Financial Regulatory Forum

COLUMN – UK rulings narrows “accepted practice” loophole for traders

By Reuters Staff
October 13, 2009

– John Kemp is a Reuters columnist. The views expressed are his own –
By John Kemp
LONDON, Oct 12 (Reuters) – The UK Financial Services Authority (FSA)’s decision to censure two Dresdner Kleinwort traders for trading while in possession of inside information about a forthcoming issue of floating rate notes by Barclays has implications that go far beyond the offence of trading ahead of a formal announcement.
By censuring the traders, the FSA is attempting to establish a precedent about how it will deal with the defence of “accepted market practice” in future, restricting it significantly, in a move that will force a wider re-examination of entrenched practices across the financial markets in London.

The actions at the centre of the FSA’s probe were not seriously in dispute. On Thursday March 15, 2007, at 1002, the traders at Dresdner Kleinwort were given “a very early heads up” to gauge their appetite for a possible forthcoming note issue by Barclays Capital acting as agent for Barclays PLC.

At that point Barclays Capital indicated the new issue would probably be announced the following Tuesday. Following the call the Dresdner unit in which the two traders worked sold $30 million of similar maturity securities already held in its book.

Later that day, in another call at 1340, Barclays Capital indicated the timetable might be accelerated and “we might in fact just go ahead and just announce it today”. The traders sold a further $35 million of similar securities a few minutes later at 1406. The new issue was formally announced an hour afterwards at 1516.


While the facts were not seriously in dispute, the construction put upon them proved much more controversial. The traders raised a number of defences, but the two most interesting were:

(1) An early heads up about a possible future issue could not constitute the type of specific, price-sensitive information covered by insider trading laws. The telephone conversations were about a potential new issue with no certainty or even reasonable expectation it would materialise.

“Premarketing sounding out or book building prior to formal deal launches were standard market practice and occurred regularly … [T]he established view of market participants at the time was that until a deal closed, no information could be specific or price sensitive”.

(2) Credit markets were different from equity markets. In the view of colleagues and other practitioners “it was perfectly acceptable to trade ahead of new issues in the market” and “fair and common practice to sell ahead” of a new issue.

Both of the key defences were rejected by the FSA’s Regulatory Decisions Committee:

(1) The FSA noted that “absolute certainty” was rarely present in the issue process, but the fact that information was provided by Barclays Capital about a potential issue by its parent the following week should have been sufficiently to give the Dresdner traders a “reasonable expectation” an issue would be announced and alerted them to the risk of dealing ahead. Information about a potential future issue could, in these circumstances, be sufficiently precise that it made the traders insiders to the transaction.

(2) The FSA accepted that the two traders did not believe they had received inside information and were acting in line with accepted market practice (AMP). But it rejected this belief as unreasonable and held they should have considered whether it constituted inside information “regardless of market practice” and guidance from the bank’s compliance department.

It was the decision to reject the “accepted market practice” defence that marks the really important aspect of the case, because it helps resolve one of the key uncertainties at the heart of the market abuse and insider trading regimes.

The general rules covering market abuse and insider trading are fairly clear (EU Directive 2003/124/EC as transposed into UK law at Section 118 of the Financial Services and Markets Act). The prohibition on trading while in possession of inside information is set out in unambiguous terms.

The directive also warns about other potential forms of abuse resulting from trading in substantial volumes affecting the price of a financial instrument; large orders in a concentrated time span causing price movements that are subsequently reversed; and orders around a specific time when reference prices, settlement prices and valuations are calculated that have an effect on those prices or valuations.

Unfortunately, the general prohibition has been muddied and undermined by the exemption for “accepted market practices” (EU Directive 2004/72/EC, transposed into UK law at Section 123 (2)).

This creates the problem of what happens when an “accepted market practice” directly contradicts the general prohibitions on insider trading and market abuse. The safe harbour for accepted practices has created a loophole a mile wide for potentially abusive practices to continue because they are hallowed by ancient practice and custom and would be expected with a shrug by other regular market users.

It also creates inconsistency. What constitutes “market abuse” in one market can be “accepted practice” in another. The issue of consistency as envisaged by the original directive, which notes laconically: “there might be circumstances in which a market practice can be deemed acceptable on one particular market and unacceptable on another comparable market within the [EU]“.

This rather elastic definition of market abuse has been a recipe for confusion. It is a bit like saying theft is a crime in some circumstances but not in others.

More importantly, it has allowed some very dubious practices to continue unchecked, with practitioners able to argue that although they might seem to be abusive they are in fact quite normal and accepted by everyone and therefore should not be changed.

It is this loophole the FSA has sought to narrow. In rejecting the Dresdner traders’ “accepted market practice” defence, the authority has ruled that even if trading ahead was quite normal in the credit market, it could not justify behaviour which seemed to contravene the general market abuse rules so directly and blatantly.

The Dresdner case does not change the law. But it does subtly shift the balance between the general prohibitions and the AMP defence in favour of the former. It is a warming that market participants will have to be much more careful in relying on accepted practices in future to protect themselves from an accusation of abusive trading.

The FSA’s decision to let both traders off with a public rebuke, at the very low end of the scale of sanctions, rather than fine them or seek to bar them from the industry, is an implicit admission the state of the law about accepted practices was not clear.

The sanctions and report will have been, in some sense, “negotiated” with lawyers acting for the traders. This is an “accepted” settlement. The authority notes that both traders have opted not to exercise their right to appeal the matter to the (independent) Financial Services and Markets Tribunal (where the FSA has lost before). The authority may have been nervous about allowing the traders to press their accepted practice claim and what the consequences if it had been accepted.

Moreover, the FSA explicitly accepted the two traders “believed” they had not received inside information and that “no clear guidance” had been provided to either the credit markets in general, or to the traders in particular. This case remedies that lack of guidance. No one else will be able to rely on the accepted practice defence in quite the same way in future.

As the FSA concludes sternly, if either trader had been found “to have acted deliberately, recklessly or in breach of compliance department guidelines, the FSA would have imposed a higher penalty, including prohibition. This would have called into question his fitness and propriety … and would have resulted in a more severe penalty, including a financial penalty and prohibition”.

(Edited by David Evans and Anthony Barker)
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Keywords: COLUMN FSA/

Tuesday, 13 October 2009 04:19:29RTRS [nLC430925 ] {C}ENDS

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