 1934 • Covers • material corporate misstatements or non disclosures, • insider trading, and • corporate mismanagement cases regarding transactions in shares or other securities • Today a major weapon to curb insider trading, as a catch-all anti-fraud provision

17. Misappropriation Theory of Insider Trading • A person violates Rule 10b-5 if • Misappropriates material nonpublic information • by breaching a duty arising out of a relationship of trust or confidence to the source of information • and uses that information in a securities transaction • regardless of whether he owed any duty to the shareholders of the traded stock

18. SEC Enforcement of the Rule 10b-5 and Rule 14e-3 • Permanent or a temporary injunction • Disgorgement of profits (most commonly used) • Correction of misleading statements • Disclosure of material information • Cease and desist orders • Disciplinary sanctions and civil penalties for securities market professionals • Bounty provisions by the §20A of ITSFEA • §21A -> civil monetary penalty of up to three times the profit gained or loss avoided by a person who violates Rules 10b-5 and 14e-3

19. Implications of Financial Fraud for Financial Markets • If investors are not convinced that the markets are reasonably fair, they will not invest. • Societies where individuals do not respect the rule of law, or where law breakers are not found and punished, find that financial markets cannot develop • In these cases, legitimate businesses operating those countries lack access to capital, cannot invest, cannot create jobs and cannot compete in international markets for their products and services.

20. Arguments for legalising insider trading • Some economists and legal scholars argue that laws making insider trading illegal should be revoked. They claim that insider trading based on material onpublic information benefits investors, in general, by more quickly introducing new information into the market.

21. Arguments for legalising insider trading • Milton Friedman said: "You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that." • Friedman did not believe that the trader should be required to make his trade known to the public, because the buying or selling pressure itself is information for the market.

22. Arguments for legalising insider trading • Legalization advocates also question why activity that is similar to insider trading is legal in other markets, such as land

23. Results of Market Surveillance • May 1995 secretary at IBM was asked to xerox documents related to secret plans to take over Lotus, to be announced June 5. • She told husband, a beeper salesman • June 2 he told two friends who immediately bought. • By June 5, 25 people spent half a million dollars to buy on this tip: pizza chef, electrical engineer, bank executive, dairy wholesaler, schoolteacher, and four stockbrokers. All caught by surveillance.

24. Emulex Corporation • Mark S. Jacob, 23, had shorted stock of his former employer, stood to lose money • Sent fake news release to Internet wire, was picked up by Bloomberg, Dow Jones News Wire and CNBC. He immediately covered. • FBI, using Internet Protocol Numbers, tracked down initial news to El Camino Community College library. Police questioned librarians, and eventually tracked him down.

25. Weakness of Securities Regulation Outside US • From 1995-99, there were only 19 successful prosecutions for insider trading in all of the UK, France, Germany, Italy and Switzerland • Manhattan Federal Court alone prosecuted 46 in that period. • European regulators do not have the budgets or sophisticated computer systems that US SEC does.

26. United Kingdom • Until 2000, varied agencies performed task of SEC. • United in 2000 under FSA (Financial Services Authority

27. UK Perspective • Criminal Offences • Insider Dealing • Criminal Justice Act 1993 • Non-public price-sensitive information • From insider • Organised securities market • Criminal sanctions • FSMA 2000 s.397 • Market Misconduct – Misleading Statements & Practices

28. More Weakness of Regulation • In Britain, Italy and Switzerland it has been impossible to bring a civil suit against insiders. Civil suits require lower burden of proof. • Britain allowed civil suits starting in 2001.

29. FSA - EU Market Abuse Directive • What is the Market Abuse Directive? The Market Abuse Directive came into force on 1 July 2005. It is a law that aims to fight cross-border market abuse by establishing a common approach among EU member states.

30. FSA “The Government has explained that the purpose of these provisions is to deter abusive behaviour which could undermine confidence in the UK financial markets and which, if unchecked, would ultimately damage the integrity of those markets” FSA 1998

31. FSA – Market Abuse • What is market abuse? Seven types of behaviour can amount to market abuse – see below for more detail. The examples illustrate the abusive behaviour the Code covers. • 1. Insider dealing – when an insider deals, or tries to deal, on the basis of inside information. Improper disclosure and misuse of information are kinds of insider dealing –

32. FSA Market Abuse • For example • An employee finds out that his company is about to become the target of a takeover bid. • Before the information is made public, he buys shares in his company because he knows a takeover bid may be imminent. • He then discloses the information to a friend. This behaviour creates an unfair market place because the person who sold the shares to the employee might not have done so if he had known of the potential takeover. • The employee’s friend also has this information and could profit unfairly from it.

33. FSA Market Abuse • 2. Improper disclosure – where an insider improperly discloses inside information to another person. • 3. Misuse of information – behaviour based on information that is not generally available but would affect an investor’s decision about the terms on which to deal.

34. FSA Market Abuse • For example • An employee learns that his company may lose a significant contract with its main customer. • The employee then sells his shares, based on his assessment that it is reasonably certain the contract will be lost. • This behaviour creates an unfair market place as the person buying the shares from the employee might not have done so had he been aware of the information about the potential loss of the contract

35. FSA Market Abuse • 4. Manipulating transactions – trading, or placing orders to trade, that gives a false or misleading impression of the supply of, or demand for, one or more investments, raising the price of the investment to an abnormal or artificial level.

36. FSA Market Abuse • For example • A person buys a large number of a particular share near the end of the day, aiming to drive the stock price higher to improve the performance of their investment. • The market price is pushed to an artificial level and investors get a false impression of the price of those shares and the value of any portfolio or fund that holds the stock. • This could lead to people making the wrong investment decisions.

37. FSA Market Abuse • 5. Manipulating devices – trading, or placing orders to trade, which employs fictitious devices or any other form of deception or contrivance.

38. FSA Market Abuse • For example • Buying shares and then spreading misleading information with a view to increasing the price. • This could give investors a false impression of the price of a share and lead them to make the wrong investment decisions.

39. FSA Market Abuse • 6. Dissemination – giving out information that conveys a false or misleading impression about an investment or the issuer of an investment where the person doing this knows the information to be false or misleading.

40. FSA Market Abuse • For example • A person uses an internet bulletin board or chat room to post information about the takeover of a company. • The person knows the information to be false or misleading. • This could artificially raise or reduce the price of a share and lead to people making the wrong investment decisions.

41. FSA Market Abuse • 7. Distortion and misleading behaviour – behaviour that gives a false or misleading impression of either the supply of, or demand for, an investment; or behaviour that otherwise distorts the market in an investment.

42. FSA Market Abuse • For example • The movement of an empty cargo ship that is used to transport a particular commodity. • This could create a false impression of changes in the supply of, or demand for, that commodity or the related futures contract. • It could also artificially change the price of that commodity or the futures contract, and lead to people making the wrong investment decisions.

43. FSA Market Abuse • What is ‘inside information’? • This is precise information that is not generally available and that a reasonable investor would use to help them make investment decisions. • It is also information that, if generally available, would be likely to significantly affect the price of an investment

44. FSA Market Abuse • Information from research or analysis is deemed to be generally available, and is not inside information. • For example, if a passenger on a train passing a burning factory calls their broker and instructs them to sell shares in the company that owns the factory, the passenger would be acting on information that is generally available. • This is because they obtained it legitimately by observing a public event.

46. The ImClone case: the key facts • December 21, 2001: ImClone GC sends email announcing a trading blackout until the FDA release on ImClone’s application for Erbitux cancer drug. • December 26, 2001: Sam Waksal learns that the FDA will reject ImClone’s application for review.􀂄That night, Sam advises daughter Aliza and others in his family (father Sam) either that the company would be receiving bad news or to sell their ImClone shares. • December 27, 2001: Aliza and family accountant begin calling Faneuil at Merrill Lynch. Aliza sells $2.5M of her ImClone shares as price falls; Jack sells $7M. Merrill Lynch blocks an attempted sale by Sam.

47. The ImClone case: the key facts • December 27, 2001: 􀂄 Stewart returns Faneuil's call from her private jet, which is en route to Mexico. At the end of a two-minute call, she instructs him to sell all $228K of her ImClone shares, at approximately $58 per share (it opened at $63.50). Martha Stewart’s earlier sale saves her about $45K on day one (although the stock continues to fall for several days to below $20). • Martha Stewart served five months in prison