AIMA

The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

A Key Area of Regulatory Focus

Alison McHaffie

CMS Cameron McKena LLP

Q4 2008

Few can have failed to notice the increased focus and visibility that Financial Services Authority (FSA) is giving to combating market abuse and insider dealing, whether it is in the public announcements of its investigations, such as into the recent suspected “trashing and cashing” of banking shares, or in the warnings in its speeches and publications promising more criminal prosecutions and increased use of its enforcement powers.

FSA has made it clear that this is a market wide issue and not just a concern for hedge fund managers. However, hedge fund managers are finding themselves in the spotlight with the publication in October 2007 of “Market Watch 24”, expressing disappointment at the “complacent” attitude of some managers towards market abuse controls and the recent introduction of the short selling disclosure requirements which were, ostensibly, aimed at tackling market misconduct.

Managers, therefore, need to ensure that they understand the issues and have taken steps to prevent, detect and deter any abuse as well as knowing what to do if they become aware or discover any instance of misconduct within the firm or outside.

How big is the problem?

The reduction of financial crime is one of FSA’s four statutory objectives and although it believes that UK markets are generally clean, it considers that a significant minority of trades are abusive. In particular, it has concerns about the extent of informed price movements ahead of public takeovers. From the figures for its 2007 analysis, it estimates that almost 20 percent of announcements are preceded by some abnormal price movement, which could be either insider dealing or legitimate informed trading.

The sudden announcement of changes to the Code of Market Conduct providing for the disclosure of significant short positions was also predicated on the basis of FSA’s view that there is increased potential for market abuse through short selling during rights issues. Many have questioned the reasoning behind these new provisions, speculating that the true purpose of this change is to protect the banks, which are suffering in the current economic climate and need to raise capital, rather then to prevent market abuse. The requirement to record telephone calls, due to come into force in 2009, was also introduced by FSA as a measure both to deter abuse and to assist it in its investigations.

The true extent of market misconduct may be open to debate but there can be no doubt that it exists and that some continue to test the boundaries of acceptable practice. Of course, the offences are not limited to insider dealing but include disseminating false or misleading information, which remains a key area of focus for FSA, particularly in the current market conditions.

What is FSA doing about it?

FSAs aim is to achieve “credible deterrence” which, if successful, means that opportunities for abuse are minimised through better controls, incidents of abuse are detected quickly and wrongdoers have a real fear of being caught and facing meaningful sanctions.

FSA has come in for criticism for the lack of market misconduct cases it has prosecuted, either under its civil or criminal powers. It has been signalling for some time that this will change and the comments made at its recent “Enforcement” conference underlined this shift of approach and its intention to be “bolder and more resolute” in the way it tackles market abuse. It admits that the threat of higher fines has not worked and that the threat of a custodial sentence would be a much more significant deterrent. Hence, its stated intention is to bring “a steady stream” of criminal prosecutions for insider dealing; it has begun three criminal proceedings so far this year and claims to have a number of further cases under investigation.

No one would doubt that criminal prosecutions resulting in custodial sentences would act as a powerful deterrent to others in the market but, as FSA itself points out, insider dealing cases are tough cases to prosecute. Relying often on circumstantial evidence, FSA will need to be bold and show that it is prepared to bring - and lose - difficult cases if it is to succeed on this front. To assist it in tackling these difficult cases FSA is bringing in measures to incentivise lesser suspects to cooperate with FSA. This will be done through the introduction of a leniency factor to take into account assistance from a minor player, which provides evidence against more culpable parties and by obtaining the statutory power to offer immunity from prosecution to cooperating witnesses. It remains to be seen whether this more determined approach will bear fruit.

In addition to the enhancement of its in-house criminal investigations, FSA has also devoted significant resources into a sophisticated equities transaction monitoring system, Sabre II. This system currently stores all the transaction reports and is used as a market surveillance tool to identify potential situations of market abuse. It is continuing to undergo development and additional functionality will be introduced in 2009, which will help FSA undertake more sophisticated analysis of the data.

One new initiative, which has attracted criticism from the market and advisers, is FSA’s use of telephone interviews or “floor calls”, where FSA telephones the trader directly and without warning seeks to interview over the phone. FSA claims that this is a useful technique to avoid lengthy investigations into innocent trades and helps it to focus on the right cases. However, there are legitimate concerns about FSA seeking to secure evidence by bouncing individuals into interviews when they have not had time to prepare or consult with a lawyer.

As well as focusing on catching the wrongdoers and in bringing cases to deter others, FSA is also concerned to ensure that firms have effective market abuse controls in place. All managers will be aware of the themed visits FSA carried out during 2007 to review these controls and the clear warnings it gave as a result of this work in October’s Market Watch. FSA is carrying out more visits and those found wanting, in keeping with its aim of credible deterrent, are likely to face enforcement action which will mean public censure and significant fines. Conversely, where abuse happens and the firm can demonstrate it has good systems and controls and is complying with them, FSA has said it will not take action against the firm.

Senior managers, particularly those holding significant influence functions, need to be aware that they will also be in FSA’s sights if control failings are found or preventable market misconduct is discovered at the firm. FSA is aware that action against individuals has a greater impact in terms of deterrence than action against firms and, as a result, FSA is committed to bringing more cases against senior management. Historically, FSA only used to take action against individuals where there was dishonesty or lack of integrity; it is now turning its attention to questions of competence as well. The recent action taken against the Chief Executive of a well-known company demonstrates this well; he was fined for system failings even though he had delegated responsibility to other senior staff.

What can firms expect?

Managers’ market abuse controls will continue to be under scrutiny. FSA plans more themed visits in this area and is also planning to send out market conduct questionnaires.

As a result of the increased attention and resources being devoted to this area, firms are likely to see an increase in investigations and may find that staff are receiving FSA’s floor calls. If FSA’s tough words are turned into action, there will also be an increase in the number of criminal prosecutions and civil market abuse proceedings and it is unlikely, if this transpires, that the hedge fund community will remain immune.

What can firms do?

Whilst there will always be instances of the determined criminal circumventing procedures and systems, it is important that all managers take heed of the clear warnings about the robustness of controls in this area. FSA takes a particularly dim view of firms that ignore clear messages, as can be seen in the recent heavy fines imposed on those selling Payment Protection Insurance in the retail sector. Effective systems and controls means amongst other things:

• A clear governance structure with responsibilities properly assigned and documented;
• A robust compliance function and a recognition that responsibility for compliance rests with the senior management and not the compliance team or external consultants;
• Independent monitoring of controls and procedures;
• Regular and appropriate training to all staff;
• Effective use of stop lists and Chinese Walls;
• Clear PA dealing policies that are regularly reviewed;
• Procedures for ensuring information is kept confidential;
• Ensuring the firm is up to speed with regulatory requirements and expectations.

Should the worst happen and the firm uncovers an incident of market misconduct, it is important that it takes the right steps including properly scoping the problem and notifying FSA in an effective and controlled manner. Above all, FSA will expect senior management to be actively engaged in dealing with the issue as well as having ensured that the mitigation of abuse was high on the firm’s list of priorities.

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