Stocks Hit By Regulatory Differences Between U.S. And U.K. Policy

The distance from New York to London is only about 3,500 miles, roughly the distance from Maine to Los Angeles, or less than 7 hours by plane, but the two couldn't be further apart when it comes to how they police of financial markets. This has become clear from a series of recent legal filings affecting fund managers and corporate executives.

"Historically, the differences between the two countries were pretty clear," reports the Financial Times. "The US aggressively enforced laws against insider trading, overseas bribery and other white-collar fraud and the UK did not." But, recently misbehavior, like Enron or the recent financial crisis has spurred legislators to crack down on financial activities, and the difference between UK and US regulation is becoming more stark.

David Einhorn's Greenlight Capital And Punch Taverns

Hedge fund manager David Einhorn is one of the people to fall victim to these differences. Einhorn, who is the founder and manager of Greenlight Capital, was ordered to pay £7.2 million (about $11.2 million USD) by the UK's Financial Services Authority (FSA) over allegations that it was inappropriate for Greenlight Capital to sell its stake in Punch Taverns after learning the company was about to announce a round of equity financing. Greenlight Capital sold 11.7 million shares, cutting its stake in Punch from 13.3% to 8.9% and, in doing so, avoided £5.8 million in losses (read the story here). Einhorn said that he did not believe he violated any rules, saying that he was not an insider to the company, as evidenced by the fact that he never signed a Non-Disclosure Agreement (NDA), but he agreed to pay the insider trading fine "rather than continue an arduous fight" (read his story here).

Einhorn was not the only person charged in this matter either. Andrew Osborne, a former Bank of America Merrill Lynch broker was fined about £350,000 for his role in the Einhorn-Punch trading. Alexander E. Ten-Holter, Greenlight's former compliance officer, was fined £130,000, or $204,000, for failing to ensure that an order to sell shares was not based on inside information. Caspar J.W. Agnew, a trading desk director at JPMorgan Cazenove, was fined £65,000 pounds for not identifying that the sale order could be suspicious and for not reporting it to his employer.

Defining Insider Trading

In this case, the primary difference between UK and US law is the way insider trading is defined. The violation charged against Mr. Einhorn and Greenlight was "market abuse" under §118 of the Financial Services and Markets Act of 2000, which makes it a violation for an insider to buy or sell shares "on the basis of inside information relating to the investment in question." In the UK, an "insider" is anyone who learns confidential information "as a result of having access to the information through the exercise of his employment, profession or duties" or which was "obtained by other means and which he knows, or could reasonably be expected to know, is inside information." This is called possession theory. It basically means that any person who is given confidential information violates the law by trading on it. In the US, the Supreme Court rejected the idea of possession theory, ruling that, "insider trading requires the government to prove the person charged had a duty to disclose arising from a relationship of trust and confidence between parties to a transaction" (Chiarella vs. United States). As such, in the US, the matter would not have warranted charges.

For as strict as the UK can be with regard to fining insider trading, it rarely levies the high fines seen in the US and can be decidedly slack with regard to criminally prosecuting executives. Take the recent case of Ravi Sinha, who was formerly the top UK executive of JC Flowers, a US private equity firm. Sinha admitted to fraudulently billing a Flowers portfolio company £1.3 million, but he was never criminally charged. Instead, he was ordered to return the money and pay an additional £1.5 million fine.

A Changing Tide

If UK solicitor general Edward Garnier gets his way, the gap between UK regulation and US will narrow. Garnier would like to introduce deferred prosecution agreements (DPAs), like the ones the SEC has (sometimes called "non-prosecution agreements" or NPA). Under a DPA, a company can admit a wrongdoing and pay a fine. They only have to bring in an independent party as a monitor as an assurance against future issues. In exchange, federal prosecutors suspend criminal charges - a non-prosecution.

The system is extremely lucrative. US Department of Justice collected roughly $7.6 billion in fines, penalties, and disgorgement ordered in DPAs and NPAs, and related settlements, in 2010 and 2011. The largest of these settlements include:

• Merck & Co. (MRK): NPA with USAO for the District of Mass. for drug misbranding: $950 million

• GlaxoSmithKline (GSK): NPA with USAO for the District of Mass. for selling adulterated drugs: $750 million

• Deutsche Bank (DB): NPA with USAO for the Southern District of New York for promotion of illegal tax shelters: $553 million

• ABN Amro Bank: DPA with the DOJ's Asset Forfeiture and Money Laundering Section (AFMLS) and the USAO for the District of Columbia for trade sanctions and anti-money laundering violations: $500 million

• Google (GOOG): NPA with USAO for District of Rhode Island regarding drug importation charges: $500 million

More recently, Richard Schimel's Diamondback Capital Management, which is one of the largest hedge funds ensnared by the government's insider trading crackdown, was able to avoid federal prosecution by paying more than $9 million in fines and penalties. Diamondback entered into an NPA with the US Attorney's office, which the government agreed to in light of the fund's "prompt cooperation and voluntary adoption of remedial measures."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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