UK: Market Abuse Update

Enforcement levels post- N2

More than a year after N2, the anticipated headline market abuse cases have not materialised. It is the Market Integrity Group (MIG) of the FSA’s Enforcement Division which is responsible for handling market abuse cases. Apparently, between 15-20 investigations were opened last year and 20-30 are active (including pre-N2 cases). However, between 5-10 have progressed to the Regulatory Decisions Committee and 60-70% of MIG’s workload is said to be insider dealing related.

To date, only one case in the Enforcement Division (which in total comprises approximately 180 people), has been through the mediation process, producing a settlement. The mediation facility has been under a one year trial period and the FSA has decided to extend the period for 6 months. It is considered appropriate for there to be an informal process under which a resolution might be achieved, avoiding the need for a hearing before the Financial Services and Markets Tribunal. Although a mediation under the FSA disciplinary procedures differs considerably from a commercial mediation given the FSA’s limited room for negotiation, it can still clarify issues and identify common ground.

MIG comprises approximately 35 people, responsible for policing insider dealing, the civil market abuse régime and disciplinary sanctions for matters such as breaches of the Listing Rules. Insider dealing is a significant issue and in any investigation the FSA will look both at trading practices of those who deal on the basis of price sensitive information and the behaviour of the source(s) of the information.

Whilst the FSA should not get too excited about technical breaches, it is difficult to set a minimum threshold of offence without accommodating experienced market abusers. Therefore, action has to be taken in certain small cases but with the focus largely being on bigger cases and more systemic issues.

There is a range of guidance available to market participants: the Code of Market Conduct, FSA consultation (e.g. its recent paper on pre-hedging convertible and exchangeable bond issues - see below); the Market Watch newsletter; and the Market Abuse Helpline for individual guidance.

The FSA’s Market & Exchanges Division supervises the market abuse régime. Over the past fifteen months or so, it has produced the Market Watch newsletter. Although it is not strictly FSA guidance, the FSA might have some difficulty in pursuing enforcement action in circumstances falling squarely within statements in the newsletter and seems unlikely in practice to do so. The Market Abuse Helpline has been receiving calls and emails from both authorised and unauthorised persons, enquiring about a range of issues from the scope of the régime to the responsibilities of those who disseminate information. Complex questions are unlikely to be answered immediately on the telephone, and the oral guidance is not binding on the FSA.

In addition, where the FSA identifies a risk in a particular sector which warrants attention, it is likely to begin its approach through proactive supervision, site visits and guidance on the standards it expects of firms, with enforcement action reserved for the most serious cases, where firms or individuals fail to comply despitereceiving guidance.

Co-operation is to be encouraged and credit should be given when it is provided. The FSA will consider whether and if so how promptly the breach was identified by the party concerned and how much assistance was provided in the subsequent investigation. Remedial steps taken by the party concerned and the chances of reoccurrence, will also be taken into account.

After a year of constant dialogue about the new market abuse régime and the potential impact of the EU Market Abuse Directive (see below), the year 2003 is likely to herald notable enforcement activity under the market abuse régime and steps towards implementation of the new Directive.

In ever changing markets, it is impossible for the FSA to introduce exhaustive rules or guidance, and the list of frequently asked questions (FAQs) annexed to the Market Conduct Sourcebook last July, will inevitably grow. Following consultation commenced immediately post-N2, the FSA annexed two sets of FAQs, providing guidance on the scope and operation of the market abuse régime, the Code of Market Conduct and the price stabilising rules.

Responses to FAQs on the Code of Market Conduct included:

• behaviour in relation to share options will fall within the scope of the market abuse régime if the subject of the options is shares traded on a prescribed market. Behaviour in relation to contracts for differences will also fall within the scope of the régime where the behaviour relates to a qualifying investment;

• the regular market user test operates as an objective standard and in case there was any doubt about it, the regular user is not a real person. Although the FSA has emphasised that it is not itself the regular user, it would initially be required to form a view about whether particular behaviour is acceptable. In these circumstances it may contact market participants to determine what they themselves would consider to be the regular user’s standard;

• as for accepted market practices which might be considered unacceptable, the FSA reiterated that it does not expect there to be frequent divergences between the standards which are generally accepted by users of the market and standards expected by the hypothetical regular user. However, if the FSA does identify a practice which is accepted in the market, but which it believes may be likely to fall short of the standards expected by the regular user, the FSA will consider whether to make its view on the practice known in the form of guidance, a statement, revisions to the Code of Market Conduct, or enforcement action;

• the FSA will not consider an intermediary who executes an abusive transaction to be engaging in, or requiring or encouraging market abuse unless the intermediary knew or ought reasonably to have known that the originator of the transaction was engaging in market abuse. The FSA will focus on the person who originates the transaction, rather than the intermediary. The régime is not intended to impose extra obligations on intermediaries, but the regular user’s assessment of an intermediary’s behaviour is likely to take account of the intermediary’s compliance with applicable rules. Therefore, the regular user will recognise the differences in the standards of behaviour expected from different kinds of intermediaries;

• The FSA expects the supervisor of a prescribed market to investigate suspected cases of market abuse and to take enforcement action where the misconduct is limited to that prescribed market, the supervisor has jurisdiction over all of the parties concerned and the supervisor’s enforcement powers are sufficient to deal with the misconduct in question. Otherwise, the FSA will conduct an investigation and refer firms to the operational guidelines agreed between various market supervisors and operators in November 2001.

The FAQs also dealt with issues relating to the investigation of suspected cases of market abuse during a take-over bid and the status of guidance on the Code of Market Conduct.

As a further result of the consultation process last year, the FSA decided to include an additional annex of specialist topics, commenting on the scope of the market abuse régime for bonds and grey market trading, including:

• where a qualifying investment trades on a prescribed market, it falls within the scope of the régime. Bonds traded on or traded subject to the rules of the London Stock Exchange are qualifying investments traded on a prescribed market;

• Eurobonds which have at no time traded on a recognised investment exchange, fall outside the régime. However, bonds admitted to trading on a prescribed market but actually traded subject to the rules of a non-prescribed market may still fall within the scope of the régime if they have previously traded on the prescribed market;

• for the unofficial or "grey" market in the buying and selling of new issues of shares before they formally become available for trading on the London StockExchange or other prescribed market, such trading will fall within the scope of the régime where it is subject to rules of a prescribed market which deal with such trading in a security or derivative of that security. This is because the definition of "traded on a market" includes trading which is subject to the rules of a prescribed market;

• behaviour which occurs in relation to a qualifying investment traded on a prescribed market and which therefore falls within the scope of the market abuse régime, will include further offerings of shares by an issuer who has already issued shares which "traded on" a prescribed market. In addition, where the effect of any behaviour persists until the security is actually traded on an exchange, that behaviour will relate to the security. For example, new issues by a previously unlisted issuer will not be "traded on" a prescribed market ahead of the issue, but will be capable of falling within the scope of the régime if information disclosed about them for trading on a prescribed market, is false or misleading.

The EU Market Abuse Directive (Insider Dealing and Market Manipulation), proposed by the Commission in May 2001, was adopted in early December 2002.

The existing European legal framework for protecting the integrity of markets is considered incomplete. The Insider Dealing Directive confines itself to preventing the misuse of privileged information. There are no common provisions against market manipulation across Europe. Within member states, rules vary greatly and legal requirements differ per jurisdiction, which may lead to competitive distortions in the financial markets. In addition, the emergence of new products and technologies, increasing cross-border trade and the development of inter-connected markets, may increase the opportunities for market manipulation, such as the dissemination of false or misleading information via the Internet.

Since the stated objective of the present Insider Dealing Directive and the Market Abuse Directive is to ensure the integrity of European financial markets and to enhance investor confidence in those markets, the Insider Dealing Directive will be repealed, leaving a common legal framework covering both insider dealing and market manipulation under the Market Abuse Directive.

The proposed Directive would apply to all transactions concerning financial instruments admitted to trading on at least one regulated market in the EU, including primary markets, whether the transaction is undertaken on a regulated market or not. It would therefore also take in markets such as Alternative Trading Systems (ATS), since these could be used for insider dealing or market manipulation in connection with financial instruments negotiated on regulated markets.

The Directive proposes that each member state should designate a single regulatory authority with a common minimum set of responsibilities. These authorities would use convergent methods to combat market abuse and would assist each other in taking action against infringement, particularly in cross-border cases. The Directive also proposes that wrongful conduct should incur the same penalty in each of the member states, which is not the case at the moment. However, it is not proposed that there be complete harmonisation of penalties. The new disciplinary framework will contribute towards some degree of convergence between national systems (which vary considerably) so as to ensure compliance with the Directive.

There has been much criticism of the Market Abuse Directive, including the fact that it purports to support a minimum standard across member states rather than a common standard and that it may interfere with effective take-over regulation. In addition, it may not effectively harmonise criminal or administrative provisions. Changes were made to the original proposals including the adoption of safe harbours for "legitimate purpose" and Chinese Walls.

Under the Lamfalussy structure which was established to expedite the introduction, implementation and enforcement of EU securities legislation, there is a four level legislative process. Under level 2, implementing measures are developed by the Commission on the advice of the Committee of European Securities Regulators (CESR). The Commission expects shortly to receive the advice of CESR following its market consultation last Summer on the level 2 implementing measures required under the proposed Directive. From the UK perspective, a matter of interest is whether the regular user, which is absent from the proposed Directive, will be restored through the level 2 implementing measures.

It is expected that the Directive, about which the FSA has expressed nervousness in the past, will take no more than eighteen months to be implemented in member states, following its adoption in early December last year.

Responses to the FSA’s consultation in relation to the somewhat controversial practice of short selling, are required by the end of January 2003.

Last September, Sir Howard Davies stated that the City should think "long and hard" before seeking controls on short selling which he described as "normal activity" benefiting speedy price adjustments. However, he said, that the FSA recognised the need for greater transparency and noted interesting issues relating to how shares lent for short selling were voted. A round table hosted by the FSA had considered various disclosure options including publication of Crestco stock borrowing figures.

Nevertheless, the new market abuse régime has brought short selling into the spotlight and prompted the FSA to publish its discussion paper in October 2002, on options for greater disclosure and enhancement to settlement arrangements.

Although the FSA recognises short selling as a legitimate activity, it accepts that there are potential risks (such as the increase in short term price volatility and the use of manipulative trading tactics), but considers these to be addressed by the current market and the new regulatory arrangements.

Four main options were set-out in the paper:

• notification and publication of short sales in the cash equity market (such as in the US), to include aggregate naked (those not covered by borrowing stock) and covered short sales;

• full reporting and publication of short positions in both the cash equity and derivatives’ markets to provide a more complete measure;

• disclosure of naked short sales;

• the release of securities lending data as a rough guide to the level of short selling.

Aggregate figures would be susceptible to double-counting and Crestco has been examining whether it might be able to extract more selective and accurate information, which would also have the advantage of avoiding extra reporting requirements. On the question of short sales settlement, the FSA is concerned about the response to trade failure and questions whether the Exchanges should be given less time to buy in securities when problems arise. An alternative might be to incorporate guaranteed delivery into all short sales’ stock.

In the latest issue of Market Watch (October 2002), the FSA has expressed concern over the practice of wash trading between market counterparties (trading the same instrument back and forth at the same price), especially in the commodity and fixed income markets. The FSA has reiterated that wash trading is artificial and likely to create a false and misleading impression which prevents market users from being able to rely upon the volumes and/or prices of trading as a basis for investment decisions.

A policy statement and guidance is expected shortly from the FSA, following last Summer’s consultation in relation to the market abuse implications of pre-hedging convertible and exchangeable bond issues. Responses were required by 31 October 2002.

Some market participants pre-hedge issues of convertible (i.e into the issuing company’s own shares) or exchangeable (convertible into a third party’s shares) bonds in order to deal with their potential exposure if the issue is not fully sold.

The purpose of consultation has been to clarify which pre-hedging practices are acceptable under the Code of Market Conduct and to identify which might amount to market abuse. There have been divergent opinions about the extent to which hedging should be permitted before the launch of a convertible or exchangeable bond issue is disclosed. The FSA identified a number of hedging strategies which may be used by underwriters:

• selling underlying shares short or entering into derivative transactions to sell the shares;

• borrowing underlying shares to cover short sales or in anticipation of entering into short sales;

• "icing" (see below) underlying shares in order to borrow the shares to cover short sales;

• hedging the credit risk associated with the issue or purchasing credit protection through a credit derivative.

The FSA stated that the regular user is likely to consider that no dealing or arranging in the underlying shares would be acceptable before disclosure of the bond launch is made. Dealing and arranging is defined as:

• selling the underlying shares short;

• entering into a derivative transaction to sell the shares• borrowing the underlying shares;

• entering into certain types of derivative transactions in relation to either type of bond in circumstances where the default provisions reference a qualifying investment.

"Icing" (the practise of arranging with a lender for stock which is to be borrowed in the future to be reserved in advance), can be done informally through a non-binding arrangement which is likely to be considered acceptable by the regular user if commercially reasonable to facilitate the potential stock loan as a hedge and does not involve contractual agreements. The same could not be said for a contractual "pay to hold" agreement which would result in shares being unavailable to other market participants whereas the person undertaking informal icing does not gain any advantage over other market participants.

In addition, the FSA indicated that entering into credit protection in respect of the bond issue prior to its launch may be regarded by the regular user as acceptable, in certain circumstances, if the credit default terms are not linked to a qualifying investment.