In R (Davis and Others) v. Financial Services Authority  EWCA Civ 1128 (Times 20 September 2003), certain points of practical importance on the exercise of the regulatory powers of the FSA and the appropriate procedures for challenging its decisions and actions, came before the Court of Appeal for the first time.
In 1998, the Securities & Futures Authority (SFA), commenced an investigation into the conduct of certain employees of a member of the London Metal Exchange. In July 2001, the SFA served notices formally commencing disciplinary proceedings against each of the individuals. However, following the coming into force of the Financial Services and Markets Act 2000 on 1 December 2001 the SFA, no longer having jurisdiction as regulator of the LME (which had passed to the FSA) discontinued the proceedings. The FSA was unable to use its power under Section 66 of FSMA 2000 to take disciplinary action against the individuals for misconduct because Section 66(4) provides that such action cannot be taken more than two years after the FSA first knows of the misconduct.
Instead, the FSA issued notices pursuant to Section 57 warning the individuals that it proposed to make prohibition orders under Section 56, prohibiting them from performing certain functions relating to regulated activities, on the grounds that they were not fit and proper persons to perform those functions. The individuals sought permission to apply for judicial review on the grounds that the issue of the notices was ultra vires, since it was improper to use Section 56 for disciplinary purposes, and an abuse of process, since the authority had not established that the individuals intended to carry on the functions to be prohibited.
At first instance, Mr Justice Lightman held that FSMA 2000 did not draw a sharp distinction between the regulatory and disciplinary powers of the FSA; that while Section 66 was disciplinary in nature, Section 56 afforded the FSA both regulatory and disciplinary powers; that the FSA’s proposed use of the disciplinary power conferred by Section 56 was not an illegitimate means of getting round the statutory bar on the use of the disciplinary power conferred by Section 66; and that, therefore, the issue of the notices had not been ultra vires. Furthermore, the factors critical to the FSA’s decision whether to make a prohibition order against an individual were that person’s character and conduct, not his intentions. The FSA was not required to establish, before issuing a warning notice, that the individual who was the subject of the proposed prohibition order intended to carry on the functions to be prohibited by the order. Therefore, the issue of the notices did not constitute an abuse of process and there was no substance in the claim. The application for permission to apply for judicial review in order to challenge the lawfulness of the decision of the FSA to issue warning notices under Section 57, was therefore refused.
The Court of Appeal upheld the decision at first instance, agreeing with the reasons of Mr Justice Lightman and adding some of its own when declining to grant permission for judicial review.
The critical issue was whether the FSA could lawfully take the action that it had given notice that it proposed to take against the applicants under Section 56. The applicants continued to argue that the issue of the notices was improper and an abuse of process, since it was proposed to use the prohibition procedure under Section 56 for disciplinary purposes in respect of alleged past misconduct in order to avoid the time bar imposed on the FSA under Section 66.
In summary the applicants’ main submissions at first instance and on the appeal were as follows:
- the FSA was not entitled to pursue the charges originally brought by the SFA, because of the time bar. The proposed use of the Section 56 power was improper. A power conferred for a specific purpose, namely the future protection of the public by prohibiting and preventing the applicants’ activities, was proposed to be used for a different purpose, namely in order to punish the applicants by disciplinary action for alleged misconduct in the past. Therefore, it was submitted, the only reason underlying the FSA’s proposed use of the "prevention route" was that the "punishment route" adopted by the SFA was blocked by the statutory limitation period;
- the issue of the warning notices was ultra vires and an abuse of process, since the FSA had not established that the applicants intended to participate in any of the activities proposed to be prohibited. The applicants had no "immediate plans" to work in a regulated industry and so there was no need to take steps to protect the public from activities which were not going to take place;
- the warning notices were an abuse of process, since the FSA had failed to consider and apply its own criteria pursuant to the Enforcement Manual, for initiating proceedings (see ENF para. 8.1 and 8.4). The FSA was unable to show the necessary risk to confidence in the market from past activities of the applicants. The applicants had no intention of being in the market and it would be inappropriate to make an order targeted on the future which was based on past misconduct, and in the absence of any future risk.
The Court of Appeal held that:
- although there are different statutory criteria for invoking the procedures in Section 56 and Section 66, there is no clear and sharp punitive/preventive divide between them. Both procedures are regulatory. Section 56 is available in cases of past misconduct, enabling the FSA to take prohibition proceedings in respect of it in order to afford the necessary future protection of the public. Section 66, under which action was time barred, is not the only provision in FSMA 2000 available to the FSA in respect of past misconduct;
- the fact that the applicants appeared to the FSA to be unfit persons was sufficient to justify the giving of the warning notice setting out the proposed prohibition order. There was no requirement that, in order to be legally entitled to give a warning notice, the FSA had to satisfy itself that the applicants had a present or a future intention to work in the financial services industry. The applicants’ assertions that they had no present plans were not an adequate substitute for or alternative to a prohibition order;
- present plans and future intentions are factual points on which the applicants would be entitled to make representations to the FSA or, failing that, to the Financial Services and Markets Tribunal on a reference to it;
- the judge had rightly rejected the submission that the FSA was acting incompatibly with its own published guidance in the Handbook, because it could not show the necessary risk to confidence in the market. What the Handbook says is that the FSA may make a prohibition order where it considers that an individual presents such a risk to the market generally that it is necessary to prevent him from carrying out any function. No reference is made in ENF 8.1.2 to the intentions of the individual. His character and conduct are the critical factors. It must be for the individual at the substantive hearing to raise, if he wishes to rely on it as a relevant factor, his present intentions, which would only be relevant in rare cases if at all: it cannot be for the FSA to have to establish this before it takes action;
- it was not correct to characterise the nature of the previous SFA proceedings as disciplinary proceedings for past misconduct. There was a forward looking element in the proceedings. The SFA was alleging that the applicants were not fit and proper persons and sought expulsion of them from the SFA’s registers. The proceedings set out not only the alleged acts of misconduct, but also the reasons why the applicants had ceased to be fit and proper persons;
- the FSA was not simply seeking to continue time barred "disciplinary proceedings" by different means. Like the SFA, the FSA was seeking expulsion on the ground that the applicants were not fit and proper persons. Section 56, not Section 66, was the appropriate procedure available to the FSA to take action, which involved virtually identical charges brought with the same objective;
- although there are different statutory criteria for making prohibition orders and for taking disciplinary action, both are available to the Authority in order to send out messages to the financial services industry and to the public about unacceptable conduct in the financial markets and in order to deter others.
At first instance, Mr Justice Lightman did not find it necessary to deal with the procedural objection that the application was premature and should be rejected on the ground that there was a satisfactory alternative procedure provided by FSMA itself, namely to make representations to the Regulatory Decisions Committee and to refer the matter to the Financial Services and Market Tribunal. On this aspect, the Court of Appeal commented as follows:
- judicial review is a remedy of last resort. In the absence of exceptional circumstances, it should not be used, unless the applicant has first exhausted available procedures for objecting to, or appealing against, the decisions sought to be judicially reviewed;
- the present application, if granted, would by-pass the comprehensive statutory scheme specifically set up by FSMA 2000 enabling persons against whom actions are taken to have recourse to the special procedures and against whom decisions are made to refer to the specialist Tribunal, with a right of appeal on points of law to the Court of Appeal;
- only in the most exceptional cases should the Administrative Court entertain applications for judicial review of the actions and decisions of the FSA, which are amenable to the procedures for making representations to the FSA, for referring matters to the Tribunal and for appealing direct from the Tribunal to the Court of Appeal;
- although there was force in the submission that the application for judicial review was premature since the only decision taken by the FSA against the applicants was to issue the warning notices pending the further procedures, the application would not have been declined on that ground alone. In the present case, the giving of the warning notices under Section 57 was likely to be followed by decision notices under Section 56 and by the making of prohibition orders.
Although the Court of Appeal did not discount the possibility of judicial review at such an early stage in the FSA enforcement process, it is clear that as a general principal judicial review should not be entertained unless all of the avenues for representations and appeal have been explored. The Regulatory Decisions Committee (RDC) of the FSA is the primary mechanism through which the FSA effects decisions on its behalf requiring the giving of supervisory, warning and decision notices, by a person not directly involved in establishing the evidence on which that decision is based (section 395(2) FSMA 2000). Thereby, use of the FSA’s enforcement powers is scrutinised by somebody who has not been involved in developing the case and is receptive to alternative views about the facts and the conclusions to be drawn.
Although the RDC is a committee of the FSA Board, it is structurally separate from the executive. However, it is not designed to be independent in the sense of article 6 of the European Convention on Human Rights, which is the function of the Financial Services and Markets Tribunal which is the responsibility of the Lord Chancellor and is administered as part of the Court Service. The RDC is part of the FSA’s administrative decision-making process and is not part of a judicial process.
The RDC meets on a weekly basis to consider recommendations that the FSA invokes its enforcement powers. The relevant papers are prepared by a project team, circulated in advance in order to give members of the RDC time to review them and seek further information if necessary. At the meeting, the project team will make a presentation to the RDC in support of the recommendation. Typically, the chairman of the RDC will summarise points which the RDC has already decided it wishes to consider and following debate with the project team, the RDC reaches a conclusion, normally by consensus. The RDC’s reasoning is then reflected in the warning notice signed by the chairman on the FSA’s behalf.
In addition to the reasoning set out in the warning notice, material relied upon by the RDC is disclosed, to enable the recipient to give intelligent consideration to the FSA’s position and to make an intelligent response. There follows the right to make representations, both written and oral, to the FSA before the final decision is taken.
The RDC takes its role very seriously during the course of representations, which are usually made to a panel of three members of the RDC: the Chairman, or one of his deputies; a practitioner (usually with experience in the relevant part of the industry); and a non-practitioner. The project team will usually provide the RDC with an analysis of any written representations provided ahead of the oral representations and will also attend any oral representations meeting in order to assist in clarifying any matter to ensure the RDC fully understands the representations.
After the meeting, the panel considers the material placed before it and normally reaches a preliminary view. At that point, it will consult with the project team to establish whether there is anything which the panel has overlooked before coming to a final decision.
At the time of consultation with the project team, the project team has the opportunity to counter the representations, thereby giving the RDC as decision-maker access to those who know the case in the greatest detail. The fact that persons under consideration are not present during such consultation, is tempered by certain factors such as:
- the obligation imposed upon the FSA to disclose all material relied upon at the time of the giving of a decision notice, including any additional material relied on by the RDC;
- the refinement of the reasons for proposed action as set out in the decision notice; and
- the right to refer the matter to the Financial Services and Markets Tribunal.
MARKET ABUSE UPDATE
Market Abuse Directive
Implementation of the EU Market Abuse Directive (MAD), by all member states, before 12 October 2004, continues somewhat off pace.
When MAD comes into force, it will repeal the EU Insider Dealing Directive of 1989. It is intended to provide a pan- European level playing field in respect of prohibitions on market abuse, although it seems that member states can provide their own additional prohibitions. MAD prohibits, unless an exemption applies:
- insider dealing - the buying or selling of financial instruments, or getting another to do so, when in possession of inside information or disclosing inside information; and
- market manipulations - creating a "false or misleading impression" about financial instruments or their issuers or distorting the market, such as by positioning prices at an artificial level.
Member states must also establish a single regulator as its "competent authority" for the market abuse offences covered by the Directive.
In the UK, of course, the existing market abuse régime covers both insider dealing and market manipulation as administrative offences. Being in similar terms to MAD’s offences, and with the FSA already present as the sole regulator for market abuse, the UK’s market abuse régime will need only minor changes. Furthermore, since MAD does not require criminal sanctions, but only administrative ones, the UK criminal offences of insider dealing and market manipulation will be able to remain essentially the same.
MAD applies to all financial instruments listed in Annex B of the Investment Services Directive together with commodity derivatives. Therefore, financial instruments include: transferable securities (as defined in the ISD, including shares, debt securities and related derivatives); money market instruments; options to acquire or dispose of financial instruments; financial futures (including equivalent cash-settled instruments, such as contracts for differences); options on currencies or interest rates (even if cash-settled); and commodity derivatives. In order to cover all financial instruments traded on a regulated market, they also include every "other instrument admitted to trading on a regulated market in a member state".
Just as with the UK’s market abuse régime, MAD applies where trading is subject to the rules of a regulated market (as opposed to an in-house market established by an investment bank or broker for its own clients and counterparties). This is the case even if the financial instruments are not yet traded on a regulated market, provided that an application for admission to trading has been made. Market abuse offences will apply, for example, to "when issued" markets in shares on the London Stock Exchange and in equity options on LIFFE, as well as other "grey market" transactions.
Furthermore, MAD urges member states to prohibit "frontrunning" (i.e. buying or selling before a recommendation to clients), but only where it constitutes market abuse. Therefore, member states will not be required to outlaw non-abusive front-running, and the FSA has already stated that front-running does not normally amount to market abuse, but merely "customer abuse".
MAD is the first to be adopted under the Lamfalussy procedure, being a four-level procedure to improve the process of financial services legislation as approved by the Counsel of Ministers in March 2001. MAD is confined at Level 1 to broad "framework principles". Level 2 contains technical implementing measures, to be adopted by the European Commission outside the Directive with advice from the Committee of European Securities Regulators (CESR). The European Parliament and the European Securities Commission (which represents member states) may also review the recommended measures and comment on them.
The remaining two levels relate to co-operation and enforcement.
Last December, CESR delivered its final technical advice on certain Level 2 implementing measures under MAD to the European Commission. The Commission published the draft legal text of the Level 2 measures (on the basis of CESR’s advice) in three working documents covering:
- definitions of inside information, market manipulation and public disclosure of inside information by issuers (MAD Article 1, 6(1) and 6(2));
- fair presentation of recommendations and disclosure of relevant interests or conflicts of interest (Article 6(5));
- exemptions from the prohibition and insider dealing and market manipulation in specific cases (Article 8).
The Commission must observe certain principles in the Directive when deciding on implementation measures, such as: needing to ensure the integrity of EU financial markets and confidence in them; imposing a level of disclosure and investor protection appropriate to the status of the investor; and establishing a level playing field by treating all market participants equally. The principals also emphasise the need to provide investors with a wide range of competing investments and to both encourage innovation in EU financial markets and foster their international competitiveness. Similar principals are set out in FSMA 2000, for the FSA to observe.
A second mandate from the Commission to CESR, requesting further technical advice on Level 2 implementing measures under MAD was issued in February 2003. In order to finalise its technical advice on these measures, CESR published a consultation paper in June 2003. The consultation paper addressed:
- accepted market practices : when considering whether to accept a particular practice, competent authorities will have to ensure that they are aware of emerging market practices, have procedures in place to facilitate the consultation of relevant market participants and publish their conclusions on the acceptability of the practice. CESR has provided a non-exhaustive list of factors to be considered by competent authorities when assessing a particular practice. These include the transparency of the practice, the prevalence of the practice among intermediaries, the risks inherent in the practice and the characteristics of the market in question;
- inside information : in relation to commodity derivatives, the definition of inside information encompasses the information which users of the commodity derivatives markets expect to receive and when they expect to receive it;
- lists of insiders : the proposed measures require issuers and persons acting on their behalf or for their account (e.g. banks, auditors and financial, economic or legal advisors) to draw up a list of persons who have or have had access to specific inside information. Such persons must be aware of and acknowledge their legal and regulatory duties and the sanctions which can arise as a result of the misuse of inside information. The list should specify the person’s functions and responsibilities, identify when the person had access to the information for the first time, the relevant matter or event and if (and if so when) the person ceased to have further access to subsequent information relating to the matter or event. Separate lists of those who have regular access to inside information within the issuer must also be created on a permanent basis. All lists must be retained until it is no longer legally possible for a case of insider dealing to be brought against the issuer, any persons acting on its behalf (or for its account) or the persons named in the lists;
- disclosure of dealings : persons discharging managerial responsibilities within an issuer (identified by CESR as persons who typically have access to inside information and have decision-making powers), must notify the competent authority of transactions conducted on their own account in the issuer’s shares (or derivatives or financial instruments linked to them) regardless of the size of the transaction (see MAD Article 6(4)). The obligation to notify also applies to all persons closely associated with those in positions of managerial responsibility. This will include all persons sharing the same household and all trusts, companies and other legal persons where the person discharging managerial responsibility is the sole shareholder or controlling shareholding of the trust, company or other legal person. Dealings must be notified to the competent authority as soon as possible (and in any event within two working days) and must contain certain information about the issuer, the transaction and the relevant person;
- suspicious transactions : EU member states must ensure that any person who professionally arranges transactions in financial instruments notifies the competent authority without delay of any transaction which they have reason to suspect might constitute insider dealing or market manipulation (MAD Article 6(9)). Criteria for determining notifiable transactions must be assessed by reference to the element of insider dealing and market manipulation defined in MAD. The consultation paper stipulates that the notification should take place immediately after a suspicious transaction has been carried out or, after completion of a transaction, immediately upon becoming aware of a fact that makes the transaction suspicious.
On the basis of CESR’s final technical advice, the European Commission hopes to finalise the legal text of the measures under MAD by the end of 2003.
One of the principal concerns in relation to MAD is the significant lack of safe harbours from prohibited conduct. In addition, it seems that MAD does not allow member states to provide their own safe harbours in relation to financial instruments traded on their own regulated markets. Although there are a few safe harbours in FSMA 2000, the FSA is allowed to provide them and it is curious that MAD should not allow member states to provide their own safe harbours for their own markets in respect of EU offences. Commentators have rightly pointed out that the Commission should have followed the example set by the FSA, which was painstaking in its consultation with the financial services industry and the CBI in order to produce the Code of Market Conduct, setting out the detailed scope of market abuse and several safe harbours needed by investment banks, stock brokers and other regulated firms as well as quoted companies, so as to be able to function properly. In addition, the Code includes a requirement in most cases for some form of intention or recklessness.
Since EU market abuse offences can be committed by companies as well as individual directors or employees, the absence of the need for some form of intention or recklessness may be particularly significant in the case of Chinese walls. For example, any director or employee in front of the wall, and therefore unaware of the true facts, may innocently say something false or misleading or buy or sell financial instruments, without knowing that the company has relevant inside information. As a result, without any provision for intention or recklessness, the company may be guilty of market abuse even though no-one with inside information has informed the particular director or employee about it or instructed him what to do or say.
On 9 July 2003, the European Commission submitted formal documents on certain level 2 implementing measures under MAD to the European Securities Commission (Articles 1 and 6, 6(5), and Article 8 of MAD (see above)). The European Securities Commission has had until the end of October to vote on these proposals.
Although the FSA has been in discussions with the Treasury about the implementation of MAD, time is running short for consultation on consequential changes to the Market Abuse régime. The FSA is expected to publish a consultation paper on implementation of MAD in the first quarter of 2004 ahead of the 12 October 2004 deadline for implementation by member states. However, it seems that the legal text of the Level 2 measures based on the technical advice of CESR, will not be completed by the European Commission until well into 2004.
Amendments to the Market Conduct Sourcebook
Meanwhile, the FSA has made changes to the Market Conduct Sourcebook including amendments to:
- update the list of prescribed markets to reflect the derecognition of CoredealMTS (MAR.1.11G);
- refer to the rule books of the prescribed markets (rather than the RIEs) (MAR 1.2.12G);
- facilitate transactions between stabilising managers and their agents in order to reallocate the economic risk of positions taken during stabilising action in respect of debt instruments (MAR 2.6.5R);
- include the rule book of OFEX within the FSA’s statement that it is satisfied that the rule books of all of the prescribed markets do not allow or require behaviour which amounts to market abuse (MAR 1.2.12G; 1.11.2G);
- establish a separate regulatory régime for alternative trading systems with some consequential amendments to various parts of the Handbook coming into effect on 1 July 2003 and the remainder on 1 April 2004 (see below).
Guidance on Convertible and Exchangeable Bond Issues
Following last Summer’s consultation in relation to prehedging of issues of convertible or exchangeable bonds and which pre-hedging practices are acceptable, the FSA has provided guidance for firms on the application of the market abuse régime to such practices.
Where the launch of a convertible/exchangeable bond issue must be disclosed to the market, any pre-hedging behaviour before disclosure (whilst in possession of information about the launch) is likely to amount to market abuse. A regular user would reasonably expect that no dealing or arranging should take place before the disclosure has been made.
To fall within the scope of the market abuse régime, the underlying shares into which the bond can be converted, or the convertible or exchangeable bond, must be traded on a prescribed market.
In order to constitute misuse of information, a person must be dealing or arranging deals in a relevant product. The following activities will fall within the definition of dealing and arranging:
- 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 the convertible or exchangeable bonds;
- "icing" the underlying shares - where a firm identifies a future need to borrow stock and arranges with a lender to reserve that stock in advance, on a formal basis, by means of a contractual arrangement such as a "pay to hold" agreement;
- informal, non-contractual icing where the icing is undertaken on behalf of a third party. However, where the arrangements in question are made with a view to subsequent borrowing for the person icing the shares, they will fall outside the definition of dealing and arranging.
In certain circumstances, it may be acceptable for the manager of a convertible or exchangeable bond issue to arrange to borrow shares from an issuer or related party before announcement of the issue. For example, where there is a genuine need to do so in order to facilitate the issue, all parties to the pre-arranged borrowing are aware of the forthcoming issue and no other market participants are disadvantaged. Therefore, when considering whether it is acceptable to make stock available to a manager, the issuer or related party should consider the extent to which the stock will or may be lent and the extent to which the stock has been available to the lending market. If a large volume of stock has been available to the market and the amount to be lent to the manager will substantially reduce that volume, withdrawing the stock may result in the issuer or related party engaging in market abuse by creating an abusive squeeze.
The FSA’s guidance also addresses the availability of the trading information safe harbour in respect of convertible and exchangeable bond issues, whereby behaviour will not amount to misuse of information if it is based on information about a person’s intention to deal or arrange deals. However, the safe harbour will not apply if dealing or arranging is based on information related to primary market activity.
ALTERNATIVE TRADING SYSTEMS
The FSA has published the final text of its rules on the operation of alternative trading systems (ATSs). Most of the rules will come into force on 1 April 2004.
Last July CESR published a final set of standards for ATSs, intended to address the potential risks posed by ATSs operated by investment firms. A consultation paper setting out implementing measures for each of the CESR standards, was published by the FSA last October.
The FSA’s proposals required ATS operators to make arrangements for their systems to accommodate and facilitate public transparency of prices and transactions, monitoring and detection of market abuse, the provision of information to users as to the risk involved in using the systems and ensuring that users have sufficient information about the instruments traded on the systems.
A number of concerns were expressed about these proposals by Respondents to the consultation paper and as a result a number of changes have been made to the proposals by the FSA including limiting the pre-trade transparency obligations to equity markets only, the scope of post-trade transparency requirements and the scope of the obligation to provide information to private or intermediate customers about instruments traded. In addition, the FSA has simplified the information which operators would be required to provide to private and intermediate customers.
Notwithstanding concerns expressed about the FSA’s intention to implement the new ATS régime before finalisation of the revised Investment Services Directive, the FSA is keen to implement the new régime now, in light of the lack of regulation of ATSs and the time that it will inevitably take to finalise the revised ISD.
Specific Questions relating to this article should be addressed directly to the author.