Is an honest, but mistaken, belief that you are not trading on inside information a defence to market abuse? The answer is “no”. The FSA’s recent decision means that market practitioners and compliance must revise preconceptions of what constitutes inside information.

SUMMARY

Morton and Parry were portfolio managers at Dresdner Kleinwort trading corporate bonds. The events described all occurred on the same day in March 2007.

As Dresdner was active in the bond new issue market, Barclays Capital rang Morton to gauge appetite for a new issue proposed by Barclays which was priced 4 basis points lower than Dresdner’s existing holding of Barclays’ bonds. Barclays said the new issue was likely to be announced
four working days later.

After the call, Morton and Parry sold to two counterparties Dresdner’s existing holding of US$65m of Barclays’ bonds and agreed that Dresdner would subscribe for US$200m of the new bond issue. The new issue was announced the same day, with the result that Dresdner’s counterparties recognised mark to market losses amounting to US$66,000 and complained.

FSA Enforcement alleged market abuse. Morton and Parry took their defence to the Regulatory Decisions Committee denying market abuse saying
that knowledge of a new issue was not regarded in the bond market to be inside information. They also said that they honestly and reasonably believed that their behaviour did not amount to market abuse. As a consequence, the FSA had no jurisdiction to impose a penalty on them.

The RDC came to the conclusion that the information regarding the proposed new bond issue was inside information because information regarding the new issue put Morton and Parry in a more advantageous position. The sales of existing bonds before the new issue was announced did amount to market abuse.

The RDC accepted that Morton and Parry honestly but mistakenly believed that the information about the new bond issue was not inside information but concluded that neither individual had a reasonable ground for his belief because “he had a responsibility to consider whether the information was capable of being inside information, regardless of the market practice and guidance from his compliance department.”

Lessons

It is not surprising that the FSA came to the conclusion that information regarding the new issue was price sensitive in relation to Barclays’ bonds given that the new issue was priced 4 basis points lower than the bonds sold before the announcement. Neither is it surprising that the bond market (and indeed compliance) was wrong to believe that knowledge of a new issue is not inside information and thus does not protect against a penalty. What is surprising is that the FSA did not impose a financial penalty or prohibition order in a clear case of market abuse, but took the exceptional step of merely stating that market abuse had occurred and the individuals should be censured.

The lessons to learn are that market abuse is very complex indeed, and that market practitioners and compliance officers must have a good working
knowledge of the legal tests as an honest but mistaken belief is no defence. In the future, it is unlikely that individuals found guilty of market abuse will escape financial penalty and exclusion from the financial services industry.

ANALYSIS

What was the information and why was it inside information?

During the book building process, BarCap told Morton, who passed on the information to Parry, that a new issue would probably be announced during the next four business days. BarCap gave information about the issuer, the terms, structure, size, currency, discount margin and timing of the new issue. It was made clear that this information was confidential. The individuals dealt after the conversation and then again later on in the afternoon of the same day after having been told that the announcement might be brought forward to later that day, as in fact it was.

According to the Financial Services Management Act, the legal test for inside information is:

information of a precise nature which:-

(i) is not generally available, and

(ii) relates, directly or indirectly, to one or more issuers of the qualifying investments or to one or more of the qualifying investments, and

(iii) would, if generally available, be likely to have a significant effect on the price of the qualifying investments or on the price of related investments.

Information is precise if it indicates circumstances that exist or may reasonably be expected to come into existence, or an event that has occurred or may reasonably be expected to occur and is specific enough to enable a conclusion to be drawn as to possible effect on the price of the investments or related investments.

Whether the price of investments is likely to be affected is an objective test and is satisfied if and only if it is information of a kind which a reasonable investor would be likely to use as part of the basis of his investment decision.

The information provided by BarCap satisfied all the factual tests for inside information and was found likely to have a significant effect on the price, not least because the complainant counterparties, taken to be reasonable investors, said knowledge of the new issue would have affected their investment decision. That is hardly surprising given that they had bought in the morning similar bonds at a price 4 basis points higher than the new issue that was announced later in the afternoon.

Why did the statutory defence fail?

The FSA cannot impose a penalty for market abuse if the person in question believed, on reasonable grounds, that his behaviour did not amount to market abuse. This is partly subjective in that the FSA must examine the belief of the individual, based, of course, on his or her state of mind. However, there is an objective element in that the belief must be held reasonably. This requires the individual’s conduct to be measured by the standards and knowledge of his peers.

In this case, the FSA accepted that the market in which Morton and Parry worked, and their compliance officers, believed that knowledge of a new issue was not inside information. However, the FSA has said that the portfolio managers should have known better. It looks like the FSA is shining the blindingly bright light of hindsight. Practitioners must ensure that they are fully versed in the first principles of the market abuse regime in case the goalposts are actually in a different place than they and their compliance officers may have believed them to be.