Under the SSR, where a market participant holds a net short position in shares admitted to trading on an EU trading venue, private and public notification obligations arise when those holdings reach certain thresholds. Importantly, these notification obligations apply on an extraterritorial basis to any firm globally that trades in in-scope instruments. They are set at the following levels:
- a private share notification must be made to the relevant competent authority when the net short position reaches 0.1% of the issued share capital of the company concerned, and again at each 0.1% increment (whether by increase or decrease, including each time the position drops to below 0.1%); and
- a public share notification must be made when the net short position reaches 0.5% of the issued share capital of the company concerned, and again at each 0.1% increment (whether by increase or decrease, including each time the position drops to below 0.5%).
Note that, owing to market volatility arising from the COVID-19 pandemic, the European Securities and Markets Authority (ESMA) has temporarily lowered the threshold for notifying net short positions under the SSR from 0.2% of issued share capital to 0.1%. This temporary measure, issued first on 16 March 2020 and subsequently renewed twice, will expire on 18 December 2020 unless further renewed.
In this briefing we explore the nature of ARCM's breaches leading to the enforcement action, and key learning points for firms going forward.
The enforcement action concerned the activities of ARCM, an asset management firm based in Hong Kong and involved in managing a series of long duration closed-end investment vehicles focused primarily on investing in debt and equity securities across Asia.
From 22 February 2017, ARCM began to build a net short position in Premier Oil through equity swaps. By 5 July 2019, ARCM this net short position was equivalent to 16.85% of Premier Oil’s issued share capital via equity swaps, the largest net short position ever held in an issuer admitted to the Official List. ARCM held this net short position for a further 106 trading days, and it was not until 3 December 2019 that ARCM made notifications to the FCA, and 4 December 2019 when it made disclosures to the public. In total, between 22 February 2017 and 3 December 2019, ARCM failed to make 155 notifications to the FCA and 153 disclosures to the public.
Whilst ARCM had in place a trading compliance management system that integrated pre- and post-trade controls, ARCM relied on third party materials in constructing the controls that it applied to trading in UK securities. These materials did not contain a comprehensive list of instruments to which the SSR applied and, crucially, did not refer to derivatives trading as within the scope of the SSR notification obligations. This led ARCM to (erroneously) believe that it was not required to apply the SSR to its derivatives trading in Premier Oil plc.
On 29 October 2019, ARCM learned of the obligation to report short selling activity through swaps in the UK, and by 8 November determined that it did have an obligation to disclose its short selling position in Premier Oil plc, at which point it immediately began preparing data and draft filings, engaging external consultants to conduct a verification exercise. However, ARCM did not inform the FCA of its failure to comply with its SSR obligations until 29 November 2019. ARCM submitted 155 notifications to the FCA on 3 December 2019, and disclosed to the public 153 of those 155 notifications on 4 December 2019. As a result, between 22 February 2017 and 3 December 2019, the market functioned without information that should have been available to it.
In determining the size of the fine to be imposed on ARCM, the FCA considered ARCM's breaches to be particularly serious and aggravated for a number of reasons, including the following:
- the importance of the SSR in supporting support effective price discovery and well-functioning markets;
- the fact that the breaches revealed weaknesses in ARCM's internal controls, systems and procedures (as evidenced by its reliance on materials that led it to incorrectly conclude the SSR did not apply to derivatives trading);
- the fact that the breaches in question were multiple, and occurred over an extended period of time;
- rather than informing the FCA promptly upon discovering its failure to comply with its SSR obligations, ARCM notified the FCA only once it had reviewed and prepared the data for disclosure; and
- the unprecedented size of the final position.
However, the FCA also considered that ARCM had no previous disciplinary history in Hong Kong or the UK, and self-identified all of its failures to comply with its obligations under the SSR. ARCM also agreed to resolve the matter and qualified for a 30% discount. Had ARCM not done so, the total financial penalty imposed would have been £1,247,312.
Enforcement context and key learning points for firms
The fine issued by the FCA is the first enforcement action the regulator has taken under the SSR, and continues to demonstrate the FCA's focus on supporting market integrity and transaction transparency. As highlighted by Mark Steward, Executive Director of Enforcement and Market Oversight, “Failure to report disclosable short positions undermines the integrity and efficiency of financial markets. ARCM repeatedly breached reporting rules and failed to provide important information to us and to the market. This fine reflects the seriousness of these breaches.”
During the pandemic period, short sale reporting under the SSR has been front of mind for many compliance teams, which have been required to ensure that their trading desks remain on top of national short selling bans and an (ongoing) reduction in the threshold for reporting net short positions from 0.2 to 0.1% of issuers' issued share capital. The FCA's enforcement action against ARCM will likely, therefore, attract significant attention, not least because this was the first instance of the UK regulator taking enforcement action against a breach of the SSR. While the facts of the case were fairly atypical, there are a number of learning points that firms can take away from the enforcement action.
A single position can lead to multiple reporting failures
ARCM's breach of the short selling rules was particularly serious for the reasons described above. Although an unreported position of this size and for this duration is unusual in nature, the FCA's Final Notice clearly demonstrates how a single short position can lead to multiple reporting failures simply as a result of how long the position persists without being disclosed to the regulator or to the wider market.
The need to effectively adapt controls to trading on foreign markets
ARCM's investment vehicles are focused primarily on investing in debt and equity securities across Asia, and, as a result, ARCM traded on EU markets relatively infrequently. ARCM was not fully aware, at least until 8 November 2019, that a position of this size was reportable, and erroneously relied on inadequate materials to determine their regulatory obligations. The FCA states in its Final Notice that:
"in ascertaining its obligations in advance of the trading, ARCM relied on third party materials about the regulatory context in the UK. Although this contained information concerning the SSR, the materials included an indicative, rather than an exhaustive, list of the instruments to which the SSR applied."
This clearly demonstrates the importance of engaging effectively and in sufficient detail with local trading regulations, regardless of how limited a firm's contact with the relevant overseas markets may be.
Complexities arising from synthetic positions
ARCM's short position arose as the result of a relatively straightforward trading strategy. It initially invested in Premier Oil through the acquisition of a debt instrument on the secondary market, and subsequently entered into a series of equity swap trades in order to hedge its exposure. However, it is clear from the FCA's Final Notice that ARCM did not flag derivatives trading activity as requiring notification under the UK short selling rules, and as a result took the erroneous view that short sale disclosure obligations did not apply to its position in Premier Oil.
Whilst the majority of firms with exposure to the SSR will be aware that reportable short positions can and do arise from derivatives trading activity, the ongoing application of short sale thresholds can in practice be complex to apply in this context. This is particularly the case where firms invest in products referencing indices or ETFs, where short selling disclosure requirements can apply on a look-through basis, depending on the availability of public information. Tracking net short positions also means taking a holistic view across all trading desks and strategies, and ensuring that, where necessary, short positions are closed out at the same point that long positions are divested.
Timescale for reporting breaches
A specific concern that the FCA identified in its Final Notice was ARCM's failure inform the FCA immediately of the breach. Instead, it went through a process of "preparing the data and notifications/disclosures required under the SSR", and "instituted a process to ensure that the notifications/disclosures made were comprehensive and accurate, reflecting the full history of the position" prior to reporting. There is a valuable lesson for trading firms here; whilst it is clearly important to ensure that regulators receive a full and accurate picture of the facts, time is of the essence in notifying the regulator as soon as it becomes clear that a breach has occurred.
Key regulatory concerns
One of the FCA's primary concerns in this case was the lack of market transparency around ARCM's (substantial) short position; this point was stressed significantly in comparison with ARCM's failure to notify the FCA directly of its short position. This reflects regulatory concerns around the market's ability to engage effectively in price formation in circumstances where there is limited or no transparency on short selling strategies. The FCA also notes that the breaches were considered to be particularly serious given that they revealed weaknesses in ARCM’s procedures, management systems and internal controls. This is consistent with the fact that regulatory breaches will generally attract a higher level of scrutiny where they are indicative of a more systemic internal systems and controls issue.
Will we see actions like this more frequently in the future?
As noted above, the facts in this case were relatively egregious, and so in that sense it is somewhat of an outlier. In addition, the Financial Times recently reported that data released under the Freedom of Information Act showed that the FCA had imposed only four fines for any rule breaking in the year to date (a drop of 76% on the same period in 2019); in other words, we are unlikely to see a deluge of similar penalty decisions in the near future. Nonetheless, the FCA has been clear that its oversight and scrutiny of financial firms is continuing as normal despite the pandemic, and the ARCM decision should be viewed as a salutary lesson in light of the heightened focus by regulators on short selling during times of market volatility.