U.K. Agency Struggles in Fight Against Insider Trading

U.K. Agency Struggles in Fight Against Insider Trading

Critics Point to Rapid Staff Turnover, Insufficient Financial Expertise; ‘FCA Hasn’t Yet Had a Big Scalp’

DAVID ENRICH and HARRIET AGNEW

Updated Jan. 4, 2014 7:43 p.m. ET

LONDON— Carl Linderum was getting ready for work one morning at his London home when he heard a pounding on his door. He figured the group of men outside were employees of his gas provider, there to badger him over a disputed bill.

In fact, they were plainclothes police officers and agents from the U.K.’s financial regulator. They had come to arrest the 36-year-old trader, who ran a small hedge fund, for suspected insider trading.

The arrests last February of Mr. Linderum and a colleague led to the collapse of their roughly $100 million hedge fund, Lodestone Investment Partners LLP. Seven people lost their jobs.

Nearly 10 months later, the Financial Conduct Authority dropped the investigation of the two Lodestone executives and a third trader from another hedge fund who was arrested at the same time.

The investigation’s outcome underscores the challenges facing the agency as it tries to remake itself as a tough-on-crime financial watchdog after years of rarely prosecuting such cases.

To critics of the FCA, the probe shows the potential for collateral damage as regulators pursue insider-trading investigations. To the agency’s defenders, it illustrates how hard it can be for regulators to prove that suspicious-seeming transactions are illegal.

The FCA stepped up its pursuit of insider trading after British officials came to believe financial wrongdoing was damaging London’s standing as a financial center. Last April, in an effort to wash away the agency’s laissez-faire reputation, it changed its name and mandate. It has poured tens of millions of pounds into hiring staff and developing computer systems to identify suspicious trading.

Margaret Cole, a top agency enforcement official from 2005 to 2012, says high-profile raids and arrests are a key component of the strategy—even if they don’t yield convictions. “A large part of the deterrent effect comes from the regulator doing this, and you don’t know when they might pop up and do it again,” she says.

Critics, including some former agency officials, say the FCA has been hobbled by rapid staff turnover and insufficient financial expertise. “The FCA hasn’t yet had a big scalp,” says Neil Swift, a partner at Peters & Peters Solicitors LLP, who represented one of those arrested in the Lodestone case.

The FCA and its predecessor, the Financial Services Authority, didn’t bring a criminal insider-trading case until 2009. Since then, it has won 23 convictions involving illicit profits totaling less than $9 million, according to a Wall Street Journal analysis of public disclosures. Five people charged with insider trading have been acquitted, and seven others are awaiting trial.

By comparison, the U.S. Securities and Exchange Commission has filed more than 50 insider-trading civil cases in each of the past three years. One recent hedge-fund case featured hundreds of millions of dollars of alleged illicit profits and avoided losses.

In part, the disparity reflects the larger size of U.S. capital markets.

Also, U.S. authorities have a more powerful array of crime-fighting weapons, including the ability to wiretap.

FCA spokesman Chris Hamilton says the agency “has a good track record in bringing criminal prosecutions, and our investigators have been commended by judges in a number of our previous cases.” Insider-trading cases, he notes, “are extremely complex and are therefore often time-consuming.”

The U.K.’s highest-profile case became public in March 2010. Some 143 agents fanned out across Greater London to conduct dawn raids and arrests at the homes of six traders, investment bankers and investors. Three others were subsequently arrested.

The FSA, as the agency was then known, announced it suspected the men were “involved in a sophisticated and long-running insider-dealing ring.” FSA investigators informed the men they were suspected of reaping at least £27 million, or roughly $40 million, in illegal profits, according to people familiar with the case.

Nearly four years later, seven of those men have been charged, but the alleged proceeds of their crimes have declined to about £3 million, according to court filings. One man pleaded guilty and received a two-year jail sentence. Another pleaded not guilty at a December court hearing. Five others said they weren’t yet prepared to enter pleas. Their trial is expected to start in the fall.

Two of the arrested men, traders Julian Rifat and Clive Roberts, have neither been charged nor cleared. Both deny wrongdoing. They have been unable to land jobs and their assets remain partly frozen, according to people familiar with their situations.

At a private hearing in November, Mr. Rifat’s lawyers petitioned to unlock his assets. A judge gave the FCA until this month to decide whether to file criminal charges, according to people familiar with the case.

“If the FCA is ready to arrest with a big hullabaloo, it shouldn’t take so long to bring charges or discontinue” the case, says Stephen Pollard, a prominent defense lawyer who briefly represented Mr. Rifat.

The FCA tracks how often the shares of companies trade abnormally in the two days before takeover announcements—a possible indication of insider-trading. In 2012, the latest year for which data are available, such abnormal trading took place in advance of about 15% of deals, down from 21% in 2010 and the lowest level since 2003.

The FCA’s chairman, John Griffith-Jones, described the data as “somewhat encouraging.”

The investigation into the Lodestone hedge fund arose from a review of what regulators thought looked like abnormal trading activity. The following account is based on interviews with nine people, including many familiar with the arrested men’s situations.

In January 2012, African Minerals Ltd. AMI.LN -0.13% , an iron-ore-mining company with operations in Sierra Leone, was preparing to issue a convertible bond, largely to finance the development of a new mine. Trying to drum up interest among investors, the company’s London brokers, from Mirabaud Securities LLP, approached Carl Esprey, a portfolio manager at hedge fund GLG Partners Inc.

Mr. Esprey, who was born in South Africa and previously worked in the mining industry, ran a stock fund at GLG, which is a unit of Man Group EMG.LN +0.99% PLC. His fund, which already held a big chunk of African Minerals stock, wasn’t eligible to invest in bonds. Mr. Esprey referred Mirabaud to Mr. Linderum, who had co-founded Lodestone in 2011 with Tim Whyte.

Messrs. Esprey and Linderum had met in 2010 when they were touring mining sites in Sierra Leone, and they had kept in touch. Mr. Esprey figured Mr. Linderum’s fund, which specialized in natural-resources investments and whose name is a reference to iron ore, might be interested in the African Minerals deal. He called Mr. Linderum to alert him that Mirabaud would be getting in touch.

Several days earlier, Lodestone had laid plans with an investment bank to “short” African Minerals shares—a bet that they would decline in value. On the morning of Jan. 27, the hedge fund executed that trade.

About two hours later, Mr. Linderum was at a lunch meeting when his cellphone rang. A Mirabaud broker on the line told him of African Minerals’ bond-issuance plans. Because the plans weren’t public yet, that meant Mr. Linderum joined Mr. Esprey on an official roster of people who were considered “insiders” for regulatory purposes. In essence, lawyers say, that meant they were restricted from making investments in the company until the deal was announced.

Before Mr. Linderum got back from lunch or explained the situation to his partner Mr. Whyte, Mr. Whyte added to Lodestone’s short position.

African Minerals announced the bond deal on Jan. 31. The company’s stock dipped slightly. Lodestone closed out its short position, grabbing about £141,000 in profits. In subsequent days, African Minerals shares rallied.

Unbeknown to Messrs. Linderum, Whyte and Esprey, the short sale had caught the FSA’s attention. The agency’s market-monitoring team deemed it suspicious that the men, who appeared to be armed with inside information, had made a profitable trade. The team scoured trading records and phone logs looking for clues.

A year passed. On Feb. 27, 2013, Mr. Esprey was summoned to a 6:30 a.m. meeting at Man Group’s corporate headquarters. He was met by the company’s compliance chief, who informed him that police officers and FSA agents were there to arrest him for alleged insider trading. Man Group immediately suspended him with pay.

As Mr. Esprey was being arrested, police and FSA officials arrived at his home. They carted away phones and computers. They rifled through his 2-year-old son’s Mickey Mouse backpack.

Searches also were under way at the homes of Messrs. Whyte and Linderum, who also were arrested. Agents raided Lodestone’s offices across the street from Hyde Park, seizing computers and documents.

The three men were brought to a police station in central London. FSA officials separately informed them that Mr. Esprey was suspected of leaking inside information and that Messrs. Whyte and Linderum were suspected of basing their short-sale of African Minerals stock on that information.

Although the FSA didn’t disclose the names of the three arrested men, within two weeks the names of all three had been widely reported in the media.

The situation spooked Lodestone investors, who asked to withdraw their money. Messrs. Whyte and Linderum decided that they had no choice but to liquidate the fund and let go their employees.

Lawyers for the Lodestone executives filed briefs stating that most of the African Minerals short position predated them learning of the bond deal, albeit only by hours. They also argued that such a bond deal normally would cause the company’s stock to rise, not fall, so it would have been illogical for them to short the stock based on advance knowledge of the bond sale.

Mr. Whyte blames what he says was a lack of financial acumen by FCA officials. The agency needs “the right financial experts who have a proper understanding of how markets and hedge funds operate,” he says.

A person familiar with the FCA says it employs many market and hedge-fund experts and that it brings in outsiders in cases where its own staff lacks the necessary expertise.

The FCA’s interviews with the suspects—their opportunity to proclaim their innocence—were initially scheduled for May 2013. The FCA delayed them until mid-September.

Desperate for advice, Mr. Linderum got in touch with Mr. Rifat—one of the men arrested more than three years earlier in the separate FSA sweep, who remained uncharged. The two men, who hadn’t previously met, sat down at a private club in London. Mr. Rifat recounted his odyssey. Mr. Linderum left rattled.

On Nov. 18, Messrs. Esprey, Linderum and Whyte received letters from the FCA saying it was dropping the investigation. On Dec. 6, the FCA issued a one-sentence statement saying the men “are no longer under investigation.”

That evening, Mr. Esprey called Mr. Whyte for the first time. They discussed ways to start repairing their reputations. “We don’t know each other,” Mr. Esprey told him, “but we shared this experience.”