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Feature Key Points�� “Layering” is illegal market abuse.�� The Swift Trade case was a conspicuous case of market manipulation which was quickly

identified.�� The substantial fine will send a wider message to all market participants.

Authors Hannah Laming and Tommy Dutton

Upper Tribunal finds “layering” constitutes market abuse In the FSA v 7722656 Canada Inc (formerly carrying on business as Swift Trade Inc), the Upper Tribunal was called upon to consider whether the practice known as “layering” was abusive and so contrary to s 118 of the Financial Services and Markets Act 2000 (FSMA). The Tribunal found that it was, and, sending a clear message to market participants, upheld the largest fine imposed for market manipulation to date.

INTRODUCTION

nOn 23 January 2013, the Upper Tribunal handed down a judgment

(FS/2011/0017-18) dismissing the reference made by 7722656 Canada Inc (formerly carrying on business as Swift Trade Inc), (“Swift Trade”), a Canadian trading firm. It accepted the FSA’s case that, for a one year period, Swift Trade systematically and deliberately engaged in a form of manipulative trading activity known as “layering”, in relation to shares traded on the London Stock Exchange (LSE). The Upper Tribunal upheld the £8m fine levied by the FSA against Swift Trade for market manipulation – the largest fine imposed for market abuse in the regulator’s history.

The decision will be of particular interest to those involved in “algo-trading” and traders who profit from high-volume day-trading, betting on intra-day price changes in equity markets.

WhaT Is “layeRINg”?“Layering” involves placing large orders on one side of an exchange’s order book, at a price set at a level unlikely to result in an actual trade, with the intention of causing a consequent move in the share price due to the change in supply and demand. A trade is then executed on the opposite side of the book, benefiting from this movement in share price. The original order is then cancelled. The behaviour is then repeated on the other side of the order book. The person engaged in layering therefore benefits from movements in share prices which he has intentionally caused.

The faCTsSwift Trade provided the facilities for dealers, located in various countries around the world, to place thousands of orders for contracts for differences (CFD’s) in relation to shares traded on the LSE. These orders were placed with Swift Trade’s direct market access (DMA) provider which was initially Merrill Lynch International (“Merrill Lynch”) and subsequently Penson Financial Services Ltd (“Penson”). When the dealers placed their orders for CFD’s, Merrill Lynch and Penson’s automated trading systems would automatically hedge these orders by placing an order to buy or sell (depending on the nature of the CFD) for an equivalent number of shares on the LSE order book. The DMA service enabled the dealers to see the LSE order book in real time and they could therefore see the impact of the hedging orders placed by Merrill Lynch or Penson on the share price. The dealers placed large CFD orders at a level where they were unlikely to execute, anticipating the automated hedging transaction which would ensue and then placed genuine orders intended to execute on the other side of the order book, thus exploiting the share price movement caused by the automated hedging position. Once this trade had executed, they would cancel the original CFD order which would also result in the automatic cancellation of the DMA provider’s hedged position. In this way, the dealers could make small regular profits through repeatedly placing and

cancelling these orders through Swift Trade’s facilities on both sides of the LSE order book.

The RelevaNT TesTThe FSA alleged that Swift Trade’s behaviour constituted market abuse contrary to s 118 of FSMA, which sets out seven separate means by which a market in qualifying investments may be unlawfully compromised. In respect of Swift Trade, the FSA contended that the relevant conduct fell within the definition of market manipulation in s 118(5). This sub-section makes it unlawful for one or more persons to effect transactions or orders (other than for legitimate reasons and in conformity with accepted market practices):�� which give, or are likely to give, a false or

misleading impression as to the supply of, or demand for, or as to the price of, one or more qualifying investments trading on a prescribed market; or�� secure the price of one or more such

investments at an abnormal or artificial level.

The FSA’s case was that the trading conducted by Swift Trade was manipulative within the meaning of s 118(5), and so unlawful.

sWIfT TRaDe’s CaseSwift Trade advanced a number of arguments against the FSA’s decision. Its key points were:�� The dealers’ conduct did not relate to

qualifying investments: The dealers’ orders for CFDs were derivatives which were not themselves orders for shares (even though the underlying securities were shares listed on the LSE), rather they were bets on price movements. As such, the dealers’ activities did not relate

Butterworths Journal of International Banking and Financial Law March 2013 165

Biog BoxHannah Laming is an Associate in the Business Crime Department at Peters & Peters Solicitors LLP. Email: hlaming@petersandpeters.com

Tommy Dutton is a Paralegal at Peters & Peters Solicitors LLP. Email: tdutton@petersandpeters.com

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to “qualifying investments” as required by s 118 of FSMA. �� The trades on the LSE were not

undertaken by Swift Trade or its dealers: The relevant orders for shares were placed on the LSE by Merrill Lynch (or later by Penson) and not by Swift Trade or the dealers. As such, Swift Trade should not be held accountable for any misconduct. �� Swift Trade could not be held

responsible for the dealers’ activities: Swift Trade argued that the trades were initiated by the dealers over whose activities it had no control; Swift Trade merely provided the secondary DMA platform. Swift Trade should therefore be treated in the same way as Merrill Lynch and Penson (against whom there were no findings of market abuse, and no penalty imposed).�� The trading was legitimate: Swift

Trade submitted that the trading activity in question was legitimate high-volume day trading, with dealers betting on intra-day fluctuations in price changes in the equity markets, and was not manipulative in nature. It also asserted that the trades were not abusive as defined in s 118, or at all. The trades that were executed did not lead to any investor incurring a loss; they were all transparent to the market and in line with market practice. �� Swift Trade had a statutory defence

under s 123(2) of FSMA: Swift Trade argued that it was able to avail itself of the statutory defence provided by s 123(2) of FSMA. This provides that the FSA may not impose a penalty on a person if they reasonably believed their behaviour was not market abuse and/or did not encourage others to engage in market abuse or they took all reasonable precautions and due diligence to avoid abusive behaviour.

The fINDINgs Of The UppeR TRIbUNalThe Upper Tribunal agreed with the FSA that the conduct did fall within the scope of s 118 of FSMA. Conduct is caught

by s 118 where it “occurs in relation to qualifying investments”. Moreover, it can be committed by “one person alone or by two or more persons jointly or in concert”. It was sufficient for the purposes of s 118 that when the orders for CFDs were placed, the person placing the order knew that it would inevitably result in the placing of a corresponding hedging order for an equivalent number of shares by the DMA provider. There was no requirement for there to be trading directly in a qualifying instrument. The wording of the statute envisaged the possibility of the market abuse occurring as a result of the actions of more than one person. Such an interpretation was consistent with market understanding and common sense.

For the same reasons, the Upper Tribunal did not uphold Swift Trade’s argument that it was Merrill Lynch or Penson who placed the orders. Although this was technically correct, the DMA providers merely responded automatically to the trades placed by the dealers through Swift Trade. The Upper Tribunal noted that anyone other than a member of an exchange had to use an intermediary such as a broker or DMA. It would be nonsensical to find that trades involving such an intermediary fell outside of the market abuse provisions.

The Upper Tribunal held that Swift Trade’s conduct was “deliberate, manipulative market abuse in the form of ‘layering’ and was not undertaken in accordance with recognised market practice”. The trading pattern revealed by the FSA was consistent with a deliberate strategy that proved Swift Trade orchestrated and encouraged their dealers to systematically place trades in high volumes without the intention of ever being executed in order to manipulate market prices in the pursuit of profit.

Furthermore, two experienced market participants gave evidence to the Tribunal explaining that they had notified the FSA of their concerns about the conduct engaged in by Swift Trade. They both agreed that the conduct had misled market participants; causing them to enter into trades (or not to enter into trades) which they would not otherwise have done and had a detrimental

impact on their revenue streams.Finally, the Upper Tribunal held that

the statutory defence in s 123(2) of FSMA did not apply. The documentary evidence pointed to the conclusion that Swift Trade knew its conduct was not legitimate but still positively encouraged it. The LSE had raised concerns with Swift Trade, and Merrill Lynch had suspended its trading facilities. The FSA also relied on emails between Swift Trade and dealers, which the Tribunal viewed as particularly damaging, demonstrating that Swift Trade and the dealers were aware that the practice was manipulative and had allowed it to continue because it was generating profit.

CONClUsIONThe £8m fine imposed by the FSA and upheld by the Upper Tribunal is the largest fine imposed to date for market manipulation and at a particularly high level given that Swift Trade’s total profit for the relevant period was £1.75m. However, a fine of this level is not surprising given the evidence led by the FSA, which demonstrated Swift Trade’s blatant disregard for minimum standards of propriety in the marketplace.

The FSA’s Head of Enforcement, Tracey McDermott, has made it clear that “layering” is illegal market abuse. This was a conspicuous case of market manipulation which was quickly identified both by other market participants and by the LSE itself. Given the systems now in place at the LSE to identify conduct of this nature, it is likely that it will be easily detected. The findings in this case together with the level of the fine should have a significant deterrent effect on anyone tempted to engage in layering. However, perhaps the real moral of the story relates less to the specific practice of layering but rather to the very dim view taken by the FSA and the Upper Tribunal of market participants who appear to brazenly ignore the rules in relation to market conduct. Its power to impose substantial fines reflecting the seriousness of the behaviour in this regard will send a wider message to all market participants. n