Market abuse and regulatory enforcement
What is market abuse, and how does the civil enforcement regime work? This article highlights some issues and the recent leading Punch Taverns case
Market abuse is a set of prescribed behaviours that amount to unfair advantage in the market or would have a detrimental distortion to the market. There have recently been a number of high profile actions brought for market abuse by the Financial Services Authority (“FSA”) as enforcer of the civil market abuse regime. Given the loss of consumer confidence in the financial services industry lately and judging by recent interventions, the FSA and its successor, the Financial Conduct Authority, look to give no quarter in bringing enforcement action against those they deem to be in breach of the regime.
This article deals with civil enforcement against market abuse in the UK. The criminal regime is invoked less frequently than the civil regime, perhaps because of the higher burden of proof required. At the time of writing the FSA has 20 individuals standing trial, 16 for insider dealing and four for misleading the market. Firms and individuals exposed to the risk of breaches of the civil regime should also be aware that the criminal regime may be enforced as well.
The Insider Dealing and Market Manipulation Directive 2003/6/EC (the “Market Abuse Directive” or “MAD”) sets out the European requirements, whilst the current UK regime is contained in the Financial Services and Markets Act 2000 (“FSMA”). The FSMA goes beyond what is strictly required in MAD and provides a Code of Market Conduct in the FSA Handbook (the “Handbook”).
What is inside information?
Inside information is defined in s 118C of FSMA as being information not generally available and which relates directly or indirectly to issuers of the qualifying investment or the investment itself. If the information were to be available generally it would be information likely to have a significant effect on the price of such qualifying investments or on the price of related investments. Whilst MAD requires that information must be price sensitive, s 118C(6) provides that information is only considered to have an effect on price if a reasonable investor would be likely to use it as part of the basis of an investment decision. This conflict between MAD’s price sensitivity test and FSMA’s “reasonable investor” can make identifying inside information less than straightforward.
What is market abuse?
Market abuse is behaviour prescribed in the Handbook or behaviour in relation to qualifying investments. A “qualifying investment” is defined at length but is typically a traded security or bond or any other transferable instrument on the capital markets. The prescribed markets are those markets established under a UK recognised investment exchange and all other markets which are regulated markets.
The behaviours prescribed by the Handbook are as follows:
Insider dealing: a dealing or attempt at dealing on a qualifying investment using inside information;
Improper disclosure: a disclosure of inside information outside of the proper scope of employment, office or profession;
Misuse of information: the disclosure of information which is not generally available to the public but, if available, would be exploited by a regular user of the market or that the disclosure is such as to make a regular user of the market regard the person making the disclosure as failing to meet the standards expected for someone in that position;
Manipulating transactions: transactions or orders which have no legitimate commercial reason and are likely to distort the market, misrepresent it or secure a price at an abnormal or artificial level;
Manipulating devices: effecting transactions or orders to trade through fictitious devices or forms of deception;
Dissemination of false or misleading information: information likely to give a false impression as to a qualifying investment by a person who knew or could reasonably be expected to know that the information was misleading;
Misleading behaviour and market distortion: any other behaviour likely to give a regular market user a false or misleading impression as to supply, demand or price of qualifying investments or likely to be regarded as such by a regular user of the market to distort the market in such investments.
Indirect abusive behaviour is also caught under FSMA, which makes it an offence for a person (“A”) to take or refrain from taking action which encourages another to engage in activity which, if A had engaged in it to begin with, would have amounted to market abuse.
A person is not, however, in breach of the code where they believed on reasonable grounds that their behaviour did not constitute market abuse. They may also demonstrate that they took all reasonable precautions and exercised all due diligence to avoid behaving in a way which would constitute market abuse.
Under FSMA the FSA has the power to impose a financial penalty of any amount for market abuse. They may also impose public censure, withdraw a person’s approved status or permission and apply to the courts for any further sanction.
The highest fine issued to date by the FSA was £6,108,707 to Indian businessman Rameshkumar Goenka in October 2011. Whilst living in Dubai, Mr Goenka submitted trade orders for shares in Reliance in the dying seconds of an auction at the London Stock Exchange. By doing so he intended to drive up the price of the shares and avoid a substantial loss on a structured product which featured Reliance shares.
The case that has drawn most attention in the financial press of late is Punch Taverns and Greenlight Capital Inc, in which a 45 minute phone call resulted in fines being imposed on Greenlight Capital and a number of individuals acting in different capacities.
Greenlight Capital Inc (“Greenlight”), a US hedge fund, held a number of shares in Punch Taverns (“Punch”). Punch was contemplating a new equity issue and Merrill Lynch International (“MLI”), acting for Punch, contacted Greenlight. The call was between Andrew Osborne at MLI and David Einhorn, Greenlight’s sole portfolio manager. At the beginning of the call Osborne invited Greenlight to be “wall-crossed”, which would allow him to disclose inside information to them. Einhorn declined and asked that the call proceed on a “non-wall-crossed” basis.
During the course of the call Osborne made disclosures of inside information. Upon ending the call Einhorn acted on that information, instructing the sale of 11.65 million shares which Greenlight held. After the equity issue was announced, Punch’s share price dropped 29.9% and Greenlight avoided a £5.8m loss.
Greenlight was fined £3,650,795, Einhorn £3,638,000, and Osborne £350,000. Of particular importance is the acknowledgment by the FSA that Osborne had not acted dishonestly or with any deliberate intention to engage in market abuse. His behaviour was described as an “error of judgment – an honest mistake made under pressure in the course of a difficult telephone call at a tough time in the market”. Despite this he was still fined.
Also worthy of note is the identification of the offending inside information. The FSA indicated that Osborne had made “no single comment [that] constituted inside information”; that there was no statement that in isolation would amount to a disclosure. Instead, the FSA deemed that the information disclosed when taken in aggregate did amount to a disclosure of inside information.
Caspar Agnew, a trading desk director at JP Morgan Cazenove, was also fined for his role in the Punch Taverns dealing. Agnew executed the relevant trades without raising any alarm as to their suspicious nature. Although Agnew’s behaviour did not fall under the market abuse behaviours described above, he was penalised for breaching the FSA’s Statement of Principle and Code of Practice for Approved Persons (“APER”). In their final notice in respect of Agnew, the FSA cite the rules on acting with due skill, care and diligence in carrying out a controlled function, and go on to focus on the requirement to report suspicious trading. Agnew’s failure to recognise that there were reasonable grounds to suspect that the transactions constituted market abuse amounted to a failure to act with the due skill and care required of an approved person.
Similarly, Alexander Ten-Holter, the compliance officer at Greenlight, was fined for breaching APER. Ten-Holter, unlike Einhorn, Osborne or Agnew, had no direct involvement with the actual conversation or decision to trade. He nevertheless failed to maintain the standards expected in making an assessment of risk by placing too much reliance on Greenlight’s group procedures. The analyst who gave Ten-Holter the sell order disclosed at the time that Punch management would have revealed “secret bad things” had Greenlight entered a non-disclosure agreement, and Greenlight potentially had a window of one week to sell the stock before it “plummets”. Ten-Holter did not take steps to find out the basis upon which Greenlight had sold shares, nor take any action to ensure there was no risk that the trade did amount to market abuse.
As well as being fined, Ten-Holter was banned from performing compliance or money-laundering functions in the future owing to him not being a fit and proper person to do so.
The Punch case clearly demonstrates well that even experienced brokers, senior fund managers with experience of wall-crossing and company compliance officers are all at risk of crossing the line between acceptable conduct and behaviour amounting to market abuse or insider dealing.
The FSA and its successor
In early 2013 the FSA will be replaced by two new entities carrying out regulatory enforcement, the Financial Conduct Authority (“FCA”) and the Prudential Regulation Authority (“PRA”).
The PRA will be an operationally independent subsidiary of the Bank of England (the “Bank”), responsible for the micro-prudential regulation of banks, insurers and other prudentially significant firms. The FCA will be responsible for regulating conduct in retail, as well as wholesale financial markets, and the infrastructure that supports those markets. The FCA will also have responsibility for the prudential regulation of firms that do not fall under the PRA’s scope.
The Government is also establishing a third new entity, the Financial Policy Committee (“FPC”), which will be a committee of the court of the directors at the Bank of England, with responsibility for delivering systemic financial stability. The Bank will take on certain market infrastructure responsibilities, including supervising recognised clearing houses and settlement systems. Once the three bodies are operational it will be interesting to see how they function, together and independently, given that the failings of the FSA have often been signalled as a lack of oversight and over-reliance on self policing by companies and financial institutions.
Tracey McDermott, director of the FSA’s Enforcement and Financial Crime Division, has spoken out pugnaciously against the financial sector. At the recent, and last, Enforcement Conference of the FSA Ms McDermott stated that the financial services sector “is no longer an industry that society respects, trusts or has confidence in”, and “it sells products to the wrong people at the wrong time in the wrong way”.
The number of recent actions against high ranking and senior management staff at firms reflects the FSA’s intention to go out with a bang. But if the financial services sector expects the aggressive enforcement to abate with the FCA it can think again. Ms McDermott recently confronted the sector with: “A good enforcer cannot operate if it is not prepared to lose”. And if the example made of Mr Osborne is anything to go by, even an honest mistake may lead to severe penalties.
The only mitigation firms can look to is to ensure that they have robust systems in place, strong compliance teams with transaction oversight, and appropriate and regular training of all staff, from management down.
Alexander Lamley is a trainee solicitor with McClure Naismith LLP