The end of term report seemed reasonably favourable with the FSA finding that, in general, hedge fund managers “appeared to have given reasonable consideration to market abuse issues”. However, as with any such report, praise was followed by “could do better”, as the FSA identified areas for improvement.
There can be no doubt as to how seriously the FSA takes its fight against market misconduct (a collective term to describe the civil offence of ‘market abuse’ and the criminal offence of ‘insider dealing’), it remains and will always be a hot topic for the regulator.
The FSA is currently engaged in three sets of criminal prosecutions for insider dealing, it has taken the unregulated sector, solicitors and accountants, to task over its responsibility for leaks of inside information from M&A transactions, reviewed the anti-market abuse systems of commodity traders and stepped up the number of market abuse actions. In September 2008, the FSA issued a Final Notice against hedge fund manager Stephen Harrison for market abuse. Mr Harrison was fined £52,500 and gave an undertaking not to engage in any regulated activity for a year.
The prediction for 2009 is that FSA enforcement action against regulated firms for failing to implement appropriate systems and controls to counter the risk that their firm may be used to commit market abuse will increase. Enforcement action could follow, even if there is no suggestion of actual market abuse. The fact that there is a risk that the firm may be used for market abuse is sufficient. The FSA is well prepared to take enforcement action for system failures, regardless of there being actual acts of market misconduct or money laundering. For example, in October 2008, the FSA fined corporate advisory firm Sindicatum Holdings Limited for poor anti-money laundering systems and controls, despite any evidence of money laundering.
The FSA will input the information obtained from the follow-up visit into future thematic reviews and supervisory visits to assess other hedge funds. Hedge fund managers would be well advised to benchmark their own firms against the report.
As with much FSA regulation, the regulated must show a willingness to adopt adequate systems and controls to counter such risks. This is so much more than paying lip service to the regulations, a tick box compliance checklist does not cut it. The FSA expects to see a firm-wide culture from the senior management down that they understand the issues, have carefully considered the firm-specific risks and can demonstrate the implementation of appropriate systems. The FSA accepts that smaller hedge funds do not warrant a separate compliance function, but there must be a degree of separation between fund management and compliance. External compliance consultants or advisers would provide some independence to the stress-testing of such systems.
The Regulator noted that many hedge funds had adopted a centralised approach to handle inside information. Whilst this is not necessarily wrong, there were areas of concern, for example:
Insufficient clear desk policies and IT systems
Surely, nothing could be more embarrassing for a hedge fund than for their cleaner or IT consultant to be found to have committed acts of market misconduct while in possession of sensitive information left on a desk or on an unprotected hard drive.
Low volume of reports
The FSA is realistic about the fact that accidental leaks of inside information do occur, especially when fund managers are consulting with market participants, but it did express its surprise at the relatively low level of reporting when such accidents occur. The regulator commented: “In our view, firms cannot simply presume few [leaks] have occurred because few are reported.”
Ad hoc suspicious transaction monitoring
The FSA commented “Of particular concern was an over-reliance on an open plan office setting for overhearing suspicious activity, and a reliance on counter-parties or other staff to detect irregular trading behaviour.” While smaller funds cannot justify the expense of transaction monitoring software, there needs to be more in place than the off chance of overhearing a suspicious conservation.
Back to school
Hedge funds received a ‘B-’ for accepting that staff required market misconduct training, however they fell down in the implementation of the training. What has been highlighted in a number of market abuse cases to date, is that even experienced city professionals fail to understand, or simply close their minds to, what might constitute inside information. The concept of insider information needs to be understood and applied to the day-to-day transactions of the fund.
The FSA is wholly unimpressed by firms’ reliance on a new member of staff or manager having received training from their previous employer. Nor is the FSA impressed by employees simply signing the declaration that they have read and understood the three inch thick compliance manual. Training can be so much more than reading a compliance manual, it may consist of bespoke seminars, interactive on-line courses and, perhaps, even a dreaded exam.
Personal account dealing
All hedge funds that had been visited had personal account dealing policies in place but the FSA identified some instances of confusion as to when dealing requests would or would not be allowed. Such confusion can easily be avoided with sufficiently clear policies and approval processes.
When heading back to the office after the Christmas break FSA-regulated hedge funds may draw some comfort from the fact that the regulator was broadly content that the hedge fund community is on message, but this should not breed complacency. So long as enforcement action against regulated hedge funds and Approved Persons makes good copy, the FSA’s focus will remain firmly on acts of market misconduct and inadequate systems that allow such misconduct. It is rare to receive second chances from the regulator, better now to address remarks of ‘could do better’ than face expulsion next term.
ABOUT THE AUTHOR
Richard Burger is a solicitor in the Commercial and Regulatory Group, Reynolds Porter Chamberlain LLP. He is a former FSA enforcement lawyer. Since returning to practice he has advised financial institutions and Approved Persons on FSA compliance issues and in regulatory investigations.