Regulatory Monitor Winter 2001/2002

Following the hectic build-up to the passing of N2 at midnight on 30 November 2001, with firms endeavouring to achieve systems and controls which comply with the new Conduct of Business Rules (COB), authorised firms may now enjoy a grace period in a number of circumstances.

There is a general 7 month transitional period to 30 June 2002, for firms previously authorised under the Financial Services Act 1986, whether by an SRO or the FSA itself. During this period, authorised firms may comply with current SRO rules, COB or a combination of SRO rules in certain areas and COB in others. The transitional period does not apply to banks whose only regulated activity is deposit-taking, or general insurance companies.

There is a 12 month period to 30 November 2002 for firms previously regulated by a Recognised Professional Body.

The transitional provisions include:

• Arrangements for the "mapping across" of client classifications so that firms will not need to re-document all of their clients after N2.
• A general permission for firms to continue to rely on pre-N2 terms of business (including for post-N2 customers), subject to specified safeguards.
• A defence against allegations of a breach of COB where a firm has complied with the equivalent rules of its pre-N2 regulator, during the relevant transitional period.
• Certain "extra time" provisions apply, to some extent, to COB relating to financial promotion, client classification, client assets, client money and information about the firm.
• Certain technical timing provisions apply such as in relation to half-yearly reports by SFA member firms to customers in respect of their portfolios. SFA rules may be applied for periods which end less than 6 months after N2.
• Firms may continue to use or rely upon pre-N2 compliant documentation or compliance work indefinitely, such as terms of business agreed by a customer before the end of any extra time transitional period. For example, an ex-SFA member firm may issue FSA compliant terms of business after N2 and before 30 June 2002, without breaching the new COB.

The customer classification rules within the Conduct of Business Source Book, merge the requirements of the former SROs. Customers are now to be categorised into one of three groups: market counter-parties, intermediate customers and private customers, with increasing levels of protection respectively.

The adequacy of a firm’s records to support customer classification is very likely to be reviewed by the FSA post-N2. This will include reviewing documentation evidencing a firm’s reasoning behind particular client classifications. It is therefore essential that all conversations and written communications relied upon for the purposes of classifying customers are recorded in writing and retained.

All relevant records must be retained for a minimum of three years from the date a firm ceases to carry on business for a particular client. The ability of firms to "map across" pre-N2 classifications directly to their appropriate new classifications and the ability to continue to rely upon terms of business and client agreements which have not changed, enable a smoother transition to the new classification regime.

On 1 December 2001, new rules and a new guidance manual in relation to changes to the Listing Rules came into force. In summary, the conclusions reached by the FSA following detailed consultation during the Summer, include:

• Clarification of the guidance on the dissemination of price sensitive information (the "PSI Guide");

• To replace the Quotations Committee with the Listing Authority Review Committee, for non-disciplinary cases;
• To withhold the introduction of a requirement for a company to make an announcement to the market if a director or relevant employee has breached the company’s code of dealing;
• To withhold the proposed new rules requiring issuers and sponsors to notify the UKLA when becoming aware that they have breached a Listing Rule;
• To emphasise that the PSI Guide is now guidance within the terms of the Act and not simply best practice.

The final Code of Market Conduct ("the Code") came into force on 1 December. In recent months the Code has been the subject of relatively little amendment. It now reflects the final versions of statutory instruments made by the Treasury, defined terms within the new Handbook of Rules & Guidance, and cross references to other material. The FSA has not made substantive changes to its policy nor altered significantly the Code since April.

There follows a summary of further guidance, reflected by final amendments to the Code.

The Prescribed Markets and Qualifying Investments Order 2001, established that the prescribed markets (ie those protected by the new market abuse regime) will be the markets established under the rules of the RIEs. RIEs will include the newly named virt-x Exchange Limited.

Market abuse is defined as behaviour which occurs in relation to qualifying investments "traded on" a prescribed market. The FSA has issued guidance on the meaning of "traded on", so as to enable market users to establish for themselves whether or not a particular investment is "traded on" a prescribed market.

The FSA has sought to allay concerns that the FSA sees itself as the regular user. The FSA has reiterated that it cannot set itself up as the regular user, nor require the regular user to act in any particular manner, to take any particular factor into account or to give any specific weight to a particular factor. However, the FSA can give guidance on the behaviour which, in its opinion, the regular user would be likely to consider as amounting to market abuse and the standards he is likely to expect. This is what the Code is intended to achieve. It sets out the general considerations relevant to the regular user’s assessment of behaviour, whilst at the same time making it clear that all cases will be viewed at the time the behaviour occurred, and not with the benefit of hindsight.

Nevertheless, it will be the FSA which will judge the conduct of the individual in relation to the regular user test upon which it provides guidance. This undoubtedly leaves a somewhat unsatisfactory state of affairs for market participants.

The treatment of accepted market practices raised a number of questions. The FSA considers that just because a practice is accepted by some users of the market, it does not constitute behaviour of a standard expected by the regular user. Nevertheless, the FSA does not expect that accepted market practice will frequently diverge from the standards expected by the regular user. Accepted practices will need to be judged against the objective standards expected by the regular user. In most cases it will often be more appropriate for the FSA to issue guidance or a statement to the markets signalling its views about unacceptable behaviour. This will enable the market participants to alter their conduct accordingly.

There may be some cases where the behaviour is so egregious or heinous and quite clearly abusive that enforcement action may be more appropriate. Other relevant factors will include how transparent and widespread the practice is. It is clear that there may be more than one accepted practice which could meet the standards expected by the regular user and each practice will be judged on its own merits.

Significant concern was expressed as to how market participants would be able to assess innovative transactions against the standards expected by the regular user. The FSA has said that it does not wish to stifle innovation but to encourage it. It will always be open to anyone to seek guidance on RIE rules or the Takeover Code directly from the RIE or the Panel. The FSA will itself offer individual guidance regarding proposed transactions from a market abuse perspective, and is committed to providing a quick and timely response. The more structured the transaction, the longer it will take to consider, but the FSA’s intent is to be helpful and prompt and to this end will expect people seeking such guidance to be open and candid and provide all the necessary details at the time of seeking guidance.

The FSA has considered more explicitly the position of RIE rules. The weight to be given to compliance with RIE rules will vary and the FSA has reiterated that compliance with RIE rules will not of itself necessarily be sufficient for behaviour not to amount to market abuse. It remains the position that it will be possible for behaviour to amount to abuse even if no RIE rules have been breached. For example, a large on-exchange position which has been accumulated over time, with each transaction executed in accordance with RIEs rules may still form part of a strategy of behaviour which amounts to market abuse.

(1) "On an equal basis"

Concern was expressed in the final consultation that the description of information which market users expected to have disclosed to them "on a equal basis" in the Code, was not compatible with some of the categories of information which were described in the Code as being "generally available". As a result, references to "on an equal basis" have been removed from the Code.

(2) Dealing

Previously, the description of behaviour covered only "dealing". This description was narrower than the statutory definition which refers to "behaviour", and which is clearly wider than mere "dealing". Accordingly, the FSA has revised the Code by broadening the definition to include "arranging deals" such that "dealing" has been replaced with "dealing or arranging deals". The FSA has also broadened the scope of the safe harbours so that they cover dealing or arranging deals and are not limited to dealing.

(3) Use of information in more than one market

The FSA’s position in the draft Code had been that behaviour would amount to market abuse where information required to be announced or disclosed in relation to one market, was used in another market to which the information was relevant ahead of the disclosure or announcement.

Particular concern was expressed by commodity market participants that:

(i) commodity producers should at least be permitted to hedge (in the commodity derivatives market) existing contractual delivery obligations before disclosing information (for example, under listing obligations) which is also relevant to the price of commodity derivatives;

(ii) in the case of a disclosure to the equity market which is also relevant to commodity derivative prices, any disclosure obligation should be in relation to the equity market, not the commodity market. Therefore, use of this information in the commodity market should not be regarded by the regular user as a failure to meet expected standards.

In light of these concerns, the FSA modified the Code to make it clear that where relevant information is to be disclosed to market A and it is also relevant to market B in which there is no disclosure obligation, dealing or arranging deals based on the information in relation to investments traded on market B will not amount to market abuse.

However, participants in these markets need to be clear that they may be subject to other requirements and obligations concerning the use of such information. Under European Directive (79/279/EEC), listed companies are obliged to disclose significant news as soon as possible. Under the FSA’s Listing Rules, significant new developments must be disclosed without delay. Therefore, a commodity producer, faced, for example, by an unexpected drop in production which will require it to issue a profits warning, will need to consider whether hedging its position in the commodity derivatives market before making a general disclosure is consistent with its obligations under any listing rules to which it may be subject, either in the UK or elsewhere.

Similarly, firms authorised by the FSA may come into possession of information which is relevant to commodities derivatives from a client relationship. Such firms will need to consider the extent to which client confidentiality, COB and RIE rules restrict their own use of such information.

The FSA has identified a number of points which it intends to explore further with the relevant market participants and the RIEs, later this year.

In response to pressure that the FSA should give greater certainty as to whether transactions which have a legitimate commercial rationale, do not amount to market abuse, the FSA amended the legitimate commercial rationale test so that it now comprises two elements, namely whether the regular user would regard:

(a) the principal purpose for the behaviour as a legitimate commercial rationale; and

(b) the way in which the behaviour has been engaged in as proper.

A "proper way" will take into account the need for the market as a whole to operate fairly and efficiently. The Code now states that:

(a) in most (but not all) cases, executing a trade in accordance with relevant RIE rules will amount to execution in a "proper way"; and

(b) a transaction executed with the purpose of creating a false or misleading impression will not be regarded as having being executed in a "proper way".

Respondents focussed mainly on the meaning of "accepted channel". In order to clarify the situation, the FSA has stated that there are two broad categories of accepted channels: channels which disseminate information which listed companies are obliged to disclose (for example, RNS) and channels operated by RIEs which disseminate information about trading (eg. LIFFE Connect). The FSA has decided not to include a list of accepted channels on grounds of practicality, since the list is likely to change frequently and the FSA would then need to consult on each change. Market users will, however, be able to check with the relevant RIE if they are unsure whether a channel is an accepted channel for dissemination of information. This information should already be known by LSE members.

As for the RNS monopoly in relation to dissemination of information which listed companies are obliged to disclose, the FSA has approved proposals to put an end to that monopoly. Eight information providers, have effectively been short listed for auditing by an approved auditor in order to determine that their systems are sufficiently secure and robust. After this audit process, it is expected that there will be four news suppliers - RNS, PR Newswire, Business Wire and Waymaker.

This section has proved to be the most controversial in the Code. The main concern has been that the section still appeared to catch legitimate behaviour (for example, one reading of the descriptions suggested that they caught block trades). The principal comments made were as follows:

(a) there was a need to introduce "purpose" throughout the distortion sections;

(b) there was a need to introduce a legitimate commercial rationale "safe harbour";

(c) it was not clear whether all squeezes were by definition abusive or whether having a significant influence over demand and supply was sufficient to render the behaviour abusive;

(d) the factors could imply that market users were, for example, under an obligation to lend a deliverable security or commodity and, if they failed to do so, their behaviour would amount to market abuse; and

(e) there was a need for a definition of "distortion".

As far as a definition of distortion is concerned, there is no universally accepted definition within one market, let alone across the broad range of markets covered by the new regime. This makes it much more difficult to establish bench marks against which to judge whether or not a market has been distorted. Nevertheless, in response to the concerns raised, the FSA has made a number of amendments to clarify the types of behaviour which would be regarded as leading to distortion. These amendments include:

(a) clarifying the requirements regarding "purpose" in the descriptions of price positioning and abusive squeezes;

(b) introducing more examples for price positioning and abusive squeezes to add further clarity;

(c) identifying more examples of acceptable behaviour (for example, an index tracker fund’s traders buying on the close as long as the way in which the traders execute the transactions would be regarded as proper);

(d) making clearer the distinction between abusive squeezes and squeezes. A statement about the visibility of the actions of long position holders has been removed; and

(e) repeating that the Code does not impose any additional obligations beyond those already in existence.

The FSA has not incorporated legitimate commercial rationale within the test for distortion, since the test itself incorporates the purpose of the person in question.

The specific issue raised in connection with the requiring or encouraging limb of market abuse, was the extent to which intermediaries might be considered to have required or encouraged another to engage in market abuse if they executed a transaction on behalf of a customer or client which amounted to market abuse. In response to this concern, the Code now provides that the focus will remain on the originator of an abusive transaction which has been executed via an intermediary. The intermediary will not have required or encouraged the originator to engage in market abuse, nor engaged in market abuse itself, unless it can be shown that the intermediary knew or ought to have known that the originator was engaging in market abuse.

Since the publication of the final Code, the FSA has been focussed upon its implementation, including the devising and publishing of operating arrangements which the FSA will have with the RIEs and the Takeover Panel.

The FSA has also been developing internal procedures for the giving of individual guidance on the Code. It is intended that there will be a central contact point for the giving of guidance, given the application of the Code to authorised and unauthorised persons.

The FSA also intends to publish a short summary of the market abuse régime. This will be aimed at a wide readership, including retail investors. There will also be a "decision tree" setting out the key elements of the market abuse régime and the types of questions which a person should ask himself when considering whether his behaviour might amount to market abuse.

In addition, the FSA will publish a post -N2 "frequently asked questions" Bulletin with the support of the FSA’s Practitioner Group on Market Abuse.

Meanwhile, the EU Commission’s proposal to introduce a Market Abuse Directive gains momentum. There are currently no EU provisions against market manipulation and the Directive on insider dealing is considered outdated. The proposed new Directive would apply to market manipulation and insider trading and would therefore incorporate and update the existing insider dealing Directive whilst adding common provisions on market manipulation.

The proposed Directive has proved to be controversial and has caused widespread criticism.

Certain commentators have suggested that the proposed Directive will mean a transfer of power from national regulators such as the FSA, to the EU. With the current proposed deadline for the introduction of the new Directive being 2005, the Conservative Party is predicting a sole EU regulator in the not too distant future!

This is a commentary to update those involved in regulated banking, investment, or corporate activities, on important developments affecting them. Since this is a quick reference facility, it is not a substitute for obtaining specific professional advice.