The Market Abuse Directive

A primer for hedge funds

Martin Harty, Crowell & Moring

"The very nature of hedge fund business means that they are vulnerable to involvement in market abuse, either advertently or inadvertently." – (FSA Discussion Paper 054).

Market abuse (a composite term including insider dealing and market manipulation) is currently a very hot topic as the above quotation from the recent FSA Hedge Fund Discussion Paper shows. Surveillance and enforcement in this area are being enhanced and include investigations into areas such as unusually active pre-announcement trading, creditportfolio trading and the use of non public information, examination of investment bank-hedge fund relationships and scrutiny of trades by investors who have been made insiders in an offer. The FSA has already brought market abuse cases, and regulators in a number of European jurisdictions have taken action in cases of alleged manipulation and insider dealing.

The scope of market abuse and the powers of European regulators to investigate and bring enforcement proceedings are about to be increased as the Market Abuse Directive ("MAD") is brought into force. In the UK, implementation of MAD from 1st July 2005 tightens the relevant law, introduces new anti avoidance measures and promotes enhanced co-operation between European regulators.

The provisions will affect issuers of securities admitted to trading on the main EU markets, their senior management and advisers, those making public comments on these issuers and their securities, financial institutions and anyone trading in such securities and related instruments. Although this article will focus on communications between issuers and hedge fund investors and on trading, it is difficult to understand the purpose and aim of the law without a little background. Unfortunately, this is rather complex so what follows is a very simplified description of a jigsaw with many pieces.

Insider dealing has been a criminal offence in the UK for over 20 years but the offence is narrowly defined and there are significant exceptions and defences. As there were few prosecutions and even fewer convictions, the UK securities regulators pressed for the introduction of a civil penalties regime – broader definitions, fewer defences, and no need to bring a case before a jury. The same logic applied to the original market manipulation criminal offence in section 47 of the Financial Services Act 1986. The solution was the introduction of the Market Abuse Regime ("MAR") in the Financial Services and Markets Act 2000 (FSMA). Since then, FSA has had the power to prosecute insider dealing and market manipulation in the criminal courts and also the option to impose penalties under MAR. Market manipulation includes the making of false and misleading statements and distorting the market – abusive squeezes, wash trades, price positioning are all examples of the latter.

FSMA required FSA to publish a Code of Market Conduct ("Code") to give guidance on what was or was not likely to be regarded as market abuse within the statutory provisions of FSMA (the courts ultimately decide what is, with FSA having the power to determine that behaviour does not amount to market abuse). FSA describes the Code as "…a complex document which requires careful study…" with the "reasonable user" (a FSMA concept) being the "cornerstone".

Put simply, there was great concern that MAR penalised behaviour on the basis of effects rather than intention – you could be held to account for something that was not intentional. The regular user test was a (partial) answer to this problem – to amount to market abuse, behaviour would have to be based on inside information that a regular user would regard as relevant to the terms of a trade or be such as to mislead a regular user of the market. Additionally, the regular user would have to regard the behaviour as a failure on the part of the person concerned to observe the standard of behaviour reasonably expected of a person in that position in relation to that market.

In the short time since it acquired its new powers, the FSA has been active in taking enforcement proceedings. The civil regime has been used in cases of insider dealing and market manipulation. As an example, in December last year FSA fined Indigo Capital LLC £65,000 and its managing partner Robert Bonnier £290,000 for giving a false or misleading impression to the regular user as to the supply of or demand for Regus shares. The case arose out of misreporting CFD positions as if they were positions in the (Regus) shares to which the CFDs were referenced. Both the company and the managing partner had been publicly censured by the Takeover Panel. Criminal proceedings have also been used, but more sparingly. (Note that there will be important changes to the Takeover Panel disclosure obligations for CFDs later this year).

MAD is part of the EU Financial Services Action Plan to create a single economic space in the area of financial services. There are actually a number of measures – MAD itself is a framework directive and there are subsequent implementing measures to give effect to the principles it contains. In large part influenced by the UK regime, it nevertheless uses different definitions and does not have a regular user test. The UK has implemented the new MAD provisions but retained much of the pre-existing UK regime. This complicates an already complex area – there are UK criminal provisions, UK Market Abuse and EU MAD regimes all with different definitions, scope, and defences.

The policy behind the directive is that there should be proper information flow to the market and that the markets should be clean and not distorted by manipulation. What does that mean in practice? Some examples are considered below.

First, contact between hedge funds and the companies they invest in. A recent report Hedge Fund Engagement with UK plcs (Linstock-May 2005) concluded that for a typical FTSE 100 company, meetings with hedge fund managers now account for more than 20% of all investor meetings. It is a fundamental requirement of EU securities law that there must be no selective disclosure of "price sensitive" information. Issuers and fund managers will have to be very sensitive to the restrictions this involves – (FSA's List! Issue 9 is required reading). In particular, possession of such information may compromise the ability of the manager to trade in the issuers' securities (or related instruments) or to make public statements or comments about the issuer or its securities.

Distressed companies

Recent press reports suggested that some hedge funds obtained confidential reports intended for the main bank lenders of two companies in difficulties and they managed to avoid signing the usual confidentiality agreements. In the past this would have been most unlikely to happen, but the growth of secondary loan trading now makes this possible. Large banks will typically have a Chinese Wall separating the "Private Side" of their activities from the "Public Side", with corresponding restrictions on the activities of the private side. This is to prevent the misuse of inside information. In May 2005, the Joint Market Practices Forum (which includes ISDA, the LMA and the Bond Market Association) issued new recommendations to take account of MAD. These emphasise the importance of establishing controls "… to ensure that non public price sensitive information obtained in the ordinary course of lending or other relationships with a company is not inappropriately shared with or used by other business units or personnel within the same institution that transact in the securities and credit derivatives market."

It is obviously much more difficult to establish such separation in a small organisation such as the typical fund. Absence of a confidentiality agreement will not be a defence to market abuse if it is clear that the information is price sensitive and came from an inside source.

The questions in any misuse of inside information are really these – what was the information, where did it come from, what were the reasons for the trade in the relevant securities, and what happened to the price when the information became public? The investigation is usually triggered by a significant price movement when the information in question becomes public. From there it is a matter of identifying those who have traded in the relevant securities or instruments and examining their reasons and sources of information.

Trading information can be inside information for these purposes – knowledge of an impending order or trade, the identity of those involved, size, and the terms or likely range of the price can be highly material. Significant price movements ahead of block trades and bought deals have been a concern. Any behaviour which disrupts the market is potentially caught. It has for some time been common for funds to have access to electronic trading screens from the large houses which enable them to take account of the market impact of an order and thereby trade off speed of execution against the effect on the price. Executing a trade in a manner which causes a significant price movement needs extremely careful analysis – particularly if the position is reversed soon afterwards.

Price positioning has already attracted attention in a number of jurisdictions – most obviously around option and futures expiry dates. Regulators are well aware of trades designed to bring a derivative position into or out of the money or trigger a knock out or barrier. These new provisions enhance the ability of the regulators to examine this area. Specific points highlighted include entering orders significantly above or below the current market price with no real intention of allowing them to be filled, quick reversals, trading concentrated around times used for pricing and wash trades.

The fact that a trade is executed in accordance with an exchange rule does not necessarily mean that it does not infringe the market abuse rules. Last year the London Stock Exchange warned that rolling over positions could be caught even if the exchange rules on opening and closing had been adhered to. This was triggered by trading in an AIM stock – on examination, virtually the whole of the trading in the stock over a period was accounted for by opening and closing what was really a limited number of positions thereby creating the risk of a false or misleading impression of the market in the stock (the majority of market abuse enquiries in any country are likely to arise in relation to less liquid securities).

Participants in the convertibles market need to be aware of the FSA view on pre hedging (acceptable in very limited circumstances only) and informal icing (locating shares and obtaining non contractual rights of first refusal – not acceptable).

Market abuse applies to behaviour in relation to securities admitted to any of the relevant EU markets. This effectively introduces an extra territorial element – you can infringe the law of one member state by behaviour in another member state. There will be a greater risk of multi-country regulatory enforcement action. Secondly, there is likely to be increasing co-operation between regulators in different member states. This should lead to the development of better common understanding of the issues. The existence of CESR (Committee of European Securities Regulators) and its continued work in this field will almost certainly promote this.

Market participants involved with relevant financial instruments need to have a clear understanding of the law, assess what risks there may be for their business and embed appropriate controls and checks in their business processes. Staff training is essential. This is an evolving area so it will be necessary to keep up to date with the law and developing standards of what is and what is not acceptable market conduct. It is often said that regulators struggle to keep up with developments in the market. The reverse is sometimes also true, namely that practitioners can fail to appreciate major developments in regulation and the institutional arrangements between regulators. MAD may prove to be one of the more significant recent regulatory developments and lack of a proper understanding or appreciation of its meaning and effects could prove very costly indeed.

Martin Harty is senior consultant to the Financial Services Practice of the London office of US law firm Crowell & Moring. The firm expertise includes funds, alternative investments and a wide range of financial services issues. Martin has over twenty years experience of international legal regulatory issues. Past positions include general counsel of the global investments business of Citibank.