By Robert Falkner, Reed Smith LLP
The U.S. Securities and Exchange Commission (SEC) has so far secured no less than 14 high profile insider dealing convictions using wire tap evidence in connection with the trading of Raj Rajaratnam, the founder of the Galleon Group hedge fund.1 The Galleon convictions disclose widespread communication of inside information by many investment professionals and its repeated misuse in the general course of business. As such it goes to the core of business practice in the world's financial markets. What makes the Galleon insider dealing cases particularly noteworthy is that the convictions were secured with heavy reliance upon the extensive use of evidence obtained by wire taps – this is both unprecedented and controversial.
In the U.S., the offence of insider trading is not as tightly defined as one might expect. The insider trading prohibitions owe their origins to common law concepts concerning misuse of confidential information by a person in a position of trust (a fiduciary) and a general theory of misappropriation of information. These concepts have been used in the application of the general anti-fraud provisions of section 10(b) of the Securities Exchange Act of 1934. A breach of the insider trading prohibition must involve a source misusing confidential information in breach of fiduciary duty or misappropriating information which may then be knowingly misused in securities dealing by another. A generous construction by the U.S. judiciary of the concepts of fiduciary duty (and imputed fiduciary duty) and property misappropriation has led to a broad prohibition against any person trading in possession of inside information.2
The EU/UK Regime
The EU insider trading prohibition is similar to that in the U.S. (except that European law does not require the prosecution to establish a fiduciary connection or misappropriation of information as such). The Market Abuse Directive3 (MAD) introduces a common EU approach and is implemented in the UK by the civil offence provisions set out in Part VIII of the Financial Services and Markets Act 2000 (FSMA).4 In the UK, criminal prosecutions for insider dealing offences are brought under Part V of the Criminal Justice Act 1993 (CJA 1993), the scope of which is similar to, but not the same as, the FSMA civil insider dealing offences which implemented the European harmonising measure and which preceded MAD – namely, the Insider Dealing Directive.5
Despite the broad legal jurisdiction to take action against insider dealing, the successful prosecution of any case where the defendant is a professional in the business of research and market trading remains fraught with difficulty. The prosecution in both the U.S. and Europe must show that the alleged insider trading was on the basis of the inside information, which on both sides of the Atlantic has proved a difficult area. To what extent can a defendant be presumed to have acted on inside information in circumstances where it may not have been the only or primary factor influencing the decision to trade or was the subject of market "rumour" amongst fellow investment professionals?
Section 53 CJA 1993 provides a defence where the defendant can show that he would have acted in the same way without the inside information or that the defendant reasonably believed the information had been disclosed to the extent those that may participate in relevant transactions would not have been prejudiced. Section 118(2) FSMA also expressly requires that a person deals "on the basis of" inside information. The Financial Services Authority's (FSA) Code of Market Conduct (MAR) at MAR 1.3.3 E lists some obvious factors to be taken into account when determining whether a deal is made on the basis of inside information. However, the listed factors are not helpful with reference to the issue concerning the circumstances in which it may be a legitimate defence to say that principal reliance was in fact placed on other market research or market "intelligence" and rumour.
In Rajaratnam's case, to convict, the jury had to be satisfied, beyond reasonable doubt, that Rajaratnam had knowingly used information misused by a person in a fiduciary position and that the information was material to his trading decisions in each of 14 counts of security fraud (the prosecution initially made charges with respect to 37 stocks but abandoned no less than 23 counts). Yet, in some cases, the link between Rajaratnam and the ultimate source of the information was tenuous. More importantly, Galleon's fund management business was research and analysis – more often than not significant support for the trading decisions made could be found independently of any inside information which may have been received (inside information which it was contended was often no more than speculation or already widely rumoured amongst market professionals). The prosecution case must have been faced with uncertain prospects at the outset, and so perhaps, the crucial factor in securing a conviction was the admission into evidence of wire tap evidence containing damning statements from the mouth of Rajaratnam himself of his deliberate intent to use inside information to make profits.
The admission of wire tap evidence in U.S. insider dealing proceedings is not yet at least to be taken for granted. Strict procedures apply with respect to any wire tap interception and a serious case to answer must be established before such evidence is admitted in court proceedings. Further, the Galleon investigation was the first time wiretaps had been used to investigate and prosecute insider dealing offences.6 The statutory power exercised to use wiretaps does not identify insider dealing as an offence for which the wiretap powers can be used.7 In the Galleon cases the wiretap application referred to probable cause for wire fraud and money laundering and the Court concluded that the U.S. Government, in good faith, sought to investigate wire fraud through its wire taps and that the incidental crime of insider dealing could therefore be properly investigated and prosecuted using wire taps. Rajaratnam's counsel has announced an intention to appeal the convictions on the grounds that the wire tap evidence should not have been put before the jury – U.S. pundits do not rate the prospects of such an appeal highly.
The prosecution in Galleon against the principal defendants was greatly assisted by plea bargains. From 6 April 2010, the FSA became a specified prosecutor entitled to exercise the plea bargain powers with a co-operating offender under sections 71-74 of the Serious Organised Crime and Police Act 2005 which was described last year by Margaret Cole, then head of enforcement and financial crime at the FSA as, "a significant step in our fight against market abuse."8But while plea bargains may have been important, the crucial factor underlying the success of the Galleon prosecutions was wiretap evidence.
In the UK, while telephone communications may be intercepted under a warrant issued by the Home Secretary only authorities such as the police and the intelligence services may obtain interception warrants,9 the FSA has no such power. Further, any material obtained under one of these warrants may only be used for background intelligence and is not admissible in court proceedings. There are FSA rules requiring taping by firms of all conversations concerning trade execution – these tapes may be admissible in court proceedings. However, this is not likely to catch the determined insider trader who will use other means to obtain or communicate inside information.10
The upshot of the Galleon case in the UK may be further review by the FSA and by regulated firms, of compliance measures to control the flow of inside information, a matter which already receives considerable attention, and which is of some considerable complexity given that information is the lifeblood of the markets. A more straightforward step, although obviously controversial, would be the conferral of wire tapping powers upon the FSA. Absent a wire tap power, a Galleon-type case may prove to be exceptional in the UK – not because it would represent an unprecedented victory in the fight against market abuse, but because it may prove to be a scarce event.
Robert Falkner is a financial services litigation partner at Reed Smith LLP. Robert's practice covers domestic and international financial services. He specialises in litigation, regulatory enforcement defence work, general regulatory and compliance advice in the securities, derivatives, commodity, and foreign exchange markets. Telephone: +44 (0) 20 3116 2980; E-mail: firstname.lastname@example.org.
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