Compliance: Theory and Practice in the Financial Services Industry

4. Market Conduct Rules

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Outline

   Market Manipulation and Related Misconduct
   Order Record Requirements
   Order Precedence and Allocation Rules
   Dealing with Clients as Principal
   Dealings for or with Employees
   Short Selling

 


Market Manipulation and Related Misconduct

Market Manipulation Techniques and Terminology
•     'Marking the close' or 'painting the tape' - manipulating the price at the close of trading so that it is higher (in that case, also referred to as 'ramping the close' or just 'ramping'), or lower, than might otherwise be the case.
•     'Pass the parcel' - trading the same parcel of securities backwards and forwards to move the stock price or to create a false impression of volume.
•     'Pooling' - two or more investors pooling their cash or securities and trading the pool backwards and forwards between different pool members to move the stock price or to create a false impression of volume.
•     'Pump and dump' - doing small trades in an illiquid security at progressively higher prices (pumping) with a view to attracting other buyers and then selling to those buyers (dumping).
•     'Hype and dump' - spreading false positive information about a stock to inflate its price and then selling at a profit.
•     'Slur and slurp' - spreading false negative information about a stock to deflate its price and then buying at a profit (often to close out a short position acquired beforehand).
•     'Rumourtrage' - spreading a (usually false) rumour about a stock to inflate or deflate its price and then trading out at a profit.
•     'Layering' or 'spoofing' - submitting a genuine order on one side of the book and multiple orders at different prices on the other side of the book to give the impression of substantial supply/demand, with a view to sucking in other orders to hit the genuine order. After the genuine order trades, the multiple orders on the other side are rapidly withdrawn.
•     'Corner' - buying up all of the available liquidity in a stock, commodity etc that has been over-shorted to force the shorts to buy from you at artificially high prices.
•     'Squeeze' - taking advantage of a natural shortage in supply or demand to extract an artificially high price (in the case of a short squeeze) or artificially low price (in the case of a long squeeze).

Daily closing prices are the ones usually reported in the financial press and that makes them particularly susceptible to manipulation. Anyone who has an interest in making a price appear higher or lower will often target the closing price for that purpose. Hence, 'marking the close' is one of the commonest forms of manipulation, with the indicia usually being multiple trades in small parcels just before the market closes.

Closing prices at certain key junctures are particularly sensitive and are closely monitored by market operators and regulators for manipulation. This includes the closing prices on the expiry dates for share price index (SPI) futures, where someone who has a significant SPI position may have an incentive to manipulate the closing price of shares on that date to favour their SPI position (as occurred in ASC v Nomura International PLC, below). It also includes closing prices at half year and full year end, where someone who has share investments on their balance sheet or in an investment portfolio may have an incentive to manipulate the closing price on that date to make their balance sheet appear stronger or investment portfolio to look more valuable (referred to as "window dressing").

As we shall see, the motives for manipulation don't always involve the manipulator seeking to profit from share trading. For example, a company might simply want to see its flagging share price supported. A bidder in a scrip takeover might want its shares to appear to have a higher value to increase the likelihood of the bid succeeding (as occurred in North v Marra Developments Ltd, below). A target in a contested takeover bid might want its shares to appear to have a higher value to help it fight off the bid. Someone who has a margin loan might want the value of shares used as security for that loan to appear higher to avoid a margin call (as occurred in DPP (Cth) v J M, below, with the accused subsequently being found guilty and sentenced to 2 years and 8 months imprisonment in R v Jacobson [2014] VSC 592). Someone who has options or convertible securities whose exercise price or conversion price is tied to the market price of the underlying security on a particular day or over a particular period might want that market price to appear lower to improve the number of securities they will receive on exercise or conversion (as occurred in Fame Decorator Agencies Pty Ltd v Jeffries Industries Ltd, below). A company executive with an incentive tied to the performance of the company's share price might want that price to appear higher so they get a larger incentive payment (as occurred in ASIC v Soust, below). An investment manager might want the value of securities in their investment portfolio to appear higher to improve their performance figures. A broker who has guaranteed to a client to buy or sell shares at VWAP (volume weighted average price) may want to manipulate VWAP to avoid making a loss on the trade (as two former heads of dealing on Macquarie's Malaysian desk did in 2011 - see Bursa Malaysia's press release dated 18 August 2011).

'Pooling' is done to form a larger trading pool than a single investor can muster, which therefore allows the manipulators to have a greater impact on price/volumes. It often involves a 'pool manager' who orchestrates the trades between the different pool members. Pooling was thought to have been rife in the lead up to the stock market crash of 1929 that precipitated the Great Depression and ultimately led to Securities Act 1933 and Securities Exchange Act 1934 being enacted in the US to substantively regulate securities activities for the first time.

The trading in 'pass the parcel' or 'pooling' strategies is typically done at progressively higher or lower prices to move the prevailing market price. Hence, in many cases, they are really a means used to achieve a 'pump and dump' strategy or a reverse 'pump and dump' (maybe 'dump and bump' or 'dash and trash'?) strategy, rather than a strategy in their own right.

During the height of the GFC, there were suggestions that a number of hedge funds with short positions in financially challenged companies (including ABC Learning, Babcock & Brown and Macquarie Group) were deliberately spreading false or misleading information about those companies in order to artificially provoke sales of securities and to reduce their market price, so that they could close out their short positions at a profit. In ASIC Advisory 08-47, ASIC warned that such conduct could breach CA s1041E and that it would be vigilant in monitoring the market to ensure this type of behaviour was detected and prosecuted. ASIC subsequently released a consultation paper proposing a regulatory guide to combat 'rumourtrage' (Consultation Paper 118 Responsible handling of rumours). However, following industry feedback, it decided not to proceed with the regulatory guide (see ASIC Advisory 10-99AD).

For an example of the sensitivity of regulators to trading at the close on the expiry date for the share price index futures, see ASIC Media Release 02/20 (where ASIC imposed conditions on the dealer’s licence of Susquehanna Pacific Pty Ltd in response to its index arbitrage trading on the ASX near the close of trading on 29 June 2001, which led to increased volatility and an unexpected increase in the price of a number of stocks that comprised the ASX S&P 200 (SPI) Index. This resulted in an increase in the SPI index and, consequently, the SFE SPI 200 contract, the settlement price of which was determined by reference to the closing price of the index. The price filters of Susquehanna's ASX participating broker were turned off at the time.

For a classic example of 'layering' or 'spoofing', see FINRA's 13 September 2010 announcement regarding Trillium Brokerage Services, LLC. Trillium, through 9 proprietary traders, entered legitimate limit orders and numerous large, layered, non-bona fide orders to create a false appearance of buy- or sell-side pressure and to generate selling or buying interest in the stocks in question. This induced other market participants to enter orders that executed against the limit orders previously entered by the Trillium traders. Once their limit orders were filled, the Trillium traders would then immediately cancel the non-bona fide orders. As a result of this improper high frequency trading strategy, Trillium's traders obtained advantageous prices that otherwise would not have been available to them on some 46,000 occasions. FINRA censured and fined Trillium $1 million and took action against the 9 traders and Trillium's Director of Trading and its Chief Compliance Officer. The 11 individuals were suspended from the securities industry or as principals for periods ranging from six months to two years. FINRA levied a total of $802,500 in fines against the individuals, ranging from $12,500 to $220,000, and required the traders to pay out disgorgements totalling about $292,000. See also the FSA's 31 August 2011 decision notice against Swift Trade imposing a penalty of £8m, and the FCA's 12 August 2015 announcement of its win in the UK High Court imposing a penalty of £7.57m against various parties, for similar conduct.

For a classic case of cornering, you only have to look at the Antimony Nickel case. In that case, a number of Sydney stockbrokers decided to short Antimony Nickel at 20¢ in March 1971 when a company associated with Gordon Barton was attempting to take control of it. The short sellers ending up selling 105% of the issued share capital of the company. Barton kept buying and drove the price to $3. At that price, a number of prominent brokers would have been bankrupted if they had to buy stock to cover their short positions. The Sydney Stock Exchange committee, which included several of the brokers who were short, creatively solved the problem by permanently suspending Antimony Nickel shares from trading. The actions of the committee were regarded as scandalous at the time and were the subject of a Parliamentary inquiry which ultimately led to our first laws regulating short selling in Australia.

(1) Corporations Act
CA s1041A - Price Manipulation
A person must not take part in, or carry out (whether directly or indirectly and whether in this jurisdiction or elsewhere):
(a)   a transaction that has or is likely to have; or
(b)   2 or more transactions that have or are likely to have;
the effect of:
(c)   creating an artificial price for trading in financial products on a financial market operated in this jurisdiction; or
(d)   maintaining at a level that is artificial (whether or not it was previously artificial) a price for trading in financial products on a financial market operated in this jurisdiction.
See ASIC v Soust [2010] FCA 68 and DPP (Cth) v J M [2013] HCA 30.

Until recently, there has been some judicial disagreement as to the meaning of "artificial price" in s1041A.

In ASIC v Soust, the managing director of a company purchased shares in his mother's name on 31 December 2007, shortly before the close of the market for the calendar year, with a view to increasing the market price of the company's shares and thereby earning a larger bonus under his service contract. He was found to have engaged in market manipulation in contravention of both CA ss1041A and 1041B. Goldberg J held that the expression "artificial price" in s1041A connotes a price created not for the purpose of implementing or consummating a transaction between genuine parties wishing to buy and sell securities, but rather for a purpose unrelated to achieving the outcome of the interplay of genuine market forces of supply and demand. He considered that the reasoning of Mason J in North v Marra Developments Ltd (see below) was equally applicable to the creation of an artificial price for trading in securities under s1041A as it was to the creation of false or misleading appearance with respect to the market for, or the price of, securities under s1041B.

In DPP (Cth) v J M, the accused, the CEO of a company who had a margin loan to finance the purchase of shares in the company, provided funds to his daughter and son-in-law to enable them to purchase shares in the company. They used the funds to purchase shares at market close allegedly so as to maintain the closing price of the shares above the level at which the accused would have a margin called on his loan. The trial judge stated a case for the Victorian Court of Appeal seeking a ruling on whether this involved the creation of an "artificial price" for the shares within the meaning of s1041A. The Victorian Court of Appeal (DPP (Cth) v J M [2012] VSCA 21) was split on this point. Nettle and Hansen JJA expressly disagreed with the finding of Goldberg J in ASIC v Soust. After looking at the legislative history of s1041A, they concluded that the term "artificial price" in s1041A was meant to capture US jurisprudential notions of cornering and squeezing and connotes a price which in truth reflects market forces of supply and demand in a free and informed market but which is the result of a monopolist or party otherwise in a position of market dominance taking unfair advantage of market power in order to extract a price different to that which would apply in times of adequate supply. Warren CJ, however, reached a different conclusion - effectively a half way house between Nettle and Hansen JJA and Goldberg J - holding that an "artificial price" is a price which does not come about through transactions reflecting basic forces of supply and demand working in an open, efficient and well-informed market and that this may capture not only cornering and squeezing, but also other transactions intended to set or maintain the market price of the type referred to in North v Marra Developments Ltd.

The High Court resolved the matter on appeal, effectively agreeing with the decision in ASIC v Soust and saying:

     

"The forces of "genuine supply and demand" are those forces which are created in a market by buyers whose purpose is to acquire at the lowest available price and sellers whose purpose is to sell at the highest realisable price. The references in s 1041A to a transaction which has, or is likely to have, the effect of creating an "artificial price", or maintaining the price at a level which is "artificial", should be construed as including a transaction where the on-market buyer or seller of listed shares undertook it for the sole or dominant purpose of setting or maintaining the price at a particular level. It is, however, important to emphasise that whether there are other kinds of transaction which have the effect of creating or maintaining an artificial price in a market for listed shares is not, and, given the terms of the case stated, should not be, decided.

     

The price that results from a transaction in which one party has the sole or dominant purpose of setting or maintaining the price at a particular level is not a price which reflects the forces of genuine supply and demand in an open, informed and efficient market. It is, within the meaning of s 1041A, an "artificial price". The offer to supply or acquire of the kind described is made at a price which is determined by the offeror's purpose of setting or maintaining the price. It is not determined by the offeror's purpose, if buying, to minimise, or, if selling, to maximise, the price paid, and it is not determined by the competition between other buyers whose purpose is to minimise the price and other sellers whose purpose is to maximise the price. If the offer results in a transaction, that is a transaction which can be characterised as at least likely to have the effect of creating or maintaining an artificial price for trading in the shares.

     

Because s 1041A prohibits transactions which are likely to have that effect, it is not necessary to demonstrate, whether by some counterfactual analysis or otherwise, that the impugned transactions did create or maintain an artificial price. It is sufficient to show that the buyer or seller set the price with the sole or dominant purpose described.

     

Further, if a transaction is made for the sole or dominant purpose of setting or maintaining a price for listed shares, it is not necessary to proffer some additional proof that the impugned transactions "went on to affect the behaviour of genuine buyers and sellers in the market" in order to demonstrate that the transactions had, or were likely to have, the effect of creating or maintaining an artificial price. On-market transactions on the ASX (like the impugned transactions in this case) are made openly. Participants in the market can be (and are) informed of the transactions which occur. Participants in the market are entitled to assume that the transactions which are made are made between genuine buyers and sellers and are not made for the purpose of setting or maintaining a particular price. Hence, as Mason J explained in North v Marra, "in the absence of revelation of their true character [as transactions to set or maintain a particular price] they are seen as transactions reflecting genuine supply and demand and having as such an impact on the market". They have, or at least are likely to have, the effect of setting or maintaining an artificial price for the shares in question."

 

CA s1041B(1) – False Trading and Market Rigging
A person must not do, or omit to do, an act (whether in this jurisdiction or elsewhere) if that act or omission has or is likely to have the effect of creating, or causing the creation of, a false or misleading appearance:
(a)   of active trading in financial products on a financial market operated in this jurisdiction; or
(b)   with respect to the market for, or the price for trading in, financial products on a financial market operated in this jurisdiction.
See North v Marra Developments Ltd (1981) 148 CLR 42 (esp. at 58-59); Fame Decorator Agencies Pty Ltd v Jeffries Industries Ltd (1998) 16 ACLC 1,235 (esp. at 1,240); ASC v Nomura International PLC (1999) 89 FCR 301; Braysich v R [2009] WASCA 178.

CA s1041B(1A), which was introduced into the Act in 2010, provides that for the purposes of the application of the Criminal Code in relation to an offence based on s1041B(1): (a) intention is the fault element for the physical element consisting of doing or omitting to do an act as mentioned in that section; and (b) recklessness is the fault element for the physical element consisting of having, or being likely to have, the effect of creating, or causing the creation of, a false or misleading appearance as mentioned in that section. This section was introduced to clarify the fault elements for an offence to be committed under s1041B(1), having regard to the deeming provision in s1041B(2) (see below). It really does nothing more than confirm the position that would apply under ss5.6(1) and (2) of the Commonwealth Criminal Code in any event.

In North v Marra Developments Ltd, Marra considered itself vulnerable to takeover because its net asset value per share was considerably higher than its prevailing market price. On the advice of a stockbroker, it proposed a bonus issue and then a merger with another company effected through a share for share takeover. The shares in the other company were trading at much better prices and it was therefore felt necessary to boost the price of Marra shares to ensure that the takeover succeeded. Over the previous 12 months, the shares had traded from $2.60 to $7.80 on very low volumes, although they were being quoted at $15 buy with no sales a couple of days before the takeover was announced. The assumed fair value of the shares that had been used in working out the share exchange ratio in the takeover was $16.50. Just before the takeover was announced, the stockbroker bought Marra shares for a company associated with it and for the directors of Marra in small volumes and moved the price up to $16.50. Thereafter during the course of the bid, it kept making small purchases at or around that price. The takeover was successful. Subsequently, the stockbrokers sued for their fees for the advice they had given on the transactions. The company resisted the claim. It was held that the claim failed for illegality. The agreement contemplated a breach of the precursor to s1041B and the parties had conspired to engage in that illegal conduct. Mason J, with whom the rest of the court agreed, said (at pp58-59):

     

"… the statutory prohibition is directed against activity which is designed to give the market for securities or the price for securities a false or misleading appearance. … It is not altogether easy to translate the generality of this language into a specific prohibition against injurious activity, whilst at the same time leaving people free to engage in legitimate commercial activity which will have an effect on the market and on the price of securities. Purchases or sales are often made for indirect or collateral motives, in circumstances where the transactions will, to the knowledge of the participants, have an effect on the market for, or the price of, shares. Plainly enough, it is not the object of the section to outlaw all such transactions.

     

It seems to me that the object of the section is to protect the market for securities against activities which will result in artificial or managed manipulation. The section seeks to ensure that the market reflects the forces of genuine supply and demand. By "genuine supply and demand" I exclude buyers and sellers whose transactions are undertaken for the sole or primary purpose of setting or maintaining the market price."

In Fame Decorator Agencies Pty Ltd v Jeffries Industries Ltd, the holder of converting preference shares which had a conversion formula tied to the weighted average sale price of the underlying ordinary shares over a 20 day period, placed a large sell order just before the close of trading on the last day of that period, with the clear intention of moving the weighted average sale price down and increasing the number of shares that would be issued upon conversion. The market was moved from 35 cents to 13 cents. This was held to be a breach of the precursor to s1041B and also misleading and deceptive conduct, on the basis that persons interested in the company’s shares were entitled to assume that the market price reflected the genuine interaction of the forces of supply and demand. Per Gleeson CJ (at p1,240):

     

"[Section 1041B] aims to preserve the integrity of the share market. Markets, in reflecting the interaction of forces of supply and demand, may suffer from a variety of imperfections, including mismatches of information, without such imperfections destroying their integrity. However, the conduct of a seller of thinly traded shares, calculated to effect sales at the lowest, rather than the highest, obtainable price, and timed so as to deflect the possibility of some purchasers bidding up the price, had both the purpose and effect of creating, temporarily, an artificial market and price.

     

… The effect of Fame's conduct upon the market for shares in Jeffries, and the market price, was not merely incidental. The central object of such conduct was to influence the market price."

In ASC v Nomura International PLC, N was a stock index arbitrageur. It had established a very large arbitrage position in SPI index futures traded on the SFE that were due to expire on 29 March 1996. It held a matching basket of securities worth about A$600m. The expiry price of the SPI contracts was determined by the level of the All Ordinaries Index on that day. The understanding of Nomura's traders (which was not entirely accurate) was that the closing level of the All Ords was determined by the weighted average of the closing price of the securities comprised within the All Ords. Nomura gave instructions to 10 separate brokers to sell its basket of securities very aggressively near to the close of trading on 29 March 1996. Many of the securities in question were illiquid and so there was a very limited opportunity for "latent demand" for these securities to emerge during the brief period of aggressive selling contemplated by Nomura. Nomura then placed matching buy orders for the same securities and in the same quantities as the sell orders but at prices much lower than prevailing market, in some cases by as much as 20%. For a variety of reasons, most of the brokers entrusted with the sell orders did not fully comply with their instructions. However, in the case of two securities, Nomura's sell orders hit its buy orders with the result that it effectively bought its own shares at depressed prices.

The court found that this strategy was designed to lower the price of securities included in the All Ords at the close of trading on 29 March 1996, thereby lowering the price of the SPI contracts and generating a profit for Nomura. In particular, the court found that it was intended to create a false and misleading appearance of active trading or price on the ASX in illiquid securities in breach of s998 of the Corps Law, the precursor to CA s1041B in respect of securities. It was also intended to do the same thing in relation to the March ’96 SPI contract and this was a breach of s1260 of the Corps Law, the precursor to CA s1041B in relation to futures. In the 2 instances where Nomura’s bid hit its offer, Nomura had both sold and purchased securities in a manner that involved no change of beneficial ownership, also in breach of s998 of the Corps Law, the precursor to CA s1041B in respect of securities. Finally, the court found the conduct was misleading and deceptive in breach of s995 of the Corps Law, the predecessor to s1041H.

The facts in Braysich v R are difficult to discern from the judgment. However, Buss JA gave an interesting exposition of the history and meaning of the market rigging provisions in the Corporations Act. In particular, he explained what was meant by "active trading" in s998(1) of the Corporations Law, the precursor to s1041B(1):

     

"The first limb of s 998(1) prohibits the creation of a false or misleading appearance of 'active trading' in any securities on a stock market. The legislation does not, however, define 'active trading'. ... The word 'active' requires something more than ordinary volume or price changes in the securities in question. ... In my opinion, it is apparent, from the statutory context and the Parliamentary intention in enacting s 998(1), that a person will create a false or misleading appearance of 'active trading' in securities for the purposes of the first limb of s 998(1) if, relevantly:

     

(a)  

the person enters into, or carries out, either directly or indirectly, any transaction or transactions of sale or purchase which do not reflect the forces of genuine supply and demand; that is, the transaction or transactions are undertaken for the purpose of establishing an artificial market or price; and

     

(b)  

the transaction or transactions in question constitute or induce a pattern of new trading in volumes or at prices that would not otherwise have occurred.

     

The false or misleading appearance is created because, in the absence of any disclosure of the illegitimate purpose, there will appear to be trading which reflects genuine supply and demand, and not a scheme to promote or maintain an artificial market or price."

In Rosenberg and ASIC [2010] AATA 654, the Administrative Appeals Tribunal held that certain special crossings did not contravene s1041B(1)(b) even though they were effected at a price considerably away from the prevailing market price. This was because special crossings are conducted off-market and are known to be capable of being done at a price that bears no relation to the market price. Therefore, they could not create a false or misleading appearance with respect to the market for, or the price for trading in, financial products on a financial market.

 

CA s1041B(2) – No Change in Beneficial Ownership/Matched Orders
For the purposes of s1041B(1), a person is taken to have created a false or misleading appearance of active trading in particular financial products on a financial market if the person:
(a)   enters into, or carries out, either directly or indirectly, any transaction of acquisition or disposal of any of those financial products that does not involve any change in the beneficial ownership of the products; or
(b)   makes an offer (the regulated offer) to acquire or to dispose of any of those financial products in the following circumstances:
  (i)   the offer is to acquire or to dispose of at a specified price; and
  (ii)   the person has made or proposes to make, or knows that an associate of the person has made or proposes to make:
    (A)   if the regulated offer is an offer to acquire - an offer to dispose of; or
    (B)   if the regulated offer is an offer to dispose of - an offer to acquire;
    the same number, or substantially the same number, of those financial products at a price that is substantially the same as the price referred to in (i).
See Braysich v R [2009] WASCA 178 and Endresz v Whitehouse (1997) 15 ACLC 936 (esp. at 952-3).

CA s1041B(2)(a) captures so-called "wash trades", while s1041B(2)(b) captures "matched orders". 'Pass the parcel' and 'pooling' manipulation strategies often involve wash trades and/or matched orders.

For these purposes, "acquisition" and "disposal" are given an extended meaning in s1041B(4) and include making an offer to acquire or dispose and making an invitation, however expressed, that expressly or impliedly invites a person to offer to acquire or dispose.

In Braysich v R, Buss JA traced the legislative history of the provisions deeming wash trades and matched orders to be manipulative and observed:

     

"... it is apparent from the case law and the extrinsic material to which I have referred that wash sales and matched orders are, ordinarily and of their nature, pernicious practices which will, invariably, have the purpose and, often, the effect of interfering with the integrity of a stock market. The interference will arise from the creation of the false or misleading appearance of trading between unassociated sellers and buyers who do not intend, by their dealings, to create an artificial market or price. Wash sales and matched orders are devices for creating or maintaining an appearance of market activity or a price. ... These features of wash sales and matched orders explain, no doubt, why the Parliament enacted the deeming provisions in s 998(5) [the precursor to s1041B(2)]."

CA s1041B(2) theoretically could present some issues for people wanting to crystallise a tax loss on shares at year end without disposing of their economic interest in the shares and for brokers who seek to facilitate that type of transaction. While it is highly questionable whether any of these schemes would survive a challenge under the anti-avoidance provisions in Part IVA of the Income Tax Assessment Act, there are 3 ways this could be done in practice: (1) cross the shares through a broker to an associate (eg a spouse, family company or family trust); (2) have a broker buy the shares from you on proprietary account or for another client and then arrange to sell them back to you or an associate at or around the same price a short time later; or (3) most likely, sell the shares on-market and effect a purchase of an equivalent number of shares on-market in your own name or in the name of an associate at or around the same time. The first of these is clearly a wash trade that falls within s1041B(2)(a) (see s1041B(3) below); the second arguably involves matched orders that fall within s1041B(2)(b) (because the broker/client would most likely be considered to be acting in concert with you and would therefore be your associate); while the third unquestionably involves matched orders that fall within s1041B(2)(b).

Illustrating the point in the previous paragraph, in April 2012, the US Commodity Futures Trading Commission (CFTC) charged the Royal Bank of Canada with conducting a multi-hundred million dollar wash sale scheme allegedly designed as part of RBC's strategy to realize lucrative Canadian tax benefits from holding certain public company securities in its Canadian and offshore trading accounts. Prior to each trade, RBC allegedly identified stocks in US and Canadian companies that RBC believed would generate a tax benefit. RBC and a subsidiary allegedly bought and sold these stocks, and also bought and sold narrow based stock index futures and single stock futures contracts written on the stocks opposite each other. According to the complaint, RBC's futures trading was conducted in a riskless manner that ensured that the positions, profits and losses of each RBC counterparty washed to zero, which resulted in a financial and position nullity for RBC while allowing it to reap the tax benefits. For further details, see CFTC Release pr6223-12.

CA s1041B(2) theoretically could also present some issues in relation to the correction of trading errors. The usual course of conduct when an error occurs is immediately to enter into an equal and opposite trade to flatten your exposure on the error. So, for example, if a client instructed you to buy 1,000 XYZ shares and the trader accidentally keyed in a sale of 1,000 XYZ shares, the accidental sale would be credited to an error account. After filling the client’s order to buy 1,000 XYZ shares (which has priority), the broker would then buy another 1,000 XYZ shares at market to clear the position in the error account. Again, the second buy transaction potentially falls within s1041B(2)(b).

It used to be a defence to a prosecution under the predecessors to ss1041B(1) and (2) (ss998(1) and (5)) if you could prove that the purpose or purposes for which the accused did the act was not, or did not include, the purpose of creating a false or misleading appearance of active trading in securities on a stock market (s998(6)). Hence one could reasonably argue that the purpose of these types of transactions was to crystallise a tax loss or correct an error and not to create a false or misleading appearance of active trading and seek to rely on this defence. This was especially so if (in the case of a tax loss crystallisation transaction) each of the sale and purchase trades, or (in the case of an error correction) the correcting trade, was done in a single line at prevailing market prices.

Buss JA explained in Braysich v R how the offence in s998(1), the deeming provision in s998(5) and the defence in s998(6) interacted:

     

"In my opinion, s 998(5)(a) facilitates proof. Section 998(5)(a) may be relied on by the prosecution to prove that the accused, by engaging in the activity described in the provision, created a false or misleading appearance of active trading in the securities in question on a stock market, within the first limb of s 998(1). Proof of the activity described in s 998(5)(a) is sufficient to produce the consequence that the accused, for the purposes of s 998(1) read with s 1311(1) of the Corporations Law, is to be judged to have created a false or misleading appearance of active trading. These observations also apply, with necessary modifications, to s 998(5)(b) and (c).

     

The prosecution is not, of course, confined to s 998(5) in proving that an accused created a false or misleading appearance of active trading. Section 998(5) expressly states that its provisions are without limitation to the generality of s 998(1). So, where the prosecution is unable or, for some reason, chooses not to rely on the deeming provisions in s 998(5), it may prove, by conventional evidentiary means, that the accused in fact created a false or misleading appearance of active trading.

     

In my opinion, where the prosecution relies on and proves beyond reasonable doubt that the accused knowingly engaged in the activity described in s 998(5)(a) then, subject to s 998(6), the prosecution will have established the offence created by the first limb of s 998(1), read with s 1311(1). The accused will have 'knowingly engaged' in the activity described in s 998(5)(a) if he or she knew that the transaction of sale or purchase of securities did not involve any change in the beneficial ownership of the securities. ... The accused cannot go behind the deeming provision once the prosecution has proved the conditions for its engagement. He or she may, however, endeavour to make out the defence conferred by s 998(6)."

Buss JA held that where the prosecution did not rely on the deeming provisions in s998(5), under s998(1), it had to prove beyond reasonable doubt that the accused's purpose was to create a false or misleading appearance of active trading in the securities in question on a stock market. However, where the prosecution relied on the deeming provision in s998(5), it was sufficient for the prosecution to prove beyond reasonable doubt that the accused knew of the relevant activity the subject of the deeming provisions. That would then deem the accused's conduct to have created a false or misleading appearance of active trading and throw the onus on to the accused under s998(6) to establish, on the balance of probabilities, that the purpose or purposes for which he or she engaged in the relevant activity did not include the purpose of creating a false or misleading appearance of active trading in the securities in question on a stock market.

The defence that used to appear in s998(6) of the Corporations Law was removed from the Corporations Act when the FSR amendments came into effect on 11 March 2002. I suspect the reason for this is that the draftsperson did not consider it necessary. Under the Criminal Code, offences have a physical element and a fault element. The deeming provision in s1042B only addresses the physical element of creating a false or misleading appearance of active trading in particular financial products on a financial market. Hence, while s1041B(2) deems a person to have done that physical element if they engage in a wash trade or matched orders, the effect of ss1041B(1A), when read in conjunction with the Criminal Code, would seem to be that the prosecution must still prove that the accused intentionally engaged in the wash trade or matched orders and was reckless as to whether it had, or was likely to have, the effect of creating, or causing the creation of, a false or misleading appearance of active trading in particular financial products on a financial market. In the examples above of trades done to crystallise a tax loss or to correct an error trade, provided the trades in question take place in a single line at prevailing market prices, the prosecution may well have difficulties in meeting that burden.

In Endresz v Whitehouse, E, the chairman of Emu Hill and a director of its major shareholder CTC, instructed a broker to sell 4m of CTC’s shares in Emu Hill on market and then instructed a different broker to buy them back on a deferred settlement basis, with the purchase price payable after 3 months. The price for both trades, at 14 cents, was significantly in excess of the prevailing market price of 9 cents. In order to put the transaction through the market at 14 cents, CTC had to buy approximately 2.7m shares at lesser prices, which purchases were outside the 3% creep rule and therefore in breach of the Takeovers Code. E asserted that the transaction was a 3 month loan to CTC secured against the 4m shares. The trial magistrate did not accept this and found that the true purpose was to rig the market. On appeal, Ormiston JA, with whom the other judges agreed, said (at pp 952-3):

     

"...the case is clear. There was a totally artificial transaction involving 4 million shares and it resulted in no change in the ownership of the shares, just an apparent surge in activity to the extent of 4 million shares on the day, forgetting altogether about the necessity to clear the market the day before. The price chosen was significantly, to the extent of 40 to 50%, above the price previously applying in the market. Even if it were right to hold that the intention of the appellant was to obtain short-term finance until the deferred delivery took place, then it was more than obvious that that price would have had the benefit which can be the only real explanation for it, namely that a value was being put on the shares which was artificially high and which would have the artificial effect of increasing the value of the shares for the purpose of borrowing "against them" and, if it be correct that the loan was effected by [the broker’s] willingness to pay out the consideration before delivery, then it is more than obvious that the amount then obtained was the higher by reason of the fact that the shares were sold at 14 cents rather than 9 or 10 cents per share. If the appellant's purpose was not to obtain a loan, then the raising of the price for a transaction of 4 million shares for no real purpose so far as that holding was concerned, must, upon the only inference available to the Court, be calculated to create a false and misleading appearance of active trading at a substantially higher price in Emu Hill shares. Whether or not the magistrate erred in his finding of fact (and it was he who heard the whole of the evidence), it could not be possible, having regard to the expense to be incurred by the transaction such as payment of duties and commission, to conclude other than that the purpose was to create a false and misleading impression of the market."

In 2015, a trader in shares and CFDs was sentenced to two years and three months imprisonment for placing matched trades in four resources stocks that materially inflated the prices of those stocks (see ASIC Media Release 15-271).

 

CA s1041B(3) – Deemed No Change in Beneficial Ownership
For the purposes of s1041B(2)(a), an acquisition or disposal of financial products does not involve a change in the beneficial ownership if:
(a)   a person who had an interest in the financial products before the acquisition or disposal; or
(b)   an associate of such a person;
has an interest in the financial products after the acquisition or disposal.
See R v Manasseh and Austin [2002] NSWCCA 27.

In R v Manasseh and Austin, the defendants were charged under the predecessors to ss1041B(1), (2)(a) and (3) and convicted at first instance for implementing a series of purchases and sales of shares between various trust companies which held the shares in question on trust for persons associated with the defendants. On appeal, the NSW Court of Criminal Appeal rejected an argument by the defendants that the convictions should be set aside because they were not dealing as principal and that the persons who should have been charged were the trust companies concerned who owned the shares. The court held that the predecessor to s1041B(1) applied to a person who engaged in the proscribed conduct even though that person so engaged by dealing in the securities of another with or without the authority of that other. The court, however, quashed the convictions because the Crown had failed to identify the persons who were the beneficial owners of the shares before and after the transactions for the purposes of the predecessor to s1041B(2)(a) and to identify the persons or their associates who held interests in the shares before and after the transactions for the purposes of the predecessor to s1041B(3).

CA s1041C - Fictitious or Artificial Transactions and Devices
(1)   A person must not (whether in this jurisdiction or elsewhere) enter into, or engage in, a fictitious or artificial transaction or device if that transaction or device results in:
  (a)   the price for trading in financial products on a financial market operated in this jurisdiction being maintained, inflated or depressed; or
  (b)   fluctuations in the price for trading in financial products on a financial market operated in this jurisdiction.
(2) In determining whether a transaction is fictitious or artificial for the purposes of s1041C(1), the fact that the transaction is, or was at any time, intended by the parties who entered into it to have effect according to its terms is not conclusive.

 

CA s1041D - Dissemination of Information About Illegal Transactions
A person must not (whether in this jurisdiction or elsewhere) circulate or disseminate, or be involved in the circulation or dissemination of, any statement or information to the effect that the price for trading in financial products on a financial market operated in this jurisdiction will, or is likely to, rise or fall, or be maintained, because of a transaction, or other act or thing done, in relation to those financial products, if:
(a)   the transaction, or thing done, constitutes or would constitute a contravention of s1041A, 1041B, 1041C, 1041E or 1041F; and
(b)   the person, or an associate of the person:
  (i)   has entered into such a transaction or done such an act or thing; or
  (ii)   has received, or may receive, directly or indirectly, a consideration or benefit for circulating or disseminating, or authorising the circulation or dissemination of, the statement or information.

This provision is intended to prohibit a person from causing a run on a financial product by spreading information about illegal transactions the person has done to manipulate the market, or about illegal transactions someone else has done to manipulate the market where the person stands to receive some consideration or benefit for spreading that information.

CA s1041E(1) - False or Misleading Statements
A person must not (whether in this jurisdiction or elsewhere) make a statement, or disseminate information, if:
(a)   the statement or information is false in a material particular or is materially misleading;
(b)   the statement or information is likely:
  (i)   to induce persons in this jurisdiction to apply for financial products;
  (ii)   to induce persons in this jurisdiction to dispose of or acquire financial products; or
  (iii)   to have the effect of increasing, reducing, maintaining or stabilising the price for trading in financial products on a financial market operated in this jurisdiction; and
(c)   when the person makes the statement, or disseminates the information:
  (i)   the person does not care whether the statement or information is true or false; or
  (ii)   the person knows, or ought reasonably to have known, that the statement or information is false in a material particular or is materially misleading.
See Endresz v Whitehouse (1997) 15 ACLC 936; R v Wright (1980) 4 ACLR 931; ASC v MacLeod (2000) 18 ACLC 424; and ASIC v MacDonald (No 11) [2009] NSWSC 287.

In Endresz v Whitehouse, above, after the transaction in question, the ASX wrote to Emu Hill and queried it about the fluctuations in its share price. E, who you will recall was the chairman of Emu Hill and a director of its major shareholder CTC, responded on behalf of Emu Hill without referring the matter to his fellow directors. He said that the board of Emu Hill was not aware of any information not known to the market that would explain the movement in its share price. The letter set out various generally known factual matters about the earlier takeover of Emu Hill by CTC and then expressed the opinion that the price movements were the result of the market’s reappraisal of the company in light of those developments. The letter also stated that CTC had purchased the 2.7m shares needed to clear the market the day before so that the 4m transaction could go through at the desired price "in the ordinary course of trading on the ASX". It did not mention the fixing of the price on the 4m transaction. E was charged and convicted at first instance of breaching the precursor to s1041E. On appeal, E tried to argue that he had answered the ASX query as chairman of Emu Hill and not as director of CTC and was precluded from disclosing in the letter information that was confidential to CTC. The court rejected this argument and dismissed the appeal, saying that some of his answers included information that could only have been known to CTC. E had also included matters of opinion, such as the comment about market reappraisal and, having opened up these matters of opinion, he was obliged to give complete and honest answers.

In R v Wright, W, a director of Wattle Gully Gold, authorised a letter to the ASX saying that the company’s consulting geologist had reported significant ore reserves in the company’s uranium lease and that at current values the reserves were worth $160m. As a consequence, the market price of Wattle Gully traded up from 8 cents to 12 cents. In fact the report had referred to possible reserves and contained nothing to justify the $160m valuation. Further, the geologist had said in the report that he did not consider the deposits to be economically recoverable. A few days later a correcting letter was sent to the ASX and the price fell back to 8 cents and subsequently even lower. W and the company were convicted of breaching the precursor to s1041E, with W jailed for 12 months and the company originally fined $20,000. Subsequently on appeal, the company’s fine was reduced to $500 as the court did not see any point in punishing the innocent shareholders in the company. An appeal by W against his conviction and jail sentence, however, was rejected.

In ASC v MacLeod, M, an independent consulting geologist, issued a report to Cambridge Gulf Exploration NL on the results of exploration it had undertaken off the coast of north-west WA with a view to mining diamonds off the sea bed. He said that based on sampling tests and the current price of diamonds, the company’s annual profits could be expected to be US$1.374b. The company issued the report to the ASX and its share price climbed dramatically. The size of the sample that had been taken was not adequate to draw the conclusions that the geologist had and, as it transpired, the company did not make anywhere near the level of recoveries or profits that the geologist had predicted. He was convicted as first instance by a magistrate of breaching the precursor to s1041E. That decision was set aside and the charges dismissed on appeal by a Commissioner of the Supreme Court of Western Australia. ASC then appealed the dismissal to the Full Court of the Supreme Court of Western Australia. The Full Court held that the geologist’s statement about the level of profits was a statement as to the future; therefore the precursor to s769C kicked in and the geologist had the onus of showing that he had a reasonable basis for making that statement. He didn’t and so it was therefore deemed to be misleading. Further it was clearly material and, on the evidence, one that was likely to induce people to buy shares in the company. The test to be applied when considering whether a person knew or should have known something was materially misleading was an objective one and, on that standard, the geologist should have known that his statements would have induced people to buy shares. Accordingly, the Full Court found that he was properly convicted of breaching the precursor to s1041E and reinstated his conviction. That decision, however, was subsequently set aside by the High Court on technical grounds (namely, that the ASC did not have the authority to bring the appeal to the Full Court): see MacLeod v ASIC [2002] HCA 37.

In ASIC v MacDonald (No 11) (the James Hardie case), the Supreme Court of NSW held that James Hardie breached s1041E (as well as s1041H) by making false or misleading statements that a separate foundation set up to take over its asbestos liabilities was "fully funded", when that was not the case. The court found that the central thrust of the statements was to quell market concern about the ability of James Hardie to meet its asbestos liabilities and that these statements were likely to induce persons to acquire James Hardie shares and to have the effect of maintaining or stabilising the price for those shares. The decision against James Hardie was affirmed on appeal by the NSW Court of Appeal in James Hardie Industries NV v ASIC [2010] NSWCA 332.

As mentioned above, during the height of the GFC, there were suggestions that a number of hedge funds with short positions in financially challenged companies (including ABC Learning, Babcock & Brown and Macquarie Group) were deliberately spreading false or misleading information about those companies in order to artificially provoke sales of securities and to reduce their market price, so that they could close out their short positions at a profit. In ASIC Advisory 08-47, ASIC warned that such conduct could breach CA s1041E and that it would be vigilant in monitoring the market to ensure this type of behaviour was detected and prosecuted.

In September 2011, the Dutch market regulator AFM fined futures broker MF Global Holdings €384,000 and one of its equity sales traders €24,000 for market manipulation for spreading false and misleading information about a proposed share issue by the Dutch-Belgian financial giant Fortis. Fortis shares fell sharply, prompting the company to issue a press release denying it. Fortis eventually collapsed during the GFC under the weight of having bought part of ABN Amro. The company was later nationalised and broken up. See the AFM Media Release dated 26 September 2011.

In July 2014, Jonathan Moylan, an environmental activist, disseminated a false media release from ANZ stating the ANZ had withdrawn a $1.2 billion loan facility to Whitehaven Coal. He was charged with, and pleaded guilty to, one count of disseminating information that was false in a material particular and was likely to induce persons to dispose of financial products, in contravention of CA s1041E. He was convicted and sentenced to one year and eight months imprisonment to be released forthwith upon entering into a recognisance of $1000 to be of good behaviour for two years. See ASIC Media Release 14-179MR.

CA s1041F(1) - Inducing Persons to Deal
A person must not, in this jurisdiction, induce another person to deal in financial products:
(a)   by making or publishing a statement, promise or forecast if the person knows, or is reckless as to whether, the statement is misleading, false or deceptive;
(b)   by a dishonest concealment of material facts; or
(c)   by recording or storing information that the person knows to be false or misleading in a material particular or materially misleading if:
  (i)   the information is recorded or stored in, or by means of, a mechanical, electronic or other device; and
  (ii)   when the information was so recorded or stored, the person had reasonable grounds for expecting that it would be available to the other person, or a class of persons that includes the other person.
See NCSC v Monarch Petroleum NL (1984) 2 ACLC 256

"Dishonest" is defined in s1041F(2) to mean: (a) dishonest according to the standards of ordinary people; and (b) known by the person to be dishonest according to the standards of ordinary people.

CA s1041F(3) gives this section an extended operation in relation to certain dealings in superannuation and RSA products.

In NCSC v Monarch Petroleum NL, a bogus letter on Monarch Petroleum letterhead and purporting to be from its chairman was delivered to the Perth Stock Exchange and read out over the floor loudspeaker system in the usual way. It referred to a possible takeover of the company by a "large Australian company" and to a potentially valuable oil discovery. This caused a run on the company’s stock and a dramatic increase in its share price. The company secretary, upon hearing the news, informed the NCSC that the letter was a forgery. The NCSC applied to have sales on the exchange declared void. The order was made. It was held that whoever had published the forged letter had committed an offence under the precursor to s1041F and that enlivened the jurisdiction of the court to grant injunctions where an offence had been committed.

Consequences of Breach
•     Criminal offence punishable by:
  •     in the case of an individual, 10 years’ jail and/or a fine equal to the greater of: (a) 4,500 penalty units; or (b) if the court can determine the total value of the benefits that have been obtained by one or more persons and are reasonably attributable to the commission of the offence, 3 times that total value; and
  •     in the case of a body corporate, a fine equal to the greatest of: (a) 45,000 penalty units; or (b) if the court can determine the total value of the benefits that have been obtained by one or more persons and are reasonably attributable to the commission of the offence, 3 times that total value; or (c) if the court cannot determine the total value of those benefits, 10% of the body corporate’s annual turnover during the 12-month period ending at the end of the month in which the body corporate committed, or began committing, the offence (s1311).
•     Ss1041A, 1041B, 1041C and 1041D are financial services civil penalty provisions (s1317E) – civil penalty of $200,000 for individuals and $1,000,000 for corporations (s1317G(1A)) and compensation orders in favour of anyone suffering loss or damage (s1317HA).
•     In the case of ss1041E and 1041F, liable to pay damages to anyone who suffers loss or damage as a result of a contravention, along with any other person "involved in the contravention" (s1041I).
•     Injunctions (s1324).
•     Order to disclose information or publish advertisement (s1324B).
•     Compensation orders (s1325).
•     If person infringing is a licensed dealer or its representative – cancellation or suspension of licence (ss915C(1)(a) and 912A(1)(c)) or banning order (s920A(1)(e)) for breach of a financial services law.

In ASIC v Soust [2010] FCA 68 ASIC, the managing director of Select Vaccines instructed his broker to purchase Select Vaccines shares in his mother's name in the last hour of the last day of trading for the 2007 calendar year with the intention of increasing the Select Vaccines share price on the ASX in order to secure the payment of the short-term performance bonus under his service contract. The amount of the bonus was linked to the market price of Select Vaccines shares on that day. It was found that he had engaged in market manipulation in contravention of ss1041A and 1041B and had also breached his director’s duties to Select Vaccines under ss181(1) and 182(1).

A similar finding was made by the NSW Supreme Court against the CEO, CFO, company secretary/general counsel and non-executive directors of James Hardie in ASIC v Macdonald (No 11) [2009] NSWSC 287. The court found that they breached their duties as directors/officers of James Hardie under ss180(1) and 181(1) because of their involvement in its breaches of ss1041E and 1041H. The CEO did not appeal the decision at first instance. The decision against the CFO was affirmed on appeal by the NSW Court of Appeal in Morley v ASIC [2010] NSWCA 331. The decision against the non-executive directors and the company secretary/general counsel was affirmed on appeal by the High Court in ASIC v Hellicar [2012] HCA 17 and Shafron v ASIC [2012] HCA 18 respectively.

An example from offshore of the seriousness with which regulators view allegations of market manipulation - in early 2011, the Korean regulator the Financial Services Commission banned Deutsche Bank’s Korean broker-dealer business from operating in Korea for 6 months, following allegations of market manipulation in KOPSI 200 options (see FSC press release dated 23 February 2011).

(2) ASX Rules
ASX MIR 5.7.1 – False or Misleading Appearance
A market participant must not make a bid or offer for, or deal in, any products:
(a)   as principal:
  (i)   with the intention; or
  (ii)   if that bid, offer or dealing has the effect, or is likely to have the effect,
  of creating a false or misleading appearance of active trading in any product or with respect to the market for, or the price of, any product; or
(b)   on account of any other person where:
  (i)   the market participant intends to create;
  (ii)   the market participant is aware that the person intends to create; or
  (iii)   taking into account the circumstances of the order, a market participant ought reasonably suspect that the person has placed the order with the intention of creating,
  a false or misleading appearance of active trading in any product or with respect to the market for, or the price of, any product.

This rule applies to both cash market products and derivative market contracts (see the definition of "product" in ASX MIR 1.4.3). The maximum penalty prescribed for breaching MIR 5.7.1 is $1,000,000.

Pursuant to ASX MIR 1.4.3, the phrase "as principal" for these purposes has the extended meaning given to that term in ASX MIR 3.2.5 (see below).

The predecessor to this MIR (ASX Market Rule 13.4.1 and before that ASX Business Rule 2.2.4) was regarded by the ASX to be one of the most fundamental and important obligations of all market participants. As the ASX noted in ASX Business Rules Guidance Note 8/00 Trading Practices:

    

"A cornerstone of fair and orderly markets is that they reflect the forces of genuine supply and demand. This concept is fundamental. ASX seeks to ensure that its markets are fair and orderly and free of manipulative trading. ASX closely monitors trading activity. There are rules regulating trading activity in ASX’s [Market] Rules and in the Corporations Act. [Market] Participants must ensure that their trading is conducted in accordance with the [Market] Rules and the Corporations Act. Aside from any disciplinary consequences, trading which is manipulative or unacceptable is damaging to ASX’s market integrity and the image and reputation of [Market] Participants themselves."

Note that (b)(iii) above puts the onus on the market participant (ie the broker) to be alive to and think about whether an order is being placed to manipulate the market. They can’t just turn a blind eye to a suspicious order. The point is illustrated by the $130,000 penalty imposed in 2017 against Share Investing Limited by the Markets Disciplinary Panel. Throughout April to May 2013, a client of Share Investing, using Share Investing's automated order processing system, was trading in the shares of a small energy company. The orders appeared to be inconsistent with the client's prior trading, but consistent with the client's interest in maintaining the value of the client's holding by supporting the price of the shares. The client orders materially altered the price of the shares, including trading at the highest price on each day and/or setting the closing price. They also appeared to have been timed to create a price impact at minimal cost. The MDP found that Share Investing ought to have identified these circumstances and to have suspected that the client placed the orders with the intention of supporting or maintaining the price of the shares and of creating a false and misleading appearance of active trading or with respect to the market for, or price of, the shares, and therefore had breached MIR 5.7.1(b)(iii). See ASIC Media Release 17-035MR.

The factors market participants are required to take into account under MIR 5.7.1(b)(iii) are set out in ...

 

ASX MIR 5.7.2 – Relevant Factors
In considering the circumstances of the order, the market participant must have regard to ... :
(a)   whether the order or execution of the order would be inconsistent with the history of, or recent trading in, that product;
(b)   whether the order or execution of the order would materially alter the market for, or the price of, the product;
(c)   the time the order is entered or any instructions concerning the time of entry of the order;
(d)   whether the person on whose behalf the order is placed, or another person who the market participant knows to be a related party of that person, may have an interest in creating a false or misleading appearance of active trading in any product or with respect to the market for, or the price of, any product;
(e)   whether the order is accompanied by settlement, delivery or security arrangements which are unusual;
(f)   where the order appears to be part of a series of orders, whether when put together with the other orders which appear to make up the series, the order or the series is unusual having regard to the matters referred to in this rule;
(g)   whether there appears to be a legitimate commercial reason for that person placing the order, unrelated to an intention to create a false or misleading appearance of active trading in or with respect to the market for, or price of, any product;
(h)   whether the transaction, bid or offer the execution of which is proposed will involve no change of beneficial ownership;
(i)   the frequency with which orders are placed by a person;
(j)   the volume of products the subject of each order placed by a person; and
(k)   the extent to which a person amends or cancels an instruction to purchase or sell a product relative to the number of transactions executed for that person.

The maximum penalty prescribed for breaching MIR 5.7.2 is $1,000,000.

See also ASX Market Rules Guidance Note 1 Prevention of Manipulative Trading and note the statement in that Guidance Note: "ASX interprets the phrase "no change in beneficial ownership" in light of the Corporations Act. This means ASX regards a transaction as involving no change in beneficial ownership if a person, or that person's associate, had an interest in the [cash market products] before the transaction, and has an interest in the same [cash market products] after the transaction." ASIC has said that it will seek to follow the published interpretations contained in pre-existing ASX Market Rules guidance notes, including Guidance Note 1, but will look to review them and issue replacement ASIC Guidance Notes in due course (see ASIC Regulatory Guide 214 Guidance on ASIC market integrity rules for ASX and ASX 24 markets, at para 57-58).

ASX MIR 5.7.3 – Automated Order Processing
A market participant must also comply with this Part 5.7 in respect of orders the subject of automated order processing.

This means that you need to include filters in automated order processing systems designed to prevent manipulative trading (eg to stop people from doing wash trades, placing matched orders or marking the close).

ASX Business Rules Guidance 8/00
"A trading participant … needs to be able to show that, taking into account the circumstances of the order, it would not have reasonably suspected that the purpose of the trading was to create a false or misleading appearance. It is important that a trading participant which receives an unusual order is able to establish that it has made due inquiries and satisfied itself as to the reason for the trading. As a minimum, appropriate notations should be made on the order record or some other record as to the reason for the trading. The most reliable record of the reason for the trading would be an audio tape of the placement of the order and the enquiries the dealer or adviser made to satisfy him/herself that a prohibited intention was not present. Such a record may protect a trading participant against any allegation of a breach of [MIR 5.7]."

Click here for a copy of ASX Business Rules Guidance Note 8/00 Trading Practices. ASX also issued a convenient Summary of ASX Business Rules Guidance Note 8/00.

ASX MIR 5.11.1(1) - Obligation to Report Suspected Market Manipulation to ASIC
If a market participant has reasonable grounds to suspect that:
(a)   ...
(b)   a transaction or an order transmitted to a trading platform has or is likely to have the effect of:
  (i)   creating an artificial price for trading in financial products on the market;
  (ii)   maintaining at a level that is artificial (whether or not it was previously artificial) a price for trading in financial products on the market;
  (iii)   creating, or causing the creation of, a false or misleading appearance of active trading in financial products on the market; or
  (iv)   creating, or causing the creation of, a false or misleading appearance with respect to the market for, or the price for trading in, financial products on the market,
  whether or not the market participant is aware of:
  (v)   the intention of any party to the transaction or order; or
  (vi)   all of the details of the transaction or order,
the market participant must, as soon as practicable, notify ASIC in writing of the details of the transaction or order (to the extent known to the market participant) and the reasons it suspects the matter set out in ... (b).

For guidance on this obligation, see ASIC Regulatory Guide 238 Suspicious activity reporting.

ASX MIR 5.11.1(2) provides that a  market participant is not required to notify ASIC under ASX MIR 5.11.1(1) if it has reported the relevant information to Austrac under AMLCTFA s41 or FTRA s16 (see lecture 7).

Breach of ASX MIR 5.11.1 attracts a maximum penalty of $20,000.

There is an equivalent requirement in the Chi-X MIR for participants in that market. There is also an equivalent requirement in Competition MIR 4A.5.2 for participants that operate a crossing system vis-a-vis transactions done on, or orders placed into, the crossing system.

For completeness, ASX MIR 5.8.2 prohibits an ASX market participant from effecting any futures market transaction where the account is the same on both sides of the transaction. ASX MIR 5.8.5 also provides that when, in the opinion of ASIC, a person or two or more persons acting in concert have acquired such control of a quoted product that the quoted product cannot be obtained for delivery on existing contracts except at prices or on terms arbitrarily dictated by such persons which are unfair, harsh, or unconscionable, ASIC may: (a) for the purpose of enabling equitable settlement to be effected on these contracts, postpone (or from time to time further postpone) the times for deliveries on contracts for any such quoted product; and (b) at any time declare that if such quoted product is not delivered on any contract requiring delivery on or before the time to which delivery has been postponed such contract will be settled by payment to the party entitled to receive such quoted product or by the credit to such party of a fair settlement price determined under MIR 5.8.6. These provisions apply only to futures market transactions on the ASX market and do not apply to cash market or options market transactions (MIR 5.8.1). There are now no longer any futures contracts actively traded on the ASX market and so these provisions have no practical operation.

(3) ASX 24 Rules
ASX 24 MIR 3.1.2(1) – False or Misleading Appearance
A market participant must not offer to purchase or sell a contract or deal in any contract:
(a)   as principal:
  (i)   with the intention; or
  (ii)   if that offer to purchase or sell or dealing has the effect, or is likely to have the effect,
  of creating a false or misleading appearance of active trading in any contract or with respect to the market for, or the price of, any contract; or
(b)   on account of any other person where:
  (i)   the market participant intends to create;
  (ii)   the market participant is aware that the person intends to create; or
  (iii)   taking into account the circumstances of the order, a market participant ought reasonably suspect that the person has placed the order with the intention of creating,
  a false or misleading appearance of active trading in any contract or with respect to the market for, or the price of, any contract.

This is essentially the same as ASX MIR 5.7.1 above. The maximum penalty prescribed for breaching MIR 3.1.2 is $1,000,000.

ASX 24 MIR 3.1.2(2) provides that for these purposes, a reference to a market participant offering to purchase or sell a contract or deal in any contract as principal includes a reference to offering to purchase, sell or deal in any contract on its own behalf or on behalf of: (a) a partner of the market participant; (b) a director of, company secretary of, or person who has a substantial holding in the market participant; (c) the spouse of, non-adult children of, family company of, or family trust of a partner, director, company secretary, or person who has a substantial holding in the market participant; (d) a body corporate in which the interests of one or more of the partners of the market participant singly or together constitute a controlling interest; and (e) a related body corporate of the market participant.

ASX 24 MIR 3.1.2(3) – Relevant Factors
In considering the circumstances of the order, the market participant must have regard to ... :
(a)   whether the order or execution of the order would be inconsistent with the history of, or recent trading in, that contract;
(b)   whether the order or execution of the order would materially alter the market for, or the price of, the contract;
(c)   the time the order is entered or any instructions concerning the time of entry of the order;
(d)   whether the person on whose behalf the order is placed, or another person who the market participant knows to be a related party of that person, may have an interest in creating a false or misleading appearance of active trading in any contract or with respect to the market for, or the price of, any contract;
(e)   whether the order is accompanied by settlement, delivery or security arrangements which are unusual;
(f)   where the order appears to be part of a series of orders, whether when put together with the other orders which appear to make up the series, the order or the series is unusual having regard to the matters referred to in this rule;
(g)   whether there appears to be a legitimate commercial reason for that person placing the order, unrelated to an intention to create a false or misleading appearance of active trading in or with respect to the market for, or price of, any contract;
(h)   whether the proposed transaction, bid or offer ... will involve no change of beneficial ownership;
(i)   the frequency with which orders are placed by a person;
(j)   the volume of contracts the subject of each order placed by a person; and
(k)   the extent to which a person amends or cancels an instruction to purchase or sell a contract relative to the number of transactions executed for that person.

Again, this is essentially the same as ASX MIR 5.7.2 above. The maximum penalty prescribed for breaching MIR 3.1.2 is $1,000,000.

ASX 24 MIR 3.1.3 – Entering Orders Without an Intent to Trade
A market participant must not enter orders where there does not exist an intent to trade. For these purposes, circumstances which indicate that there does not exist an intent to trade include:
•     orders which are entered at price limits substantially higher or lower than the previous settlement price of the specific contract, or alternatively, entered with unusually large volume levels; or
•     placement, modification and cancellation of orders during the pre-opening phase, which are entered with intent to affect the opening price of any futures or options contract.

The maximum penalty prescribed for breaching MIR 3.1.3 is $1,000,000.

ASX 24 MIR 3.1.12(1) - Wash Trades
A market participant must not allow trades to occur such that both sides of the trade are on behalf of the same account.

The maximum penalty prescribed for breaching MIR 3.1.12 is $100,000.

MIR 3.1.12(1) does not prohibit: (a) a transaction where both sides are taken by the same market participant where the ultimate clients are different; (b) a transaction where both sides are by the same entity but acting in different capacities; or (c) a transaction where each side is for a different division of the same market participant entity which is trading separately and for different purposes (MIR 3.1.12(2)).

MIR 3.1.12(3)-(5) impose a requirement on market participants to report certain wash trades to ASIC and to maintain a register of other wash trades that are not required to be reported to ASIC.

Return to Outline


Order Record Requirements

Note: the order record requirements in the Corporations Act and the ASX and ASX 24 MIRs, while very straightforward, are very important in practice. Often, the first thing a regulator will ask for if it comes to do an audit or investigation of a financial services licensee is its order records. Deficiencies in order records often are symptomatic of, or contribute to, other compliance deficiencies.

(1) Corporations Act
CR r7.8.19 - Records of Instructions
A financial services licensee who receives instructions to deal in financial products (i) on behalf of a client or (ii) on the financial service licensee’s own account, in either case through licensed markets or through other financial markets (whether inside or outside Australia), must keep records setting out brief particulars of the following matters:
(a)   the instructions;
(b)   if the instructions were received on behalf of a client - the client;
(c)   the person who gave the instructions to the financial services licensee;
(d)   the date and time of receipt of the instructions, and the person who received the instructions;
(e)   the date and time of transmission of the instructions, and the person who transmitted the instructions;
(f)   the date and time of execution of the instructions (r7.8.19(1) and (2)).

The financial services licensee must keep the records for at least 5 years after the particulars are created (CR r7.8.19(5)). Records relating to instructions given by a client to deal in financial products must be kept in a manner that makes the records identifiable separately from records relating to instructions to deal in financial products on the financial services licensee’s own account (CR r7.8.19(4)).

Under CR r7.8.19(3), if a financial services licensee transmits for execution on a financial market outside Australia and the external Territories instructions to deal in financial products and it is not reasonably practicable for the financial services licensee to set out the date and time of execution of those instructions in its records, the financial services licensee must set out the date and time as precisely as is reasonably practicable.

CR r7.8.20(5) – Additional Record Keeping Requirements for Transaction's on Licensee's Own Account
A financial services licensee must:
(a)   keep records of the following matters relating to each financial products transaction entered into by the financial services licensee on the financial service licensee’s own behalf:
  (i)   a description of the financial products transaction;
  (ii)   the date and time of receipt of the instructions for the financial products transaction;
  (iii)   the date and time of transmission of the instructions to the licensed market concerned;
  (iv)   the date and time of execution of the instructions;
  (v)   the source of the funds or financial products to effect the financial products transaction; and
(b)   keep the records in a manner that makes the records identifiable separately from records of the financial services licensee.

CR r7.8.20(5) seems to duplicate many of the requirements of r7.8.19. It is unclear why both regulations have been included.

In this regard, CR r7.8.20(5) appears in a regulation headed "Dealings with non-licensees". It has been made pursuant to CA s991E(7), which also appears in a section headed "Obligations of financial services licensee in relation to dealings with non-licensees", although it confers a general discretion for the regulations to impose requirements for the keeping of records relating to financial product transactions entered into by a financial services licensee on their own behalf.

(2) ASX Rules
ASX MIR 4.1.1(2) – Client Order Records
Subject to MIR 4.1.7, in addition to complying with the requirements of the Corporations Act to the extent that those requirements apply to dealing in the market, a market participant must maintain sufficiently detailed records showing:
(a)   particulars of the instructions, including, without limitation:
  (i)   the financial product to be bought or sold;
  (ii)   the number thereof;
  (iii)   any price or time related instructions;
  (iv)   any time limit on the instructions;
  (v)   the date and time the market participant received the instructions;
  (vi)   instructions or decisions to purchase or sell financial products pursuant to a managed discretionary account (including, without limitation, the financial products to be bought or sold and the number thereof, any price or time related instructions or decisions and the name of the person who generated the instruction or made the decision), whether the instruction or decision was executed or not; and
  (vii)   the authority of the client (if any) for accumulation and price averaging under MIR 3.4.2;
(b)   the name of the client;
(c)   the name of the person who gave the instructions (or, if the trading message was received by automated order processing, the information set out in MIR 5.5.3);
(d)   any amendment of any kind to the instructions or trading message (including, without limitation, cancellation of an instruction or trading message, variation of the number of financial products to be bought or sold or variation of any price or time related instructions), including the date and time of any amendment to the instructions or trading message;
(e)   the name of the person who received the instruction (or, if the trading message was received by automated order processing, the information set out in MIR 5.5.3);
(f)   the name of any other person who passed the instruction on between the person who initially received the instruction and the trading platform, and the date and time they passed it;
(g)   the name of the DTR who entered a trading message into a trading platform (or, if the trading message was submitted by automated order processing, the information set out in MIR 5.5.3);
(h)   the time the DTR entered a trading message into a trading platform (or if the trading message was submitted by automated order processing, the time at which the trading message was initiated by the open interface device);
(i)   if the trading message gives rise to a market transaction, the date and time that occurs; and
(j)   the derivatives market contracts arising from instructions that are nominated for accumulation and price averaging under the Clearing Rules.

As the lead-in words to this MIR state, the requirements of this MIR operate in addition to the requirements of CR r7.8.19.

This MIR applies to a market participant who receives instructions to enter into a market transaction on behalf of a person (a "client"), whether or not a trading message corresponding to those instructions is entered into or matched on a trading platform (MIR 4.1.1(1)).

The maximum penalty prescribed for breaching MIR 4.1.1 is $100,000.

MIR 4.1.5 and 4.1.6(1) provide that a trading participant may rely on ASX's electronic trading records to meet its obligations under (g), (h) and (i) above, provided it meets the conditions set out in MIR 4.1.6(2).

MIR 4.1.7 provides that a market participant who instructs another trading participant to enter into a market transaction on behalf of a client does not have to comply with (e)-(j) above in respect of that instruction. Instead, they must maintain sufficiently detailed records in respect of the instruction showing: (i) the name of the person who received the instruction; (ii) the name of any person who passed the instruction on between the person who initially received the instruction and the person instructing the trading participant to enter into the market transaction; (iii) the name of the person who instructed the trading participant to enter into the market transaction; and (iv) the time the person instructed the trading participant to enter into the market transaction.

ASX MIR 4.1.2(2) – Proprietary Order Records
Subject to MIR 4.1.8, a market participant must, in addition to complying with the requirements of the Corporations Act to the extent that those requirements apply to dealing in the market provided by the market operator, maintain sufficiently detailed records showing:
(a)   particulars of the decision or instructions, including, without limitation:
  (i)   the name of the person who generated the instruction or made the decision;
  (ii)   the financial products to be bought or sold;
  (iii)   the number thereof;
  (iv)   any price or time related instructions or decisions; and
  (v)   any time limit on the instruction;
(b)   any amendment of any kind to the instructions or trading message (including, without limitation, cancellation of an instruction or trading message, variation of the number of financial products to be bought or sold or variation of any price or time related instructions), including the date and time of any amendment to the instruction or trading message;
(c)   the name of any other person who passed the instruction on between the person who initially gave the instruction or made the decision and a trading platform, and the date and time they passed it;
(d)   the name of the DTR who entered a trading message into a trading platform (or if the trading message was submitted by automated order processing, the information set out in MIR 5.5.3);
(e)   the time the DTR entered a trading message into a trading platform (or if the trading message was submitted by automated order processing, the time at which the trading message was initiated by the open interface device); and
(f)   if the trading message gives rise to a market transaction, the date and time that occurs.

Again, as the lead-in words to this MIR state, the requirements of this MIR operate in addition to the requirements of CR r7.8.19.

This MIR applies to a market participant who makes a decision or gives instructions to enter into a market transaction on its own account, whether or not the market transaction is executed (MIR 4.1.2(1)).

The maximum penalty prescribed for breaching MIR 4.1.2 is $100,000.

MIR 4.1.5 and 4.1.6(1) provide that a trading participant may rely on ASX's electronic trading records to meet its obligations under (a)(i) to (iv), (b), (d), (e) and (f) above, provided it meets the conditions set out in MIR 4.1.6(2).

MIR 4.1.8 provides that a market participant who instructs a trading participant to enter into a market transaction on its behalf does not have to comply with (c)-(f) above in respect of that instruction. Instead, they must maintain sufficiently detailed records in respect of the instruction showing: (i) the name of any person who passed the instruction on between the person who initially gave the instruction or made the decision and the trading participant instructed to enter into the market transaction; (ii) the name of the person who instructed the trading participant to enter into the market transaction; and (iii) the time the person instructed the trading participant to enter into the market transaction.

Timing and Retention Requirements
•     Records must be made "immediately" after the event to which they relate and record the time of the relevant event (MIR 4.1.3).
•     Records must be kept for 7 years from the date the record is made (MIR 4.1.4).

The maximum penalty prescribed  for breaching MIR 4.1.3 or 4.1.4 is $100,000.

ASX MIR 5.5.3 – Trading Management Arrangements
A trading participant must have arrangements in place so that at all times the trading participant can determine the origin of all orders and trading messages, including:
(a)   the different stages of processing each order (regardless of whether a trading message is generated) and the time at which each stage occurred;
(b)   the order that corresponds to a trading message;
(c)   the identity and capacity of the person placing the order that corresponds to the trading message;
(d)   whether the trading message was the result of automated order processing;
(e)   the open interface device and the computer or other device of the trading participant connected to an open interface device of the trading participant through which the trading message was submitted into the relevant trading platform;
(f)   the DTR with responsibility for that open interface device or computer or other device connected to the open interface device (unless the trading message was the result of automated order processing); and
(g)   whether the trading message was submitted on the trading participant's own account or for a client.

The maximum penalty prescribed for breaching MIR 5.5.3 is $1,000,000.

These records have to be maintained for 7 years (MIR 5.5.4). The maximum penalty prescribed for breaching MIR 5.5.4 is $100,000.

MIR 5.5.3 and its predecessors have often been interpreted as a rule prescribing IT system requirements (ie how orders being processed through the participant's internal trading systems can be matched against bids/offers being submitted into the ASX's trading platform and the resultant executions). However, I believe that the requirement in this rule for a trading participant "at all times" to be able to link a trading message back to an order has broader compliance ramifications.

For example, it seems to me to prevent a DTR from submitting a "fictitious" bid/offer into the ASX trading platform that the DTR does not intend to execute (eg a bid/offer away from market that the DTR intends to cancel if and when the market starts to move towards it). Even if the DTR has an order in the relevant product and discretion as to the price at which it is executed, you can't really say that the bid/offer in question "corresponds to" that order (in terms of the requirement in paragraph (b) above) when there was never any intention to execute the order at the price bid/offered.

Similarly, it is common practice for brokers to aggregate careful discretion and VWAP (volume weighted average price) orders received from clients prior to the open of trading, to execute them as a "bunched order" over the course of the trading day and then to assign an average price for the executions to the clients participating in the bunched order. That is seen to have the advantage of ensuring that all clients get the same price. MIR 5.5.3 requires a broker to be able to link each trading message back to an order at all times. So if a broker is going to bunch orders in this manner, to comply with this rule, it should use a VAR ('various') or similar code when it transmits the bunched orders for execution to the ASX to signify that the transmission relates to a number of clients, and have proper (upfront) records identifying which clients are participating in the bunched orders and in what proportions. If they don't, then it seems to me that the only proper manner to execute the orders is to do so initially on principal account and, when the resultant executions are allocated to the clients to satisfy their orders, to do so in compliance with the principal trading rules. Note that to help avoid disputes with clients over this type of trading, a broker really should include in its client agreements a provision entitling it to bunch orders and to assign average prices.

(3) ASX 24 Rules
ASX 24 MIR 2.2.4(1) – Client Order Records
A market participant, other than a principal trader, must maintain internal records of instructions received from clients and trades executed for clients for a period of not less than 5 years from the date of the trade, containing the following information:
(a)   the nature of the instructions received, including information about: the commodity, the name of the market, delivery month, buy or sell, number of lots and price/limit;
(b)   the client name/account number and client ID;
(c)   the person who gave the instructions;
(d)   the time and date of receipt of the instructions, and the person who received the instructions;
(e)   the time and date of transmission of the instructions, and the person who transmitted the instructions; and
(f)   the time and date of execution of the instructions, and the person who executed the instructions.

This MIR essentially repeats the requirements of CR r7.8.19 when it comes to client records.

The maximum penalty prescribed for breaching MIR 2.2.4(1) is $100,000.

ASX 24 MIR 2.2.4(2) – Proprietary Order Records
A market participant must maintain records of its representatives' trading for a house account for a period of not less than 5 years from the date of a trade, containing the following information:
(a)   the time and date of receipt of instructions;
(b)   the nature of the instructions received;
(c)   the person who received the instructions;
(d)   the time and date of transmission of the instructions, and the person who transmitted the instructions; and
(e)   the time and date of execution of the instructions, and the person who executed the instructions.

Again, this MIR essentially repeats the requirements of CR r7.8.19 when it comes to proprietary order records.

The maximum penalty prescribed for breaching MIR 2.2.4(2) is $100,000.

Return to Outline


Order Precedence and Allocation Rules

By way of introduction, the order precedence and allocation rules in the Corporations Act and the ASX and ASX 24 MIRs regulate (amongst other things) a financial services licensee competing with its clients for the same financial product. They are intended to ensure that licensees treat their clients fairly in these circumstances.

(1) Corporations Act
CA s991B(2) - Priority to be Given to Client Orders
If:
(i)   a person (the client) has instructed a financial services licensee to buy or sell financial products of a particular class that are able to be traded on a licensed market;
(ii)   the licensee has not complied with the instruction;
(iii)   the client is not an associate of the licensee; and
(iv)   regulations made for the purposes of this paragraph do not exclude those financial products from this section,
the financial services licensee must not, except as permitted by s991B(3) [see next slide]:
(a)   enter into a transaction of purchase or sale of financial products of that class either on their own behalf or on behalf of an associate of the licensee; or
(b)   instruct another person to enter into a transaction of purchase or sale of financial products of that class on behalf of the licensee or an associate of the licensee.

This slide has been paraphrased to combine ss991B(1) and (2). The word "associate" in (iii), (a) and (b) above takes its meaning from ss11, 13 and 15 of the Corporations Act. It includes directors and secretaries of a company, partners of a partnership, related bodies corporate, and certain trusts.

CA s991B(2) is complemented by CR r7.8.18(3), below, which basically says that if a licensee wants to deal in financial products on its own account and the person who is going to effect that dealing is aware of instructions of a client to deal in the same products at or near the market price, then they cannot transmit the instructions for the principal order until the client order has been transmitted.

CR r7.8.17(2) provides that s991B(2) does not apply to a transaction if, at the time that the instruction is issued, the financial services licensee is not a participant in the licensed market on which the particular financial product is being traded. This exclusion, however, does not apply if: (a) the financial services licensee deals, or has dealt, in a financial product traded on the market on its own behalf (whether directly or through an agent or other representative) or on behalf of a client; or (b) an associate of the financial services licensee is a participant in that market mentioned in that subregulation (r7.8.17(3)).

CA s991B(3) – Exception for Instructions Attaching Specified Conditions or Where Permitted by Regulations
S991B(2) does not apply in relation to the entering into of a transaction, or the giving of an instruction, by the licensee if:
(a)   the client's instructions required the purchase or sale to be effected only on specified conditions relating to price and the licensee has been unable to comply with the instructions because of those conditions; or
(b)   the transaction, or the giving of the instruction, is permitted by regulations made for the purposes of this paragraph.

 

CR r7.8.17(1) – Exception for Transactions Permitted Under the Rules of a Licensed Market

If a participant in a licensed market:

(a)   enters into a transaction; and
(b)  

complies with all of the participant’s obligations in relation to the transaction under the market integrity rules and the operating rules of the licensed market;

s991B(2) does not apply in relation to transaction.

As can be seen from the previous slide, CA s991B(3)(b) permits the regulations to exclude a transaction from the client order precedent rules in CAs991B(2). CR r7.8.17(1) essentially means that the client order precedence rules in s991B(2) do not operate where a transaction is conducted on a market in accordance with its market integrity rules and operating rules. As we shall see below, CR r7.8.18(3) – restricting the execution of principal orders where there is an extant client order at or near the market price – also does not apply if the market integrity rules or operating rules of the relevant licensed market otherwise provide (r7.8.18(1)).

Both the ASX and the ASX 24 markets have their own client order precedence rules that effectively displace the operation of s991B(2) in relation to those markets (see below).

CR r7.8.18 – Execution and Allocation
(1)   This regulation applies in relation to all instructions received by a financial services licensee to deal in financial products through licensed markets, except to the extent that the market integrity rules, or the operating rules of a licensed market in relation to which the financial services licensee is a participant, otherwise provide.
(2)   Subject to r7.8.18(3), the financial services licensee must transmit, in the sequence in which they are received, all instructions to deal in a class of financial products at or near the market price for financial products of that class prevailing immediately before execution of the instructions.
(3)   If:
  (a)   a financial services licensee proposes to deal in a class of financial products on the financial services licensee’s own account; and
  (b)   the person by whom or on whose instructions the instructions for the dealing are to be transmitted is aware of instructions of a client of the financial services licensee to deal in that class of financial products at or near the market price for a financial product of that class prevailing at that time (being instructions that have not been transmitted);
  that person must not transmit, and must not give instructions to any other person to transmit, the instructions to give effect to the proposal of the financial services licensee to deal in that class of financial products before the instructions of the client are transmitted.
(4)   If:
  (a)   during a particular period, a financial services licensee transmits instructions (whether or not those instructions consist of, or include, instructions giving effect to a proposal of the financial services licensee to deal in the class of financial products concerned on the financial services licensee’s own account) to deal in a class of financial products at or near the market price for a financial product of that class prevailing immediately before execution of the instructions; and
  (b)   dealings in that class of financial products are effected pursuant to those instructions;
  the financial services licensee must allocate the dealings to those instructions:
  (c)   in the sequence in which the dealings were effected; and
  (d)   in the sequence in which the financial services licensee transmitted the instructions.

CR r7.8.18 has been made pursuant to CA s991C, which (among other things) authorises the making of regulations imposing requirements relating to the order in which instructions are to be transmitted to a market and market dealings are to be allocated.

CR r7.8.18(6) defines a reference to the transmission by a financial services licensee of instructions to deal in a class of financial products as a reference: (a) if the financial services licensee has direct access to the licensed market on which the instructions are to be executed - to the transmission of the instructions to that licensed market; or (b) if the financial services licensee has access to the licensed market on which the instructions are to be executed only through another financial services licensee - to the transmission of the instructions to that other financial services licensee.

To the extent that paragraph (2) above requires "at market" orders to be transmitted in the sequence they are received, it basically codifies the common law position: see Constable v Meyer (1972) 3 DCR(NSW) 41. In that case, a client (M) telephoned his broker and asked the market price in T. He was told that there was a buyer at $1.30 but no seller. M asked the broker to buy him 2,000 shares in T at market ASAP. The order was handed to a floor operator along with an order from another client to buy 2000 shares. The floor operator bought 4,000 shares at prices from $1.65 to $2.00. He informed the broker of the purchases, who then advised M that his order had been filled but that the broker at that stage did not know at what price. M was told that the market had jumped to between $1.80 and $2.00, whereupon he asked the broker to buy him another 3,000 shares. The floor operator came back with a number of purchases at the end of the day for M and other clients. In accordance with firm practice, the operator allocated the original 4,000 purchase to M and the other client at an average price for the total purchase. The balance of purchases for the rest of the day were allocated to M and the remaining clients also at an average price for the total balance. M rejected the purchases as not being in accordance with his instructions and the broker then sued M for payment. The District Court of NSW held that where a stockbroker is instructed by a number of clients to buy shares at market price in a rapidly rising market, its duty to those clients is to execute their commissions as expeditiously as possible and strictly in the order in which they are received. The broker had failed to do that in this instance and so judgment was entered for the client.

Note the words in italics in r7.8.18(1) above. Both the ASX and ASX 24 Market Integrity Rules contain provisions dealing with client order precedence and so rr7.8.18(2)-(4) will not apply to dealings on the ASX and ASX 24 markets. That is quite fortunate as there are real problems with the drafting of rr7.8.18(2)-(4) (these problems are discussed in further detail under the heading '3C(ii) The inappropriate extension of former futures laws to OTC derivatives and other financial products - Order precedence requirements' in Lewis, "A Decade On - Reforming the Financial Services Law Reforms".

One of the main problems stems from the fact that the phrase "near the market price" is not defined in the CA or CR, nor is it a term commonly used or understood in the market. Its meaning is altogether vague. How far away from the current market price must an order price be to not be "near the market price"?

For example, suppose the current market asking price is at $1.01 and the client wants to buy at 99¢. If this is considered to be "near the market price", r7.8.18(3) would require the client buy order to be transmitted to the market at 99¢ before any house order. But that would not stop the house then transmitting a buy order at $1.00 and taking price priority over the client. On that scenario, the regulation would seem to have achieved little.

On possible way of interpreting the phrase "at or near the market price" has regard to the manner in which markets normally operate and reflects the fact that, at any point in time, there is usually a bid-ask spread in the market (ie there is no single "market price" as such). On this view, a buy order could be considered to be "near the market price" if it is equal to or more than the current bid price but less than or equal to the current ask price and a sell order could be considered to be "near the market price" if it is less than or equal to the current ask price but equal to or more than the current bid price. To illustrate, suppose the market price for a financial product is bid 99¢ /ask $1.01. An "at market" buy order would be processed at $1.01 (the current asking price). Conversely, an "at market" sell order would be processed at 99¢ (the current bid price). On this view, any buy order from and including 99¢ up to and including $1.01, and any sell order from and including $1.01 down to and including 99¢, should be consider "near the market price" since that represents the potential range of executable market transactions at that point in time.

That said, the clearly safer course for any licensee to follow who receives an order to buy or sell a financial product at a particular price (as distinct from a "careful discretion" or "best price" style order) is to transmit the order to the market as soon as it is received, regardless of how close it is to the current market price. That way, if the market price moves rapidly in favour of the order, the licensee won't face any issues with the timing of the transmission of the order.

There is also a provision in CR r7.8.18(5) requiring a licensee to keep client instructions confidential. We look at that provision in lecture 9.

(2) ASX Rules
ASX MIR 5.1.3 - Client Order Precedence
A market participant must deal fairly and in due turn with:
(a)  clients’ orders; and
(b)  a client order and an order on its own account.

As mentioned above, this MIR effectively displaces the operation of s991B(2) and CR r7.8.18 on the ASX market by reason of the operation of s991B(3)(b) and rr7.8.17(1) and 7.8.18(1), mentioned previously.

The maximum penalty prescribed for breaching this MIR is $1,000,000.

ASX MIR 5.1.1 – Meaning of "Orders on its Own Account"
Subject to MIR 5.1.2, a reference to a market participant having an order for [sic on] its own account means:
(a)   in relation to cash market transactions, that the cash market products to be bought or sold are (in the case of a sale) or will be on the completion of the transaction (in the case of a purchase) beneficially owned by the market participant or a prescribed person, where the cash market products beneficially owned by a market participant or prescribed person include cash market products which would appear as assets on the balance sheet or consolidated balance sheet of that market participant or prescribed person; and
(b)   in relation to derivatives market transactions, having an order to enter into a derivatives market transaction on its own behalf or for the benefit of a prescribed person.

Under MIR 5.1.2, the following are not regarded as orders on a market participant's own account: (a) an order placed by a life insurance company registered under the Life Insurance Act (or equivalent State legislation) on behalf of a statutory fund; or (b) an order placed by a controller or a related body corporate of the market participant or of a controller on behalf of clients of, or funds managed by, them or their related bodies corporate.

ASX MIR 1.4.3 – Meaning of "Prescribed Person"
Prescribed Person in relation to a market participant =
(a)   an employee, director, partner, or responsible executive of the market participant;
(b)   a controller of the market participant or a related body corporate of that controller;
(c)   the immediate family of a person referred to in (a) or (b);
(d)   a family company or family trust of a person referred to in (a) to (c);
(e)   where a market participant or a person referred to in (a) to (d) is a body corporate, any body corporate or other entity controlled by that body corporate.

Compare this definition with the definition of "connected person" used in ASX MIR 5.4 for the purposes of requiring the participant to monitor and approve certain trades on behalf of employees and employee controlled entities (see below).

The ASX Market Integrity Rules define "employee" of a market participant to include "a director, employee, officer, agent, representative, consultant or adviser of that market participant, or an independent contractor who acts for or by arrangement with a participant" (ASX MIR 1.4.3). It seems clear that the words "who acts for or by arrangement with a participant" only apply to independent contractors. Accordingly, it would seem that the inclusive reference to "employee" in this definition means a person who legally stands in an employer/employee relationship with the participant. Many brokers are part of a larger corporate group and the persons who work in their business are often employed by another entity in the group. Technically, therefore, these persons are not employees of the participant in the normal legal sense. However, they are probably caught by the expanded definition of "employee" on the basis that they are agents or representatives of the participant.

Note that the expressions "responsible executive", "controller", "immediate family", "family company" and "family trust" also have defined meanings under the ASX Market Integrity Rules (see MIR 1.4.3).

Given its obligations under MIR 5.1.3, a participant needs to be able to identify orders that come from a prescribed person (especially employees and their immediate family and family companies and family trusts) and label them as such in its order management system. This essentially requires it to have an employee trading policy that extends to the immediate family and family companies and family trusts of employees and that requires these accounts to be disclosed to the employer.

ASX MIR 5.1.4(1) - Relevant Factors
In considering whether MIR 5.1.3 has been complied with, the following factors are relevant:
(a)   the market participant acts in accordance with its instructions;
(b)   orders that do not involve the exercise of discretion by the market participant in relation to the time or price or quantity of the order are entered in the relevant trading platform in the sequence in which they are received, and otherwise as expeditiously as practicable;
(c)   orders of a client (which is not a prescribed person) that involve the exercise of discretion by the market participant in relation to the time or price or quantity of the order are given preference, within the meaning of MIR 5.1.4(2), over orders on the market participant’s own account, unless the client otherwise consents [this consent may take the form of a disclosed allocation policy to which the client consents];
(d)   if the sequence of entry of orders into a trading platform is not clearly established by the time the orders were received, and one of the orders is for the market participant’s own account, the market participant gives preference to the order of a client over any order for the market participant’s own account;
(e)   if the market participant has acted in accordance with its procedures to ensure that a person initiating, transmitting or executing a dealing who is aware of instructions of a client (which is not a prescribed person) to deal in the relevant products that has not been entered in a trading platform does not use that information to the disadvantage of that client;
(f)   the market participant buys or sells for a wholesale client;
(g)   allocation of market transactions occurs in accordance with MIR 5.1.5;
(h)   a market participant’s orders on its own account are not knowingly interposed between orders of its clients that would otherwise have crossed.

MIR 5.1.4(2) provides that for the purposes of (c) above, a reference to a market participant giving preference to an order of a client over an order on the market participant’s own account, means that from the time of receipt of the order until it is fully executed, the market participant does not enter into, on its own account, a market transaction for the same products on the same terms unless: (a) the products are allocated to the client in accordance with MIR 5.1.6(c); or (b) the products are allocated to the client [sic - the words "to the client" presumably should not appear here or else the provision makes no sense] pursuant to an allocation policy previously disclosed to the client, to which the client consents, under which the market participant may buy or sell (and be allocated) the same products on its own account.

This effectively means that a broker can’t execute house or employee orders while it has an extant client order unless it does so pursuant to an allocation policy previously disclosed to the client, to which the client has consented. That could be a real problem if the broker were trying to cover a balance sheet exposure. It is therefore critical that brokers who trade on their own account have an allocation policy which acknowledges that they can execute principal orders at the same time as client orders and that they get client consent to that policy. Clearly, the best way to do that is for brokers to build the required consent into their client agreements. However, some institutional clients are reluctant to sign formal client agreements and so it would be wise to have a separate short-form consent for them to sign in lieu.

MIR 5.1.4(3) provides that for the purposes of MIR 5.1.4(2), a limit order which cannot be executed owing to price differences is not on the same terms.

Under MIR 5.1.4(4), a market participant must keep a record of any consent given by a client for the purposes of (c) above.

One point to note. Remember that "own account" in (c) and (d) above includes trades for “prescribed persons”, as defined above, which includes employees. The effect of (c) and (d) therefore is that a broker may have to postpone an employee trade to a client trade. Brokers should include a proviso to that effect in their employee trading policy.

ASX MIR 5.1.5 - Allocations
A market participant must allocate market transactions fairly.

MIR 5.1.5 is the flip side of MIR 5.1.3 above. MIR 5.1.3 deals with how you execute orders. MIR 5.1.5 deals with how you allocate transactions that you have entered into via bunched orders (eg for multiple clients or for mixed client and house) or through the house account (eg as a mix of client facilitation and house trades).

The maximum penalty prescribed for breaching MIR 5.1.5 is $1,000,000.

ASX MIR 5.1.6 - Relevant Factors
In considering whether MIR 5.1.5 has been complied with, the following factors are relevant:
(a)   allocation of market transactions is immediate and automatic, unless circumstances or instructions justify later or manual allocation;
(b)   market transactions executed pursuant to instructions (whether an order of a client or an order on its own account) are allocated in the sequence in which the market participant received those instructions, entered those instructions or the market transactions were effected;
(c)   the client’s instructions;
(d)   allocation of a market transaction occurs in accordance with the disclosed allocation policy of the market participant; and
(e)   except as provided in these Rules, a market participant does not allocate market transactions to fulfil all or part of an order for its own account when it has an unfulfilled order on the same terms for those market transactions from a client.

Again, remember that "own account" in (e) above includes trades for “prescribed persons”, as defined above, which includes employees. In light of (e), brokers should therefore include a proviso in their employee trading policy to the effect that an employee trade may have to be postponed to a client trade.

ASX MIR 5.1.8 – Disclosure of Allocation Policy
A market participant must when requested to do so by a client, disclose to the client … the policy it adopts in the allocation of market transactions to fill orders placed with it … The market participant must keep a record of disclosure made under this Rule.

The maximum penalty prescribed for breaching MIR 5.1.8 is $20,000.

ASX Market Rules Guidance Note 11
"[MIR 5.1.3 and 5.1.4] provide more flexibility to Trading Participants in relation to trading of principal orders and orders on behalf of a Prescribed Person, provided that the over-riding obligation of the Trading Participant to act in the best interests of its client is adhered to. In particular the Trading Participant must not give unfair preference to itself, to any Prescribed Person or to any client, over another client."
"[MIR 5.1.5 and 5.1.6] recognise that a 'first in, first served' allocation policy, particularly between clients, may not always be the fairest way to deal with competition between clients for priority to trade, (for example where the Trading Participant has received buy or sell orders in the same thinly traded Security from a number of institutional clients over a short period of time). The Rule allows the Trading Participant more flexibility, provided the Trading Participant has disclosed to its clients its allocation policy in a clear and meaningful way, prior to trading."

In other words, unless you want to deal on a first-come first-served basis and defer house orders to client orders, it is critical that you have an allocation policy and that you get client consent to that policy. The best way to do that is to build the required consent into your broker client agreement. Note that some institutional investors sometimes refuse to sign client  - for those, you will need a separate short-form consent to your allocation policy for them to sign.

Click here for a copy of ASX Market Rules Guidance Note 11 Client Order Priority.

ASIC has said that it will seek to follow the published interpretations contained in pre-existing ASX Market Rules guidance notes, including Guidance Note 11, but will look to review them and issue replacement ASIC Guidance Notes in due course (see ASIC Regulatory Guide 214 Guidance on ASIC market integrity rules for ASX and ASX 24 markets, at para 57-58).

ASX MIR 5.1.7 – Participant not to Trade in Options as Principal While Holding an Unexecuted Order in Underlying Financial Products
If a trading participant has or receives an order to buy or sell an underlying financial product in the underlying market which may materially affect:
(a)   the market price of the underlying financial product in the underlying market; or
(b)   the level of an underlying index, the level of which is calculated by reference to the value of that underlying financial product and other products,
the trading participant must not make bids or offers to enter into an options market transaction over that underlying financial product as principal until the order in the underlying financial product has been executed in the underlying market.

The maximum penalty prescribed for breaching MIR 5.1.7 is $1,000,000.

(3) ASX 24 Rules
ASX 24 MIR 3.1 – Sequence of Execution of Orders
•    

A market participant must transmit orders to the trading platform as soon as they are received (MIR 3.1.4).

•    

A market participant must:

  •     transmit orders in the sequence in which they are received;
  •     not leave an order in the trading platform and then promote another client order to take the place of a cancelled client order;
  •     not promote an order to take the place of a cancelled client order;
  •     reduce the volume of an aggregated order by the amount remaining of a cancelled order where a client cancels an order which was part of the aggregated order; and
  •     not engage in broking or offering of a favourable queue position (MIR 3.1.5).
•    

A market participant must not aggregate orders for entry into the trading platform, unless permitted under MIR 3.1.6(2) (MIR 3.1.6).

•     A market participant must give priority to the client's instructions where there is a conflict between the client's interests and the market participant's interests (MIR 3.1.13(1A)).
•     A market participant must allocate trades to clients in the sequence in which the orders are received, unless permitted under MIR 3.1.16(3) (MIR 3.1.16).
•     A market participant must not offer and/or allocate trades to a client unless those trades have been obtained pursuant to instructions previously obtained from that client (MIR 3.1.17).

As mentioned above, these MIRs effectively displace the operation of s991B(2) and CR r7.8.18 on the ASX 24 market by reason of the operation of s991B(3)(b) and rr7.8.17(1) and 7.8.18(1).

The maximum penalty prescribed for breaching MIR 3.1.4, 3.1.13 and 3.1.16 is $100,000. The maximum penalty prescribed for breaching MIR 3.1.5, 3.1.6 and 3.1.17 is $1,000,000.

MIR 3.1.4 does not apply to pre-negotiated business under MIR 3.3.1 or block trades under MIR 3.4.1. It also does not apply to (a) orders that cannot be transmitted to the trading platform such as "market on close", "stop loss" or "market if touched"; (b) "at best" orders, provided these orders are transmitted to the trading platform at such time as the market participant forms the view that the best price may be achieved; and (c) orders where client instructions preclude immediate transmission unless those instructions would cause the market participant to breach the MIR (MIR 3.1.4(3)).

Under MIR 3.1.5(2), orders may be transmitted and executed outside of the sequence in which they are received where they are aggregated under MIR 3.1.6.

MIR 3.1.6(2) provides that the only types of orders which, when received, may be aggregated for placement into the trading platform, are: (a) all futures or options orders received when the market is neither open, nor in the pre-opening phase; (b) spread or custom market orders received during the pre-opening phase of the market; (c) all futures or options orders received and recorded at exactly the same time; (d) orders that, by definition, cannot be entered upon receipt, for example "market on open" or "market on close"; and (e) orders negotiated under Part 3.3 of the MIR (pre-negotiated business).

For the purposes of MIR 3.1.13, 3.1.16 and 3.1.17, the clients of a participant which is a corporation include a related body corporate or a division of the participant which is separate from its futures division.

MIR 3.1.16(3) permits a market participant to allocate out of sequence where: (a) orders are aggregated under MIR 3.1.6; (b) the market participant uses either of the volume weighted average method or the percentage method to allocate the trades on a pro rata basis; (c) the market participant has advised, in writing, each client whose orders may be allocated out of sequence of their method of allocation; and (d) the market participant has retained a record of the advice sent to the client while the client remains a client of the market participant and for a period of 5 years after that client ceases to be a client of the market participant.

Under MIR 3.1.16(4), a market participant must notify ASIC in writing prior to adopting or changing its policy of allocating orders on one of the pro rata methods set out in MIR 3.1.16(3)(b).

Return to Outline


Dealing with Clients as Principal

By way of introduction, the rules in the Corporations Act and the ASX and ASX 24 MIRs on dealing with clients as principal regulate (amongst other things) a financial services licensee buying financial products from, or selling financial products to, or entering into the other side of a derivatives transaction with, its clients. They are intended to ensure that licensees treat their clients fairly in these circumstances. For a good example of the potential conflicts in this scenario, see the US$150 million penalty imposed by the New York Department of Financial Services against Barclays Bank for using a foreign exchange trading system that had an inbuilt delay and filters to automatically reject client orders that would be unprofitable for the bank because of subsequent price swings during milliseconds-long latency periods (see the NYDFS's announcement dated 18 November 2015).

(1) Corporations Act
CA s991E(1) – Obligation to Disclose or Obtain Consent
A financial services licensee must not, either personally or through an authorised representative, enter into a financial product transaction on their own behalf:
(a)   that relates to a financial product that is able to be traded on a licensed market; and
(b)   that is with a person (the non-licensee) who is not a financial services licensee or an authorised representative;
if:
(c)   the licensee has not (in accordance with applicable regulations) disclosed to the non-licensee the fact that the licensee will be acting on their own behalf in the proposed dealing; or
(d)   the non-licensee has not (in accordance with applicable regulations) consented to the licensee so acting in the proposed dealing.

The requirements that must be satisfied to make a disclosure in accordance with s991E(1)(c), or to give a consent in accordance with s991E(1)(d), are set out in CR r7.8.20(2) (see the next slide).

Note this section does not apply to products that are traded "over the counter" rather than on a licensed market (by virtue of the words in (a) above). It also does not apply to sales or purchases of securities or interests in registered managed investment schemes by issuers under the fund raising provisions in Chapter 6D or Part 7.9 (CR r7.8.20(1)).

Note also that this section only applies if the other party to the trade is a non-licensee. Trades that occur on market technically take place between the two brokers executing the trade as principals, even where those brokers are acting for a client. Most brokers will hold a financial service licence (unless they are proprietary traders who deal solely on their own account and do not make a market and therefore have no requirement to hold an AFSL) and so this section will not generally apply to trades done on-market in the ordinary course. Most institutional clients will also be financial services licensees. So this rule will generally only apply in practice to a broker who crosses on-market as principal on one side for a non-institutional client on the other side, or who trades off-market as principal with a non-institutional client.

The breadth of the expression "able to be traded" in (a) above has been narrowed by CR rr7.8.20(1A) and (1B). Prior to the introduction of those regulations, there was a concern that a licensee might not know whether a particular financial product is able to be traded on a financial market on which the licensee was not a participant or did not have access through a third party. CR r7.8.20(1A) provides that subject to r7.8.20(1B), s991E(1) does not apply to a transaction if, at the time of the transaction, the financial services licensee is not a participant in the licensed market on which the particular financial product is being traded. CR r7.8.20(1B) provides that r7.8.20(1A) does not apply if: (a) the financial services licensee deals, or has dealt, in a financial product traded on that market on the licensee's own behalf (whether directly or through an agent or other representative) or on behalf of a client; or (b) an associate of the financial services licensee is a participant in the market mentioned in r7.8.20(1A).

CR r7.8.20(2) - Form of Disclosure/Consent
•     A disclosure referred to in s991E(1)(c) must be given to the non-licensee:
  •     in writing; and
  •     if the transaction is an on-market transaction - in relation to the particular transaction, a class of on-market transactions which includes the transaction, or all on-market transactions.
•     A consent referred to in s991E(1)(d):
  •     may be given orally, or in writing, by the non-licensee; and
  •     is effective until it is revoked, either orally or in writing, by the non-licensee.
•     If the non-licensee gives an oral s991E(1)(d) consent to the financial services licensee, or revokes a s991E(1)(d) consent orally, the financial services licensee must:
  •     make a written record of the consent or revocation; and
  •     provide a copy of the written record to the non-licensee within 10 business days after the day on which the consent is given or revoked.

It is a good idea for a broker to include a written s991E(1)(c) disclosure and s991E(1)(d) consent in its client agreements and to have a separate short form disclosure and consent to be signed by those institutional clients who may not wish to sign a client agreement.

CA s991E(3) – Restriction on Right to Charge Brokerage, Commission or Other Fees
If a financial services licensee, either personally or through an authorised representative, enters into a transaction of sale or purchase of financial products on their own behalf:
(a)   that relates to a financial product that is able to be traded on a licensed market; and
(b)   that is with a person (the non-licensee) who is not a financial services licensee or an authorised representative;
the licensee must only charge the non-licensee a brokerage, commission or other fee in respect of the transaction if the charge is permitted by the regulations.

The assumption underlying this restriction is that if you are selling a market-traded financial product to a client, or buying a market-traded financial product from a client, as principal you are likely to be making a margin on the transaction and it is unfair for you to charge commission as well. Note that the restriction only relates to a transaction of "sale or purchase" of market-traded financial products. The better view would seem to be that it does not capture entering into the other side of a derivatives transaction on-market as principal with a client. While it is common to refer to this as having entered into a "sold position" or a "bought position", they are not really transactions of "sale or purchase" in the normal sense.

CR r7.8.20(3) – When Brokerage, Commission or Other Fees are Permitted
For s991E(3), a brokerage, commission or other fee is permitted in respect of a transaction between a financial services licensee and a non-licensee only if:
(a)   the financial services licensee is a participant in a licensed market;
(b)   the financial services licensee has complied with all of the financial services licensee’s obligations in relation to the transaction under the market integrity rules and the operating rules of the relevant licensed market;
(c)   the market integrity rules or the operating rules permit a brokerage, commission or fee to be charged to non-licensees of the same kind as the non-licensee;
(d)   the non-licensee has authorised the financial services licensee to charge the non-licensee in respect of the transaction;
(e)   the financial services licensee discloses to the non-licensee the amount of the brokerage, commission or fee, or the basis on which it will be calculated, before the non-licensee gives the authorisation mentioned in paragraph (d); and
(f)   the amount of the brokerage, commission or fee is reasonable having regard to the amount that would have been charged by the financial services licensee to the non-licensee if the financial services licensee had entered the transaction with the non-licensee as agent and not on its own behalf.

In relation to (c) above, the ASX MIRs have provisions regulating how and when a market participant can charge a brokerage, commission or fee when it deals as principal with a client (see below). The ASX 24 MIRs do not. This arguably reinforces the interpretation in the notes to the  previous slide that s991E(3) does not apply to entering into the other side of a derivatives transaction on-market as principal with a client on the ASX 24 market.

CR r7.8.20(4) (see next slide) specifies the form of authorisation that is required to meet (d) above and the disclosure that must be given to meet (e) above.

CR r7.8.20(4) – Form of Authorisation and Disclosure Required to Charge Brokerage, Commission or Other Fees
•     A r7.8.20(3)(d) authorisation given to the financial services licensee by the non-licensee:
  •     may be given orally, or in writing, by the non-licensee; and
  •     is effective until it is revoked, either orally or in writing, by the non-licensee.
•     If the non-licensee gives an oral r7.8.20(3)(d) authorisation to the financial services licensee, or revokes a r7.8.20(3)(d) authorisation orally, the financial services licensee must:
  •     make a written record of the authorisation or revocation; and
  •     provide a copy of the written record to the non-licensee within 10 business days after the day on which the authorisation is given or revoked.
•     A disclosure under r7.8.20(3)(e) of the amount of the brokerage, commission or fee, or the basis on which it will be calculated, must be given by the financial services licensee to the non-licensee:
  •     in writing: and
  •     if the transaction is an on-market transaction - in relation to the particular transaction, a class of on-market transactions that includes the transaction, or all on-market transactions.

Again, it is a good idea for a broker to include a r7.8.20(3)(d) authorisation and r7.8.20(3)(e) disclosure in its client agreements and to have a separate short form authorisation and disclosure to be signed by those institutional clients who may not wish to sign a client agreement.

Consequences of Breach
•     Criminal offence, punishable by 25 penalty units and/or imprisonment for 6 months for individuals (s1311 and schedule 3) and 125 penalty units for corporations (s1312)
•     Other party to trade may rescind contract within 14 days of the date of the contract (ss991E(4) and (5))
•     Injunctions (s1324)
•     Compensation orders (s1325)
•     Cancellation or suspension of licence (ss915C(1)(a) and 912A(1)(c)) or banning order (s920A(1)(e)) for breach of a financial services law

CA s991E(4) provides that if s991E(1) or (3) is contravened in relation to a transaction (whether or not anyone is convicted of an offence in respect of the contravention), the non‑licensee may, subject to s991E(5), rescind the contract effecting the transaction, unless the contract was for the purchase of financial products by the non‑licensee and the non‑licensee has disposed of those products.

CA s991E(5) provides that the right under s991E(4) to rescind the contract can only be exercised during the period of 14 days starting on the day on which the contract was entered into or any later day specified in the regulations and must be exercised by notice in writing to the licensee.

(2) ASX Rules
ASX MIR 3.2.2 – Disclosure and Consent
Before entering into a market transaction as principal with a client, the market participant must disclose, or have previously disclosed, in accordance with CA s991E(1)(c), that it is acting, or may act, as principal and have obtained the consent of the client, in accordance with CA s991E(1)(d).

These rules apply where a market participant enters into a market transaction with a client as principal, except where the client is a market participant or a participant or member of a recognised stock exchange (MIR 3.2.1).

The maximum penalty prescribed for breaching MIR 3.2.2 is $100,000.

For a sample clause that addresses the requirements of this Market Integrity Rule, see the notes on Jones v Canavan in lecture 9.

ASX MIR 3.2.5 – Extended Meaning of Dealing as Principal
Except where a market participant is dealing as a trustee of a trust in which the market participant has no direct or indirect beneficial interest, a reference to a market participant dealing or entering into a market transaction as principal, includes a reference to a market participant entering into a market transaction on its own behalf or on behalf of any of the following persons:
(a)   a partner of the market participant;
(b)   a director, company secretary or substantial holder of the market participant;
(c)   the immediate family, family company or family trust of a partner, director, company secretary or substantial holder of the market participant;
(d)   a body corporate in which the interests of one or more of the partners singly or together constitute a controlling interest;
(e)   any related body corporate of the market participant, except where that related body corporate is dealing as a trustee of a trust in which it, or the market participant, has no direct or indirect beneficial interest.

Note that the expressions "substantial holder", "immediate family", "family company" and "family trust" have defined meanings under the ASX Market Integrity Rules (see MIR 1.4.3).

A reference to dealing on behalf of a substantial holder means that the relevant product is, or will be on the execution of the transaction, beneficially owned by the substantial holder (MIR 3.2.5(2)). This includes products that appear, or would appear, as assets on the balance sheet or consolidated balance sheet of that substantial holder's assets and liabilities (other than a life insurance company registered under the Life Insurance Act or the equivalent Act of a State where the products are held for or on behalf of that life insurance company's statutory funds) (MIR 3.2.5(3)).

Note also that MIR 3.2.6 requires market participants to keep a register of the persons referred to in paragraphs (a)-(e) of MIR 3.2.5, with a maximum penalty for breach of $100,000. The purpose of this presumably is to have a register that DTRs can look at before executing an order to see whether or not it is a principal order. This is pretty unrealistic in the context of the large multi-national corporate groups nowadays (the list of related bodies corporate caught under (e) alone will often run into the thousands and will change on a regular basis).

ASX MIR 3.2.3 - Confirmation Must Include Disclosure
When a market participant enters into a market transaction with a client as principal, the confirmation issued by the market participant under MIR 3.4.1 in respect of a market transaction must state that the market participant entered into the transaction as principal and not as agent.

The maximum penalty prescribed for breaching MIR 3.2.3 is $100,000.

In 2016, CommSec was penalised $700,000 by the Markets Disciplinary Panel and voluntarily refunded $1.1 million in brokerage to more than 25,000 clients, in part for breaching MIR 3.2.3. Between 16 May 2011 to 13 February 2014, CommSec issued 50,484 confirmations to retail clients in relation to which CommSec had entered into transactions as principal but which did not contain the required statement that CommSec entered into the transactions as principal and not as agent. See ASIC Media Release 16-289MR.

ASX MIR 3.2.4 - Brokerage and Commission
When a market participant enters into a market transaction as principal with a client, the market participant must not charge the client brokerage, commission or any other fee in respect of the market transaction, except in the following circumstances:
(a)   where the client is a prescribed person of the market participant;
(b)   where the client is a wholesale client who has consented to the market participant charging brokerage, commission or the other fee (and that consent has not been withdrawn); or
(c)   where otherwise permitted by the CA.

The maximum penalty prescribed for breaching MIR 3.2.4 is $100,000.

"Prescribed person" is defined in MIR 1.4.3 (see above), which expands the notion of when an order is placed on the participant's "own account" and therefore attracts the client order precedence rules. It includes (amongst others) employees, directors and partners of the participant and related bodies corporate of the participant, dealings on behalf of whom are treated as dealing as principal under MIR 3.2.5. Notably, it does not include substantial holders of the participant, even though a transaction done on behalf of a substantial holder is treated as a transaction on the participant's own account under MIR 3.2.5.

In relation to (b) above, the market participant must keep a written record of the consent given by the wholesale client and send a copy of the record to the client as soon as practicable (MIR 3.2.4(2)).

Again, for a sample clause that addresses the requirements of this Market Integrity Rule, see the notes on Jones v Canavan in lecture 9.

ASX MIR 5.1.8 – Disclosure re Potential Crossings with Principal Orders
A market participant must when requested to do so by a client, disclose to the client … in relation to crossings under the Market Operating Rules … if the market participant deals as principal, that the client’s orders may match opposite orders in a trading platform on behalf of the same market participant as principal. The market participant must keep a record of disclosure made under this Rule.

This disclosure technically is only required where a client specifically requests it, which seems rather silly. Most brokers would (and those that don’t should) include this disclosure as a matter of course in their client agreements.

Again, for a sample clause that addresses the requirements of this Market Rule, see the notes on Jones v Canavan in lecture 9.

(3) ASX 24 Rules
There are no ASX 24 Market Integrity or Operating Rules governing dealings with clients as principal. This matter is regulated by CA s991E(1) and therefore requires disclosure or consent.

Unlike the ASX market, there are no ASX 24 Market Integrity or Operating Rules specifically permitting a trading participant to charge brokerage, commission or other fees where it takes the other side of a trade to a client. It is common practice for ASX 24 trading participants to do this. That raises an issue as to how this can be reconciled with s991E(3) and r7.8.20(3) above. As mentioned above, the better view is that taking the other side of a futures contract or option is not "a transaction of sale or purchase of financial products" and there s991E(3) does not apply.

Return to Outline


Dealings for or with Employees

(1) Corporations Act
CA s991F – Dealings Involving Employees
(1)   A financial services licensee and an employee of the licensee must not, on their own behalves, jointly acquire a financial product.
(2)   A financial services licensee must not give credit to an employee of the licensee, or to a person who they know is an associate of an employee of the licensee, if:
  (a)   the credit is given for the purpose of enabling the person to whom the credit is given to acquire a financial product; or
  (b)   the licensee knows or has reason to believe that the credit will be used for the purpose of acquiring a financial product.
(3)   A person:
  (a)   who is an employee of a financial services licensee that is a participant in a licensed market; and
  (b)   who is so employed in connection with a business of dealing in financial products;
  must only, on their own behalf, acquire or agree to acquire a financial product of a kind that is able to be traded on that market if the licensee acts as the agent of the person in respect of the acquisition.

In the case of a body corporate, "employee" includes officer (s991F(4)).

In relation to s991F(1), CR r7.8.20A provides that a financial services licensee and one or more employees of the financial services licensee may, on their own behalves, jointly acquire a financial product if it is a risk insurance product as defined in CA s761A. Presumably this is intended to relate primarily to directors and officers (D&O) insurance and to allow licensees to acquire these types of insurance policies jointly for themselves and their directors and employees.

CR rr7.8.21(5) and (6) qualify the operation of s991F(3). CR rr7.8.21(5) provides that subject to r7.8.21(6), s991F(3) does not apply unless: (a) the particular financial product that is acquired or proposed to be acquired is a financial product traded on a market in which the financial services licensee is not a participant at the time of the acquisition or the proposed acquisition; or (b) the particular financial product is a derivative the value of which is derived from a financial product mentioned in (a). In turn, r7.8.21(6) provides that r7.8.21(5) does not apply if: (a) the financial services licensee deals, or has dealt, in a financial product traded on that market either on the licensee’s own behalf (whether directly or through an agent or other representative) or on behalf of a client; or (b) an associate of the financial services licensee is a participant in the market mentioned in r7.8.21(5).

CR r7.8.21(1) - Financing Exception for Banks and Employee Share Plans
S991F(2) … does not have effect in relation to:
(a)   a bank; or
(b)   a body corporate that gives credit in good faith to a person (not being a director of the body corporate) employed by the body corporate, or by another body corporate that is related to the first body corporate, to enable the person to acquire financial products that are:
  (i)   fully paid shares in the body corporate; and
  (ii)  to be held in beneficial ownership by the person.

Note that the exemption in (b) above only applies to the acquisition of fully paid shares. It does not apply to the acquisition of partly paid shares or interests in managed investment schemes.

CR r7.8.21(1A) also provides that s991F(2) does not have effect in relation to a financial services licensee that gives credit in good faith to a person employed by the financial services licensee or a person related to the financial services licensee to enable the person to acquire an insurance product in relation to a credit facility provided by the financial services licensee to the person (eg mortgage insurance or consumer credit insurance provided in relation to a credit facility).

CR r7.8.21(2) - Dealing Exception for Group Employees
For s991F(3), a body corporate that is related to a financial services licensee may act as the agent of an employee of the financial services licensee, in respect of the acquisition mentioned in that section, only if:
(a)   before the acquisition, the employee has informed the related body corporate that the employee is acquiring, or agreeing to acquire, the financial product on the employee’s own behalf; and
(b)   the financial services licensee has in place arrangements with the related body corporate to allow the licensee to be informed of, and to gain access to records relating to, the acquisition.

This regulation acts as an exception to the general rule in s991F(3) that an employee of a licensed market participant must only acquire products traded on that market through their employer. It allows an employee to trade through a related body corporate of the licensee provided the conditions in (a) and (b) are met.

Many brokers form part of a larger corporate group and the persons who work in their business are often employed by another entity in the group, such as the parent company or a service company. Technically those employees would not be caught by s991F(3) as they are not employees of the broker. Hence, it is not really clear what r7.8.21(2) is directed to, unless it relates to those groups that have more than one broker within the group (eg one that acts for institutional clients and another that acts for retail clients).

CR r7.8.21(3) - Dealing Exception for Employees of Other Licensees
For s991F(3), a body corporate may act as the agent of a person who is an employee of a financial services licensee that is a participant in a licensed market and is so employed in connection with a business of dealing in financial products, in respect of an acquisition mentioned in that section, if:
(a)   the body corporate holds an Australian financial services licence;
(b)   the body corporate is a participant in the same licensed market as the licensee;
(c)   the employer has given consent in writing to the particular acquisition before the acquisition takes place; and
(d)   the employee gives the employer a copy of the confirmation of the transaction.

This regulation also acts as an exception to the general rule in s991F(3) that an employee of a licensed market participant must only acquire products traded on that market through their employer. It allows an employee to trade through an unrelated market participant provided the conditions in (a)-(d) are met.

CR r7.8.21(4) - Dealing Exception for Employees not Directly Connected with Dealing Business
For s991F(3), a person who is:
(a)   an employee of a financial services licensee that is a participant in a licensed market; and
(b)   employed in connection with a business of dealing in financial products;
may, on the person’s own behalf, acquire, or agree to acquire, a financial product that is able to be traded on that licensed market, without the licensee’s acting as an agent in respect of the transaction, if the person’s employment is not directly connected with the licensee’s business of dealing in financial products on that licensed market.

CR r7.8.21(4) effectively excludes from the prohibition in s991F(3) an employee of a financial services licensee whose employment is not directly connected with the licensee’s business of dealing in financial products on the relevant licensed market. It clarifies the intended operation of s991F(3)(b) and confines it to employees who are employed in connection with the licensee's business of dealing in those financial products that are actually traded on the relevant licensed market.

The Explanatory Statement for the regulations adopting this provision (the Corporations Amendment Regulations 2003 (No 8) SR 282/2003) stated: "Persons whose employment is directly connected with a licensee's business of dealing in financial products on a licensed market would include persons employed as dealers/traders on the market, employees in the 'back office' (eg. settling and recording trades) and employees with management responsibility for the licensee's activities on that licensed market. The requirements of subsection 991F(3) will continue to apply to such employees."

Consequences of Breach
•     Criminal offence, punishable by 25 penalty units and/or imprisonment for 6 months for individuals (s1311 and schedule 3) and 125 penalty units for corporations (s1312)
•     Injunctions (s1324)
•     Compensation orders (s1325)
•     Cancellation or suspension of licence (ss915C(1)(a) and 912A(1)(c)) or banning order (s920A(1)(e)) for breach of a financial services law

 

(2) ASX Rules
ASX MIR 5.4.2 – Supervision of Employee Trades
(1)   A market participant must not enter into a market transaction by or for the account of its connected persons, whether the market transaction is conducted through that market participant or through another market participant unless the market transaction has been approved in writing in accordance with (4) below by a responsible executive, director or partner of the market participant or a person with written delegation for that responsibility from a responsible executive, director or partner (other than the employee concerned).
(2)   A market participant must obtain a separate approval under (1) above for each relevant market transaction.
(3)   A market participant must take reasonable steps to ensure that a person who approves a market transaction under (1) above takes into account the circumstances of the proposed transaction and anything which might materially affect the price of the relevant cash market product (or, in the case of a derivatives market transaction, the price or value of the relevant contract series) the subject of the market transaction.
(4)   For the purposes of (1) above, the approval in writing must include:
  (a)   all the information required by MIR Part 4.1 for orders, whether or not the market participant will be executing the order to which the approval relates; and
  (b)   the date and time of approval.
(5)   If a market transaction referred to in (1) above is conducted through another market participant, that market participant must, as soon as practicable after entering into the market transaction, give to the employing market participant a confirmation in respect of the market transaction.

The requirements of this MIR operate in addition to the requirements of CA s991F.

The maximum penalty prescribed for breaching this MIR is $100,000.

For these purposes, "connected person" is defined to mean, in effect, an employee or a company or trust controlled by an employee (see ASX MIR 5.4.1 and the definition of "controlled trust" in MIR 1.4.3). Compare this to the range of officers, employees and associated family members, companies and trusts that are caught by the definition of "prescribed person" in MIR 5.1.1 in determining when an order is placed on the participant's "own account" and therefore attracts the client order precedence rules (see above). An ASX participant will need to monitor whether an order it receives is on its own account and so a good case can be made that its employee trading policy should extend to the broader definition of "prescribed person" used in MIR 5.1.1 rather than the narrower definition of "connected person" above.

As mentioned above, the expression "employee" includes "a director, employee, officer, agent, representative, consultant or adviser of that market participant, or an independent contractor who acts for or by arrangement with a participant" (ASX MIR 1.4.3). Many brokers are part of a larger corporate group and the persons who work in their business are often employed by another entity in the group (usually the holding company or a separate service company). A person who is employed in this way technically will only fall within this rule if they act as an "agent" or "representative" of the broker. Notwithstanding this, some Australian financial services groups that include an ASX broker apply these requirements across the entire group and oblige all group employees, even those not involved in the broking business, to comply with their employee trading policy. Typically this will require employees, their immediate family and family companies and family trusts to maintain their broking accounts with the house broker and to seek prior approval from Compliance to transactions in those accounts. In addition to ensuring compliance with MIR 5.4.2 for broking staff, this also facilitates the monitoring of compliance with Chinese walls requirements across the entire organisation.

ASX MIR 2.5.5(d)(i) - DTRs Not to Trade on Own Account Without Approval
A trading participant must ensure that ... a DTR does not execute any order in a trading platform for or on behalf of, or which will benefit, directly or indirectly, the DTR or any associate or relative of the DTR, without the prior approval of the trading participant.

The requirements of this MIR operate in addition to the requirements of CA s991F.

The maximum penalty prescribed for breaching this MIR is $1,000,000.

For these purposes, "associate" is not specifically defined and therefore takes its Corporations Act meaning (MIR 1.4.2). "Relative" means a spouse, parent or remoter lineal ancestor, son or daughter or remoter issue, or brother or sister of that person (MIR 1.4.3).

(3) ASX 24 Rules
There are no ASX 24 Market Integrity or Operating Rules governing dealings for or with employees. The matter is regulated by CA s991F.

Return to Outline


Short Selling

CA s1020B(2) – Prohibition Against Short Selling
A person must only, in this jurisdiction, sell s1020B products to a buyer if, at the time of the sale:
(a)   the person has or, if the person is selling on behalf of another person, that other person has; or
(b)   the person believes on reasonable grounds that the person has, or if the person is selling on behalf of another person, that other person has;
a presently exercisable and unconditional right to vest the products in the buyer.

"Section 1020B products" is defined to mean securities; managed investment products; foreign exchange contracts that are neither derivatives nor immediately settled exchanges of currency (as per s764A(1)(j)); and other financial products prescribed by the regulations (s1020B(1)).

CR r7.9.80B effectively extends the short selling prohibition to warrants by prescribing for these purposes any financial product that is transferable and that is: (a) a derivative under s761D; (b) a financial product that would, apart from the effect of s761D(3)(c), be a derivative for s761D of the Act and is excluded from that paragraph only because it is a security under paragraph (c) of the definition of security in s761A; or (c) a legal or equitable right or interest in an interest in a managed investment scheme of the kind mentioned in s764A(1)(ba).

Paragraphs (a) and (b) of r7.9.80B are intended to capture warrants (see the Explanatory Statement for the Corporations Amendment Regulations 2003 (No 8) SR 282/2003, which introduced this regulation). Note, however, that the way in which these products are described in r7.9.80B differs in a number of respects from the way in which warrants are defined for the purposes of Chapter 7 (see lecture 12B).

Under s1020B(7), the expression "sell" has an extended meaning. A person who: (a) purports to sell s1020B products; (b) offers to sell s1020B products; (c) holds himself, herself or itself out as entitled to sell s1020B products; or (d) instructs a financial services licensee to sell s1020B products, is taken to sell the products.

On its face, s1020B(2) applies to brokers selling securities on behalf of their clients. If the client doesn’t have the securities and the broker doesn’t know and doesn’t have reasonable grounds to believe that the client has the securities, then the broker breaches by selling on behalf of the client. It would therefore be wise for a broker to include a warranty in its client agreements that unless the client instructs otherwise, whenever they place a sell order with the broker, they will be taken to have represented that they have a presently exercisable and unconditional right to vest the securities in the buyer.

As an example of something that happens from time to time – a client places an order to buy 100,000 shares over the course of a day. The broker, because of market conditions or through carelessness or whatever, only manages to buy 95,000 by the close of trading. Rather than send out a confirmation for a partial fill, the remaining 5,000 are credited to the client’s account and debited to the broker's error account, with a market trade placed the next day to buy 5,000 to cover the short in the error account. Unless a stock borrowing arrangement is put in place to cover that short, this is a clear case of short selling in breach of s1020B(2).

See generally ASIC Regulatory Guide 196 Short selling.

Consequences of Breach
•     Criminal offence, punishable:
  •     for a first offence - 25 penalty units and/or imprisonment for 6 months for individuals (s1311 and schedule 3) and 125 penalty units for corporations (s1312);
  •     for a further offence - 100 penalty units and/or imprisonment for 2 years (s1311 and schedule 3) or 500 penalty units for corporations.
•     Injunctions (s1324).
•     Compensation orders (s1325).
•     If person infringing is a licensed dealer or its representative – cancellation or suspension of licence (ss915C(1)(a) and 912A(1)(c)) or banning order (s920A(1)(e)) for breach of a financial services law.
•     Vendor probably can’t sue upon contract (this would involve relying on its own illegal act).

 

CA s1020B(3) – Meaning of Presently Exercisable and Unconditional Right
For the purposes of s1020B(2):
(a)   a person who, at a particular time, has a presently exercisable and unconditional right to have s1020B products vested in the person, or in accordance with the directions of the person, has at that time a presently exercisable and unconditional right to vest the products in another person; and
(b)   a right of a person to vest s1020B products in another person is not conditional merely because the products are charged or pledged in favour of another person to secure the repayment of money.

The interpretation of the phrase "presently exercisable and unconditional right" was somewhat muddied by ASX Business Rules Guidance Note 11/97. That Guidance Note was published at a time when the predecessor to the now repealed s1020B(4)(d) (the securities borrowing exception) was on foot. The former s1020B(4)(d) provided:

     "Section 1020B(2) does not apply in relation to ... a sale of s1020B products in the following circumstances:
     (i)   the person who sold the products is not an associate of the body corporate that issued the products;
     (ii)   arrangements are made before the time of the sale that will enable delivery of products of the class sold to be made to the buyer within 3 business days after the date of the transaction effecting the sale; and
     (iii)   if the sale is made on a licensed market:
       (A)   the price per unit in respect of the sale is not below the price at which the immediately preceding ordinary sale was effected; and
       (B)   the price per unit is above the price at which the immediately preceding ordinary sale was made, unless the price at which the immediately preceding ordinary sale was made was higher than the next preceding different price at which an ordinary sale had been made;

    

 

and the operator of the market is informed as soon as practicable that the sale has been made short in accordance with this subparagraph."

The restriction in (iii) above was often paraphrased as "the sale must take place on the uptick".

Amongst other things, ASX Business Rules Guidance Note 11/97 dealt with when a securities borrowing arrangement would give rise to a presently exercisable and unconditional right to vest securities. On this topic, the ASX said:

    

"The Exchange takes the view that the phrase 'presently exercisable and unconditional right to vest the security in the buyer' encompasses more than mere ownership of securities. Accordingly, if a seller has entered into an enforceable agreement which grants the seller an unconditional right to transfer a number of securities to the buyer, the seller has a 'presently exercisable and unconditional right to vest the Security in the buyer'. It follows that, in such a situation, there is no short selling under the Corporations Law and the Business Rules ...

    

"Assume a seller [who does not own the relevant securities] entered into a securities borrowing arrangement with an owner of securities prior to making a sale. In such circumstances the issue is whether the seller having a borrowing arrangement in place has a 'presently exercisable and unconditional right to vest the security in the buyer'? This will depend on the terms of the borrowing arrangement. Each arrangement must be considered on its own terms ... For example, where there is a master securities borrowing agreement and the agreement requires:

    

(i)  

the seller/borrower to make a request for a transfer of the securities when he/she wishes to borrow the securities; and

    

(ii)  

the transfer of securities is conditional upon the lender’s agreement,

    

the Exchange is of the view that the seller/borrower does not have a 'presently exercisable and unconditional right to vest the security in the buyer' until such time as the lender has agreed to the request of the seller/borrower. If, at the time of the sale of securities the lender has not agreed to the request of the seller/borrower, the seller does not have a presently exercisable and unconditional right to vest the security in the buyer."

The underlined words in italics were interpreted, somewhat creatively, by some market players and legal advisers as supporting the view that if a lender agreed to a securities borrowing request, however informally, that would give rise to a presently exercisable and unconditional right on the part of the borrower to vest the securities and therefore any subsequent sale by the borrower of those securities was not a short sale. That, in turn, led to some fairly dubious securities lending arrangements being put in place to circumvent the prohibition on short sales and, in particular, the requirement in s1020B(4)(d)(iii) for a short sale relying on the securities borrowing exception to take place on the uptick. In the writer's view, that interpretation was (at its most charitable) misguided.

It would be a fairly unusual securities lending agreement that would, by the lender simply indicating an informal agreement to lend securities, give the prospective borrower an unconditional and presently exercisable right to vest the securities in a buyer. That is evidently so when you have regard to the exception that used to appear in s1020B(4)(c) and that now appears in s1020B(4) (see below). The fact that an express exception was thought necessary for short sales covered by purchases that are conditional only on payment of the purchase price and delivery of title and transfer documentation would suggest that it does not take much conditionality at all around the delivery of borrowed securities to prevent the borrower having a presently exercisable and unconditional right to vest them in a buyer.

In this regard, the market standard Australian Master Securities Lending Agreement ("AMSLA") requires that the terms of each securities loan should be agreed prior to the commencement of the relevant loan, either orally or in writing (including any agreed form of electronic communication) and confirmed in such form and on such basis as is agreed between the parties (cl 2.1). Normally this is done by the borrower delivering a written request to borrow securities which is accepted by the lender before a contract to lend the securities comes into being.

Unless the requirement for collateral is waived, on the settlement date specified in the borrowing request, the borrower must deliver agreed collateral to the lender simultaneously against delivery of the borrowed securities by the lender to the borrower (cl 6.1).

While the AMSLA does not expressly deal with the point, it seems strongly arguable that the obligation of the borrower to deliver agreed collateral, and the obligation of the lender to deliver the borrowed securities, are cross-conditional. So a lender formally accepting a borrowing request under an AMSLA, of itself, does not give the borrower a presently exercisable and unconditional right to vest securities in a buyer since the borrower's ability to vest those securities is conditional on it delivering collateral and the lender providing the necessary documents or instructions to transfer the borrowed securities to the borrower.

[As an aside, were the position otherwise, there would hardly have been any need for the exception in the now repealed s1020B(4)(d) and the uptick rule would never have had any scope for operation. The reference in the repealed section to arrangements having been made before a sale that "enable" securities to be delivered within 3 business days after the sale must have meant that there was a securities lending agreement in place at the time of the sale, with the lender indicating that they had or were able to get the securities in question and were prepared to lend them to the seller. Hence, for the former s1020B(4)(d)(iii) to have had any scope to operate, there was an assumption underpinning the section that a borrower in that position still would not have had a presently exercisable and unconditional right to vest securities in a buyer.]

The securities borrowing exception in s1020B(4)(d) has now been repealed and in its place a new disclosure regime has been enacted in ss1020AA-1020AF for short sales covered by securities lending arrangements. This new disclosure regime appears to operate on the assumption that an arrangement to borrow securities under an AMSLA style securities lending agreement will give the borrower a presently exercisable and unconditional right to vest the securities to be borrowed in a buyer. The regime applies where, before the time of the relevant sale, the seller has "entered into or gained the benefit of a securities lending arrangement" and, at the time of the sale, "intends that the securities lending arrangement will ensure that some or all the [securities] can be vested in the buyer" (s1020AB(1)(b) and (c)). This necessarily assumes that a seller in this position has a presently exercisable and unconditional right to vest the securities in the buyer in order to avoid the general prohibition against short selling in s1020B, since there is no longer an equivalent exception to the repealed s1020B(4)(d). I am not sure that view is correct, for the reasons outlined above and in greater detail under the heading '5. Short selling' in Lewis, "A Decade On - Reforming the Financial Services Law Reforms".

Note that ASIC’s view is and has been that a seller only has a presently exercisable and unconditional right to vest s1020B products in a buyer if, at the time of sale, the seller has the absolute ability to give the buyer title to the product (RG 196.28).

In an earlier iteration of RG 196, ASIC said that this meant that a seller relying on a securities lending arrangement must have an enforceable obligation against the lender and have satisfied all their obligations under the arrangement at the time of sale. The logical extension of that view is that unless the obligation to deliver agreed collateral has been satisfied or waived, the borrower of securities under an AMSLA would not have a presently exercisable and unconditional right to vest those securities in a buyer and therefore could not purport to sell them without breaching the law against naked short selling. On a strict interpretation of the law, that conclusion has to be correct.

ASIC subsequently squibbed on the issue of collateral in its April 2010 and April 2011 revisions of RG 196. After noting the "common market practice to rely on securities obtained under a securities lending arrangement to satisfy the need to have a presently exercisable and unconditional right to vest the securities in the buyer" (RG 196.30), ASIC now simply opines that a borrower will only have a presently exercisable and unconditional right to vest products if the lender has given the borrower a firm (ie legally binding) commitment to deliver the products (RG 196.32) and that an agreement to deliver on a 'best endeavours basis' will not suffice (RG 196.33). ASIC notes that a borrower usually has to give the lender collateral as security (RG 196.31) but says nothing further on the issue other than its warning that: "We recognise that arrangements between lenders and borrowers will vary. Whether the arrangements are sufficient to reflect a presently exercisable and unconditional right to vest will depend on the particular circumstances of these arrangements" (RG 196.34).

There may, however, be another way to get to the same end point as was assumed in ASX Business Rules Guidance Note 11/97 and appears to be assumed in ss1020AA-1020AF and now by ASIC in the latest iteration of RG 196. At law, a securities "lending" agreement is, in fact, an agreement by the lender to transfer securities to the borrower for consideration with a promise by the borrower to re-transfer equivalent securities back to the lender at the conclusion of the "loan". Accordingly, there is a perhaps contrived but not entirely disrespectable argument, as yet untested in the courts, that if a lender has agreed to a written borrowing request under clause 2.1 of an AMSLA, that gives rise to a contract on the part of the borrower to "purchase" the securities (ie accept a transfer of the securities for consideration) which is conditional only on the payment of the "purchase price" (ie delivery of the collateral) and the delivery of title and transfer documentation for the securities. If that argument is correct, then the securities lending agreement would fall within the exception in s1020B(4) (see below) and any sale of the securities intended to be borrowed would not infringe s1020B(2) but would still fall within the disclosure regime in ss1020AA-1020AF!

ASIC itself hints that it might be amenable to this argument in its comment in the note to RG 196.31 that: "While securities lending is a sale with an undertaking to return the transferred securities (or their equivalent), this guide uses the common market terminology to describe the transaction and parties."

 

CA s1020B(4) – Exception for Sales Covered by Conditional Purchases
S1020B(2) does not apply in relation to a sale of s1020B products by a person who, before the time of sale, has entered into a contract to buy those products and who has a right to have those products vested in the person that is conditional only upon all or any of the following:
(a)   payment of the consideration in respect of the purchase;
(b)   the receipt by the person of a proper instrument of transfer in respect of the products;
(c)   the receipt by the person of the documents that are, or are documents of title to, the products.

CA s1020B(4) allows a seller to sell products acquired through the purchase agreement even though the seller may not have a presently exercisable and unconditional right to vest the products in the buyer because, at the time of sale, the purchase agreement to acquire the products has yet to complete (ie it is still conditional on payment of the purchase price and delivery of title and transfer documentation).

This exception does give some guidance to how the phrase “presently exercisable and unconditional right” should be interpreted. The very fact that the legislature felt the need to include this exception supports the view that it does not take much in the way of conditionality for a person not to have a “presently exercisable and unconditional right” to vest the relevant s1020B products in the buyer. The fact that you expect to get, say, securities you have short-sold under some contractual arrangement that you have entered into (eg under an option to have the securities issued to you) will not meet the requirement of having a "presently exercisable and unconditional right" to vest the securities in the buyer if that right is not presently exercisable (eg because the option is not yet exercisable) or if there are any conditions that apply to the option (eg that you have to give a notice exercising the option and to pay the option exercise price).

Exception for Sales Covered by Securities Lending Arrangements(??)
Disclosure requirements in CA ss1020AA-1020AF and CR rr7.9.99-7.9.102) apply to a sale of s1020B products by a person who:
•     has, before the sale, entered into or gained the benefit of a 'securities lending arrangement'; and
•     at the time of the sale, intends that the securities lending arrangement will ensure that some or all the s1020B products can be vested in the buyer (see below).
These provisions appear to proceed on an assumption that a person who has entered into or gained the benefit of a securities lending arrangement and who has arranged to borrow securities under it has a presently exercisable right to vest those securities in a buyer and therefore does not infringe s1020B(2) by agreeing to sell those securities. This assumption is not necessarily correct in all circumstances and really ought to be fixed in the regulations or in amending legislation.

The reasons why this assumption is not necessarily correct in all circumstances (indeed, is probably incorrect in many circumstances) are explained in the notes above relating to CA s1020B(3).

CA s1020AA(1) defines a 'securities lending arrangement' as an arrangement under which: (a) one entity (the lender) agrees that it will: (i) deliver particular securities, managed investment products or other financial products to another entity (the borrower) or to an entity nominated by the borrower and (ii) vest title in those products in the entity to which they are delivered; and (b) the borrower agrees that it will, after the lender does the things mentioned in para (a): (i) deliver the products (or equivalent products) to the lender or to an entity nominated by the lender and (ii) vest title in those products (or those equivalent products) in the entity to which they are delivered.

The provisions that came into force on 11 December 2009 were introduced by the Corporations Amendment (Short Selling) Act 2008 and the Corporations Amendment Regulations 2009 (No. 8). For an explanation of the intention behind the provisions, see the Explanatory Memorandum for the Act and the Explanatory Statement for the Regulations.

The Explanatory Memorandum for the Act said:

    

"Section 1020B generally prohibits the sale of a section 1020B product unless a person has a ‘presently exercisable and unconditional right’ to vest the product at the time of sale.

    

Short sellers need to make arrangements to cover their delivery obligations before they fall due. This is normally done by:

    

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making a matching purchase at some point following the sale but before delivery falls due; or

    

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borrowing an equivalent amount of securities before delivery falls due, either before they enter into the sale or at some time between making the sale and when required to make delivery.

    

A naked short sale occurs where a seller does not own or has not borrowed or arranged to borrow securities at the time of sale but intends to purchase or borrow securities in order to meet the three business day settlement obligation.

    

There is some discussion about what constitutes a covered short sale. The broadest approach is to focus on whether borrowing takes place to meet delivery obligations. On this approach a covered short sale occurs where the seller has arranged to borrow stock in order to meet their delivery obligations.

For those not familiar with securities lending transactions, the Australian Securities Lending Association website has quite a useful introduction: see http://www.asla.com.au/about-securities-lending/#history_of_securities_lending.

For a detailed analysis on the legal characterisation of securities lending arrangements, see Beconwood Securities Pty Ltd v ANZ Group Limited [2008] FCA 594.

 

Other Exceptions
•     Short sales of securities or managed investment products that result from the exercise of an ETO (CO 08/764)
•     Short sales that are done by the giving or writing of certain ETOs (CO 09/1051, para 4(a)).
•     Short sales covered by presently exercisable ETOs (CO 09/1051, para 4(b)).
•     Short sales of (i) government bonds, or (ii) debentures or bonds of a body corporate with an aggregate face value in excess of $100m, through Austraclear, RITS or another licensed CS facility where arrangements are in place for the bonds or debentures to be vested before the due date for delivery (CO 09/1051, para 5).
•     Short sales to hedge risk from market making activities (CO 09/774).
•     Short sales resulting from certain deferred purchase agreements (CO 10/111).
•     Persons who have placed portfolio securities into a securities lending program provided by an established securities lending business and who wish to sell those securities before they have completed a recall of those securities from the program (ASIC Advisory AD08-23: no action position for owners selling from stock lending portfolios).
•     Individual "no action positions" (RG 196.64 – 196.73).
•     Note no exception for short sales covered by company issued options or convertibles (see also ASX Business Rules Guidance Note 11/97).

In relation to the third bullet point, there is a formula in CO 09/1051, para 6 for working out the amount of coverage provided by ETOs.

In relation to the last bullet point, ASX Business Rules Guidance Note 11/97 correctly said that a short sale covered by shares that will be issued in the future under company issued options constitutes an unlawful short sale because at the time of sale all that the seller has is a contractual right against the listed company for the allotment of securities in the future through the exercise of the options. That is not a "presently exercisable and unconditional right to vest the shares in the buyer". In addition, the short sale will also amount to a contravention of ASX MIR 5.10.1 because, at the time of the sale, the securities dealt with will not have been admitted to official quotation. Official quotation can only be applied for after the options have been exercised and shares have been allotted. These breaches will arise even if the seller is able to fulfil its settlement obligation by having the options converted and the shares admitted to official quotation by the time settlement is required. By extension, the same reasoning will apply to other convertible or converting securities.

So to sum up ... "naked" short selling of s1020B products is generally prohibited by s1020B(2), subject to the technical exceptions in the slide above. "Covered" short selling is permissible provided the cover takes the form of having already purchased the products under an agreement that meets the requirements of s1020B(4), being able to borrow the products under a securities lending arrangement (as per ss1020AA-1020AF and rr7.9.99-7.9.102) or being able to obtain the products under a presently exercisable ETO (CO 09/1051, para 4(b)).

Disclosure of Short Sales Covered by Securities Lending Arrangements
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Sellers of listed s1020B products must advise their executing broker when the sale is a "covered short sale" (ss1020AB(1)(a)(i), (3) and (4)(a)).

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Brokers must also ask whether a sale is a covered short sale before making the sale and record the answer in writing (s1020AE).

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Brokers must report to the relevant market operator disclosed covered short sales for clients (s1020AC) and any covered short sales on principal account (ss1020AB(1)(a)(ii), (3) and (4)(b)).

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The market operator must publicly disclose reported short sale information on its website on a daily basis (s1020AD and r7.9.102).

•     Sellers also have to disclose to ASIC their net short position in products issued by listed entities on or before 9am on the third business day after entering into an agreement to sell that causes a net short position to occur and re-disclose that net short position on each subsequent business day, even if it has not changed from the previous business day (CR r7.9.100(4)-(7)).
•     ASIC must publicly disclose reported net short positions on its website on a daily basis (s1020AD and r7.9.102).

In other words, market operators (such as the ASX) publish transactional (gross) short selling information on a T+1 basis and ASIC publishes positional (net) short selling information on a T+4 basis.

Failure to comply with the above provisions is a criminal offence, punishable by 25 penalty units and/or imprisonment for 6 months for individuals and 125 penalty units for corporations.

The disclosure regime above applies to sales made on a licensed market (such as the ASX) and sales that occur through on or off market crossings where, before the time of the sale, the seller had entered into or gained the benefit of a securities lending arrangement and, at the time of the sale, the seller intends that the securities lending arrangement will ensure that some or all the s1020B products can be vested in the buyer (s1020AA). It applies whether the seller is inside or outside Australia (s1020AB(2)).

A seller entering into a covered short sale through a financial services licensee must disclose to the licensee at the time of entering into the agreement to sell: (a) the number of s1020B products that the seller will vest in the buyer under the arrangement; (b) a description of the product; and (c) the name of the entity that issued the product (CR r7.9.100(1) and (2)). Again, it would be wise for a broker to refer to these notification requirements in its client agreements and (for retail customers) in its financial services guide.

A financial services licensee must disclose the particulars received from its clients to the relevant market operator by 9am on the next trading day (unless the information is provided after 7pm but before the start of the next trading day, in which case it has to be reported to the market operator by the second trading day) after the licensee is given the information: CR r7.9.101.

A financial services licensee selling on principal account must disclose the same particulars relating to their own covered short sales to the market operator by 9am on the next business day (unless the sale is made after 7pm but before the start of the next trading day, in which case it has to be reported to the market operator by the second trading day) after entering into the agreement to sell (CR r7.9.100(2)(b)).

A seller who enters into an agreement to sell that causes a "short position" to occur must on or before 9 am on the third reporting day after entering into the agreement give to ASIC particulars of that short position (CR7.1.100(4)-(7)). They must continue to give those particulars on or before 9 am on each subsequent reporting day that the seller continues to have a short position (even if there has been no change in that position).

For these purposes, "reporting day" means a day on which the Sydney office of ASIC is open for business (CR r7.9.99(1)) and a "short position" means a position in relation to a s1020B product in a listed entity where the quantity of the product which a person has is less than the quantity of the product which the person has an obligation to deliver (r7.9.99(2)). A person "has" a product if: (a) the person is holding the product on the person’s own behalf; (b) another person is holding the product on the person’s behalf; (c) the person has entered into an agreement to buy the product but has not received it; or (d) the person has vested title in the product in a borrower, or in an entity nominated by the borrower, under a securities lending arrangement (r7.9.99(3)). The "product which the person has an obligation to deliver" is the product which the person has: (a) an obligation to deliver under a sale agreement where the product has not been delivered; (b) an obligation to vest title in a lender under a securities lending arrangement; or (c) any other non-contingent legal obligation to deliver (r7.9.99(4)).

Note also ASX OR 3501 (which imposes an obligation on trading participants to provide a short sale report to ASX in accordance with the Procedures).

A broker needs to have good processes and controls around short selling. In 2015, the HK SFC fined JP Morgan HK$12m for short selling compliance failings between 2010 and 2013. It found that two local JP Morgan securities subsidiaries had incorrectly aggregated the inventory positions controlled by their principal trading desks across two offshore affiliates. The errors meant they were unable to determine their net long or short position in a security. As a consequence, the two firms wrongly conducted more than 41,000 uncovered short sale trades as long trades, in breach of the HK equivalent of CA s1020B(2). It also found that 34% of the short-selling orders placed by these two entities for their principal trading in May 2012 did not have the appropriate documentary assurance in place to confirm that the sales were "covered" when the short-sale orders were placed (HK law at the time required a short seller, when passing a short-selling order to an agent for execution, at the same time to provide the agent with " documentary assurance" that it has the right to vest the securities to which the order relates or, where the securities have been borrowed, that the lender has the securities available to lend to the seller). The failures included not obtaining documentary assurance for some short selling orders or obtaining it after the sale and the borrowed quantity not being specified in some documentary assurances or not being sufficient to cover the quantity of the short sale (see http://www.sfc.hk/edistributionWeb/gateway/EN/news-and-announcements/news/enforcement-news/doc?refNo=15PR123).

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