The Financial Services Authority has imposed a significant fine on a hedge fund and its portfolio manager for market abuse insider dealing, notwithstanding that the manager received the information in question on the express understanding that he was not being made an insider or “wall-crossed”.
The FSA’s decision is likely to have a number of important practical implications not only for investors and fund managers but also banks, issuers, brokers, compliance teams and analysts. In particular, listed companies should be aware of the FSA’s statement on cleansing announcements, as it affects their obligations to make announcements to the market.
Background
It is market abuse for an insider to deal or attempt to deal in a qualifying or related investment on the basis of inside information (Section 118(2) Financial Services and Markets Act 2000). It is also an offence to disclose inside information outside the proper course of employment, profession or duties (Section 118(3)).
Inside information is information which is precise, not generally available, relates directly or indirectly to an issuer or investment and would, if generally available, be likely to have a significant effect on the price of the investments (Section 118C FSMA).
Facts
- David Einhorn was the owner and sole portfolio manager of Greenlight Capital Inc. Greenlight held a 13.3% stake in Punch Taverns plc.
- Punch was considering an equity fund raising. Its broker contacted various shareholders and potential investors prior to announcement of the transaction in order to gauge interest (“pre-soundings”).
- The broker contacted Greenlight and invited it to be wall-crossed in relation to Punch (i.e. to be made an insider subject to the terms of a non-disclosure agreement).
- Greenlight and Einhorn refused, but arranged to speak to the broker and Punch management on a “non-wall crossed” basis.
- During that conversation details of a possible significant equity fundraising were disclosed.
- Immediately following the conversation Einhorn directed that Greenlight sell its stake in Punch and over the next three days Greenlight sold a large number of shares, reducing its stake in Punch to 8.98%.
- Punch announced a rights issue to the market six days after the conversation with Einhorn. Following the announcement its share price fell by 29.9%. Greenlight’s sale of shares prior to the announcement had resulted in its avoidance of a loss of approximately £5.8 million.
Decision
The FSA’s decision notice deals with a number of points.
Was Einhorn given inside information?
Although there was no single statement of inside information, the FSA stated that the conversation in question had to be taken as a whole and in its context and on that basis the FSA’s view was that there was inside information.
Precise?
Information is considered “precise” if it (i) indicates circumstances or events which exist or may reasonably be expected to come into existence and (ii) is specific enough to enable a conclusion to be drawn as to its possible effect on price (Section 118C(5) FSMA).
In the FSA’s view, information was given on the call which was precise as it enabled Einhorn to understand the likely amount and purpose of the rights issue, that Punch was consulting all major shareholders and that they had been asked to sign an NDA which would last for less than a week (which indicated that the rights issue was at an advanced stage of preparation). It did not matter that the transaction was not a certainty at the time of the discussions. The FSA discounted Einhorn’s arguments that he and others on the call regarded the discussion of the issue as conceptual and that they did not feel it was reasonably expected to occur. The FSA said disclaimers made on the call should be disregarded if the other information on the call made clear that the discussion was not in fact merely conceptual.
This serves as a reminder that the regulator always has the benefit of hindsight, which is likely to give rise to a presumption that what did actually occur could be reasonably expected to occur, whereas it is much more difficult for those looking forward to a possible transaction or event to judge whether it can reasonably be expected to occur.
Significant effect on price
The FSA stated that the information was likely to have a significant effect on price as it was information which a reasonable investor would be likely to use as part of the basis of his investment decisions. This is a further example of the FSA taking the controversial approach demonstrated in the Massey case, that the fact a reasonable investor would be likely to use the information as part of the basis for investment decisions of itself means that it is likely to have a significant effect on price. Many commentators believe this is too broad an interpretation of the legislation, but nonetheless market participants need to be aware that this is the FSA’s approach.
Is it a defence that Einhorn expressly asked not to be wall-crossed?
Under Section 123(2) FSMA, the FSA may not impose a penalty on a person if there are reasonable grounds for it to be satisfied that: (i) the person believed, on reasonable grounds, that his behaviour did not fall within the market abuse regime or (ii) the person took all reasonable precautions and exercised all due diligence to avoid behaving in a way which breached the market abuse regime. Einhorn argued that because he had explicitly refused being wall-crossed and had refused to sign an NDA he was entitled to assume that any information he received was not inside information. The FSA said that Einhorn should have been aware that he had inside information or at least that there was a risk of this, and had a responsibility to consider whether the information received was inside information before selling. The fact he was asked to sign an NDA (even though he refused) “should have made him even more diligent”. Therefore he could not rely on the Section 123 defence.
Did Einhorn deal on the basis of inside information?
Einhorn argued that he had not dealt on the basis of the inside information about the issue, but on the basis of general concerns about the valuation and prospects for the company. Against this, the FSA said he had inside information and had failed to rebut the presumption that he dealt on it. He had not shown that the equity issue did not play a material part in his decision, even though the FSA accepted that there were other reasons for dealing and Greenlight had not dealt as aggressively as it might have done (e.g. it had not sold the whole position).
The FSA’s decision on this point shows that it is applying the approach taken by the European Court of Justice in the Spector case: if a person deals while in possession of inside information it is presumed that he has dealt on the basis of that information and the onus is on him to rebut the presumption. The presumption will not be rebutted just because the inside information was one of several motivations for dealing.
FSA enforcement approach and penalties
The penalty imposed took into account the size and importance of the dealing (i.e. 3% of the share capital and a very significant part of the daily volume). The FSA considered this a serious case of market abuse even though the behaviour was not deliberate or reckless. The penalty was intended to be a deterrent to “highly visible and influential investors” – such market participants must act with due caution when liaising with companies and their brokers. It also took into account that Einhorn did not take compliance or legal advice before dealing even though this would have been readily available to him.
Other parties
The FSA has also fined the broker who carried out the transaction for failing to notify the suspicious transaction to his compliance department and the Greenlight trader who ordered the transaction (and was also compliance oversight officer) for failing to question the suspicious order. The latter was also banned from being a compliance officer.
Comment
This decision illustrates the responsibility of market participants to consider carefully whether they may be committing market abuse and the importance of taking appropriate advice. Moreover, if a person possesses inside information (which will be judged with the benefit of hindsight) and deals, the burden will be on him to rebut the presumption that he dealt on the basis of that information (rather than for other reasons).
The decision in particular highlights some of the risks involved when investors are invited to discuss a potential transaction with issuers or their advisers in order to gauge their reaction to, or potential support for, the proposal. Where the pre-sounding involves the transmission of inside information, the recipient is “brought across the wall” and should be subject to confidentiality and non-dealing restrictions. Issuers and their advisers should be aware of their duties regarding inside information and this clearly requires inside information to be recognised as such, in order to avoid inadvertent transmission of inside information - particularly in a case such as this where the recipient did not wish to be made an insider, so that he would be free to deal.
The FSA decision notice describes the process of wall-crossing and also includes a statement about how investors can be “cleansed” (and so cease to have inside information and be free to deal). The FSA states that an insider will be cleansed, in the context of a transaction, either when the transaction is announced or, if it does not proceed, when an announcement is made to the market stating that a transaction was contemplated, but did not proceed. This description of cleansing, which is not pertinent to the facts of the Einhorn case, could be regarded as something of an over-simplification. It is possible to envisage circumstances in which a possible transaction does not proceed where there would be no reason to make an announcement to the market. However, it does indicate that the FSA will normally expect a cleansing announcement following the failure of a deal, so there will need to be clear reasons where one is not made.
Our guide to wall-crossing and pre-soundings (which has been updated in light of the Einhorn decision) is available here.
The final decisions for Einhorn and Greenlight are available here and for the trader and broker here.
