A key priority of the FSA’s Enforcement division is market abuse by hedge funds and the institutions that serve them. In a recent speech, Margaret Cole, the FSA’s Director of Enforcement, confirmed that: “Of particular interest to us in Enforcement is the FSA’s belief that some hedge funds may be testing the boundaries of acceptable practice with respect to insider trading and market manipulation. In addition, given their payment of significant commissions and close relations with counterparties, they may be creating incentives for others to commit market abuse” (“The UK FSA: Nobody does it better?”, 17 October 2006) .

After the speech, Margaret Cole explained that one area of particular interest was systematic and repeated abuse of the market: “one area that we have said is a priority is what we call systematic market abuse — market abuse that isn’t just a one- off but where there are organised rings” . Although the FSA rightly says that when compared to the SEC, it is not an enforcement-led regulator, it remains very keen to pursue enforcement action against hedge funds and traders suspected of insider dealing. The aim is to deter, using enforcement action to send ‘messages to the market’ that standards or conduct need to rise.

The FSA’s interest in hedge funds can be dated back to 2003 when the FSA published its Policy Statement on pre-hedging convertible and exchangeable bond issues . After consultation, the FSA informed the market that it would view any attempt at pre-hedging or ‘icing’ of stock before an issue of convertible bonds as amounting to market abuse. In this policy statement, the FSA gave an early indication of the market standards that it intended to enforce going forward.

The most recent example of the FSA’s interest in hedge funds is the GLG/Jabre case. The case arose out of a 2001 convertible bond issue by Sumitomo on the Tokyo market. In August 2006, the FSA imposed fines of £750,000 on each of GLG and Philippe Jabre for market abuse, and breach of Principles 35 (market conduct). In reaching its decision, the FSA found Jabre’s conduct to have been reckless, rather than deliberate. Contrary to Enforcement’s original case, the FSA did not find Jabre guilty of a breach of Principle 1 (integrity), and did not withdraw his status as an approved person. The case has important implications for the rest of the hedge fund industry.

For funds themselves, the finding of market abuse against GLG confirms that the FSA treats it as a fundamental principle that firms will be held responsible for the conduct of their traders and senior staff. The FSA did not just charge GLG with breaches of systems and controls requirements. GLG was also charged with market abuse and ultimately held responsible for the alleged conduct of its fund manager. If an individual trader or fund manager is said to have committed market abuse, the FSA will also seek to convict the firm of market abuse. In short, the FSA believes that the ‘rogue trader’ defence is a bad one. That is one of the least well known, but perhaps most important points coming out of the GLG case. GLG defended the case on the grounds that it was not fair or lawful to hold GLG as a whole responsible for the alleged actions of an individual. On this point, GLG failed.

Another important aspect of the case is how the decisions were made. Decisions to take disciplinary action are made by the FSA’s Regulatory Decisions Committee, following an investigation by the FSA’s Enforcement division. The RDC was intended to be an independent decision making body, separate from the FSA’s Enforcement division. However, until last year, the way in which the RDC heard cases and made decisions was in many ways unfair. Although the accused person or firm was entitled to anoral hearing, prior to the hearing FSA Enforcement would brief the committee and would make private submissions in writing that the firm or individuals was not allowed to see. After the firm or individual had made its submissions, FSA Enforcement staff would remain and be given an opportunity (in private) to rebut the points made. The individual or firm did not get to hear all the submissions made against them, and had no right of reply.

When these practices were considered by the Tribunal in the Legal & General case, they were subjected to strong criticism. The Tribunal concluded that the system was “open to inadvertent abuse and an enemy of transparency” . The FSA responded by setting up an Enforcement Process Review. The results of the review were published in July 2005. Forty-four recommendations for improvement were made, all of which have been accepted by the FSA and implemented. The RDC now gets legal advice from an independent source, rather than from Enforcement. Private communications between the RDC and Enforcement have now ceased and the Enforcement case team no longer has access to the RDC after the conclusion of the hearing.

As a result of these reforms, allegations made by Enforcement are subjected to much more rigorous examination by the RDC. Individuals and firms can expect a fairer and more complete hearing than was previously available. In the case of Philippe Jabre, he was originally accused of breach of Principle 1 (lack of integrity) and the FSA sought to revoke his authorisation. The RDC disagreed, reduced the fine, concluded that the allegation of breach of Principle 1 could not be sustained, and did not revoke his authorisation.

Jabre then appealed to the Financial Services and Markets Tribunal. The FSA responded by renewing its attempt to withdraw Jabre’s approvals, despite these points being decided in Jabre’s favour by the RDC.

At a preliminary hearing, the Tribunal decided that the FSA was allowed to reintroduce these issues. The reasoning was that an appeal to the Tribunal is a fresh hearing of all the issues and the penalty imposed can therefore move up or down. This preliminary decision of the Tribunal imposes substantial risks on individuals and firms, who may find that their decision to refer the case to the Tribunal leaves them worse off. It can only discourage individuals and firms from exercising their legal right to refer cases to the independent Tribunal.

Looking to the future, it is becoming clear that the FSA is changing its tactics. Instead of pursuing fines and withdrawing authorisation to trade, the FSA has decided to bring more criminal prosecutions. There are strong signs that the FSA is keen to see some fund managers in the dock. Margaret Cole has recently confirmed that “we expect to bring more criminal prosecutions going forward” .

However, to date, the FSA has only used its powers to prosecute for ‘criminal market abuse’ once – the successful prosecution of directors of AIT Group for recklessly making false and misleading statements to the market. The two directors involved were sent to prison for 18 months and nine months respectively. The sentences were originally higher, but were reduced on appeal. Although securing criminal convictions before a jury is often difficult, the powerful deterrent effect of criminal sanctions may encourage the FSA to bring more criminal prosecutions in the future.