Associated Legislation and Regulation CH 3

Associated Legislation and Regulation

This section provides an overview of key legislation and regulations relevant to financial markets, focusing on market abuse, money laundering, bribery, disclosure, and capital adequacy.

Market Abuse Regulation (MAR)

The EU Market Abuse Regulations (MAR), now converted into UK MAR, were established to combat market manipulation and ensure proper information disclosure. The regulations define and prohibit market abuse and mandate preventative measures. MAR applies to both unexecuted orders and requests for quotes (RFQs), as well as executed orders.

What Constitutes Market Abuse?

• Information not generally available, which would impact price if disclosed.

• Activities likely to create a false or misleading impression of supply, demand, or value of investments.

• Actions likely to distort market prices.

FCA Guidance on MAR

The Financial Conduct Authority (FCA) provides guidance on EU MAR matters, but these are not binding rules. These guidelines serve as important recommendations for firms to adhere to the spirit of the regulation.

Specific Market Abuse Offences

MAR details four specific offences related to market manipulation:

• Manipulating transactions: Such as trading large volumes at the end of the day to force prices up artificially.

• Manipulating devices: For example, buying shares and spreading false information to drive up prices.

• Dissemination: Posting deliberately false or misleading information about a company online to impact share price.

• Benchmark manipulation: Providing false data submissions for benchmark compilation.

Inside Information Definitions

Inside information is precise, non-public information that, if made public, would likely significantly affect the price of a financial instrument or commodity derivative. For those executing orders, it also includes information conveyed by a client related to pending orders.

Prohibited Actions Involving Inside Information

• Trading in instruments to which inside information relates.

• Cancelling or amending orders to which inside information relates.

• Recommending that another person trades in instruments to which inside information relates.

• Recommending that another person cancels or amends orders to which inside information relates.

Suspicious Transaction and Order Reporting (STOR)

Firms must report suspicious activities to the Competent Authority (FCA) in a timely manner after a full investigation. This includes providing detailed information on the identity of the submitter, the nature of the order/transaction, reasons for suspicion, and identifying all involved parties.

Acceptable Market Practices (Not a Breach of MAR)

The following are generally considered acceptable and do not breach MAR:

• Behaviour by parties without access to private information.

• Acting as a market maker.

• Executing orders on the instruction of a third party.

• Where an order was placed before inside information was acquired.

• Certain information acquired during a takeover.

• Stakebuilding activity using own knowledge.

Sounding

A sounding is an attempt to gauge market interest for a new securities issue, which may involve disclosing inside information. This practice places obligations on both the disclosing and receiving parties.

Penalties for Market Abuse

The Financial Services and Markets Act (FSMA) grants the FCA powers to impose penalties for market abuse, which is a civil offence. Penalties include:

• Withdrawal of approval or authorisation.

• Unlimited civil fine.

• Public statement of engagement in market abuse.

• Injunctions to prevent or remedy market abuse, or freezing orders.

• Restitution orders.

• Payment of compensation to victims.

Insider Dealing (Criminal Offence)

Insider dealing is a criminal offence under the Criminal Justice Act (CJA) 1993, involving using or disclosing inside information for personal gain or to distort market prices.

Elements of Insider Dealing Under CJA 1993

To be found guilty, an individual must be an insider in possession of inside information that is:

• Relevant to securities traded on regulated markets (e.g., UK/EEA/Gibraltar Regulated Market, MTF, OTF, NASDAQ, SIX Swiss, NYSE).

• Specific or precise.

• Not public.

• Price-sensitive (also known as unpublished price-sensitive information).

An insider knows the information is inside information and that it was knowingly acquired from an inside source.

Specific Offences of Insider Dealing

An individual commits insider dealing if they:

• Deal in price-affected securities when in possession of inside information.

• Encourage someone else to deal in price-affected securities when in possession of inside information.

• Disclose inside information, other than in the proper performance of their employment, office, or profession.

Scope of Investment Instruments

Only specific investment instruments fall under insider dealing legislation:

• Transferable securities: Shares, bonds, money market instruments.

• Units in Collective Investment Schemes (CIS).

• Derivatives: Options, futures, swaps, forward rate agreements relating to securities, currencies, interest rates, yields, emission allowances, financial indices, and commodities.

• Financial contracts for difference (CFDs).

• Emission allowances.

Defences for Insider Dealing

For dealing or encouraging others to deal:

• The defendant did not expect dealing to result in profit or avoid loss due to the information.

• The defendant believed, on reasonable grounds, that the information was sufficiently disclosed.

• The defendant would have acted the same way regardless of the information.

For disclosing only:

• The defendant did not expect any person to deal.

• The defendant expected someone to deal but did not expect it to result in profit or avoid loss due to the information.

Exceptions and Safe Harbours

• Market Makers: Not guilty if acting in good faith in the course of business.

• Market Information: If the information held was market information (e.g., about a block trade) and it was reasonable to act as they did.

• Price Stabilisation Rules: FCA rules allow price stabilisation after new issues, providing a "safe harbour" if conformity is shown.

Penalties for Insider Dealing

The Financial Services Act 2021 introduced maximum sentences:

• Summary conviction: Fine and/or up to 12 months jail.

• Conviction on indictment: Fine and/or up to 10 years jail.

The FCA can prosecute insider dealing offences under the CJA, applying principles similar to the Code for Crown Prosecutors.

Misleading Statements and Impressions

The Financial Services Act 2012 outlines criminal offences related to misleading market information.

Offences Under FSA 2012

1. Making misleading statements (section 89).

2. Creating false or misleading impressions (section 90).

3. Making misleading statements in relation to benchmarks (section 91).

Defences Against Misleading Statements

• Belief that the act was not creating a misleading impression.

• Actions related to legitimate stabilisation practices.

• Actions conforming to FCA control of information rules (information barriers).

Managers' Transactions (PDMRs)

Persons Discharging Managerial Responsibilities (PDMRs), and those closely associated with them, must notify the issuer (or emission allowance market) and the FCA of all transactions in shares, debt instruments, or related derivatives. For emission allowance market participants, this includes transactions relating to emission allowances, auction products, or derivatives.

Closed Periods

PDMRs are restricted from conducting transactions in their company's shares or related instruments during a closed period of 30 calendar days before the announcement of interim or annual financial reports. This restriction can be lifted in exceptional circumstances (e.g., severe financial difficulty) or for transactions under employee share schemes where beneficial ownership does not change.

Money Laundering (ML)

Money laundering is the process of converting illicitly obtained funds (dirty money) into legitimate-looking assets.

Regulatory Framework for ML

Key legislation and guidelines include:

• Proceeds of Crime Act 2002 (POCA 2002).

• Criminal Finances Act 2017 (CFA 2017).

• Serious Organised Crime and Police Act 2005 (SOCPA 2005).

• Money Laundering Regulations 2017 (MLR 2017).

• Senior Managers Arrangements (SYSC) Sourcebook.

• Joint Money Laundering Steering Group (JMLSG) Guidance.

Three Stages of Money Laundering

1. Placement: Introducing illicit funds into the financial system.

2. Layering: Moving money through complex transactions to obscure its origin.

3. Integration: Reintroducing the "cleaned" money into the legitimate economy.

Example: Anonymous donation to a "ghost charity" (placement), transferring funds through multiple accounts globally (layering), then investing extracted money into a legitimate business (integration).

POCA 2002 Offences and Penalties

• Concealing, Arrangements, Acquisition, Use, and Possession: Fine and up to 14 years jail.

• Failure to disclose: Fine and up to 5 years jail (regulated sector only).

• Tipping off: Fine and up to 2 years jail (regulated sector only).

• Prejudicing an investigation: Fine and up to 5 years jail.

Money Laundering Regulations (MLR) 2017

These regulations impose obligations on businesses to apply Customer Due Diligence (CDD) when establishing relationships or carrying out transactions. Failure to comply is an offence, subject to up to two years jail and an unlimited fine.

• Risk-based approach: Firms must document and maintain risk assessments, proportionate to their size and nature.

• Policies, controls, and procedures: Must be written and cover risk management, internal controls, CDD, reporting, record-keeping, monitoring, and internal communication.

• Reliance: Firms remain responsible for CDD even if relying on another party. Reliance on "high risk" countries is prohibited.

• New Criminal Offence: Recklessly making a false or misleading statement in an ML context is punishable by fine and/or up to two years imprisonment.

Anti-Money Laundering (AML) Systems and Controls

Firms must establish systems to identify, assess, monitor, and manage ML risks, considering customer profiles, distribution channels, transaction complexity, and operating environment.

Key Roles

• Director/Senior Manager: Has overall responsibility for AML systems and controls.

• Money Laundering Reporting Officer (MLRO): Appointed by firms, responsible for receiving internal suspicion reports, investigating them, and reporting to the National Crime Agency (NCA) if necessary. The MLRO is an FCA-required function and must approve staff training on ML requirements.

Joint Money Laundering Steering Group (JMLSG) Guidance

The JMLSG notes provide comprehensive guidance, approved by HM Treasury. Adherence to this guidance can serve as evidence of compliance in legal proceedings.

• Part I: General guidance for all financial sector firms, including international context and UK legislative framework.

• Part II: Sector-specific guidance.

• Part III: Specialist guidance, including the UK financial sanctions regime.

The UK financial sanctions regime requires absolute compliance, mandating firms to stay updated with sanctions lists and prevent business in breach of sanctions.

Customer Due Diligence (CDD)

Derived from MLR 2017, CDD involves three aspects at the outset of a new business relationship:

1. Identify the customer/beneficial owner: Obtain name, address, DOB; for non-personal customers, identify beneficial owners.

2. Obtain verification of identity: Conduct additional checks.

3. Obtain information about the intended nature of the business relationship.

If identity cannot be satisfactorily verified, the firm should not proceed and should consider reporting to the NCA. For individuals acting on behalf of customers, their identity and authority must be verified.

Types of Due Diligence

• Standard Due Diligence (SDD): Basic identification and verification.

• Enhanced Due Diligence (EDD): Required for high-risk situations (e.g., high-risk third countries, complex/unusual transactions).

• Politically Exposed Persons (PEPs): All PEPs are subject to EDD, with a segmented approach based on risk assessment.

• Simplified Due Diligence (SDD): Assessed on a case-by-case basis for relationships or transactions presenting lower ML/TF risk.

Reporting Suspicions

An employee with a suspicion of money laundering must disclose it to the MLRO (or Nominated Officer). The MLRO then investigates and decides whether to report to the NCA.

Terrorist Financing

Terrorism involves the use or threat of actions designed to cause serious violence, endanger life, disrupt systems, or intimidate the public for a political, religious, or ideological cause.

Overlap with ML

Terrorist financing (TF) often overlaps with ML, but presents unique challenges:

• Smaller sums of money are typically involved.

• It is difficult to identify when legitimate funds transition into terrorist property.

Offences Under Terrorism Act 2000 and Anti-Terrorism Crime Security Act 2001

An offence is committed if a person enters into an arrangement that facilitates the retention or control of terrorist property. Failure to report is liable to up to five years jail and a fine.

Bribery Act 2010

The Bribery Act 2010 created four new offences, with a maximum penalty of ten years imprisonment for individuals, and an unlimited fine for the corporate offence.

Offences Under Bribery Act 2010

1. Offering, promising, or giving a bribe to another person.

2. Requesting, agreeing to receive, or accepting a bribe from another person.

3. Bribing a foreign public official.

4. Failure to prevent bribery (corporate offence).

Financial Advantage and Corporate Hospitality

A "financial advantage" can include corporate hospitality, but it is not a bribe if it has a legitimate business aim, is reasonable, proportionate, and appropriate. Facilitation payments are generally an offence unless local law permits public officials to participate.

Defence for Corporate Offence

A firm has a defence against failing to prevent bribery if it can demonstrate "adequate procedures." The Ministry of Justice provides six principles for implementing such procedures:

• Proportionality.

• Top-level commitment.

• Risk assessment.

• Due diligence.

• Communication.

• Monitoring and review.

Disclosure and Transparency Rules (DTRs)

The DTRs, made by the FCA, apply to issuers of securities listed on certain markets.

Purpose of Disclosure Rules

• Promote prompt and fair disclosure of relevant market information.

• Specify circumstances for delaying public disclosure of inside information.

• Ensure confidentiality of inside information to protect investors and prevent insider dealing.

Requirements for Control of Inside Information

• Denying access: Issuers must implement arrangements to restrict access to inside information to only those requiring it for their functions.

• Breaches of confidentiality: Measures must be in place for public disclosure via an Approved Regulated Information Service (RIS) if confidentiality cannot be maintained.

Panel on Takeovers and Mergers (PTM)

The PTM (or Takeover Panel) is the UK's competent authority for regulating takeovers, guided by the Takeover Code.

Principles of the Takeover Code

1. All holders of the same class of securities must receive equivalent treatment; other security holders must be protected when control is acquired.

2. Security holders must have sufficient time and information to make informed decisions.

3. The offeree company board must act in the best interests of the company and not deny shareholders a decision on the bid's merits.

4. False markets must not be created to distort prices or market function.

5. An offeror must announce a bid only after ensuring full consideration can be met.

6. An offeree company should not be hindered longer than reasonable by a bid.

Key Terms in the Code

• Acting in concert: Persons actively cooperating to obtain or consolidate control of a company.

• Dealings: Acquisitions/disposals of securities, involvement in derivatives, or other actions affecting security holdings.

• Interests in shares: Owning shares, having voting rights, or being interested through derivatives.

• Relevant securities: Securities with voting rights, equity share capital, conversion/subscription rights, etc.

Disclosure Requirements for Holdings

EU Transparency Directive Thresholds

Notification is triggered when holdings reach, exceed, or fall below 5%, 10%, 15%, 20%, 25%, 30%, 50%, and 75%. The shareholder informs the issuer, who then informs the market.

US Disclosure Requirements

The SEC requires disclosure for beneficial interests of 5% or greater of any listed class of shares. The acquirer must issue a statement to the SEC and the company within ten days.

UK Notifiable Interests

• Threshold: 3% and movements through whole percentage points above this.

• Example: A holding from 3.6% to 4.1% must be reported; from 3.6% to 3.8% does not.

• The investor must also inform the company if their holding falls below 3%.

An interest is also notifiable if 3% of voting rights are held, even if not directly holding shares (e.g., through financial instruments or indirect holdings).

Voting Rights Disregarded in Six Cases

1. Shares for clearing and settlement within three trading days.

2. Shares held by a custodian or bare nominee.

3. 3. Shares held (if less than 10%) by a declared market maker. 4. Shares held (if not more than 5%) in an investment firm's or credit institution's trading book. 5. Shares held as collateral. 6. Shares acquired for stabilisation, if voting rights are not exercised.

Connected Parties

Holdings by spouses, children (under 18), companies controlled by the investor, and concert parties are aggregated. If combined holdings reach 3% or more, they are notifiable.

Changes must be reported in writing to the company within two business days. Listed companies must report to a Primary Information Provider (PIP) by the end of the next business day.

Company's Right to Demand Information

Public companies can demand information on shareholdings, or past holdings (last three years). Failure to respond can result in freezing of share rights.

Transaction and Trade Reporting

Firms are required to report transactions in most securities and certain funds to the FCA for market surveillance.

Transaction Reporting

Provides information on deals for regulatory purposes, aiding the FCA's market surveillance via its Transaction Monitoring Unit (TMU). Reporting occurs through Approved Reporting Mechanisms (ARMs).

• Domestic deals on LSE via CREST by 8pm on trade day.

• International deals via OMGEO (US Depositary Trust and Clearing Corporation) by 9pm on trade day.

Trade Reporting

Provides market depth and liquidity information, promoting transparency and price discovery.

• Trades on LSE electronic order books (SETS and IOB) are automatically reported.

• Off-order book transactions must be reported via LSE systems within three minutes of execution.

• Only the most senior party (typically market maker/broker) is required to report.

European Market Infrastructure Regulations (EMIR) and Securities Financing Transaction Regulations (SFTR)

• EMIR: Requires all derivative transactions to be reported to an approved "trade repository." Both EEA counterparties must report, unless one agrees to report for the other.

• SFTR: Aims to extend reporting requirements for securities transactions to a similar level as derivatives under EMIR.

EU Short Selling Regulations (SSR)

Gives the FCA additional powers for reporting and permitting short selling during market crises.

Data Protection

The Data Protection Act 2018 (DPA 2018) and the UK General Data Protection Regulation (UK GDPR) set out requirements for processing personal data.

Six Principles of Data Protection

1. Processing must be lawful and fair.

2. Purposes of processing must be specified, explicit, and legitimate.

3. Personal data must be adequate, relevant, and not excessive.

4. Personal data must be accurate and kept up to date.

5. Personal data must be kept for no longer than necessary.

6. Personal data must be processed securely.

Information Commissioner's Office (ICO)

Data controllers processing personal data must register with the ICO. The ICO can impose two tiers of penalties for breaches:

• Higher maximum: For failure to comply with data protection principles
  Higher of £17.5 million or 4% of annual turnover.

• Standard maximum: For breaches of administrative requirements
  Higher of £8.7 million or 2% of annual turnover.

Breaches can also lead to criminal prosecution with unlimited fines.

Record Keeping

The FCA's SYSC Sourcebook and COBS provide record-keeping requirements:

• MIFID business records must be kept for at least five years.

• Non-MIFID business records must be kept for at least three years.

Capital Adequacy

Firms are required to maintain financial resources equal to or exceeding their financial resources requirement to ensure solvency.

Capital Requirements Directive (CRD) Framework

Based on three Pillars:

1. Pillar 1: Minimum capital requirements for credit, market, and operational risks.

2. Pillar 2: Additional capital for risks not covered in Pillar 1.

3. Pillar 3: Disclosure of information on risks, capital, and risk management to improve market discipline.

Firms must provide detailed monthly reports on capital adequacy and comply with provisions on capital quality.

Capital Tiers

1. Core Tier One capital: Permanent share capital, reserves, externally verified interim profits.

2. Tier Two capital: Long-term subordinated debt and revaluation reserves.

3. Tier Three capital: Short-term subordinated debt and interim trading book profit/loss.

CRD IV and CRD V

• CRD IV: Implemented Basel III, phased in from 2014, requiring banks to hold more capital, establishing new governance frameworks, and creating a single rulebook.

• CRD V: Further implements Basel III's enhanced Pillar 2 approach for managing interest rate risk in the banking book, with measures implemented between 2020 and 2022.

Key Takeaways

• Market Abuse Regulation (MAR): Prohibits market manipulation and ensures transparent disclosure, with both civil penalties by the FCA and specific criminal offences under the FSA 2012.

• Insider Dealing: A criminal offence under CJA 1993, involving using unpublished price-sensitive information, with severe penalties including imprisonment and unlimited fines.

• Money Laundering: Involves three stages (placement, layering, integration) and is governed by POCA 2002 and MLR 2017, requiring rigorous CDD checks and suspicious activity reporting by MLROs.

• Bribery Act 2010: Creates offences for giving, receiving, and failing to prevent bribery, with a "adequate procedures" defence for firms.

• Disclosure Rules: Mandate transparency in security holdings, particularly for PDMRs and substantial share holdings (e.g., 3% in the UK) to prevent undue influence and ensure fair markets.

• Capital Adequacy: Regulations like CRD IV and V ensure financial institutions hold sufficient capital to remain solvent and stable, based on Pillar 1 (minimum capital), Pillar 2 (additional risks), and Pillar 3 (disclosure) framework.