In this issue for Spring 2015 we cover recent developments in legislation and the approach of regulators to the enforcement of market abuse in Asia, Europe and the US.
Asia: Hong Kong
Hong Kong listed companies and their directors continue to be on the SFC’s radar
In February 2015, the Court of First Instance ordered that China Metal Recycling (Holdings) Limited (CMR) be wound up in the public interest. This is the first time that the Securities and Futures Commission (SFC) has obtained a court order to wind up a Hong Kong-listed company under section 212 of the Securities and Futures Ordinance to protect a company's minority shareholders, creditors and the investing public. The SFC's action followed its investigation, which found evidence suggesting that the company overstated its financial position in its IPO prospectus and gross profit in its subsequent annual reports in 2008 and 2009 by over HK$8bn and HK$1bn respectively. The SFC alleged that China Metal Recycling used its wholly owned Macau subsidiary as a conduit for a substantial part of the company's annual profits between 2007 and 2012 which involved fake shipments of scrap metal between the US and the Mainland, the production of false shipping documents and false accounts and highly complex round robin transactions spanning continents. The CMR's Macau subsidiary made a total of around US$2.4bn to its purported key suppliers in the US and Hong Kong in 2012 and around 98 per cent of those funds appear to have made their way back to the Macau subsidiary through bank accounts owned by multiple entities around the world, all controlled by China Metal Recycling.
The SFC's Executive Director of Enforcement, Mr Mark Steward said: "This is an audacious and dishonest scheme using multiple secret nominees established all around the world to deceive Hong Kong investors and creditors into believing this company had a track record and a performance that it simply did not have. It has been stopped and control will vest with independent, court appointed liquidators… This has been a very challenging investigation… The SFC will continue this pursuit to combat corporate misconduct like this and there is no doubt our work in this matter is not finished yet"1.
SFC takes action over company research
In recent years, overseas research companies have been monitoring PRC-based listed companies, often publishing negative research reports claiming to be based on their own findings. After publication, the share prices of the companies subject to these negative reports typically fall significantly.
In December 2014, the SFC initiated proceedings in the Market Misconduct Tribunal against the head of Citron Research (a US-based publisher of research reports on listed companies) for allegedly publishing a report on a Hong Kong listed company that contained false and misleading information, while short-selling the company’s shares in advance of the publication.
The SFC is likely to continue to monitor the circulation of information on listed companies that creates market volatility and there is now clear precedent for taking action against those believed to be involved in creating a false market in the relevant securities.
Retention order against Alpari UK’s Japanese subsidiary
Following the announcement that Alpari UK, a UK-based currency broker, had been placed in insolvency procedures the Kanto Local Finance Bureau (KLFB) took a series of administrative actions, including an asset retention order, in relation to Alpari Japan K.K., Alpari UK’s Japanese subsidiary (Alpari Japan). The KLFB stated, “it is necessary to fully ensure that interests of creditors and investors are not damaged by the outflow of Alpari Japan’s assets to overseas affiliated companies,… triggered by the announcement of Alpari UK”2.
On 16 January 2015, the KLFB ordered Alpari Japan to retain certain assets within the country, in an amount equal to all domestic liabilities for one month in accordance with the Financial Instruments and Exchange Act (Act No. 25 of 1948)– the primary securities law in Japan. Assets outside Japan are not subject to the Retention Order.
In addition, the KLFB issued a business improvement order to Alpari Japan for investor protection, requiring it to accurately identify investors and their invested assets and to take necessary measures to ensure that these assets are not inappropriately used.
This is not the first time that the KLFB has taken administrative action to protect investors, which it did following the Lehman Brothers collapse, but it shows the continued willingness to take action to protect Japanese investors in similar circumstances.
Japan’s regulator takes first decision on bond futures manipulation case
As reported in the last issue, in September 2014 the Securities and Exchange Surveillance Commission (SESC) recommended to the Financial Services Agency (FSA) that a 330,000 yen (approximately US$2,800) administrative fine be imposed on a Singapore-based trader for suspected market manipulation of 10 year Japanese government bond (JGB) futures. The FSA has followed the SESC’s recommendation and this is the first administrative fine of an investor for manipulation of JGB futures.
Asia: People's Republic of China
CSRC cracks down on insider trading using data analysis
Since the latter half of 2013 the China Securities Regulatory Commission (CSRC) has used a new data analysis system to aid its investigations of insider trading. Since then, the CSRC has launched 142 investigations into insider trading, and referred 125 individuals and three firms to the police for criminal investigation3.
The CSRC also imposed administrative penalties on 11 fund houses for lack of compliance and risk controls4. China Asset Management Company, China’s second largest fund house, received the harshest penalty among the 11 and was banned from issuing new mutual fund products for six months.
In late January 2015, the Chairman of the CSRC vowed to build on its recent success and strengthen its enforcement actions against insider trading activity, stating that there will be “zero tolerance".
CSRC focus on information disclosure requirements
The CSRC is also cracking down on breaches of information disclosure requirements by listed companies and their advisors. During 2014, the CSRC formally investigated 43 cases of information disclosure violations and handed down administrative penalties against 16 listed companies, 5 of their advisor firms and 171 directors and senior executives5. Among them, 21 individuals were banned from the market and referred to the police for criminal investigation.
CSRC finds broker firms breaching margin trading rules
In December 2014, the CSRC conducted a two-week on-site inspection of the margin trading businesses at 45 securities firms. Breaches identified included expired margin contracts being extended in violation of the regulations and margin trading services being made available to unqualified clients. As a result, the CSRC imposed penalties on 12 firms (3 of which were banned from opening new margin accounts for three months)6. The CSRC declared that it would continue to strengthen supervision over margin trading businesses and that it would be carrying out on-site inspections at another 46 securities firms in early 20157.
Insider-trading trial suspended
Under French legislation, the same market abuse conduct can be subject to both administrative and criminal sanctions. A criminal trial of individuals accused of insider dealing has been suspended since October 2014 pending a challenge as to whether they should face criminal prosecution for allegations that were dismissed by the civil authorities.
On 17 December 2009, the Sanctions Commission (“Commission des Sanctions”) of the French Financial Markets Authority (“Autorité des Marchés Financiers”) (AMF), dismissed charges against 17 executives from EADS, Lagardère and Daimler accused of insider dealing being the use of inside information about the increasing delays and cost overruns for the A380 aircraft project when selling stock options8.
In late 2013, the investigating magistrate referred 7 individuals and 2 companies (Lagardère, Daimler and former shareholders of EADS) to the Paris Criminal Court in respect of alleged insider dealing based on the same facts.
Since 3 October 2014, the trial has been suspended to allow the Constitutional Court (“Conseil Constitutionnel”) to rule on whether the proceedings are constitutional9. The defendants argued that, in line with the principle of ne bis in idem, the same market abuse conduct cannot be subject to criminal sanctions when the AMF has already cleared the defendants of market abuse.
There is a potential conflict in existing case law between the French and European courts on the interpretation of the ne bis in idem principle:
- the French Supreme Court refused to apply the principle of ne bis in idem in cases where administrative jurisdictions had rendered their decisions before the criminal jurisdictions;
- On 4 March 2014, the European Court of Human Rights rendered its judgment in the Grande Stevens case (Grande Stevens et al. v. Italy), entering judgment against the State of Italy for having prosecuted several individuals for market manipulation even though they had already been charged with administrative sanctions by the Italian stock market regulator;
- On 26 September 2014, the Paris Criminal Court imposed suspended prison sentences and fines of up to €2.5m on 4 defendants accused of insider trading after they were sanctioned in 2008 for the same offence by the Sanctions Commission of the AMF. The Criminal Court did not disregard the Grande Stevens et al v Italy decision but sanctions delivered by the AMF against the defendants do not qualify as criminal sanctions;
- On 8 October 2014, the Constitutional Court considered the principle of ne bis in idem in relation to administrative penalties for tax offences, and held that the double sanction is not contrary to the French Constitution in that context;
- The decision of the Constitutional Court in the EADS case is expected shortly.
The defendant may refer the matter to the European Court of Human Rights if the decision from the Constitutional Court is unfavourable.
Court considers whether the content of a legal report and resulting resolution could be inside information giving rise to an obligation to disclose this information to the market
The Higher Regional Court of Frankfurt decided that the delivery of a report prepared by legal counsel for an internal investigation to the supervisory board and the supervisory board’s resolution can constitute insider information which, on the facts of the particular case, resulted in a market disclosure obligation for the issuer10.
The supervisory board of the issuer instructed external counsel to conduct an investigation into certain loss-making transactions executed by former members of the management board. The report concluded that the former members of the management board had breached their duties by executing the transactions and were liable for any losses caused. On the basis of the report, the supervisory board adopted a resolution to pursue a claim for damages against those individuals.
The Higher Regional Court of Frankfurt found that the resolution to pursue a claim could be inside information because the supervisory board was the competent corporate body to draw specific conclusions from the legal analysis in the report. The completion of the report, on the other hand, did not, in the opinion of the court constitute inside information in itself because the report contained a purely legal analysis of the conduct.
This is another example of a decision in which the Higher Regional Court of Frankfurt has considered the key question of when exactly inside information comes into existence in a process concerning an internal investigation, resulting in an ad hoc market disclosure obligation. It remains to be seen whether the Federal Supreme Court will uphold this decision11.
Italy’s constitutional court to consider ne bis in idem rule for market abuse
According to the judgment of the European Court of Human Rights (ECHR) in March 201412, sanctions proceedings pursued by CONSOB (Italy’s market regulator) for market abuse were in breach of article 6(1) ECHR (right to a fair hearing) and the ne bis in idem principle that no one shall be tried or punished in the same jurisdiction for the same matter for a criminal offence for which he has been finally acquitted or convicted.
In a recent decision in Italy, the Court of Cassation has referred the issue of the validity of CONSOB’s sanctioning powers in such a situation to the Italian Constitutional Court13. The key issue for determination is whether CONSOB’s sanctioning proceedings are criminal in nature consistent with the ECHR ruling. The Court of Cassation has asked the Constitutional Court to rule on the relevant Italian statute imposing administrative sanctions and pursuing criminal prosecutions in market abuse cases so to make consistent the Italian market abuse discipline to principles stated by European Court of Human Rights. The Italian discipline would comply with the European Directives that require market protection and sanctioning measures that are more effective, balanced and deterrent.
Court orders compensation bond for publishing misleading accounts
Following the financial crisis, there were mergers and reorganisations in Spain’s banking sector. Banco Financiero y de Ahorros (BFA) was created in December 2010. In April 2011, BFA became the sole shareholder of Bankia. A few months later, Bankia had an initial public offering to raise capital. Market conditions were harsh and Bankia’s shares were sold at a discount of 74 per cent. The impairment of the book value of Bankia’s shares held by BFA was not reflected in the Bankia/BFA annual accounts, which showed a consolidated net profit of €309m and the auditors refused to issue an opinion. The 2011 accounts were restated the following year under a new management team, reflecting a net loss of approximately €3,000m. The Spanish Government was obliged to rescue the troubled bank and Bankia, the fourth largest bank in Spain at that time, was nationalised.
In addition to multiple civil claims, a small political party brought a criminal complaint in 2012 against Bankia, its parent company BFA and their directors for offences including falsifying the 2011 annual accounts, fraud and price fixing of the shares. In an unprecedented decision and after an investigation lasting almost three years, the judge has made an order for a bond of €800m to cover compensation for the potential civil liabilities of the former heads of Bankia, Bankia and BFA14. The decision was made in the light of expert reports that show that the annual accounts did not accurately reflect the company’s financial position.
It has been determined that BFA will bear 60 per cent of the compensation (€480m) ordered by the court relating to the 2011 public listing and Bankia has included a provision in its 2014 annual accounts to cover the remaining €320m.
FCA reports on market abuse controls at asset managers
The FCA has published its findings from its thematic review of how asset management firms control the risks of insider dealing, improper disclosure and market manipulation, with a primary focus on insider dealing in equities. The FCA reviewed the systems at 19 firms and indicated that few firms met its high expectations of comprehensive controls, and the review identifies areas in which the FCA may decide to focus further supervisory and enforcement resources in relation to all financial institutions.
The FCA described its findings and expectations in the following key areas:
- managing the risk of receiving and identifying inside information when not expecting it - firms generally had effective policies to identify and control inside information in clear situations but practices were often informal or inconsistently applied when inside information was not expected;
- controlling access to inside information when received – firms need a policy to limit the sharing of inside information to those who needed to know it and the effectiveness of those policies needed to be tested;
- using pre-trade controls to reduce market abuse risk – a segregated dealing function helps firms to conduct a review to flag potentially manipulative transactions prior to execution and restrict trading where the firm holds inside information;
- conducting post-trade surveillance – only two firms demonstrated post-trade surveillance that highlighted and properly investigated potentially suspicious trades. Common barriers to surveillance were lack of documentation and poor awareness of front-office activity;
- controlling personal account dealing - all of the firms had a personal account dealing policy but should consider these to ensure that the requirements under COBS 11.7 are met, including adequate arrangements aimed at preventing market abuse; and
- adequate training for staff - nearly all of the firms conducted training on market abuse but should consider the frequency and quality of such training to ensure staff knowledge is sufficiently current for the firm to effectively identify, manage and monitor the risk of market abuse.
North America: US
US court reins in insider trading prosecutions
Dealing a significant blow to the US government’s campaign against insider trading, the US Court of Appeals for the Second Circuit overturned the convictions of two hedge fund managers in December 2014. In United States v Newman15, the court ordered that the indictments be dismissed because the government failed to prove that the defendants had traded on confidential information that they specifically knew had been disclosed by corporate insiders in exchange for a personal benefit.
The defendants in Newman, both of whom were hedge fund managers, were several layers removed from the insiders or “tippers” and had no knowledge of any personal benefit that the insiders may have received, a not uncommon occurrence in insider trading situations.
The court’s ruling demonstrates that there are limits on the prohibitions against insider trading and recognises that the flow of even nonpublic, material information from public companies to analysts and traders can be lawful. The court did acknowledge, however, that “information about a firm’s finances could certainly be sufficiently detailed and proprietary to permit the inference that the tippee knew that the information came from an inside source.”
Since Newman, the US government has struggled to find its footing. It asked the court to reconsider its ruling, stating that the decision “will dramatically limit the government’s ability to prosecute some of the most common culpable and market threatening forms of insider trading.” In the meantime, insider trading defendants have been asking judges to dismiss their cases. One judge has already vacated the guilty pleas of four defendants.
SEC administrative proceedings on the rise
The SEC has continued to bring an increasing number of cases (including insider-trading cases) before agency-appointed Administrative Law Judges rather than filing them in federal court. As mentioned in our summer 2014 issue, these proceedings do not afford defendants the procedural protections they would receive in court and these proceedings are generally much faster.
The SEC has been more successful in administrative hearings than in court16. Over a 12 month period, the SEC won all six contested administrative hearings that reached a verdict. By comparison, the SEC succeeded in 11 of 18 cases that when to trial in federal court.
The SEC has signalled an intention to bring more administrative cases as part of a continued vigorous enforcement effort in 2015.