Inside edge

Neil Baker

In August 2004 the banking giant Citigroup did something that was both very clever and also very stupid. Its European bond trading group executed a short sale on Eurozone government bonds. That sounds simple enough, but this particular market play targeted 119 different bonds across 11 trading platforms. The bank used a computer program, known to its traders as “Dr Evil”, to stun the market with 188 simultaneous sell orders. The idea was to drive down the price of the bonds, and then buy them back when they were cheaper. The strategy worked and the bank made €15m. But then the trouble started.

The bank’s counterparties, and its regulators, didn’t like the fact that Citigroup had made a profit by causing panic in the markets. Regulators – and criminal authorities – across Europe looked at what the bank had done. The UK’s FSA described the failings as “very serious” and hit it with a fine. The bank’s chief executive, Chuck Prince, used more direct language – the traders had been “knuckleheaded”, he said.

Apart from the FSA, the market authorities across Europe took little or no action against Citigroup. Their weak response underlined the need to reform the European approach to insider dealing and market abuse – and pan-European reform was already on its way. The EU now has a common legal framework for dealing with market abuse and insider dealing. So has the situation improved since the Citigroup affair?

Failure
The FSA led the regulatory action against Citigroup, because the questionable trades took place in London. It found that the bank had failed to conduct its business with due skill, care and diligence, and failed to exercise proper controls over its London-based bond trading team. Citigroup had failed to achieve the high standards expected from a bank of its size, the FSA said. It had also failed to put adequate risk management systems in place. However, the regulator stopped short of finding Citigroup guilty of the much more serious offence of market manipulation and made no findings against any individuals.

The market authorities across Europe conducted their own investigations into what Citigroup had done. Regulators in France, Spain, Ireland and Greece decided to take no disciplinary action. The Italian and German regulators considered that there was a potential case to answer for market manipulation, which was a crime in both jurisdictions. But neither had the power to take criminal proceedings and referred the matter to their local criminal prosecutors.

The German prosecutor disagreed with the German regulator’s view of the case, and sent its files back. This happens in about three quarters of the suspected insider dealing cases that the regulator sends for criminal prosecution. The situation is similar in France. The country’s financial regulator, the AMF, has powers to seek administrative sanction for violations of insider trading rules, but still has to send criminal prosecutions to the Public Prosecutor's office. However, in either case the manpower available is limited.

Market abuse
Perhaps Citigroup was fortunate in that it carried out its dodgy bond deal just before a new EU Directive on Market Abuse had come into effect. Adopted in July 2005, this created a regime to tackle market manipulation in the EU and updated existing insider dealing legislation. All members were then supposed to introduce the requirements of the Directive into their national laws. The idea was that the directive would harmonise the legal approach to market abuse and insider dealing across Europe.

 Most EU members have since adopted the Directive, but not all. Furthermore, the Directive did not tell EU nations how to enforce the new laws or what kinds of sanctions to impose. Behaviour that merits a regulatory fine in one state can still result in criminal charges in another.

This has led to a confusing patchwork of different approaches in Europe. Last November CESR, an independent committee of European Securities Regulators created to advise the EU on financial market issues, published an analysis that details how laws and enforcement still vary. Regulators in eight EU jurisdictions cannot issue a fine for insider dealing, for example. In one – Bulgaria – it isn’t even a criminal offence. For market manipulation, regulators in four jurisdictions cannot impose a fine – including Denmark and Sweden – and in four there is no criminal sanction. That includes Austria and – again – Bulgaria.

The level of sanction varies enormously, too. In the UK, the fine for market abuse is unlimited; in Italy, it is €75m or ten times the profit; in Austria, just €50,000. For insider dealing, the UK fine is – again – unlimited. In Lithuania, the maximum for an individual is just €1,450.

As for the likelihood of spending time behind bars – all but two EU jurisdictions can imprison someone convicted of insider dealing. In Belgium, the maximum spell in jail is one year; in Latvia it is fifteen years.

Common approach
The EU is supposed to have a common approach to insider dealing and other forms of market abuse, but clearly enforcement practice varies enormously between member states. The fact that the regulatory authorities in the EU’s 27 member states do not all have the same powers is a major barrier to effective action. CESR says that getting all regulators on the same footing is a “precondition” both to credible cross border enforcement and a convergence of the ways in which EU members treat cases of insider dealing.

There are efforts to iron-out these differences. CESR produced two guidance papers aimed at encouraging convergence last year and currently has a third out for consultation. The EU is separately reviewing how well the legal framework on market abuse works and will report by the end of the year.  “We are determined to continue efforts to achieve better supervisory convergence in the EU, says Kurt Pribil, chair of the CESR operational group on market surveillance and coordinated enforcement, and chair of the Austrian Financial Markets Authority, that country’s regulator.

Such developments should be welcomed, says Chris Warren-Smith, a partner specialising in financial disputes and investigations at law firm Fulbright & Jaworski. “It’s encouraging to see regulators taking more steps to use their criminal and civil powers. There has been too little action taken in most if not all member states to try and combat market abuse and insider trading. Most member states are beginning to address that,” says Mr Warren-Smith.

However, efforts to harmonise sanctions and enforcement powers across Europe will not be enough on their own, he cautions. Regulators and criminal authorities need the funding required to actually investigate and prosecute cases. The FSA has recently more than doubled the number of staff working in its insider dealing unit – but only from12 to 30 staff.

Tougher stance
Recent events suggest that European nations might be raising their game in this area. The Financial Services Authority (FSA) in the UK has pushed market abuse further up its agenda and high profile investigations are underway in several countries, notably France.

In June, French financial police laid preliminary insider trading charges against Noel Forgeard, former joint chief executive of Europe’s largest aerospace company, EADS. The allegation is that Mr Forgeard sold shares ahead of an announcement that the company’s Airbus division was having production problems with its A380 super-jumbo jet.
Also in the firing line is Jean-Paul Gut, the company’s one-time head of strategy, who was released on bail of €400,000 after being held for 24 hours by financial police in Paris.

 Police are investigating other current and former executives from EADS and Airbus. In May the French financial regulator AMF said it had evidence against 17 individuals. All deny wrongdoing.

At the start of the year the FSA brought its first ever criminal charges over insider dealing – normally it relies on civil fines – and has since launched high profile investigations into suspect trading in the shares of two banks, HBOS and Bradford & Bingley. The FSA has also fined high street retailer Woolworths €443,000 for failing to release price sensitive news to the market quickly. And it has published guidance for all listed companies on how better to handle sensitive information about mergers and acquisitions. The FSA says that nearly a third of all merger and acquisition announcements is accompanied by what it calls “informed price movements” – a hint that people are trading on the back of leaked news.

There has been action in Ireland, too. Jim Flavin, the executive chairman of DCC, one of the country’s larger public companies, has just been forced to resign over an insider dealing scandal. And the FSA of Ireland, the lead financial regulator, is investigating suspect trading patterns that it detected in March. The regulator said its investigators were working the case with their counterparts at the FSA.

Cooperation
Such cooperation is likely to become more common in future. “CESR members work together very closely in cross-border cases and we have certainly witnessed an increasing trend in the intensity of this cooperation,” says Mr Pribil. CESR members were also starting to work together much earlier in an investigation, he adds. “All of this suggests that [we] are very serious in combating insider dealing.”

When it comes to cracking down on insider dealing and other forms of market abuse, the European Union certainly talks tough. It has introduced high-level directives in recent years to create a pan-European approach to the law in this area. But enforcement on the ground is patchy, at best. Europe has a reputation for not doing anything like enough to tackle the problem and there is still one member state where insider dealing isn’t even a criminal offence.   

There is another reason why this ramshackle approach to market abuse is so serious. Many traders treat the offence as little more than a joke. To them, insider dealing is so ingrained in the culture of markets that it would be impossible to stamp it out. When regulators like the FSA talk tough, the traders just laugh it off. Is that going to change? Europe’s politicians say it will, but their actions so far say it won’t.

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