Chapter 13: Fraudulent behaviour

Chapter learning objectives

Upon completion of this chapter you will be able to:

• recognise the nature and legal control over insider dealing and market abuse.
• recognise the nature and legal control over money laundering.
• recognise the nature and legal control over bribery.
• discuss potential criminal activity in the operation, management and winding up of companies
• distinguish between fraudulent and wrongful trading.

1 Insider dealing

The value of a share reflects the profitability and futureprospects of a company. This type of information is usually onlyavailable to a prospective purchaser after it has been made availablepublicly. However, if a prospective purchaser could gain access to suchinformation before it was made public, he could anticipate which way theprice was likely to move and thereby make a profit. This is known as'insider dealing'. Insider dealing has been made a criminal offence asit is perceived to undermine the integrity of the stock market.

Legislation

Insider dealing is a crime under part V of the Criminal Justice Act 1993.

The offences

The Criminal Justice Act 1993 sets out the three distinct offences in s52.

An individual will be guilty of insider dealing if they have information as an insider and:

• they deal in price-affected securities on the basis of that information
• they encourage another person to deal in price-affected securities in relation to that information
• they disclose the information to anyone other than in the proper performance of their employment, office or profession.

Dealing

Dealing is defined in s55 as acquiring or disposing of securities,whether as a principal or agent, or agreeing to acquire securities.

Inside information

S56 defines inside information as information which:

• relates to particular securities or to a particular issuer of securities
• is specific or precise
• has not been made public
• if made public would be likely to have a significant effect on the price.

Insider

S57 states that a person has information as an insider only if theyknow that it is inside information and they have it from an insidesource.

A person has information from an inside source if:

• he has it through being a director, employee or shareholder of issuer of securities
• he has it through having access to the information by virtue of his employment, office or profession

Consequences

On summary conviction an individual found guilty of insider dealingis liable to a fine not exceeding the statutory maximum and/or amaximum of six months imprisonment.

On indictment the penalty is an unlimited fine and/or a maximum of seven years imprisonment.

If the individual concerned is a director, he is in breach of hisfiduciary duty and may be liable to account to the company for an profitmade.

Defences

The defences to insider dealing are where:

• the individual concerned did not expect the dealing to result in a profit (or the avoidance of a loss) attributable to the fact that the information in question was price sensitive.
• the individual believed on reasonable grounds that the information had been widely disclosed.
• the individual would have done what he did even if he had not had the information.
• the individual can prove that he reasonably believed that the recipient of the information would not act upon it.

Test your understanding 1

(1)Which statute contains the legislation on insider dealing?

(2)What are the three sub-categories of the offence of insider dealing?

(3)What are the three general defences to a charge of insider dealing?

2 Market Abuse

Legislation

The Financial Services and Markets Act 2000 introduces the concept of market abuse.

Under s118 (1) market abuse is defined as:

• behaviour in relation to any qualifying investment;
• likely to be regarded by regular users of the market as falling below the standard reasonably expected of a person in that position; and
• that falls within at least one of three categories:

(1)Based on information notgenerally available to users of the market which, if available to aregular user, would be likely to be regarded by him as relevant inregard to the terms on which to deal in those investments.

(2)Is likely to give a regular user a false or misleading impression as to the market value of such investments.

(3)Is regarded by a regular user as likely to distort the market in such investments.

Qualifying investments are those which are traded on the UK's'prescribed markets', as well as those traded on other Europeanregulated markets.

The Financial Services Authority have also drawn up a Code of Market Conduct to detail the ways in which market abuse can occur.

There are seven types of behaviour which can amount to market abuse.

Insider dealing

As discussed above in section 1, insider dealing is when an insider deals, or tries to deal, on the basis of inside information.

Improper disclosure

This is where an insider improperly discloses inside information to another person and is also classified as insider dealing.

Illustration

An employee finds out that his company is about to become thetarget of a takeover bid. Before the information is made public, he buysshares in his company because he knows a takeover bid may be imminent.He then discloses the information to a friend.

This behaviour creates an unfair market place because the personwho sold the shares to the employee might not have done so if he hadknown of the potential takeover. The employee's friend also has thisinformation and could profit unfairly from it.

Misuse of information

This is any behaviour based on information that is not generallyavailable but would affect an investor's decision about the terms onwhich to deal. This is also a type of insider dealing.

Illustration

An employee learns that his company may lose a significant contractwith its main customer. The employee then sells his shares, based onhis assessment that it is reasonably certain.

This behaviour creates an unfair market place as the person buyingthe shares from the employee might not have done so had he been aware ofthe information about the potential loss of contract.

Manipulating transactions

This is trading, or placing orders to trade, that gives a false ormisleading impression of the supply of, or demand for, one or moreinvestments, raising the price of the investments to an abnormal orartificial level.

Illustration

A person buys a large number of a particular share near the end ofthe day, aiming to drive the stock price higher to improve theperformance of their investment. The market price is pushed to anartificial level and investors get a false impression of the price ofthose shares and the value of any portfolio or fund that holds thestock. This could lead to people making the wrong investment decision

Manipulating devices

This is trading, or placing orders to trade, which employs fictitious devices or any other form of deception or contrivance.

Illustration

A person buys shares and then spreads misleading information with aview to increasing the price. This could give investors a falseimpression of the price of a share and lead them to make the wronginvestment decision.

Dissemination

This is the giving out of information that conveys a false ormisleading impression about an investment or the issuer of an investmentwhere the person doing this knows the information to be false ormisleading.

Illustration

A person uses an internet bulletin board or chat room to postinformation about the takeover of a company. The person knows theinformation to be false or misleading. This could artifically raise orreduce the price of a share and lead to people making the wronginvestment decisions.

Distortion and misleading behaviour

This is behaviour that gives a false or misleading impression ofeither the supply of, or demand for an investment, or behaviour whichotherwise distorts the market in an investment.

Illustration

There is movement of an empty cargo ship that is used to transport aparticular commodity. This could create a false impression of changesin the supply of, or demand for, that commodity or the related futurescontract. It could also artificially change the price of that commodityor the futures contract, and lead to people making the wrong investmentdecisions.

Consequences

Market abuse is defined in the Code can result in an unlimited fineand a public reprimand by the Financial Services Authority under civillaw.

3 Money laundering

Definition

Money laundering is the process by which the proceeds of crime areconverted into assets which appear to have a legal rather than anillegal source. The aim of disguising the source of the property is toallow the holder to enjoy it free from suspicion as to its source.

Legislation

Money laundering is primarily regulated by the Proceeds of Crime Act 2002.

The legislation imposes some important obligations uponprofessionals, such as accountants, auditors and legal advisers. Theseobligations require such professionals to report money laundering to theauthorities and to have systems in place to train staff and keeprecords.

The three phases

Money laundering usually comprises three distinct phases:

• Placement – the initial disposal of the proceeds of criminal activity into an apparently legitimate business activity or property
• Layering – the transfer of money from business to business, or place to place, in order to conceal its initial source.
• Integration – the culmination of the previous procedures through which the money takes on the appearance of coming from a legitimate source.

The offences

The Proceeds of Crime Act 2002 created three categories of criminal offence: laundering, failure to report, and tipping off.

Laundering

It is an offence to conceal, disguise, convert, transfer, or removecriminal property from England, Wales, Scotland or Northern Ireland:s327 Proceeds of Crime Act 2002.

Concealing or disguising criminal property includes concealing ordisguising its nature, source, location, disposition, movement orownership, or any rights connected with it.

'Criminal property' is defined as property which the allegedoffender knows (or suspects) constitutes or represents benefit from anycriminal conduct.

'Criminal conduct' is defined as conduct that:

• constitutes an offence in any part of the UK
• would constitute an offence in any part of the UK if it occurred there.

Failure to report

Under s330 individuals carrying on a 'relevant business' may beguilty of an offence of failing to disclose knowledge or suspicion ofmoney laundering where they know or suspect, or have reasonable groundsfor knowing or suspecting, that another person is engaged in launderingthe proceeds of crime.

This offence only relates to individuals, such as accountants, who are acting in the course of business in the regulated sector.

Any individual who is covered by s330 is required to makedisclosure to a nominated money laundering reporting officer withintheir organisation, or directly to the Serious Organised Crime Agency(SOCA), as soon as is practicable.

Tipping off

Section 333 states that it is an offence to make a disclosurelikely to prejudice a money laundering investigation. It thereforecovers the situation where an accountant informs a client that a reporthas been submitted to SOCA.

Penalties

The maximum penalty for the s327 offence of money laundering is 14 years' imprisonment.

Failure to report and tipping off are punishable on conviction by a maximum of five years' imprisonment and/or a fine.

Money Laundering Regulations 2007

Secondary regulation is provided by the Money Laundering Regulations 2007.

The Money Laundering Regulations 2007 implemented the EU's Third Money Laundering Directive.

The Regulations require firms to put preventative measures inplace. They require firms to ensure that they know their customers byconducting customer identification and verification and undertakeongoing monitoring where applicable, to keep records of identity and totrain their staff on the requirements of the Regulations.

The Regulations cover most financial firms such as banks, buildingsocieties, money transmitters, bureaux de change, cheque cashers andsavings and investments firms. In addition the Regulations cover legalprofessionals, accountants, tax advisers, auditors, insolvencypractitioners, estate agents, casinos, high value dealers when dealingin goods worth over 15,000 Euro and trust or company service providers.

There are various regulators and professional bodies who have beengiven supervisory authority. For example, the Financial ServicesAuthority supervises all financial firms covered by the Regulations andthe Office of Fair Trading supervises all consumer credit firms andestate agents.

Test your understanding 2

(1)Which Act contains the legislation on money laundering?

(2)To which organisation must you report suspicions of money laundering?

(3)Which of the three moneylaundering offences only applies to individuals, such as accountants,who are in business in the regulated sector?

(4)What is meant by the term 'money laundering'?

4 Bribery

Definition

Bribery is an act implying money or gift given that alters thebehaviour of the recipient. It is the offering, giving, receiving, orsoliciting of any item of value to influence the actions of an officialor other person in charge of a public or legal duty.

Legislation

The Bribery Act 2010 came into force on 1 July 2011.

The Act creates four offences:

• bribing a person to induce or reward them to perform a relevant function improperly (S1)
• requesting, accepting or receiving a bribe as a reward for performing a relevant function improperly (S2)
• using a bribe to influence a foreign official to gain a business advantage (S6)
• a new form of corporate liability for failing to prevent bribery on behalf of a commercial organisation (S7).

Commercial organisation has a wide meaning and includespartnerships, limited liability partnerships and companies which carryon business.

Defence

Under S9 for a commercial organisation it is a defence to have inplace 'adequate procedures' to prevent bribery. This may includeimplementing anti-bribery procedures. It is important that firmsconsider what adequate procedures are most appropriate for their firmgiven the risks they face and they way they run their business. Theprocedures should be proportionate to the risk posed.

For some firms there will be no need to put bribery preventionprocedures in place as there is no risk of bribery on their behalf.Other firms may need to put in place measures in key areas, such asgifts and hospitality, as this is the area where they have identified arisk.

Penalties

The penalty for individuals is a maximum sentence of 10 years.

For commercial organisations there maybe an unlimited fine.

5 Potential criminal activity in the operation, management and winding up of companies

Introduction

There are a number of criminal offences that could be undertaken byindividuals concerned in the operation, management or winding up of acompany. Many of these points have been covered in earlier chapters andso are only dealt with in outline here.

Failure to file accounts or annual returns

Failure to deliver accounts or annual returns on time is a criminaloffence. All the directors of a company in default could be prosecuted.If convicted, a director could end up with a criminal record and a fineof up to £5,000 for each offence.

Providing misleading information to an auditor

Under s499 CA 2006, an auditor is entitled to require from thecompany's officers and employees such information and explanation as hethinks necessary for the performance of his duties as auditor. It is acriminal offence for an officer of the company to:

• provide misleading, false or deceptive information or explanations, or
• fail to provide information or explanations required by the auditor.

An individual can defend such a charge if he can prove that it wasnot reasonably practicable to provide the information or explanationsrequired.

Companies Act 2006

Under s82 CA 2006 it is a criminal offence to use a business namethat requires prior approval, if that approval has not been obtained.

It is also a criminal offence to fail to disclose the businessdetails that the Act requires. These details include stating thecompany's corporate name and address for the service of documents.

Company Directors Disqualification Act 1986 (CDDA 1986)

Under s13 CDDA 1986, any person who acts in contravention of adisqualification order (or while an undischarged bankrupt) is guilty ofan offence. The maximum penalty is:

• two years' imprisonment and/or a fine on conviction on indictment
• up to six months' imprisonment and/or a fine not exceeding the statutory maximum on a summary conviction.

S15 CDDA 1986, provides that anyone who is involved in themanagement of a company while disqualified, or who acts on theinstructions of someone who is disqualified, shall be personally liablefor the company's debts incurred during the time they acted.

Phoenix companies

S216 and s217 Insolvency Act 1986 (IA 1986) are aimed at so-called'phoenix companies'. They apply where a person was a director or shadowdirector of a company at any time in the period of 12 months ending withthe day before the company went into liquidation.

The provisions apply for the five years following liquidation. Theyprevent the person being a director of a company with a similar name,or a name which suggests an association with the previous company,without leave of the court.

It is a criminal offence to contravene the provisions, punishableby imprisonment and/or a fine. In addition, the director will bepersonally liable for any debts of the new company which are incurredwhen he was involved in its management.

The Fraud Act 2006

The Fraud Act 2006 radically changed the law of criminal fraud.

Before the Fraud Act came into force, the statutory fraud offencesunder the Theft Act 1978 were based on deception. They included:

• Obtaining property by deception.
• Obtaining a money transfer by deception.
• Obtaining a pecuniary advantage by deception.
• Obtaining services by deception.

The Fraud Act swept all of the old statutory deception offencesaway. Instead a new offence of fraud has been defined as follows:

• The defendant must have been dishonest, and have intended to make a gain or to cause a loss to another; and
• The defendant must carry out one of these acts:

- s2: fraud by making a false or misleading representation, thisbeing where any person makes "any representation as to fact or law ...express or implied" which they know to be untrue or misleading.

- s3: fraud by failing to disclose information whereby a personfails to disclose any information to a third party when they are under alegal duty to disclose such information.

- s4: fraud by abuse of position where a person occupies a positionwhere they are expected to safeguard the financial interests of anotherperson, and abuses that position; this includes cases where the abuseconsisted of an omission rather than an overt act.

The new offence of fraud is intended to be wide and also flexible.There is no reliance on the concept of "deception". It does not matterwhether the false information actually deceives anyone, it is themisleading intention which counts.

6 Transactions at an undervalue and preference

A liquidator may apply to the court to set aside companytransactions at an undervalue (s238 Insolvency Act 1986) or where thecompany gives a preference (s239 Insolvency Act 1986).

Undervalue

A company enters into a transaction at an undervalue if the companymakes a gift or otherwise enters into a transaction on terms that thecompany receives not consideration or insufficient consideration.

The transaction would not be set aside if it was entered into ingood faith on the reasonable belief that it would benefit the company.

Preferences

A company gives a preference if it does anything to put a creditorin a better position in the event of the company's insolvent liquidationthan they would otherwise be.

The court will not make an order unless the company was influencedby a desire to prefer the creditor. Therefore, a payment or chargecreated in favour of a creditor who is threatening legal proceedingsmight be a defence. However, if the preference was given to a connectedperson it is presumed that the company was influenced by its desire togive a preference.

7 Fraudulent and wrongful trading

Fraudulent trading

Fraudulent trading occurs where the company's business is carried onwith intent to defraud creditors or for any fraudulent purpose.

Fraudulent trading can give rise to:

• civil liability under s213 Insolvency Act 1986 if the company is in the course of being wound up
• criminal liability under s993 CA06 whether or not the company is in the course of being wound up.

It is necessary to establish dishonest intent. In Re William C Leith Bros (1932)it was said that if the directors carry on the business and cause thecompany to incur further debts at a time when they know that there is noreasonable prospect of those debts being paid this is a properinference of dishonesty. The court also added that if the directorshonestly believed the debts would eventually be paid there would be nointent to defraud.

R v Grantham (1984)

The second point required to establish liability is that the person concerned shall be knowingly a party to the fraudulent trading.

In Re Maidstone Buildings (1971) it was established that aperson is not 'party' merely by reason of knowledge. They must take someactive step, such as the ordering of goods.

Fraudulent trading can give rise to the following consequences:

• The court can order the individual to contribute to the company's assets.
• If a director, they may be disqualified for 15 years under CDDA86.
• If found guilty of the criminal offence, the individual can be fined and/or imprisoned for up to 10 years.

Wrongful trading

Wrongful trading occurs where on a winding-up it appears to the courtthat the company has gone into insolvent liquidation and, before thestart of winding up, the director knew or ought to have known that therewas no reasonable prospect that the company would avoid going into insolvent liquidation: S214 Insolvency Act 1986.

The provision of 'wrongful trading' contained in S214 IA86 isdesigned to remove one of the difficult obstacles to the establishmentof being party to fraudulent trading – namely proving dishonesty. It applies only to directors and shadow directors.

The director is expected to reach those conclusions and take such steps as a reasonably diligent person would take.

The legislation also expects such a director to:

• have the general knowledge, skill and experience which may reasonably be expected of a person carrying out the same functions as were carried out by that director (i.e. this is an objective test)
• use the general knowledge, skill and experience he himself has (i.e. this is a subjective test).

When considering the director's functions, the court will haveregard not only to those functions he carried out but also to thoseentrusted to him. This means that the director could be made liable forthose actions he should have carried out but failed to.

Re Produce Marketing Consortium Ltd (No 2) (1989)

Wrongful trading can give rise to the following consequences:

• a liquidator may apply to the court for an order that the director should make such contribution to the company's assets as the court thinks fit, thereby increasing the assets available for distribution to the creditors
• They may be disqualified for 15 years under CDDA86.

Test your understanding 3

Explain the main differences between a director fraudulently trading and wrongfully trading.

(Your answer must not exceed 40 words.)

Chapter Summary

Test your understanding answers

Test your understanding 1

(1)Criminal Justice Act 1993.

(2)Dealing in securities.

(3)Did not expect the dealing toresult in a profit. Believed the information had been disclosed. Wouldhave done what he did even without the information.

Test your understanding 2

(1)The Proceeds of Crime Act 2002.

(2)Serious Organised Crime Agency.

(3)Failure to report.

(4)Money laundering is the processby which the proceeds of crime are converted into assets which appear tohave a legal rather than an illegal source. The aim of disguising thesource of the property is to allow the holder to enjoy it free fromsuspicion as to its source.

Test your understanding 3

Fraudulent trading is trading with intent to defraud creditors andis a criminal offence. Wrongful trading occurs when it was known orought to have been known that insolvency was unavoidable, and is not acriminal offence.

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