An inside job by watchdogs

March 23 was Julian Rifat's birthday. At 5.30am he should have been in the car that took him every morning from Oxford to the offices in London's West End where he worked as a trader for Moore Capital, one of the world's biggest hedge funds. Instead he was trying on a dressing gown given to him by his wife and thus running late.

Ten minutes later the dawn silence was broken by yells and urgent thumping on his front door. When he opened it, a stream of unsmiling officers from the Serious Organised Crime Agency, two in uniform and the rest in jeans and leather jackets, burst in accusing Rifat of insider dealing and demanding that he wake up his children and turn over their computers and iPhones. Within half an hour, about 20 officers, from both Soca and the Financial Services Authority, chief regulator for the City of London, were rummaging through his house.

At almost exactly the same time, more than 100 officers from both organisations bashed on the doors of 15 premises linked to nine individuals the regulator suspected of insider trading. By midday the FSA had issued a press release stating it had arrested six people – two from prominent City banks and one from a hedge fund – in its "largest ever operation against insider trading”.

A day after the raids and arrests, including that of Rifat, US authorities arrested Igor Poteroba, a UBS healthcare banker, charging him with leaking information about pending deals to two friends in a ring that allegedly netted $US1 million over four years.

Linking all these cases is the issue that concerns all regulators as they strive to maintain the integrity of financial markets: insider trading.

Trading on the use of privileged, or not public, information is as old as any stock market. The battle to stamp it out has, however, in recent years become an important goal of regulators of major financial centres. Leading regulators believe that getting a grip on the problem is central to re-establish confidence in financial systems after the battering they took during the financial crisis.

However, the world's leading regulators – the Securities and Exchange Commission in New York and the FSA in London – have historically taken different approaches. In the US the emphasis has been enforcement. Wrongdoers are aggressively and swiftly pursued, using the full armoury of the law, and then hefty fines and prison sentences are used to make examples of them.

In London the approach used to be lighter touch and principles-led. The regulator largely relied on firms to police themselves and their staff according to generally accepted codes.

But recently the FSA has dramatically changed its approach, moving towards that of the US. It is now bent on setting examples to deter market abuse – deploying all available measures in the process, as Rifat discovered. This has not been uncontroversial. Indeed, some critics describe it as a politically motivated last-ditch attempt – denied by the FSA – to save itself from being disbanded by a Conservative party that, in opposition, had promised to hand many of its powers to the Bank of England.

Now the FSA appears to have been given a reprieve. The new Conservative-Liberal Democratic coalition of Prime Minister David Cameron signalled this week that the authority could yet survive. While it awaits the final decision on its future Hector Sants, its chief executive, says it is determined to continue the fight against insider trading, and as publicly as possible.

Sants says: "We do want publicity. We do want people to be afraid, to say, ‘Hold on, maybe I don't want to do this. Maybe the FSA will catch me'.”

The case against Rifat and the six others arrested in the UK will be a test case of this resolve. The FSA told them it suspected them of being part of a sophisticated ring of individuals who had made £21.6 million trading on privileged information related to about 10 companies including Scottish & Newcastle, the Edinburgh brewer, and Barclays, the British bank. Then the suspects were sent home. No one expects charges to be laid for months, possibly even a year.

Contrast this with the case of Poteroba. The US Department of Justice immediately made public a 17-page criminal complaint laying out specific trades in half-a-dozen securities, and details of coded e-mails and bank transfers that it says supports its case. At a hearing a day later, a prosecutor told the presiding judge that Poteroba had admitted wrongdoing to investigators. Poteroba's attorney did not respond to requests for comment.

The case, still pending, is nothing special for US enforcers. In the 25 years since the arrest for insider trading of Ivan Boesky, resulting in an early high-profile conviction for the US enforcers, the DoJ and SEC have locked up dozens of people for insider dealing, including bankers and traders at virtually every major Wall Street group.

Few doubt the ability of US authorities to put together compelling market abuse cases, and draconian sentencing guidelines put pressure on the accused to cut deals. Seven months after authorities unveiled their high-stakes case involving the Galleon hedge fund in October 2009, 11 of 22 defendants have pleaded guilty, though a judge has yet to rule on the admissibility of the wiretaps on which the government's case is based.

By contrast, many in the City still question whether the FSA has the skill and nerve to tackle market abuse by true insiders. The regulator has won three criminal cases. Only one touched a major UK firm. This year it secured a 21-month jail term – relatively light by US standards – for Malcolm Calvert, a retired partner of Cazenove, stockbroker to the Queen, for insider dealing. But the FSA never identified his information source and the case rested upon a cooperating witness.

The raids that took place on March 23 shocked the Square Mile precisely because the FSA for the first time seemed to be going after people well known in the City and working for high-profile institutions. Those arrested alongside Rifat were real City players, including executives at Deutsche Bank and Exane BNP, part of BNP Paribas. All have denied wrongdoing.

Martyn Dodgson, a corporate financier at Deutsche Bank, is an insurance specialist who was part of a team of bankers advising the government. Clive Roberts, head of sales trading at Exane BNP and before that at ABN Amro, is a well-known and well-connected City figure often seen at the races or at Lord's cricket ground.

Messrs Rifat, Dodgson and Roberts would have been given access to restricted information on hundreds of deals in any one year, and Messrs Rifat and Roberts would have dealt in billions of pounds in trades for many of the UK's leading fund managers.

"This isn't the usual FSA arrest of a fringe operator,” says one fund manager. "We know these guys.” As word of the arrests spread, traders throughout the Square Mile put in calls to their compliance officers to ask what the offence might have been.

Many continue to doubt the FSA's ability to make cases stick, however.

The regulator's record is patchy when it comes to prosecuting regular traders – lawyers say it is much harder to convince a jury that particular trades were improper when they are part of a wider pattern of trading.

It also has fewer investigative tools at its disposal. The FSA only this month announced plans to require banks and brokers to record their employees' mobile phone conversations, too late to help the current investigation and years after the US.

US white-collar crime investigators use techniques honed in gangster cases, such as phone taps and wire-wearing moles, as illustrated by the Galleon case. The FSA, meanwhile, obtained formal power just last month to grant immunity from prosecution to people co-operating with them.

It might surprise some to find that, on paper, UK laws against improper dealing are broader than those of America. Under British law it is market abuse to trade while in possession of any market-moving non-public information; US enforcers must show that the information was stolen or leaked in violation of a duty to keep it confidential.

In theory it should also be easier for the FSA to bring cases because it has both civil and criminal authority, while the SEC can only bring civil cases and must enlist prosecutors at the DoJ if it believes traders should go to prison.

The real difference has been one of attitude: the SEC has viewed itself as an enforcement-led agency for decades, and the US public supports tough penalties for white-collar criminals as a deterrent to misbehaviour.

"You have to keep after it and hammer the message home for every generation,” says one former US prosecutor, adding that the need for constant enforcement came home to him when he interrogated a group of young bankers caught for trading ahead of merger announcements. "They didn't even know who Ivan Boesky was.”

Although the FSA's powers are broader than those of the US regulator, historically it has been more reticent to use them. But the stakes have been rising. A recent FSA study of market cleanliness found that suspicious trading preceded 29 per cent of all announced takeover deals in 2008, up from 24 per cent in 2005.

Lawyers have noticed the change in attitude at the UK regulator. They attribute it first to the financial crisis, which made clear that most markets are not self-policing. They also point to the leadership at the authority, particularly Margaret Cole, director of the enforcement division, and Sants, who put elimination of insider trading at the top of his agenda when he joined in 2005. Both are strong proponents of using enforcement cases to deter market abuse.

"They have recognised that the US model is more effective in terms of deterrence and punishment,” says Lord Goldsmith, a former UK attorney-general.

Under Sants and Cole, the FSA has restructured and expanded its enforcement division, increasing its budget and recruiting more staff with significant City experience. Cole has also embarked on a multi-year campaign to improve the quantity and quality of cases brought by the watchdog, an effort that she says is now bearing fruit.

"I give them credit. They've just discovered that they can enforce insider-trading laws if they want to. It suggests that their prior lack of success had more to do with passivity and indifference than problems gathering evidence,” says John Coffee, Columbia University law professor.

The FSA's tough new attitude coincides with an equally big push in the US, where the SEC and DoJ are both anxious to show they can be tough on Wall Street misbehaviour in the wake of the financial crisis.

Companies and lawyers on both sides of the Atlantic are seeing sharply increased regulatory activity and co-operation. The FSA recently went to court to defend its ability to gather information for the SEC; the two regulators now meet regularly to share information and ideas.

"We really have seen a shrinking of borders and regulators working together,” says Bob Jossen, a US lawyer with the international firm Dechert.

This will provide small comfort for Rifat. He and the others accused will spend the summer gathering evidence and information that they hope will counter whatever charges the FSA may eventually lay against them. All deny wrongdoing and some hope that, in the absence of concrete evidence, the regulator will drop its case. Meanwhile the legal bills are mounting and their futures look uncertain.

Rifat might find some consolation in the knowledge that the UK regulator's future remains unclear, despite this week's news. A few doors down from him in Oxford, Sants – who plans to step down from the FSA this summer – will also be contemplating his future.

Copyright The Financial Times Limited 2010.