Insider deals still doing a roaring trade

Ground Floor: The UK Commons Treasury Select Committee announced this week it was considering an investigation into insider trading on the basis that those caught represent only a small fraction of those actively engaged in the illegal activity, writes Sheila O'Flanagan.

Insider trading is about people in the know using information to screw people who aren't. When we talk about insider trading, we're generally referring to financial markets although, you get the same picture when you think about rigged horse races or dog races or any other activity where someone knows something someone else doesn't (but should) and uses that information to make money.

Financial markets are regulated to prevent this because while many of us don't bet on horses or dogs we all, in some way or another, have a stake in financial markets. Even if you don't own shares, you may have invested in a tracker bond or a pension or some other product that's linked into the markets. And so you want to believe that nobody is trading on information that you don't have which might affect the price of your holdings.

Many of us have heard of situations whereby a company director buys shares and shortly afterwards, that firm's share price rises dramatically. There is always the temptation to look at the deal and think that the guy concerned "knew something". But then directors and chief executives of companies should know a lot about them! And they can put their faith in their business by continuing to buy the shares. Because they're an "insider" in the company that's insider trading, in this instance legitimate.

Insider trading is illegal, however, when the director has used information which isn't in the public domain to influence his decision. If, for example, our director had bought shares in the company because he knew they were about to be part of a takeover bid, that would be illegal.

Measuredmarkets, a research company in Toronto, recently did a survey for the New York Times on trading around merger and acquisition deals in the US. The analysis showed that out of the biggest mergers over the past year, trading in the shares of 41 per cent of the companies which saw buyout bids was suspect in the weeks before the deals became public knowledge. Measuredmarkets concluded that those trading activities probably involved insider trading. The financial regulator in the UK has also seen a particular pattern to stock trading before mergers which they find worrying.

In the past few years - and particularly since the dotcom bubble burst and following the Enron collapse - financial regulators have tightened the rules and the sanctions for breaking them, around insider trading. Of course, what makes the headlines is the amount of money involved in insider trading cases and the high profiles of the people who may ultimately be convicted. Quite often they are people who are well respected in the corridors of financial power. And so it's shocking and disappointing when you discover someone who you believed was simply a good trader turns out to have feet of clay.

George Soros (the man who broke the Bank of England after he speculated hugely against sterling and saw it leave the European Exchange Rate Mechanism in 1992) was convicted of insider trading for his role in the attempted takeover of the French bank Société Générale in 1988. He had decided against getting involved in the bid when asked, but bought shares in the company and made $2 million (€1.56 million) as a result. Although he later claimed the knowledge had been in the public domain, his conviction was upheld and he was fined the same amount.

Ivan Boesky, who amassed a fierce reputation as a trader and arbitrageur (someone who makes money out of pricing discrepancies) was another high-profile convict. Boesky was so successful, though, that everyone knew he was working from insider information, it just took the authorities a long time to do anything about it.

There have been many individuals convicted on insider trading or charges stemming from insider trading, but what the Securities and Exchange Commission (SEC) in the US and the UK's Treasury Select Committee are now investigating is the relationship between investment banks and clients.

This is a huge area because one arm of an investment bank may have information on a client which the trading arm could use very profitably. In fact, the whole one-stop shop element of modern finance, where all the financial services can be provided by a single firm, is a regulatory headache.

This is why there are supposed to be Chinese walls within firms to stop information leaking from one division to another. My faith in Chinese walls is low, however. Whether deliberate or inadvertent, it is very difficult to maintain silence on a mutual client in a particular environment - and often it is also as much about what you don't say as what you do.

It's incredibly difficult to keep your face impassive as a colleague talks about a company about which you have specific information - information that would help him make a more informed decision about a particular course of action.

Information which might help him make a lot of money.

Information is power. We want to know more and we want to use that knowledge to outperform someone else. It's human nature. But if you use insider business information, it's illegal and too many people have made too much money at the expense of others for it to go unchecked.

www.sheilaoflanagan.net