Alternative Investment Management Association
Ian Mason and Lucy Frew
Barlow Lyde & Gilbert
The UK Financial Services Authority (FSA) has made it very clear that it is committed to taking firm action against market abuse. Hedge funds, now under increased scrutiny by the FSA, should be particularly alert to this. Hector Sants, the FSA's Wholesale and Institutional Markets Managing Director, has said that the FSA will “carry out proactive surveillance rather than simply waiting for cases to be reported to us by exchanges or other market participants”, and that already this year it has undertaken thematic projects focused on institutions. Many of these focus on the potential to abuse conflicts of interest, which has allowed the FSA “to consider the increasing involvement of hedge funds and other new investors in this sector and the perceived abuse of material non-public information in these markets”. Mr Sants has also previously noted that a few hedge fund managers were “testing the boundaries of acceptable practice concerning insider trading and market manipulation”.
Hedge funds should also take note of the FSA's increasing emphasis on senior management responsibility and the move towards a more principles-based approach. Some recent cases illustrate this. (In line with AIMA's policy, companies and individuals are not named.)
In August 2006, the FSA announced that it had fined a well known hedge fund manager and its former managing director £750,000 each for market abuse and breaches of certain of the FSA Principles. The FSA found that the managing director had committed market abuse by continuing to trade in a Japanese stock whilst in possession of relevant information. He had been “wall crossed” (or made an insider) by a salesman from another firm as part of the pre-marketing of a new issue of convertible bonds (convertible into the stock). The managing director had previously referred the FSA’s decision against him to the Financial Services and Markets Tribunal, but had withdrawn the reference after the Tribunal ruled in the FSA’s favour on two preliminary jurisdictional issues. The case is important for a number of reasons:
• The FSA attached considerable weight to the managing director’s failure to consult his firm’s compliance department after he had been wall crossed. It is advisable for firms as part of their procedures to require employees to consult with the compliance department after they have been wall crossed or made insiders, and also to have a system of ‘stop lists’ to prohibit trading in investments where a member of the firm has been made an insider;
• The FSA held the managing director’s firm accountable for his market abuse. His seniority and status appears to have been an important factor in this. The fine imposed on him was the highest yet imposed by the FSA on an individual;
• It is not possible to circumvent the UK market abuse regime by trading in a UK listed stock on an overseas market; and
• The Tribunal has the power to impose a different or greater sanction than that imposed by the FSA at the Regulatory Decisions Committee (RDC) stage. This may deter firms and individuals from referring cases to the Tribunal.
Another particularly significant decision relating to market abuse (albeit not involving a hedge fund) relates to two individuals. In May 2006 the Tribunal cleared both men, the first of whom was executive director of trading at the financial spread betting firm which handled the spread bet at the centre of this case, of market abuse. The facts were complex, but the Tribunal ruled “that the Authority has not discharged its burden of proving, to the requisite standard of probability, that [the second individual, majority shareholder in the company in question] either created, or took part in, the scheme or arrangement to facilitate the flotation of [the company in question]”.
The Tribunal also went on to find that, even assuming that the allegations against the two individuals had been proved, the scheme would not have amounted to market abuse because the AIM rules did not require disclosure and the Code of Market Conduct does not have the effect of modifying or extending any disclosure obligations that apply in relation to any prescribed market. Moreover, even had the two individuals engaged in market abuse as alleged, the appropriate penalty would have been a public statement, not a financial penalty.
The FSA is facing more challenges in market abuse cases: another individual is challenging in the Tribunal a fine of £300,000 imposed by the FSA for alleged market abuse relating to spread betting.
The above indicates that the FSA is finding it difficult to prove market abuse to the satisfaction of the Tribunal. The Tribunal did not have the opportunity to consider the merits of the FSA’s substantive case of market abuse against the former managing director referred to in the first case example, as he withdrew his reference.
Emphasis on senior management responsibility
Recent FSA pronouncements indicate that senior management responsibility remains high on the FSA's agenda. Margaret Cole, the FSA’s Director of Enforcement, has stated: “The FSA expects senior management to take responsibility for ensuring firms identify risks, develop appropriate systems and controls to manage those risks, and ensure that the systems and controls mitigate the risks in practice. Failure to manage risks properly is now, more then ever, likely to result in disciplinary action being brought against individuals as well as firms. Senior managers need to understand this and ensure that they are taking appropriate action to identify and mitigate risks to protect their firm, and increasingly, themselves.”
Firms would be well advised to document their senior management responsibilities for systems and controls, to ensure that they have procedures for reporting suspicious transactions and to maintain lists of insiders. (This also applies in areas like the credit market, which the FSA has recently been examining.)
Towards a principles-based approach
The FSA's Handbook (rulebook) contains a mixture of high-level FSA Principles and detailed rules and guidance. The FSA has made it clear (in a variety of recent statements including the 2006/7 FSA Business Plan) that it is changing the balance significantly towards a more principles-based approach. This will involve more enforcement cases based on principles alone, without needing to identify breaches of detailed rules. Two further cases are recent examples of this, although neither case involved findings of market abuse.
In June 2005, the FSA fined a firm £13.9 million for breaches of Principles 2 and 3 by failing to conduct its business with due skill, care and diligence and failing to control its business effectively. Using a pre-planned strategy, the firm’s traders had, over time, built up a large long position in Eurobonds and then, in one hour on August 4 2004, exited the market, causing a sharp drop in prices (and a £9.9 million profit for the firm). While the strategy itself was not regarded as market manipulation, the FSA was concerned by the firm's failure to have due regard to the risks and likely consequences of the strategy for the efficient and orderly operation of the market. Moreover, its lack of adequate systems and controls meant the strategy was “never fully considered at an appropriately senior management level”.
In April 2006, the FSA imposed a penalty of £6,363,643 on another firm for breaching Principles 2 and 5 by failing to conduct its business with due skill, care and diligence and failing to observe proper standards of market conduct, in relation to two separate transactions conducted by the firm during March 2004. The first was in relation to a book build in one company’s shares, while the second involved the stabilisation of a second company’s shares. The FSA also fined an individual, the firm’s former Head of European Cash Trading, £350,000 for being knowingly concerned in the failure to observe proper standards of market conduct in the one of the transactions.
In his June speech Hector Sants cited case examples 3 and 4 as ones in which the key message the FSA has “been seeking to make to the market is that we will use our principles-based approach to ensure firms pay due regard to having effective systems and controls, and pay due regard to the impact of their trading strategies on the quality of the market. Poor systems and inappropriate behaviour can have the effect of harming market confidence even in cases where the conduct falls short of being market abuse.”
There has been some debate as to whether Principle based cases will lead to unfairness due to uncertainty as the 11 high-level Principles are in terms of outcomes rather than detailed rules. John Tiner (the CEO) said that the FSA recognises that there is “a legitimate concern that in order for consequences legitimately to be attached to the breach of a Principle it must be possible to predict, at the time of the action concerned, whether or not it would be in breach of a Principle. But as long as the action or actions in respect of which discipline is being brought could reasonably be predicted to be in breach of the Principle, we do not consider that there is anything unfair about taking Enforcement action for the breach of Principles.”
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It is fair to say that professionals in other areas are subject to regular civil proceedings for negligence which involve a very similar assessment of standards of conduct based on the high-level general obligations to use reasonable skill, care and diligence. Such civil cases are not seen as inherently unfair. However, firms will need to ensure they remain alert to this issue, and it will be interesting to see how the FSA applies the test of “reasonable predictability” in practice.