European Union: Market Abuse - The EU Directive on Insider Dealing and Market Manipulation

The EU Directive on Insider Dealing and Market Manipulation (the "Directive" or "MAD"), aims to harmonise market abuse rules across the EU.¹

Although the existence of the current UK market abuse regime means that we have something of a head start in this area, the MAD introduces a number of significant new compliance measures aimed at preventing market abuse.

This article summarises the key provisions of the MAD as they will affect UK-listed companies and their advisers, including:

• changes to the Listing Rules on disclosure of price-sensitive information
• a requirement for companies to maintain lists of people who have inside information
• a requirement for senior managers and their "close associates" to disclose dealings in their company’s securities
• an obligation on companies to ensure that persons with access to inside information acknowledge their duties and understand the sanctions attaching to misuse of it
• an obligation on companies to establish effective arrangements to deny access to inside information to persons other than those within the company who need to know
• a revised market abuse regime with EU-wide safe harbours for specified stabilisation and share buy-back activities
• new obligations on investment banks to notify suspicious transactions
• a new disclosure regime in relation to investment research and recommendations.

The Directive is due to be implemented in member states by 12 October 2004. On 18 June 2004 HM Treasury and the FSA published a joint consultation document (the "Consultation Paper") seeking comments on draft regulations implementing the MAD in the UK. Comments are invited on the proposals by 10 September 2004.

It is hoped to finalise the legislative and rule changes by the end of November 2004, with a three-month period for the market to accommodate these final changes before they become effective around the end of February 2005. The UK will thus be late in fully implementing the MAD, although it is likely that a number of other member states will also be somewhat delayed in implementation.

As is clear from its title, the primary focus of the Directive is to combat market abuse throughout the EU through the creation of offences of insider dealing and market manipulation. To a large extent these offences overlap with existing UK criminal and civil provisions regulating market conduct.

The Treasury’s approach to implementation seeks to make as few changes as possible to the existing UK regime while at the same time ensuring full implementation of the Directive. The result is that the criminal provisions on insider dealing and market manipulation under the Criminal Justice Act 1997 and section 397 of the Financial Services and Markets Act 2000 ("FSMA") are left unaltered alongside the civil market abuse regime under section 118 of FSMA, which is adapted to be consistent with the Directive. However, elements of the existing UK market abuse regime which are "superequivalent" to the Directive are retained.

Broadly speaking, the Directive applies where securities or other financial instruments are admitted to trading on a "regulated market". However, as implemented under UK law, the principal market abuse offences will extend to other prescribed markets, including the Alternative Investment Market ("AIM"). The new disclosure of inside information, insider lists and disclosure of management transactions provisions will only apply to companies with securities admitted to trading on "regulated markets", which, following the decision by the London Stock Exchange to operate AIM as an "exchange-regulated" market from 12 October 2004, will not include companies traded on AIM. ³

The Directive introduces a new regime governing the disclosure of material information by companies with securities admitted to trading in the UK. Companies will be required to announce publicly any inside information relating directly to them as soon as possible. This regime will replace the existing obligations to disclose price-sensitive information to the market under Chapter 9 of the Listing Rules and the UKLA’s Guidance on the Dissemination of Price-Sensitive Information.

The FSA has stated that the new rules do not result in a material change to the current regime for the disclosure of price-sensitive information. However, listed companies and their advisers will need to recognise that the new rules governing the disclosure of information could, in some circumstances, lead to different conclusions as to a company’s obligations.

The new rules are set out in a format similar to that which will apply to the Listing Rules as a whole following the substantial reorganisation and rewriting that will result from the implementation of the Prospectus Directive and the wider review of the Listing Rules.⁴ This involves incorporating guidance alongside the rule to which it relates, and will mean that the UKLA’s Guidance Manual, including the PSI Guide, largely disappears.

"Inside information" is defined as information of a precise nature that is not generally available but, if made generally available, would be likely to have a significant effect on the price of the company’s securities. Whether the impact on price will be significant must be assessed in the context of whether a reasonable investor would use that information as part of an investment decision.

In new guidance, which derives from the existing Listing Rules 9.1 and 9.2 that set out a listed company’s general obligations of disclosure, the FSA indicates that inside information would potentially include significant information relating to:

• the assets and liabilities, performance or expectations, financial condition or business of the company
• major new developments in the company’s business or
• information previously disclosed to the market.

While each of these are elements of the existing requirements under the Listing Rules, by widening the category of inside information to include all information which "directly" concerns the company, disclosure may be required of matters which do not necessarily impact the company’s business but which are nonetheless considered price-sensitive.

For example, if a company becomes aware that a major shareholder is planning to sell a large portion of its holding, this would not necessarily impact the company’s business and require disclosure under the current regime. However, under the new regime, it could be considered as information directly applicable to the company which when made public would have a significant effect on the company’s share price and, as such, would require disclosure.

The existing Listing Rules require companies to announce all price-sensitive information "without delay". The new disclosure rules require companies to announce inside information "as soon as possible". In practice, this change in form is unlikely to have a significant impact.

In addition to disclosing inside information via a Regulatory Information Service, as is presently the case, under the new regime the information must be posted on the company’s website by the day after its official announcement and remain there for one year. As at present, care must be taken to ensure that information is not released on the company’s website before it has been officially announced.

As under the current regime, a company may delay the disclosure of inside information in certain circumstances. However, the new rules are in some respects narrower than the existing provisions contained in Listing Rules 9.4 and 9.5.

Delaying disclosure of inside information will only be permitted where:

• the company has "legitimate interests" to protect
• the omission is not likely to mislead the public
• any recipient of the information before its public disclosure owes a duty of confidentiality to the company and
• the company is able to ensure the confidentiality of the information.

It is the company’s responsibility to determine whether it can satisfy the above requirements, although, rather ominously, the FSA indicates that delay will also be under the company’s "own responsibility and at its own risk", without giving an indication of what it means by this. Clearly if a company’s decision to delay disclosure is unjustified then it risks breaching its obligations under the new disclosure rules. What is unclear is whether this is intended to signify any greater risk to companies, e.g. liability to investors. If this is the intention of the FSA’s proposal, this would represent an unwelcome step change in the UK liability regime.

As is presently the case, delay will be permitted where a matter is subject to negotiation or is an event that threatens the financial viability of the company or an impending development that could be jeopardised by premature disclosure. In addition, companies with dual board structures are permitted to delay disclosure where, for example, the ratification of a supervisory board is required. These examples of permitted circumstances are mandated by the MAD, but are expressly stated to be non-exhaustive.

As indicated above, disclosure should not be delayed if the market is being misled as a result. At first sight, this may seem to make it very difficult to delay any disclosure. The FSA’s guidance states, however, that "delaying disclosure of inside information will not always mislead the public". It is accepted that some information must be kept confidential until developments are sufficiently advanced for disclosure not to prejudice the interests of the company, although this will not provide blanket protection for companies.

For example, where the price of a company’s securities has reacted to market rumours, it is probable that the market will be misled by the continued delay in disclosure. Price movements may also suggest that the company has failed to preserve the confidentiality of the information. In these circumstances an announcement will be required as soon as possible. Previously the Listing Rules only required an announcement in such circumstances where it was thought that there had actually been a leak. It now seems that wherever market rumours are impacting a company’s share price at a time that inside information is being withheld from the market, regardless of the source of such rumours, the company must react by making an announcement.

The FSA is also clear that matters impacting the company’s financial viability must pose a grave and imminent danger to the company’s future to justify delaying disclosure. This will not include mere matters of financial difficulty or a worsening of the company’s financial condition, where disclosure must still be made as soon as possible. By way of example, where a default under a company’s banking facilities would result in imminent insolvency, a delay in disclosure may be justified to enable renegotiation of those facilities. By contrast, the disclosure of a gap in the company’s balance sheet or the loss of a major trading contract cannot be delayed because the company is trying to negotiate a solution. This approach reflects a number of the FSA’s recent pronouncements in this area where the search for a solution has been rejected as a reason to justify delaying the disclosure of a problem. Instead, companies should announce the existence of a problem to the market and subsequently, when a solution is found, announce the solution. Equally, where a company does not know the full scope of a problem, it must issue an announcement alerting the market to the general nature of the problem, followed up with more detailed analysis when that is available.

As under the existing regime, a company may make selective disclosure of inside information to certain categories of person while delaying general disclosure to the market. Under the new regime, it is clear that this will only be permitted where the recipient owes a duty of confidentiality to the company and requires the information to carry out duties to the company. Helpfully, the categories of person to whom information can be disclosed have been extended to include major shareholders of the company, its lending banks and credit-rating agencies. This is in line with market practice in this area.

It is worth noting that the categories of permitted recipients of selective disclosure do not include research analysts at investment banks so that pre-briefing of analysts in a non-advisory capacity ahead of a public announcement remains a questionable practice.

One concern as regards the draft provisions set out in the Consultation Paper is that those permitting selective disclosure are only contained in guidance, which arguably is not sufficient to override the basic obligations not to make selective disclosure, which are contained in rules.

As at present, companies will be required to take all reasonable care to ensure that announcements they make are not false or misleading. A further requirement will be to ensure that the company does not combine marketing of its services with a Regulatory Information Service announcement in a manner likely to be misleading. In addition, all companies with securities admitted to regulated markets will have to have in place measures to:

• preserve the confidentiality of information
• limit access to inside information to those that strictly require the information to carry out their job and
• train employees on the scope of their duties and responsibilities in respect of inside information and on the sanctions attaching to the misuse or improper circulation of inside information, not merely under the Listing Rules, but under the market abuse regime more generally.

The significance of these new process requirements is likely to be further enhanced if, as is likely as part of the wider review of the listing regime, the FSA introduces a listing principle requiring companies to have appropriate procedures in place to ensure compliance with obligations under the rules.

As a measure intended to help prevent market abuse, the Directive requires all companies admitted to trading on a regulated market, and those acting for them, to prepare and keep up-to-date lists of all individuals with access to inside information.

These provisions, which will be incorporated into new FSA rules, will require companies to draw up and maintain lists of those with access to inside information, to include the following:

• the names of all individuals with access to inside information relating directly or indirectly to the company, whether on a regular or an occasional basis
• the specific matter concerned
• each individual’s function/responsibility
• the date on which the person first had access to inside information (and, where appropriate, the date on which access to the inside information ceased) and
• a statement that the person is on the list because he/she has access to the inside information in question.

Companies are also required to ensure that similar insider lists are maintained by their agents and advisers (for example banks, accountants and lawyers). In each case, insider lists should be kept for a period of five years, to be disclosed to the FSA at any time upon request.

The preparation of insider lists is likely to be a considerable administrative burden for many companies. In the regulatory impact assessment contained in the Consultation Paper, the Treasury argues that listed companies already maintain such lists as a matter of best practice. In our experience, however, detailed lists of the type contemplated by the new rules may be maintained by some companies in connection with individual major transactions, but not generally on an on-going basis. Professional advisers may also draw up such lists in response to specific regulatory inquiries but would not otherwise normally do so.

Companies may consequently need to review their internal compliance procedures and look to adopt systems designed to facilitate compliance across their entire organisations. The FSA offers no guidance as to what steps companies are expected to take to ensure that their advisers or agents draw up insider lists in accordance with the rules, nor as to the consequences for companies if their advisers and agents fail to do so.

The Directive extends the scope of the existing UK requirements imposed on directors to disclose transactions in a company’s securities to cover a wider category of persons.

The new requirement to report transactions in a company’s securities extends to persons discharging managerial responsibilities within that company and their "close associates". This obligation will apply in respect of all companies with securities admitted to trading on regulated markets in the UK.

Under the MAD "persons discharging managerial responsibilities" are defined as:

• directors of the company
• senior executives of the company, who are not directors, but who have:
• regular access to inside information concerning the company and
• the power to make managerial decisions affecting the company’s future development and business prospects.

"Close associates", who are also obliged to notify their transactions, are defined to include:

• "connected persons" under section 346 of the Companies Act 1985 – this broad definition will catch a spouse or child together with any entities controlled by those exercising managerial responsibilities as well as any trusts of which they, their families or controlled entities are beneficiaries
• any relatives who have shared the same household for at least 12 months
• any other body corporate of which the person discharging managerial responsibilities or a close associate is a director or senior manager – this provision seems to go some way beyond the specific requirement of the MAD and in particular may raise commercial sensitivities while catching dealings over which an individual non-executive director, for example, may have no control.

Any transaction conducted on the account of persons discharging managerial responsibilities or their close associates in the shares of the company or in derivatives or other financial instruments relating to those shares must be notified. Notification of the transaction must be given to the company within two working days of the transaction taking place.

Where a company receives a notification that a transaction has taken place, it must disclose this via a Regulatory Information Service as soon as possible (and, in any event, no later than the day after receipt of the notification).

Companies will need to make sure that the correct people within the company understand and comply with these notification obligations.

The FSA has new powers to fine companies, managers and persons connected to them if they fail to comply with these obligations.

The Model Code on dealings by directors and relevant employees will continue in place in substantially its present form. The Model Code prohibits dealings at a time when there is unpublished price-sensitive information about the company (this is defined in a way which is similar but not identical to the new "inside information" definition). The Model Code also requires directors and employees, so far as possible, to restrict dealings by their connected persons within the meaning of section 346 of the Companies Act 1985, a slightly narrower definition than that of "close associate".

At present in the UK market misconduct offences are regulated by the civil market abuse regime and certain criminal provisions. It is proposed to maintain the existing UK criminal sanctions and to amend the UK market abuse regime to take account of the specific requirements of the Directive. In practical terms, this means the breadth of the current UK market abuse regime will be maintained, with the specific types of problematic behaviour identified by the Directive being added to it.

The Code of Market Conduct, giving guidance on the type of behaviour which will or will not constitute market abuse, has been rewritten. The new version is much shorter than the existing Code of Market Conduct – in part because of the FSA’s commitment to shortening its Rulebook generally.

The existing market abuse regime under section 118 of FSMA identifies three broad categories of behaviour constituting market abuse: misuse of information, creating a false or misleading impression and market distortion. The amended section 118 of FSMA will identify seven types of market abuse of which the first five are those mandated by the MAD:

• insider dealing - where an insider deals or attempts to deal in securities on the basis of inside information
• improper disclosure - where an insider discloses inside information to someone else otherwise than in the proper performance of his or her duties
• manipulating transactions - where a transaction gives a false or misleading impression to the market of the supply, demand, price or value of a security or secures the price of a security at an artificial level (provided that the transaction is not carried out for a legitimate reason and in conformity with an "accepted market practice")
• manipulating devices - where a transaction employs a fictitious device or other form of deception or contrivance
• dissemination - where false or misleading information is knowingly or negligently disseminated to the market.

In addition, two residual categories remain, based on the existing heads of market abuse in the UK. These cover types of behaviour not caught by one of the above categories but which involve either:

• the misuse of relevant information that is not generally available to the market or
• other forms of misleading behaviour or market distortion,

in each case, that a regular user of the market in question would consider to be a failure to observe reasonable standards of behaviour.

Behaviour in connection with the market abuse regime will, as at present, include both action and inaction. This is one of the areas of superequivalence of the UK regime over that set out in the Directive.

It should also be noted that the existing "secondary offence" of requiring or encouraging another person to engage in market abuse will be maintained in the new regime.

In relation to the insider dealing and improper disclosure offences of the market abuse regime, the definition of inside information is slightly wider than that used in the disclosure regime described earlier in this article. Companies are only required to disclose inside information that directly relates to them. However, in relation to insider dealing and improper disclosure the definition of inside information is extended to include information that is indirectly related to the company as well. This could include, for example, information, such as a change in tax treatment, that relates to a particular business sector that could impact the share price of all companies in that sector equally, rather than just a specific issuer.

An insider is a person who has inside information as a result of:

• membership of the administrative, management or supervisory board of a company which has securities admitted to trading
• holding securities in such a company
• their employment, profession or duties
• any other criminal activities or
• other means, but where they know, or could reasonably be expected to know, that they hold inside information.

As will be apparent from the above list, the "regular user" test, which, under the current regime, provides a benchmark for acceptable behaviour, no longer operates across the whole range of market abuse offences. As the Directive does not recognise the concept of the regular user, the test only remains relevant to the residual categories of market abuse and not to the five specific offences based on the Directive. For the offences derived from the Directive a patchwork of different defences or qualifications may apply. For example, in relation to the manipulating transactions offence, if behaviour is carried out for legitimate reasons and in conformity with accepted market practices then an offence will not be committed. The FSA has identified only one category in the Consultation Paper proposals – activities in accordance with the London Metal Exchange’s document "Market Aberrations: The Way Forward".

This term has a narrower and more specific meaning in the Directive than currently in the UK market abuse regime. Only two safe harbours are provided under the Directive – for price stabilising activities and repurchases of own shares – in each case only in so far as permitted by the detailed requirements of the safe harbours. Accordingly, many of the current safe harbours in the Code of Market Conduct are to be reclassified as behaviour that will not amount to market abuse, while a number of safe harbours, which did not really represent safe harbours at all, have been deleted.

Existing safe harbours in relation to the current misuse of information offence, where dealing is required for another reason or is not based on the relevant information, have been removed as they really only reflected elements of the substantive offence itself.

Safe harbours that have been reclassified as acceptable behaviour include, in relation to the misuse of information, insider dealing and improper disclosure offences in the new regime, those existing safe harbours relating to:

• trading information, i.e. where the inside information you hold is the knowledge that you are planning to deal or
• takeover activity, including stakebuilding, the seeking of irrevocable undertakings and the making of arrangements to issue securities or offer cash as part of a takeover offer.

Companies repurchasing shares under a general shareholder authority for on-market purchases in the UK may do so within the terms of a safe harbour under the market abuse regime, provided that the reasons for the buy-back, the maximum consideration to be paid, the maximum number of shares to be repurchased and the duration of the authority have been disclosed via a Regulatory Information Service at the time that shareholder approval is given. Repurchases under such an authority may not be at a price higher than the last independent trade or highest current bid on the relevant exchange and may not represent more than 25% of the average daily volume of shares traded on that day on the relevant market.⁵

Repurchases of shares effected through derivative financial instruments must be approved as part of any other buy-back of shares if they are to fall within the safe harbour. Where such transactions constitute a "contingent purchase contract" in the UK, they will require specific shareholder approval in any event.

Repurchases of shares within the safe harbour will not be permitted during closed periods under the Model Code or when the disclosure of inside information to the market has been delayed by a company, unless:

• the company has in place a programme where the dates, quantities and price of shares to be repurchased are fixed when the programme is set up or
• the programme is managed by an investment firm that makes trading decisions on the timing, etc. of purchases independently of the issuer.

Where share repurchase activities do not fall within the safe harbour, that is not to say that they will constitute market abuse. However, it will be necessary to consider more closely whether the elements of one of the market abuse offences may apply to the buy-back activities.

Financial intermediaries executing transactions in the UK are to be required to notify the FSA without delay if they "reasonably suspect" that a transaction might constitute insider dealing or market manipulation under the new regime. In such circumstances, there is no need for actual evidence of abuse before a requirement to notify may arise, provided that there is a "sufficient indication" that a transaction might be abusive.

Where the whistleblowing obligation applies it will override client confidentiality obligations and will also prevent the financial adviser concerned from notifying the person on whose behalf the transaction is carried out of the fact that a notification has been made.

Investment banks and others who publish investment research and other investment recommendations are subject to new provisions requiring fair presentation that include obligations to disclose sources and methodologies used and to clearly distinguish facts from opinions or estimates. In addition, certain relationships with the company subject to any recommendation must also be disclosed to ensure that any potential conflicts of interest are identified. These include corporate finance activities undertaken for the company and holdings of securities in the company in excess of 5%.

The requirements in relation to investment recommendations are in addition to the FSA’s rules requiring firms to have in place a policy to ensure the effective management of conflicts of interest in relation to research, which took effect in July 2004.

The breadth of the UK market abuse regime has been maintained through the implementation of the Directive, although the loss of the "regular user" as an indicator of acceptable behaviour for those parts of the regime specifically derived from the Directive could be considered to have widened the regime in some respects.

Equally, the requirement for companies to disclose inside information does not mark a significant departure from the existing Listing Rules requirements in this area. However, the processes and procedures surrounding the management of inside information by companies have become more onerous, in that:

• lists of those with access to inside information must be kept at all times and maintained for five years
• employees must be trained in order to understand their obligations under the regime, including senior managers as regards their obligations in relation to dealings in securities by themselves or their close associates.

Although the implementation of the Directive is being presented by the FSA in many respects as "business as usual", the new regulatory regime will, as a result of the above, pose new challenges for companies.

If you require further information on the matters discussed in this report or would like assistance in responding to HM Treasury and the FSA on matters raised in the Consultation Paper, please contact Lucy Fergusson on 020 7456 3386 or your usual contact at Linklaters.

This article is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts at Linklaters.