The boom in merger and acquisition deals has led to a surge in insider trading. But is anyone taking the crime seriously? Indeed, should they bother? Simon Wilson reports
What is insider trading?
It is trading in shares (or other assets, or derivatives) when in possession of price-sensitive information not known to the market at large. It most commonly takes the form of people involved in takeover bids buying up shares in the target company to profit from a one-off boost when the bid is announced. Usually, such traders will get their spouses’ or relatives’ friends to deal on their behalf. Or they might sell the privileged information for a cut of a third party’s profits. Sometimes, insider dealing is more daring: in February, the Securities and Exchange Commission (SEC), America’s markets watchdog, charged a Hong Kong firm, Blue Bottle, with market abuse. It had made $2.7m by trading on information gained by hacking into computers.
Why is insider trading illegal?
It hasn’t always been. In the old days of the City, when a gentleman’s word was his bond, practices that would now be classed as insider trading were widely accepted as a perk of the job. As long as no one got too greedy, bankers and brokers routinely earned a bit extra by dealing ahead of the market. Moreover, there are some free-market fundamentalists, including Milton Friedman, who have argued that insider trading is perfectly natural and indeed to be encouraged. Why? Because it benefits all investors by bringing new information to the market. After all, if a company is to be taken over, the sooner this is factored in by the market the better.
What’s wrong with this view?
It’s too idealistic. It assumes that markets operate in an ideal world where perfect information is equally available to all participants. In truth financial markets are marked by an uneven spread of power and knowledge. Insider traders effectively steal from ordinary small investors who don’t have access to privileged information – which is why it’s treated as fraud and is against the law. They also distort the market and thus undermine confidence in it.
How widespread is insider trading?
According to a 2005 analysis by the Financial Services Authority, about a quarter of deals are subject to insider trading. But an anonymous source told the FT recently that “it is more like less than a quarter of [insider] deals don’t leak. No one thinks they are going to get caught and if they do the worst that can happen is a fine.” Certainly, anecdotal evidence suggests insider trading is surging. Recently there have been plenty of suspicious share spikes.
Such as?
At Hanson a fortnight ago, when a sharp upward price movement forced its suitor HeidelbergCement into a premature announcement of its intentions. At the same time, a false rumour was put about that Irish building materials firm CRH was about to receive a takeover bid – giving insider traders the perfect cover for buying Hanson on the grounds that the whole sector would be due a lift. This shows how insider traders are becoming bolder – speculating not just on imminent deals but on imaginary ones. In recent months, several high-profile firms have seen massive intra-day price rises (some of more than 10% and a ludicrous 21% in the case of Rio Tinto last week) thanks to unfounded takeover talk. No mergers were announced, but plenty of people banked untold profits for doing nothing.
What’s going on?
A more sophisticated market and financial instruments, more opportunities and places to trade, and the rise of hedge fund activity – all these factors mean that insider dealing is on the up. Observers note that hedge funds have an interest in fostering stockmarket volatility and an even greater interest in being able to predict it. They use derivatives to make huge profits from even tiny share-price movements. Meanwhile, the private-equity boom – leveraged takeovers involving large consortia of individuals and firms – means that a wider circle of people know about transactions before they are announced.
What can the Financial Services Authority (FSA) do?
It says it is developing more sophisticated software to identify ever-more complex patterns of suspicious behaviour. But until it is granted US-style sanctions in the form of lengthy prison sentences for offenders, it is likely to remain a pretty toothless force. The FSA reckons that its most successful prosecution to date, against hedge-fund manager Phillippe Jabre and his employers GLG Partners, has served as a significant deterrent. But without the threat of prison sentences, insider trading is a mere economic calculation – just another risk to factor into the equation. Jabre has coped with his £750,000 fine and FSA censure by moving to Geneva and setting up a new hedge fund. Some punishment.
Insider dealing in the United States
Insider dealing is also on the up in the land of famed 1980s fraudster Ivan Boesky, who was jailed and fined $100m. But the SEC has had some big recent successes. A married couple of Wall Street analysts were charged with using call options to make a 12-fold profit on a private equity deal to buy a nursing homes business. And a 13-strong group of fund managers and bankers — mostly junior or middling-rank employees (now sacked) of UBS, Bear Stearns and Morgan Stanley – were busted for illegally trading ahead of mergers and analysts’ stock tips. The scam, which netted $15m, highlights the difficulties faced by the authorities: one ringleader was a Morgan Stanley compliance officer.