Market Abuse - No need for an intent to mislead or distort the market in FSA proceedings

Summary

The Financial Services and Markets Tribunal has found in favour of FSA in upholding its case against Winterflood and two of its traders. Winterflood had challenged FSA’s interpretation of the market abuse provisions in the Financial Services and Markets Act (the “Act”) arguing that for there to have been market abuse under s118 there had to be a form of subjective mental element or “actuating purpose” on the part of the accused to mislead or distort the market. The Tribunal found that an actuating purpose was not a necessary element for market abuse under s118.

In commenting on the decision Margaret Cole, FSA's Director of Enforcement, said, “ The FSA expects market professionals to always be alert to obvious indications of wrongdoing. There were clear warning signs that should have made Winterflood think something was amiss but it failed to recognise and react to them. Instead of challenging the trades, Winterflood allowed them to go ahead and made large profits as a result…..Taking this action against Winterflood shows that we are determined to tackle abusive behaviour and to deter market participants from threatening the integrity of our markets.”

The Facts

Winterflood is a market maker specialising in smaller company securities including those listed on AIM. It provided a market making service in the shares of Fundamental – E Investments Plc (“FEI”), an AIM. listed company. A Mr Eagle was looking to secure control of an AIM shell company as an investment vehicle to acquire electronic technology companies. Mr Eagle agreed with the original shareholders who held 85% of the issued share capital of FEI to arrange for their shares to be sold. In July 2003 he arranged with Winterflood that the original shareholders would approach Winterflood to sell their shares and that he would then buy the stock back. Thereafter, Mr Eagle set up an illegal share ramping scheme in the FEI shares, the effect of which was to inflate the share price from 2.5p as at May 2003 to a high of 11.75p by July 2004.

The FSA investigation found that Winterflood and its traders behaviour in executing rollover trades, delayed roll over trades and consistently selling shares to SP Bell (an agency only stockbroking firm owned by Mr Eagle) created a distortion in the market for FEI shares and misled the market as to the supply, price or value of and demand for the FEI shares.

Actuating Purpose

For the purposes of the issue before the Tribunal, Winterflood accepted that the behaviour could fall within the conditions specified under s118 of the Act in that:

1. It occurred in relation to a qualifying investment traded on a prescribed market

2. It was likely to give a regular user of the market a false or misleading impression as to demand or as to the price or value of the shares and/or was such that a regular user of the market would or would be likely to regard the behaviour as behaviour which would or would be likely to distort the market in investments of the kind in question

3. It was likely to be regarded by a regular user of AIM as a failure to observe the standards of behaviour reasonably expected of market makers in their position

4. It occurred in the UK.

Winterflood argued that merely satisfying the statutory definition of market abuse under s118 was not enough and that the Code of Market Conduct (the “Code”) required FSA to also prove that in engaging in the behaviour it had an actuating purpose to mislead or distort the market.

Winterflood argued that the provisions of the Code dealing with “artifical transactions” and “price positioning” contain clear descriptions of behaviour that FSA does and does not consider amounts to market abuse and that these descriptions make it clear that only behaviour with the relevant “actuating purpose” amounts to market abuse. Actuating purpose is defined by FSA as a “purpose which motivates or incites a person to act”. Accordingly, Winterflood maintained, by virtue of section 122, it was entitled to rely upon that identification to the extent that it indicates behaviour does not amount to market abuse.

The Decision

In finding that there was no requirement for FSA to prove an actuating purpose, the Tribunal relied on the fact that the Code does not purport to specify exhaustively all types of behaviour which may or may not amount to market abuse. Indeed, where it identifies behaviour which cannot amount to market abuse it categorises it a safe harbour and that therefore if the intention had been for behaviour without an actuating purpose not to be market abuse, the draftsman of the Code would have provided an express safe harbour provision to that effect.

The Code also specifically states that the definition of market abuse does not require the person engaging in the conduct to have intended to abuse the market. The Tribunal did accept that that the Code does recognise that an actuating purpose is a factor which will be taken into account in assessing whether a regular user would regard the principal rationale as a legitimate commercial rationale but it did not accept that the existence of this purpose was an additional requirement.

Commentary

This is a significant decision for FSA in its continuing commitment to tackle market abuse. It comes at a time when FSA’s commitment to tackling market abuse is very much in focus with FSA obtaining a conviction in its first criminal prosecution for insider dealing with FSA’s promise of more to follow and the announcement of a series of arrests in connection with organised insider dealing.

Clearly, if an actuating purpose had been found to be a requirement FSA would have a higher hurdle to overcome in establishing the offence and FSA accepted that it its case against Winterflood would have failed. FSA has come in for significant criticism in its failure to tackle market abuse both through the civil market abuse regime and in the criminal courts. This case is the most significant case FSA has brought using its civil powers under the market abuse regime (rather than for breach of FSA Principles) as the penalties FSA had decided to impose shows - £4 million on Winterflood and £200,000 and £50,00 for the two traders. It serves as an important reminder of the type of behaviour that can amount to market abuse even when it is acknowledged that those involved had no intent to mislead the market and the significant penalties which will be imposed on those involved in this sort of behaviour. However, this may not be the end of the challenge as we understand that Winterflood is seeking permission to appeal the decision to the Court of Appeal.

For more detail on the recent convictions for insider dealing please click here.