FSA enforcement and lessons from Galleon

Hot on the heels of securing convictions and a custodial sentence for insider dealing in R v McQuoid [2009], further signs of the Financial Services Authority (FSA)’s renewed vigour for combating market abuse continue to emerge.

Suspicious Transaction Reports (STRs)

On 1 September 2009, a final notice from the FSA was issued to Mark Lockwood, a former investment adviser at a retail stockbroking firm, for failure to observe proper standards of market conduct. Lockwood was fined £20,000 for not identifying a transaction as suspicious in the face of ‘clear warning signals’ and failing thereafter to prevent the trade or report it.

The facts of FSA v Lockwood [2009] are straightforward. Client X notified Lockwood of an imminent share placing by Amerisur Resources Plc and that the additional shares were being offered at a substantial discount. Lockwood duly generated and signed an insider’s log to confirm that he was a party to the information.

Events then took a turn for the worse. Lockwood was telephoned by Client Y, who intimated that he too was aware of the placing. Client Y was told that it was ‘better to say nothing’. When Client Y mooted their intention to offload existing shares in Amerisur and take up the offer of the discounted shares from the placing, they were advised that to do so would not be ‘breaking any rules’. The unhappy saga was complete when Lockwood subsequently arranged the sale of Client Y’s shares before confirming with Amerisur’s broker their participation in the placing.

In its conclusions published in the final notice, the FSA emphasised its reliance ‘on firms making appropriate STRs to help it detect potential market abuse’ and found that Lockwood’s actions ‘increased the risk that market abuse… would proceed and remain undetected’. The regulator went on to state that ‘it is unacceptable and insufficient to simply ignore the situation or fail to take steps to understand the full picture’.

As the raft of recent criminal prosecutions underlines the FSA’s commitment to punishing those who facilitate or benefit from insider dealing, it is perhaps cases such as Lockwood’s that demonstrate a determination to clamp down on those who simply turn a blind eye.

Reasonable suspicion

The obligation to report suspicious transactions arises from article 6(9) of the Market Abuse Directive. Under Supervision 15.10.2 R:

‘A firm which arranges or executes a transaction with or for a client in a qualifying investment admitted to trading on a prescribed market and which has reasonable grounds to suspect that the transaction might constitute market abuse must notify the FSA without delay.’

Quite clearly, the test of ‘reasonable suspicion’ was reached and breached in Lockwood. This is effectively a negligence test and is the same as that applied under ss330-331 of the Proceeds of Crime Act 2002, which criminalise failures to disclose money-laundering offences. It is not a high threshold to cross.

Increased financial penalties

The changes to the calculation of financial penalties that the FSA proposed in July 2009 appear to dovetail with the credible deterrence philosophy and reflect a significantly more draconian approach. In gauging the change in attitude, it is instructive that although Lockwood was fined £20,000 for breaches that occurred in 2007, the regulator’s current proposal is a minimum £100,000 penalty for individuals involved in future market abuse cases.

August’s MarketWatch publication sought to remind firms of their obligations in respect of STRs. It noted that in cases where suspicious trading comes to light and no corresponding STRs have been submitted, there is increased enthusiasm from the FSA to initiate telephone contact ‘as a matter of course’.

Such measures are again indicative of a more aggressive approach. Firms must, therefore, be mindful not only to ensure that they have adequate staff training to enable identification and notification of suspicious transactions but also to deal with such approaches from the regulator.

Increased emphasis on reporting

In 2005, when the obligation to report suspicious transactions took effect, the FSA’s message was very much that it hoped that such reports would be made on a qualitative rather than a quantitative basis. There appeared to exist a fear that it might be swamped with ‘defensively made’ reports, with firms absolving themselves of responsibility for suspicion by deluging the FSA. It would seem that the industry took the regulator at its word. The FSA said in August that since 2005 ‘over 1,000’ reports have been made, which may seem disproportionately low in the context of the regulator’s suspicions that a significant percentage of corporate deals are preceded by suspicious trading activity. By way of contrast, in 2005 alone, nearly 195,000 money laundering reports were made to the Serious Organised Crime Agency (SOCA).

It is perhaps surprising that the regulator has not until now put a greater emphasis on reporting requirements, particularly since STRs remain the largest single source of referrals of cases for investigation. As the FSA acknowledged in Lockwood, it is reliant upon the financial industry to provide intelligence in respect of insider dealing, without which its scope for enforcement is severely hampered. It is this dependency on the accurate reporting of information, whether suspicious or otherwise, which underlies the FSA’s attitude to such matters and provides the rationale for measures such as the £2.45m fine meted out recently to Barclays.

Evidential challenges

If reports are not forthcoming, the FSA is reliant on its own monitoring of transactions to identify whether any suspicious transactions have taken place. The challenge for the regulator is in proving thereafter that those transactions were motivated by inside information.

Usually, the evidence is circumstantial. A suspicious transaction is identified and telephone billing or other records may demonstrate proximate communications between parties under suspicion. Absent contemporaneous recording or credible witness evidence of the content of the information communicated, it may be impossible to fatally undermine an assertion by the dealer that their profit from a deal is a consequence of prescient analysis of legitimate market information, and not the exploitation of illicit inside knowledge.

FSA v Uberoi [2009]

That was the precise issue before the jury the recently concluded criminal trial of FSA v Uberoi [2009]. Two members of the Uberoi family were prosecuted by the FSA and convicted of 12 counts of insider dealing. The allegations related to a series of transactions by Neel Uberoi, which coincided with his son Matthew’s internship at corporate broker Hoare Govett.

At the time, Hoare Govett advised on significant corporate deals involving NeuTec Pharma, Balfour Beatty and Gulf Keystone Petroleum. Acting on inside information provided by Matthew Uberoi in respect of those deals, his father profited extensively by purchasing stock before the public disclosure of the information lifted share prices.

The Uberois contended that any discussions between them about these companies were anodyne and imprecise, and that profits were the product of rigorous research and good fortune. To that extent Uberoi perfectly illustrates the dichotomy customary in insider dealing cases. Unfortunately for the Uberois, the father’s sudden predilection for the stocks of companies advised by Hoare Govett, together with his uncanny ability to presage good news just prior to official announcements, presented the jury with a set of circumstances that compelled them to convict. Yet while Neel Uberoi benefited to the tune of £110,000, one imagines that the FSA has its sights set on bigger prizes.

The past three years has seen a significant sea-change in the approach taken by the FSA towards market abuse. The director of the enforcement division, Margaret Cole, has described insider dealers as ‘criminals in suits masquerading as city professionals’ and has spoken of her desire for the FSA to be regarded as a ‘feared and respected criminal prosecutor’. To date, however, the FSA has yet to prosecute a high-value case featuring anyone from a major financial institution or blue-chip corporate.

future moves: sophisticated enforcement needed to tackle cases of increased size and complexity

The arrest in New York of Raj Rajaratnam, the head of the Galleon Group, and his alleged accomplices from blue-chip names Intel and IBM, marks the beginning of what is likely to be the largest insider dealing case ever brought.

Rajaratnam, according to Forbes, the world’s 559th richest man, and Galleon, which counted Barclays and Bank of America among its key brokers, consistently achieved a market-beating performance. It is now suggested, however, that that performance was unlawfully enhanced.

Covert techniques

The individuals and the sums involved have understandably attracted a wealth of publicity. The headlines have also focused on the methods of investigation employed in the US investigation. The use of telephone surveillance for example has drawn comparison in the newspapers with tactics used by US prosecutors to combat the mafia.

The fact that US investigators in Galleon [2009] are using covert tactics in insider dealing investigations is interesting. It is worth noting that in appropriate circumstances, as a relevant body under ss28-29 of the Regulation of Investigatory Powers Act 2000, there would be no barrier to the FSA employing surveillance techniques. Nevertheless, whether here or in the US, those cases where such methods can and are effectively employed will continue to be few and far between.

Those prosecuted by the FSA to date have generally been individual opportunists, in relatively isolated incidents or short series. Covert monitoring after the event is unlikely to yield benefits in such cases.

The US Department of Justice (DoJ) characterises the Galleon case as an altogether different beast. Systematic corruption of well-placed individuals is alleged to have facilitated insider dealing on a grand scale over several years. The DoJ appears confident that its evidence presents a compelling case.


The DoJ’s case relies not only on incriminating covert evidence, but also on a ‘co-operating witness’. That witness is said to be Roomy Khan. She is alleged to have contacted Rajaratnam in late 2005, whereupon she offered information about Polycom, according to the criminal complaint, ‘in the hopes of securing a position with Galleon, and in anticipation of receiving inside tips from Mr Rajaratnam in exchange’.

Khan is believed to have begun her co-operation with investigators in November 2007 after the New York Stock Exchange identified unusual trading in Hilton stock. That nearly two years passed before arrests were made may suggest that investigators have been able to gather a wealth of evidence against Rajaratnam and his alleged co-conspirators.

The FSA will shortly be added to the list of UK prosecution agencies with statutory powers to grant immunity from prosecution to individuals. Whereas in the UK immunity is a relatively recent development it is well established in the US. As Khan may demonstrate in the Galleon case, immunity can be a powerful weapon in otherwise evidentially difficult investigations.

For Galleon, the impact of the investigation has already been drastic. No-one wished to be tainted by association and within days of the arrests, it had announced an ‘orderly wind down’. For Rajaratnam personally, things are far worse as attentions now appear to be turning to alleged funding links with the Tamil Tigers.

As cases go, the DoJ and Securities and Exchange Commission (SEC) could hardly have hoped for a brighter torch with which to shine a light on insider trading. A high-profile, high-value case supported by apparently powerful evidence, is exactly the sort of case that the FSA would wish to prosecute.

An ongoing challenge

Cases such as Galleon are a rare treat for regulators. The investigation is the product of a multi-agency approach from the SEC, DoJ and the FBI, which in addition to surveillance techniques and witness evidence, relied on a data-mining project to track suspicious clusters of trades. Being able to work collaboratively with other agencies and having the resources to conduct an investigation or prosecution effectively is an essential component of a successful resolution.

In the UK, the FSA regularly liaises with other agencies, including the Serious Fraud Office, the Crown Prosecution Service and the Revenue and Customs Prosecutions Office, and has participated in the Fraud Review and Fraud Mapping Project. Moreover, like its American counterpart the SEC, the UK regulator recognises the value of sophisticated technology in its fight against market abuse and is currently implementing the next phase of the Surveillance and Automated Business Reporting Engine (Sabre) II programme, which will install a system to provide automatic alerts of transactions that might represent insider dealing.

The FSA also seeks to strengthen its position by increasing its coterie of lawyers and investigators. Recruitment continues apace and according to this year’s business plan, the desired level and quality of resources will be achieved by the end of 2010.

All of these developments chime with positive noises that ‘significant enforcement activity’ will continue to increase. Margaret Cole has publicly announced a key change in the regulator’s approach, apparent to observers for some time, whereby ‘the FSA will prosecute unless there is a reason not to do so’.

By changing the emphasis from civil fines to criminal prosecution where appropriate, the FSA hopes to effect wider cultural and behavioural change. Tough action against individuals and organisations perceived to have failed in their reporting obligations should be viewed in the same light.

The FSA is clearly committed to proving its credentials as the powerful regulator required to restore public confidence in the financial industry. It recognises that effective deterrence requires enforcement of the strictest possible sanctions. The consequences of such sanctions, as Galleon shows us, can be fatal.

Firms must be aware of the need to ensure that the monitoring and reporting systems they put in place meet not only minimum requirements but offer adequate protection against employees who may seek to exploit the markets. Should robust internal systems fail, effective management and early intervention are crucial to ensure an effective response and damage limitation.

By Kenneth McArthur, solicitor, Russell Jones & Walker.

E-mail: k.mcarthur@rjw.co.uk.