Bovill, the compliance consultancy founded and led by Ben Blackett-Ord (pictured), has recently spent a great deal of its time focusing on insider-dealing. This article, the second in a series, surveys the market abuse regime of which that offence is a part.

Insider-dealing is by far the subject on which Bovill gets most questions from its clients; less so market manipulation. Later in this series, Beth Cazalet will discuss a recent 'market watch' newsletter from the Financial Conduct Authority that touches on such manipulation, while explaining how to deal with rumours that affect markets. In this article, we continue our look at the UK's market abuse regime as a whole.

Many of Bovill's client-firms are focusing on what inside information is. As we saw in the first article, market abuse falls into six categories of behaviour. Insider-dealing, one abusive type of behaviour, takes place when an insider deals or attempts to deal in a qualifying investment or a related investment on the basis of inside information relating to the investment in question.

Let us say that I have just told Mr X that the company I work for is publishing a quarterly report in a few weeks and the tidings are not good. Mr X now has that information. Mr Y, who works in Mr X's company, trades in that particular stock. The FCA wonders how Mr Y happens to be picking such good stocks, talks to the regulated firm and starts to ask questions. Is Mr Y trading on the basis of inside information? The regulators might conclude that he probably is not, because he did not know what Mr X knew, but given that Messrs X and Y are in the same company, they have coffee together and they can share tips at meetings, it would be very difficult for Mr Y to argue that he was not trading on the basis of inside information. This is why Chinese walls are really important. On top of this, PA dealing policies, if followed, should have required Mr Y to 'flag' that trade before he executed it and Mr X should have told the compliance officer that he had inside information relating to that stock. The compliance officer would then have prohibited Mr Y from dealing in that particular investment.

What is inside information?

When one is deciding whether to label a piece of information as 'inside information,' that information has to satisfy no less than four criteria, all at the same time. The first condition is that it ought to be information of a precise nature. This is the case when, say, someone has a good idea of what is going to happen in the future in relation to a particular company. He must have a good idea beyond reasonable doubt; in other words, he must know what is going to happen.

Inside information is also not generally available, so other people do not have it and they cannot obtain it. For example, I might charter a very expensive helicopter. If I fly over some crop fields in the United States and I see that those fields are not doing very well, perhaps because they are on fire or something like that, and I trade on that information, all I have done is make use of publicly available information. Anyone can do that if they can afford it. Equally, I could pretend to be a window-cleaner who wants information about Swiss Re, so I go up the Gherkin, I get up to the tenth floor, I look through the window at the computer screens, and I see inside information. One could argue that anyone can do that, it's a freely available opportunity to take, but it is obviously very different in that I have broken privacy and confidentiality laws.

Inside information has to relate to an issuer or to qualifying investments, a list of which we published in the last article. Lastly, according to the regulator, it "would, if generally available, be likely to have a significant effect on price." The Financial Conduct Authority has recently said that that phrase does not mean what we think it means. It has said that actually "would, if generally available, be likely to have a significant effect on price" means if and only if you, or someone in the market, would take this information into account when trading that particular stock. The FCA has therefore gone from a rather narrow definition to a very wide one.

Improper disclosure

Market abuse, to recap from last time, consists of six types of behaviour: insider-dealing; improper disclosure; the manipulation of transactions; the manipulation of devices; dissemination; and distortion and misleading behaviour.

Inside information, then, relates to the first type of market abuse. It also relates to the second, improper disclosure. This is all about keeping everything on a need-to-know basis. Improper disclosure happens when an insider discloses inside information to another person otherwise than in the proper course of the exercise of his employment, profession or duties.

I was at a large meeting with a client last week and the head of compliance said to me: "We're an advisor to this listed fund and I think we're going to have to liquidate it – it's not doing very well for all the following reasons. I think I've got inside information. What do you think?" I said "Well, I haven't read this. It's a quarterly report that came out the other day, so you may or may not but you've definitely made an improper disclosure to the room as a whole." One must be wary when one shares pieces of information around the company.

Manipulating transactions

We now come on to number three – the manipulation of transactions. This, according to the regulator, is "behaviour that consists of effecting transactions or orders to trade (otherwise than for legitimate reasons and in conformity with accepted market practices on the relevant market) which:

• give, or are likely to give, a false or misleading impression as to the supply of, or demand for, or as to the price of, one or more qualifying investments; or
• secure the price of one or more such investments at an abnormal or artificial level."

Around the time of quantitative easing, in one of the cases Mark Stephenson traded in gilts with a view to increasing the price at the time when the Government was buying gilts as part of the QE process. That is an example of a manipulative transaction, where the transaction itself was inflating the price of a gilt.

Manipulating devices

The transaction itself can therefore manipulate the market, but what about manipulating devices? This is to do with combining a transaction with information in a market. Recently, Twitter was subject to a fake £31 million takeover bid. Its stock rocketed briefly by 8% when a story that looked as though it came from Bloomberg suggested that it was in receipt of an acquisition offer. Apparently they mis-spelt the CEO's name – that is how it was spotted – and obviously Twitter issued denials. The person behind the event would have disseminated fictitious information to the market and (probably) traded on the basis of that information. That is an example of a manipulated device.

Dissemination

The 'misbehaviour' of 'disseminating' is, according to the regulator, "behaviour that consists of the dissemination of information by any means which gives, or is likely to give, a false or misleading impression as to a qualifying investment by a person who knew or could reasonably be expected to have known that the information was false or misleading."

Dissemination does not have to relate to the stock itself, it is just an element of market abuse. In this situation you could have an individual who does not trade after his dissemination but just disseminates rumours to the market place regardless. You cannot spread rumours.

Distortion and misleading behaviour

The last type of behaviour, number six, is a sort of catch-all one. It is, according to the FCA, behaviour that does not fall into the other categories that we have just looked at "but is still likely to give a regular user of the market a false or misleading impression as to the supply of, demand for or price or value of, qualifying investments; or would be, or would be likely to be, regarded by a regular user of the market as behaviour that would distort, or would be likely to distort, the market in such an investment."

This could be where I, in my massive wealth, hire a big oil tanker privately and fit it up myself in a port somewhere. I could give off the impression that there is plenty of that particular type of oil around the place, for example with a view to inflating the price of that commodity.

Getting down to cases

There have been some sizeable regulatory market abuse cases in recent years. Mark Stevenson was banned from financial services and fined because he deliberately manipulated the gilt price, hoping to sell to the Bank of England as part of quantitative easing. Using his own algorithm, Michael Coscia placed thousands of false orders (layering), taking advantage of price movements, and was fined £600,000.

David Einhorn is a good example. He ordered the sale of shares in Punch Taverns on the basis of inside information and was fined a princely sum – £3 million. In his arguments at the tribunal he was saying "well, I had inside information in relation to Punch Taverns but actually it was just one of many things I took into account when I made my investment decision." Actually his argument was completely false and the FSA said "pull the other one."

Irrespective of that, this shows that your firm cannot rely on the argument that inside information is just one of many factors that it has taken into account. The FCA will still know that inside information formed part of your investment decision-making process and you cannot escape the rules by blending that inside information with other information that you have as well.

Controlling access to inside information

My firm, Bovill, thinks that it is a good idea to control access to inside information to prevent dissemination and to prevent people from trading on the basis of that information. In conversation with our clients and our peers, we have been told a variety of different things. Here, in italics with my comments afterwards, are the things that they say to us.

• I tell everyone. Some people say "when I get inside information I tell everyone in the company because it's a small company and I think that that's the best way of stopping people trading on inside information." This might be the case but I am far from sure that it is the best way. Maybe it is for a small company but the compliance officer has to ask whether everyone needs to know. It is a good fundamental principle that a private bank, fund firm or other firm should surround this information with controls and keep things on a need-to-know basis.
• I use the investment analysts as a buffer between the inside information and the manager. The firm that said this was saying that the analyst often receives inside information but he writes a research note and the portfolio manager, who is making the decision at the end of the day, does not really know this inside information and this is therefore fine – but it is not fine. No firm can really use that as a strategy.
• The network drives are only accessible by particular people. I reckon a pound to a penny that if you check your network drives you will probably find that the list of inside information or restricted stocks that the compliance officer has is accessible by most people in the organisation. Is that appropriate?
• I have a designated person responsible for dealing with soundings. This is a good control.
• If one person has it, I assume that everyone has it. Maybe you should! In a small organisation it is often difficult to control access to inside information but does this assumption absolve a firm from implementing proper controls?
• If one entity in a group has it, I assume everyone has it. Yes, but again, you must find out whether that is because you have not bothered to set up appropriate controls and Chinese walls.
• There are data read restrictions in the system. This can happen when there are multiple deal teams. One team does not know what the other team is doing. This seems appropriate because they do not need to know it for the proper performance of their jobs.
• I have Chinese walls between teams. This, too, is a good control.

Front office v compliance

Where should responsibilities for curtailing market abuse lie between compliance and the business proper? Here are nine jobs to ponder.

• The identification of inside information.
• The prevention of market manipulation.
• The detection of market manipulation.
• The lifting of trade restrictions.
• Surveillance.
• Keeping the insider/restricted list.
• Approval for PA deals.
• The implementation of MAR controls.
• The oversight of MAR information technology.

Looking through these different areas, you will probably agree with us that the responsibility to identify inside information, to prevent market manipulation, etc. would rest both on compliance and also on the business. Maybe the approval of PA deals is something that best resides in compliance, maybe the job of keeping the insider/restricted list resides in compliance as well rather than business, but there are no strict rules on this. Every firm must have a think about the balance of where the should be between compliance and the business when it comes to rules and controls. In the next article, Beth Cazalet will look at some of the practical implications of all this.

* Mike Booth's main focus is on alternative fund managers. He can be reached on +44 (0)20 7620 8440.