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 future prospects of a company. This type of information is usually only available to a prospective purchaser after it has been made available publicly. However, if a prospective purchaser could gain access to such information before it was made public, he could anticipate which way the price was likely to move and thereby make a profit. This is known as 'insider dealing'. Insider dealing has been made a criminal offence as it 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 they know that it is inside information and they have it from an inside source.

A person has information from an inside source if:

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

Consequences

On summary conviction an individual found guilty of insider dealing is liable to a fine not exceeding the statutory maximum and/or a maximum 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 his fiduciary duty and may be liable to account to the company for any profit made.

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 concept of market abuse.

Under s118 (1) market abuse is defined as:

• behaviour in relation to any qualifying investments;
• 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:

Qualifying investments are those which are traded on the UK's 'prescribed markets', as well as those traded on other European regulated 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 the target of a takeover bid. Before the information is made public, he buys shares 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 person who sold the shares to the employee might not have done so if he had known of the potential takeover. The employee's friend also has this information and could profit unfairly from it.

Misuse of information

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

Illustration

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

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

Manipulating transactions

This is trading, or placing orders to trade, that gives a false or misleading impression of the supply of, or demand for, one or more investments, raising the price of the investment to an abnormal or artificial level.

Illustration

A person buys a large number of a particular share near the end of the day, aiming to drive the stock price higher to improve the performance of their investment. The market price is pushed to an artificial level and investors get a false impression of the price of those shares and the value of any portfolio or fund that holds the stock. 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 a view to increasing the price. This could give investors a false impression of the price of a share and lead them to make the wrong investment decision.

Dissemination

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

Illustration

A person uses an internet bulletin board or chat room to post information about the takeover of a company. The person knows the information to be false or misleading. This could artificially raise or reduce the price of a share and lead to people making the wrong investment decisions.

Distortion and misleading behaviour

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

Illustration

There is movement of an empty cargo ship that is used to transport a particular commodity. This could create a false impression of changes in the supply of, or demand for, that commodity or the related futures contract. It could also artificially change the price of that commodity or the futures contract, and lead to people making the wrong investment decisions.

Consequences

Market abuse as defined in the Code can result in an unlimited fine and a public reprimand by the Financial Services Authority under civil law.

3 Money laundering

Definition

Money laundering is the process by which the proceeds of crime are converted into assets which appear to have a legal rather than an illegal source. The aim of disguising the source of the property is to allow 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 upon professionals, such as accountants, auditors and legal advisers. These obligations require such professionals to report money laundering to the authorities and to have systems in place to train staff and keep records.

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 remove criminal property from England, Wales, Scotland or Northern Ireland: s327 Proceeds of Crime Act 2002.

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

'Criminal property' is defined as property which the alleged offender knows (or suspects) constitutes or represents benefit from any criminal 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 be guilty of an offence of failing to disclose knowledge or suspicion of money laundering where they know or suspect, or have reasonable grounds for knowing or suspecting, that another person is engaged in laundering the 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 make disclosure to a nominated money laundering reporting officer within their 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 disclosure likely to prejudice a money laundering investigation. It therefore covers the situation where an accountant informs a client that a report has 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 in place. They require firms to ensure that they know their customers by conducting customer identification and verification and undertake ongoing monitoring where applicable, to keep records of identity and to train their staff on the requirements of the Regulations.

The Regulations cover most financial firms such as banks, building societies, money transmitters, bureaux de change, cheque cashers and savings and investment firms. In addition the Regulations cover legal professionals, accountants, tax advisers, auditors, insolvency practitioners, estate agents, casinos, high value dealers when dealing in goods worth over 15,000 Euro and trust or company service providers.

There are various regulators and professional bodies who have been given supervisory authority. For example, the Financial Services Authority supervises all financial firms covered by the Regulations and the Office of Fair Trading supervises all consumer credit firms and estate 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 money laundering 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 the behaviour of the recipient. It is the offering, giving, receiving, or soliciting of any item of value to influence the actions of an official or 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 includes partnerships, limited liability partnerships and companies which carry on business.

Defence

Under S9 for a commercial organisation it is a defence to have in place 'adequate procedures' to prevent bribery. This may include implementing anti-bribery procedures. It is important that firms consider what adequate procedures are most appropriate for their firm given the risks they face and they way they run their business. The procedures should be proportionate to the risk posed.

For some firms there will be no need to put bribery prevention procedures 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 as gifts and hospitality, as this is the area where they have identified a risk.

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 by individuals concerned in the operation, management or winding up of a company. Many of these points have been covered in earlier chapters and so 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 criminal offence. All the directors of a company in default could be prosecuted. If convicted, a director could end up with a criminal record and a fine of up to £5,000 for each offence.

Providing misleading information to an auditor

Under s499 CA 2006, an auditor is entitled to require from the company's officers and employees such information and explanation as he thinks necessary for the performance of his duties as auditor. It is a criminal 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 as charge if he can prove that it was not reasonably practicable to provide the information or explanations required.

Business Name

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

It is also a criminal offence to fail to disclose the business details that the Act requires. These details include stating the company'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 a disqualification order (or while an undischarged bankrupt) is guilty of an 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 the management of a company while disqualified, or who acts on the instructions of someone who is disqualified, shall be personally liable for 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 shadow director of a company at any time in the period of 12 months ending with the day before the company went into liquidation.

The provisions apply for the five years following liquidation. They prevent 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, punishable by imprisonment and/or a fine. In addition, the director will be personally liable for any debts of the new company which are incurred when 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 offences under 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 offences away. 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, this being 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 person fails to disclose any information to a third party when they are under a legal duty to disclose such information.

- s4: fraud by abuse of position where a person occupies a position where they are expected to safeguard the financial interests of another person, and abuses that position; this includes cases where the abuse consisted 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 matter whether the false information actually deceives anyone, it is the misleading intention which counts.

6 Transactions at an undervalue and preference

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

Undervalue

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

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

Preferences

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

The court will not make an order unless the company was influenced by a desire to prefer the creditor. Therefore, a payment or charge created in favour of a creditor who is threatening legal proceedings might be a defence. However, if the preference was given to a connected person it is presumed that the company was influenced by its desire to give a preference.

7 Fraudulent and wrongful trading

Fraudulent trading

Fraudulent trading occurs where the company's business is carried on with 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 the company to incur further debts at a time when they know that there is no reasonable prospect of those debts being paid this is a proper inference of dishonesty. The court also added that if the directors honestly believed the debts would eventually be paid there would be no intent 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 a person is not 'party' merely by reason of knowledge. They must take some active 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 court that the company has gone into insolvent liquidation and, before the start of winding up, the director knew or ought to have known that there was 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 is designed to remove one of the difficult obstacles to the establishment of 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 have regard not only to those functions he carried out but also to those entrusted to him. This means that the director could be made liable for those 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 to result in a profit.

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 process by which the proceeds of crime are converted into assets which appear to have a legal rather than an illegal source. The aim of disguising the source of the property is to allow the holder to enjoy it free from suspicion as to its source.

Test your understanding 3

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

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