Casting a wider net to catch market abuse
How will a new Directive and Regulation on criminal sanctions for market abuse affect the financial sector? Christopher Robinson, partner, and Elisabeth Øverland, senior associate at Freshfields, discuss the ambitious package of market abuse reforms.
The Council of the European Union’s adoption of a Regulation and Directive on criminal sanctions for market abuse has been welcomed by the European Commission. The draft laws will mean existing market abuse rules will be broadened to include abuse on the electronic trading platforms that has proliferated in recent years. The proposed laws are expected to be published in the Official Journal in June 2014. Member states will have 24 months to implement the measures.
How will market abuse rules be broadened in light of this new Regulation?
Elisabeth Øverland (EO): There are a number of changes to the current regime.
Scope of the rules
One of the key changes relates to the scope of the investments that fall within the market abuse rules, which will be significantly expanded. The new regime will include financial instruments, such as derivatives and securities, traded on a much wider range of trading venues and platforms. Whereas the current Market Abuse Directive 2003/6/EC (MAD) broadly applies to financial instruments admitted to trading on a regulated market, the Market Abuse Regulation (the Regulation) expands the coverage of the market abuse regime to include financial instruments that are admitted multilateral trading facilities (MTF), as well as organised trading facilities (OTFs). Besides impacting those trading in such investments, the expanded scope imposes obligations on a new range of issuers and trading venues.
OTFs represent an entirely new trading venue category that is being introduced by the revised Markets in Financial Instruments Directive (MiFID II). This is potentially a significant expansion of the regime. Although the current UK market abuse regime does go beyond what’s required by the MAD, the Regulation extends that approach across the EU and to a much wider range of trading venues. In effect, we will end up with all financial instruments that are traded on some form of exchange or organised trading platform in the EU falling within scope of the new regime.
We will see some practical issues with trying to identify which instruments are within scope of the new regime, and in wanting to avoid inadvertently committing market abuse. This is largely going to be addressed by the European Securities and Markets Authority (ESMA) publishing a list of all the relevant financial instruments on its website, although that list will not be definitive.
As a result of this, the Regulation also significantly widens the extra-territorial application of the European market abuse regime. Outside of the EU, non-EU parties may be captured by the regime—even if they are trading securities which are primarily listed and traded outside of the EU—if those securities also happen to be traded on an MTF or OTF in the EU.
Another change worth mentioning is the new prohibition on the manipulation of a benchmark in the wake of the LIBOR rigging scandal. This will prohibit:
- transmitting or providing false or misleading inputs in relation to a benchmark, and
- any other behaviour that manipulates the calculation of a benchmark—‘benchmark’ is widely defined for this purpose
Price significance and insider information
The Regulation also throws up concerns for market participants relating to price significance. There is uncertainty around whether any assessment of price significance will remain part of the definition of ‘inside information’. The definition of inside information may have been expanded by importing into the Regulation itself the explanatory provisions currently included in the Level 2 materials. At the moment, those provisions supplement the price sensitivity test.
Although the Regulation retains the provision that inside information is information which, if it were made public, would be likely to have a significant effect on price, it now also provides that this shall mean information that a reasonable investor would be likely to use as part of the basis of his or her investment decisions. This appears to equate the reasonable investor test with the price significance test, whereas the plain meanings of the two tests are very different. As a result, it’s possible, going forward, that no assessment of price sensitivity will be required and that you would only consider whether the information is something that a reasonable investor would use. However, in order to give the ‘significant effect on price’ test some meaning, it would make sense if the investment decision of the reasonable investor would be a decision to buy or sell investments, and not merely a decision to continue to hold investments they already have. So, the inside information definition could potentially become broader than it is. But it is worth mentioning that the reasonable investor test is one that the UK regulator has in practice been using.
The interpretation will clearly have an effect on market participants who are trading in relevant investments, but it also has significance for issuers, as it could expand the type of information that an issuer would be required to publish.
What does this mean for high-frequency trading (HFT) markets?
EO: Regulators have for some time been concerned about the market disruption that abusive behaviour in the form of certain HTF strategies could cause. The Regulation contains descriptions of behaviours that are specifically stated to constitute market manipulation. It doesn’t mean that these types of behaviour are not considered manipulative under the current regime, but they are now subject to additional focus. This is combined with an increased level of transparency relating to the use of algorithms and HFT under MiFID II, which may make it easier for regulators to detect and successfully enforce the legislation in relation to such abuses.
What is the timeline for implementation of the Regulation and the Criminal Sanctions Market Abuse Directive (CSMAD)?
Christopher Robinson (CR): The target for publication in the Official Journal is around June 2014. There will then be a two-year period before the instruments come into force. This two-year period is for two reasons:
- firms will need time to update their systems and controls, especially those issuers and institutions that are going to be caught by this regime for the first time (and member states will need time to implement CSMAD into national law)
- there is technical guidance that ESMA is required to produce to support the operation of the new regime (due to be finalised towards the end of 2014)—consultation process on this technical guidance is taking place over the course of this yearThere will be no formal retrospective effects.
What scope do individual jurisdictions have to impose penalties?
CR: The EU has been concerned for some time at the lack of consistency within the EU in the investigatory powers given to enforcement agencies and the level and type of penalties that different member states impose on market abuse perpetrators. The basic purpose of the new civil and criminal penalties regime in the Regulation and CSMAD is to increase the deterrent effect of the market abuse regime by raising the level and aggression of enforcement activity across the EU.
The Regulation deals with civil penalties. Member states’ enforcement agencies must be given the power to impose penalties of at least a specified level (a ‘minimum maximum’ level). That level for individuals is €5m—for corporates the level is 15% of their annual turnover which, for a large corporate, can amount to a huge figure. However, it is important to note that this minimum ceiling figure won’t be imposed in every case where a firm is found liable for market abuse—it is simply a fine that each enforcement agency must be able to apply.
Criminal minimum sanctions are going to be introduced through CSMAD. Because criminal sanctions fall within the justice and home affairs section of the Lisbon Treaty, the UK is not obliged to implement the provisions. We don’t have a final decision from the UK government as to whether it is going to opt-in. Even if the UK does not opt-in, CSMAD will be relevant to UK firms which have operations in other member states or which engage in trading from the UK which could be caught by the market abuse regimes in other member states.
CSMAD requires the criminalisation of deliberate insider trading or market manipulation. However, it goes beyond that by introducing a requirement for at least a form of criminal liability to be imposed on a firm whose employee engages in market abuse, where either the person who undertook such behaviour was a ‘leading person’ in that organisation, or where a lack of supervision of control by a ‘leading person’ allowed the market abuse to take place. It’s not quite the same as the UK’s Bribery Act 2010, which imposes criminal liability on firms for systems and control failures (in particular there is no clear ‘adequate procedures’ defence), but it’s analogous. It will be interesting to see how this requirement for corporate liability is implemented in member states, and whether member states seek to impose criminal penalties (which could have far-reaching and unintended consequences like potential debarment) or if instead they implement something more in the nature of an administrative penalty, which CSMAD appears to leave some room for. This is definitely a key issue for firms to watch out for as CSMAD is implemented.
CR: The short answer is, time will tell.
There are two problems attached to taking enforcement action against cross-border market abuse that frequently arise. The type of situation that can arise is someone based in London, for example, who is given inside information by someone in New York, which he then uses to deal on a French exchange. There are two problems with enforcement in these circumstances:
- you need evidence to prove the offence, which in cases such as these, can be found not just in Member States but also outside the EU, and
- even once authorities have managed to get all the material together, there is then the jurisdictional question to settle as to who should take the lead in taking enforcement action against whom
There is an intention that ESMA should play a much greater role in the co-ordination and enforcement of the Regulation in the EU in particular where market abuse has a cross-border aspect. There are provisions for ESMA to be notified by a national authority when it becomes aware that market abuse conduct may have taken place that has a cross-border effect of some kind. ESMA has the power to co-ordinate the investigative process and assist in determining which regulator should take the lead in the imposition of penalties. It also has a new role in coordinating member states’ co-operation with regulatory authorities outside the EU. At the moment, for example, if the Financial Conduct Authority (FCA) began an investigation that also had effect in the US, the FCA will tend to deal directly with the US authorities under memorandums of understanding with the US authorities. The Regulation isn’t intended to do away with this, but it does give ESMA a role in standardising the format of these memorandums of understanding. We may see ESMA taking a more active role itself in investigations that have a cross-border effect in Europe—for example, coordinating not just between national authorities within Europe, but also with regulatory authorities outside the EU in jurisdictions which hold evidence which needs to be obtained.
EO: In terms of the ability to detect market abuse, I think the EU was hoping to achieve broader market surveillance across borders, taking into account post-trade data going into a consolidated tape. It’s not yet clear if this will be achieveable.
CR: The first draft of technical guidance issued at the end of last year suggested that ESMA intends to standardise the suspicious activity reports submitted in different member states, to achieve a single, Europe-wide report that can be drawn upon by different national authorities and make it easier to detect when something improper has been going on. Of course, there are practical and linguistic challenges in achieving that.
Could/should the Commission have gone further?
EO: I think the broader extra-territorial effect of the regime will be a challenge for parties outside the EU. It would be helpful to see further international cooperation in this area.
CR: This is a very ambitious package of legislation, and some parts of it may give rise to practical problems that may not have been fully thought through—the most concerning example being corporate liability under CSMAD. The imposition of criminal penalties on a corporate (without provision in CSMAD for mitigants such as an ‘adequate procedures’ defence or the avoidance of a prosecution by some form of deferred prosecution agreement) could potentially have serious and far-reaching consequences.
Another example in the enforcement context is that the Regulation permits member states to provide rewards for whistleblowers. This is a system that in the US can give rise to huge financial rewards for individuals, but has the potential to lead to people exaggerating information or providing information on a speculative basis.
Overall, though, I don’t think you can criticise the European authorities for a lack of ambition in this package of market abuse reforms.
Interviewed by Duncan Wood.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.