UK: Financial Services Bulletin - Market Abuse: The New Regime

Last Updated: 23 August 2002

Key Points At A Glance

This article analyses:

  • the purpose of the market abuse regime;
  • the key elements of market abuse (must relate to qualifying investments traded on a relevant market, the three conditions -misuse of information, false or misleading impressions or distortion, and the regular user test);
  • the role of the FSA’s Code of Market Conduct and the concept of safe harbours.

Market Abuse - The New Regime

Purpose of the Market Abuse Regime
It is important to step back from the legal framework and consider the fundamental policy objective behind the market abuse regime. The objective is to ensure as far as possible that the market operates fairly and cleanly and as a result to enhance the integrity, transparency and competitiveness of the UK’s financial sector. Market abuse undermines the confidence of market participants, whether professional or retail, and damages the reputation of the market.

Essence of Market Abuse
Market abuse occurs in three principal ways. Each is characterised by a market user being unreasonably disadvantaged (directly or indirectly) by other market users who:

  • use to their own advantage information which is not generally available; or
  • create a false or misleading impression; or
  • distort the market.

Market Abuse Under the FSMA - Key Elements
1. Behaviour must occur in relation to qualifying investments traded on a relevant market; and

2. the behaviour must satisfy one of the following three conditions:

• the behaviour must be based on information not generally available to those using the market but which if available to a regular user of the market would be regarded by him as relevant when deciding the terms on which transactions in investments of the kind should be effected; or

• the behaviour must be likely to give a regular user of the market a false or misleading impression as to the supply of or demand for or as to the price of investments of the kind in question; or

• a regular user of the market would, or would be likely to, regard the behaviour as behaviour which would, or would be likely to, distort the market in investments of the kind in question; and

3. the behaviour must be likely to be regarded by a regular user of that market as a failure on the part of the person or persons concerned to observe the standard or behaviour expected of a person in his or their position in relation to the market.

Qualifying Investments and Markets
The principal qualifying investments are:

  • Deposits;
  • Contracts of insurance;
  • Shares;
  • Instruments creating or acknowledging indebtedness;
  • Government and public securities;
  • Instruments giving entitlements to investments;
  • Certificates representing certain securities;
  • Units in a collective investment scheme;
  • Rights under a stakeholder pension scheme;
  • Options;
  • Futures;
  • Contracts for differences.

The qualifying markets are (currently):

  • Coredeal Limited;
  • The International Petroleum Exchange of London Limited;
  • Jiway Limited;
  • LIFFE Administration and Management;
  • The London Metal Exchange Limited;
  • London Stock Exchange plc (including AIM);
  • OM London Exchange Limited;
  • virt-x Exchange Limited;
  • virt-x plc;
  • OFEX.

The First Element - Misuse of Information
This element anticipates that market users would expect certain types of information to be made available to all market users on an equal basis. If only a limited number of users have access to this information and trade on it to their own advantage, confidence in the integrity of the market will be prejudiced.

The Code (see below) provides that two categories of information are likely to be regarded by a regular user as relevant when deciding the terms on which transactions in investments should be effected:

  • information which has to be disclosed to the market pursuant to a legal or regulatory requirement ("disclosable information");
  • information which is usually disclosed publicly though is not subject to a formal disclosure requirement ("announceable information").

The restriction on those who possess announceable information from acting on it is new and will include such matters as a company’s credit ratings, government and economic statistics and so on.

The Code gives detailed guidance on when information would be regarded by a regular user as relevant when deciding whether to invest or not, or the terms of investments.

The Code acknowledges that there will be many occasions when particular users of the market have access to information that is not always available to others. In this type of situation it may well be entirely legitimate for those possessing the information to use it for profit. Consequently information obtained by research or analysis is exempt from any prohibition enabling it to be freely used.

There is also an exemption for "order flow information" -information concerning a person’s own or any other person’s intention to deal or not in a qualifying investment. This exemption is, however, subject to any relevant conduct of business rules such as those regarding trading ahead of published recommendations.

The Second Element - False or Misleading Impressions
A classic example of behaviour which may give a false or misleading impression is artificial transactions. Under the Code a person is prohibited from entering into a transaction where that person:

"knows (or could reasonably be expected to know) that the principal effect of a transaction (or series of transactions) on the market will be, or is likely to be, artificially to inflate or depress the apparent supply of, or demand for, or the price or value of, a qualifying investment or relevant product such that a false or misleading impression is likely to be given to a regular user, unless the principal rationale for the transaction in question would amount to what a regular user would consider a legitimate commercial rationale, notwithstanding the effect of the transaction."

The test is designed to allow a distinction to be made between two apparently identical transactions which have the same principal effect but where one initiator has a legitimate commercial rationale but another does not.

In addition to artificial transactions this test will also be breached where a person disseminates information which:

  • he knows, or could reasonably be expected to know, is false or misleading; and
  • the information is disseminated to give a false or misleading impression.

The Third Element
A classic example of market distortion provided by the FSA is abusive squeezes. These occur where a person:

  • has a significant influence over the relevant supply of a product or the delivery mechanisms of a market in that product;
  • has entered into deals on a market under which he has the right to require others to deliver to him (or those colluding with him) quantities of that product or to take delivery from him (or those colluding with him) of quantities of that product; and
  • uses these circumstances to dictate arbitrary and abnormal prices for the settlement and release of obligations to him (or those colluding with him) arising under those deals.

The Regular User Test
The regular user test is a key part of the market abuse regime. In order to amount to market abuse, behaviour must be within one of the three elements and be likely to be regarded by a regular user of the market as a failure on the part of the person concerned to observe the standard of behaviour expected of a regular user of the market.

The regular user is someone who regularly deals on the market in investments of the kind in question. The regular user will take into account compliance with the rules of a recognised investment exchange, other rules or codes of conduct and good practice in deciding whether behaviour falls short of reasonably expected standards.

The regular user, when determining the standards of behaviour required of a person, does take into account that person’s position in relation to the market - there is no universal standard. The standards expected will vary according to a person’s skill and level of knowledge. For obvious reasons the standards expected of a professional market participant will be more exacting than those applying to a retail investor.

The Code of Market Conduct and the Concept of Safe Harbours

Section 119 FSMA provides that the FSA must prepare and issue a code containing guidance on whether or not conduct amounts to market abuse. The FSA has issued a Code of Market Conduct. The Code contains three types of material:

  • descriptions of behaviour that, in the opinion of the FSA, amounts to market abuse;
  • descriptions of behaviour that, in the opinion of the FSA, does not amount to market abuse;
  • factors that, in the opinion of the FSA, are to be taken into account in determining whether or not behaviour amounts to market abuse.

Key Points Regarding the Code

  • The point of the Code is to describe the FSA’s view of the three tests of market abuse and the operation of the regular user test. The Code gives guidance. It is not a comprehensive list of all behaviour that does or does not amount to market abuse.
  • If the Code describes specified behaviour as not amounting to market abuse, that is definitive and a person can be certain that this behaviour does not amount to market abuse. "Safe harbours" is the term used to describe conduct declared by the FSA not to amount to market abuse.
  • Aside from "safe harbours" which are definitive, the other provisions of the Code have evidential value (eg are taken into account in deciding whether or not behaviour amounts to market abuse) but are not definitive.
  • The Code recognises specific FSA and RIE Rules which, if complied with, amount to safe harbours. Compliance with FSA and RIE Rules does not amount generally to a safe harbour though it is a factor taken into account in deciding whether or not market abuse has occurred.

Market Abuse - Legal Framework for Authorised Persons

Part VIII FSMA - Penalties for Market Abuse.

Financial Services Authority - Code of Market Conduct.

Existing Insider Dealing Rules

Existing Market Manipulation Rules

FAQs

The FSA has issued a guidance note on frequently asked questions on the Code. This includes:

  • guidance on whether the Code covers "grey market" or "when issued" trading (ie before products are traded on an exchange). In broad terms, if a security trades on a prescribed market it will fall within the scope of the regime. If a prescribed market has rules for "grey market" or "when issued" trading in a security or in derivatives, and trading in that security or derivative is subject to the rules of a prescribed market, then it will fall within the market abuse regime;
  • a rebuttal of the idea that the FSA itself is the regular user. The FSA gives guidance on the standards required by the regular user but it is the Financial Services Tribunal that will determine the standard;
  • guidance on the position of an intermediary who conducts an abusive transaction. The FSA would focus on the client who originated the transaction. The FSA is unlikely to regard the execution by the intermediary either as engaging in market abuse jointly with the customer or as requiring or encouraging the customer to engage in market abuse unless the intermediary knew or ought reasonably to have known that the transaction itself was abusive.

Four Key Points

  • The Code of Market Conduct applies to unauthorised as well as authorised persons. This is a significant change for non-FSA regulated persons who are subject currently only to the criminal provisions (ie the insider dealing and market manipulation rules).
  • The Financial Services and Markets Act confers on the FSA the right to bring proceedings for the criminal offences of insider dealing and market manipulation - this is intended to result in more effective prosecution of offences under these provisions.
  • Compliance with an FSA Rule does not (unless the FSA Rule specifically so provides) automatically provide a safe harbour.
  • The FSA provides guidance on the Code in answering "frequently asked questions". The guidance is extremely helpful and well worth reviewing.

Although every care is taken in the preparation of the Bulletin no liability is accepted for any loss which may arise from relying on its contents. The Bulletin is not a substitute for legal advice, which should be taken when appropriate.

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