On 14 October 2020, the UK Financial Conduct Authority (FCA) issued a Final Notice, imposing a fine of £873,118, on Asia Research and Capital Management Ltd (ARCM) for its failure to notify the FCA under the EU Short Selling Regulation (SSR)1 of net short positions held by ARCM in Premier Oil plc between February 2017 and July 2019. Although a number of other European regulators have issued fines for similar notification breaches, this is the first known fine imposed by the FCA for such a breach.

In this Update we describe the case and provide commentary on the key issues arising out of the FCA findings.

Facts and FCA findings

According to the FCA’s Final Notice, ARCM is a Hong Kong-based asset management firm, focused primarily on securities in Asian markets, that trades infrequently in EU markets. However, on 17 October 2016, it began building a credit position in London Stock Exchange (LSE)-listed Premier Oil plc through acquisition of a debt instrument. ARCM continued building its credit position throughout 2017-19. Alongside this position, to hedge its credit risk exposure, ARCM entered into a series of short equity swap transactions on Premier Oil plc during the same period.

Under the SSR, net short positions in shares admitted to trading on a trading venue in the EU are notifiable to the relevant EU regulator when the position is equal to or exceeds 0.2% of the issuer’s outstanding share capital and at each 0.1% threshold above that (although, following the exercise of emergency powers by the European Securities and Markets Authority (ESMA), the initial threshold as at the date of this Update has been reduced to 0.1%; see our Update).

When the position is equal to or exceeds 0.5% and at each 0.1% threshold above that, the position must be disclosed to the public.

In the case of asset management firms, the SSR provides that net short positions in an issuer should be aggregated across a firm’s funds and accounts. Firms can determine which regulator their net short positions should be reported to in respect of particular shares by identifying the “upcoming RCA” (i.e. relevant competent authority) for the share, as shown in ESMA’s Financial Instruments Reference Data System (FIRDS).

During the relevant period, ARCM built a net short position of 16.85% of Premier Oil plc’s issued share capital. The FCA noted that this was the largest net short position ever held in an issuer on the FCA’s Official List with shares admitted to trading on the Main Market of the LSE.

As ARCM’s net short position varied throughout 2017-19, it triggered over 300 notification and/or disclosure obligations that ARCM failed to meet. ARCM’s 16.85% net short position was held for 106 trading days following 5 July 2019, before the position was finally notified to the FCA.

As explained by the FCA, ARCM’s failure to make the necessary notifications was largely attributable to a misunderstanding of the scope of the SSR. In particular, ARCM had relied on third-party materials in its compliance procedures, due to its unfamiliarity with EU markets. However, these materials were indicative and non-exhaustive; specifically, they did not reference derivatives trading as being within scope of the position calculation requirements under the SSR. As a result, ARCM incorrectly believed the net short position reporting requirements did not apply to its trading in Premier Oil plc.

On 29 October 2019, ARCM became aware that the SSR applied to swaps and that its trading in Premier Oil plc might trigger reporting obligations. By 8 November 2019, it confirmed such obligations were indeed triggered and began preparing the required data for submission to the FCA. This work was disrupted by social unrest in Hong Kong. On 29 November 2019, ARCM notified the FCA of its failure to make notifications and disclosures. The missing 155 notifications were submitted to the FCA on 3 December 2019.

The FCA Final Notice highlights that the FCA considers ARCM’s breach to be particularly serious due to

(a) its scale (ARCM failed to make 155 notifications and 153 disclosures over a two-year period) (b) the unprecedented size of the final net short position (c) ARCM’s delay in notifying the FCA after discovering the breach (d) the weaknesses in ARCM’s compliance procedures and internal controls

The FCA therefore imposed a fine of £873,118 on ARCM (post-application of a 30% (stage 1) early settlement discount).

Sidley commentary The fine imposed by the FCA is its first in relation to the failure of a position holder to notify a net short position under the SSR. Whilst the case is exceptional in terms of the scale of the identified breaches, there are several lessons for asset management firms, including non EU firms.

Extraterritorial effect of the SSR

There are two aspects to the SSR’s extraterritorial effect that firms should be aware of.

First, when a share (or EU sovereign debt) is in scope of the SSR, the net short position reporting regime applies regardless of the location of the position holder and so will apply to non-EU asset managers (who must report on the positions held by the funds or accounts they manage). Notwithstanding that ARCM is a non-EU firm that traded infrequently in EU markets, the FCA’s Final Notice is critical of ARCM’s lack of familiarity with the scope of the SSR’s reporting requirements.

Second, shares that might not appear to have an EU nexus at first glance may nonetheless be caught by the SSR net short reporting obligation. This is because many non-EU issuers whose shares are listed outside the EU may also have their shares admitted to trading on one or more EU trading venues and thus be brought within the scope of the SSR’s net short position reporting obligations. Although ESMA maintains an “exempted shares list” of shares whose “principal trading venue” (in essence, primary liquidity) is outside the EU, the exempted shares list may not cover all non-EU issuers and might not also be updated as frequently as might be expected.

Calculating net short positions in shares

When calculating a person’s net short position in shares, one must include short positions established through any instrument that confers a financial advantage in the event of a decrease in the price or value of the relevant share. That includes derivatives, American depositary receipts (ADRs), and global depositary receipts (GDRs) relating to in-scope shares.

Importance of tracking position moves

The number of failed notifications generated by ARCM’s trading highlights the importance of tracking position movements once a net short position has been established. In particular, it is not merely the opening and closing trades that must be accounted for. ARCM’s total of 308 missed notifications and disclosures demonstrates how quickly breaches can build up over time. Increments of 0.1% over the initial thresholds trigger further reporting requirements under SSR when moving up and down. Firms should therefore be aware that even slight variations in a position, over relatively short periods of time, could require them to make multiple notifications/disclosures.

Timing of notification

Net short positions should be calculated as at midnight at the end of the relevant trading day and notified to the relevant EU member state regulator by 3:30 p.m. on the next trading day. Because these times are measured by reference to the local time of the regulator, this can be more challenging for non-EU firms on different time zones.

Compliance environment

The FCA noted that in ascertaining its obligations in advance of the trading, ARCM relied on third-party materials about the regulatory context in the UK. Although this contained information concerning the SSR, the materials included an indicative, rather than an exhaustive, list of the instruments to which the SSR applied. Specifically, the materials did not reference derivatives trading as requiring notification.

Asset managers should obtain specific advice on the laws and regulations of the countries in which they trade financial instruments in order to avoid missing important points such as that missed by ARCM here.

Cooperation with the FCA

The FCA’s comments on ARCM’s cooperation are also worthy of note. Although the FCA noted that ARCM had fully co-operated with the investigation over the period of the COVID-19 global pandemic, the FCA nonetheless treated ARCM’s delay in notifying it of the potential breach until a resolution was identified as an aggravating factor. Although ARCM is not directly regulated by the FCA, the FCA nonetheless still expects to be made aware of anything it might reasonably require notice (this is encapsulated as Principle 11 of the FCA’s Principles for Businesses in relation to FCA-authorised firms). The FCA expected to have been made aware of ARCM’s potential issues as soon as ARCM became aware of them, rather than only once the matter had been resolved.

As such, if a firm does identify an SSR reporting failure, the firm should make the FCA aware of the issue promptly, even if the reporting breaches have not yet been rectified.

Impact on the proper functioning of the market

Firms should also take note that although in this instance the FCA was satisfied that ARCM’s omissions were merely compliance oversights, they had an inherent impact on the proper functioning of the market. The FCA further noted that failure generally to comply with SSR obligations could disrupt market liquidity and efficient price formation.

In other circumstances, the FCA could consider whether there was an intention to commit market manipulation and could draw an adverse inference from a firm’s failure to disclose publicly notifiable net short positions as an attempt to obfuscate its trading activities in the absence of any other credible explanation. The FCA has very extensive powers to require the provision of information in market abuse cases and is likely to consider all the surrounding circumstances when investigating the reasons for a failure to make timely disclosure of short positions, including the trading strategy being adopted, the profits generated by the trading, and the potential disadvantage to other market users.

Conclusion

The FCA’s expectations of firms have been made clear in the Final Notice, and serve as a reminder to firms of their obligations under the SSR.

It should be noted that, even after the end of the Brexit transitional period (which ends on 31 December 2020), the UK will still have its own “onshored” version of the SSR , so there will be no immediate change to position holders’ obligations. However, firms should be alert to the fact that there may be situations where net short position reports have to be made both in the UK and in an EU member state, for example in the case of a UK issuer whose shares are also traded on an EU trading venue, in circumstances where the ESMA exempted shares list has not been updated to exclude such shares from the EU version of the SSR. It is also possible that the UK’s version of the SSR deviates from the EU version over time meaning that firms will have to assess their net short positions under two distinct regimes.