True purpose trumps false trading
Hong Kong’s Court of Final Appeal (CFA) has allowed the appeals of two traders, quashing their convictions for creating a false or misleading appearance of active trading contrary to the market misconduct provisions of the Securities and Futures Ordinance (SFO), and setting aside their sentences. This case brings welcome clarity as to what constitutes a successful defence: it was not the purpose of the traders to create a false or misleading appearance.
Two day traders were trading derivative warrants in 2004–2005, buying and selling with each other and usually exiting at the end of the day. The profit made on each trade was small but such profits were possible because the warrant issuer, in common with other warrant issuers in Hong Kong at that time, offered a commission rebate scheme. Commission rebate schemes were banned in September 2006, the reason being that they had the potential to attract investors seeking to generate commission rebates rather than using derivative warrants as a form of investment.
The scheme allowed the warrant issuer to pay the traders a commission rebate per trade, and this rebate was higher than the brokerage fee for the trade. Simply, the traders could, and did, generate risk-free profit from trading, taking the difference between the rebates and the brokerage costs as their profit.
By trading frequently, the small profits made on each trade resulted in a significant amount over time. The trades also generated volume in the market, for example, on one of the days investigated, the traders did 74 trades representing 76% of the total market turnover.
The traders were charged with false trading, that is, the creation of a false or misleading appearance of active trading in securities contrary to section 295(1) of the Securities and Futures Ordinance (SFO) — section 295(1) provides the general prohibition, section 295(6) makes it an offence. The trades described are usually quoted as examples of ‘matched orders’; under the SFO section 295(5) this activity is presumed to be false trading. ‘Wash sales’, where the trading does not result in change of beneficial ownership, are also subject to this same presumption.
There was no dispute that:
• the traders conducted these activities to obtain the commission rebates, and
• the result of these activities was in fact the creation of a false or misleading appearance of active trading in the warrants.
The CFA decision
The Court of Final Appeal (CFA) held that, in the case of matched orders, there is a defence if there is an absence of a purpose to create a false or misleading appearance. This is so, even though the traders were reckless as to whether their trading caused a false or misleading appearance.
Useful guidance from the CFA
The CFA examined section 295 in depth and its judgment provides many observations that will be useful guidance for the financial services industry and market players.
A defence is available for wash sales and matched orders
The Court held that wash sales and matched orders will be regarded as false trading offences, unless there is an innocent explanation, that is, by showing that the purpose of the trading was not, or did not include, the purpose of creating a false or misleading appearance. The burden of proving this, on the balance of probabilities, fell on the traders.
The Court also provided other possible examples of innocent explanations, such as rearrangements of corporate structures or family relationships or fiscal structures.
Determining the purpose for the activity is key
The Court observed (there was no dispute on this point) that the traders’ conduct gave rise to a false and misleading appearance of active trading, but it concluded that their purpose was not or did not include the purpose of creating a false or misleading appearance of active trading: they engaged in their trading to earn the commission rebates that were on offer. Although the traders did not give evidence – a ‘Statement of Admitted Facts’ had been produced at trial – the Court inferred this from their conduct and the market conditions in which they acted, on the assumption that they were doing so in pursuit of their economic interests.
‘Looking at the matter objectively,’ Justice Litton NPJ said, ‘there was of course an appearance of active trading, and in one sense an illusion of liquidity, on the days the appellants performed their operation. It was the result of such operation – the inevitable result. It was not the purpose of the operation.’
Use experts in the right way
Section 295 refers to three states of mind: intention, recklessness and purpose. The Court commented that none of the three expert witnesses called had expertise to express an opinion about somebody’s state of mind, albeit they were experts on the market conditions and practices. ‘The function of the experts was to put forward facts and matters concerning the derivative-warrant market from which the court may draw an inference concerning the defendants’ subjective intention and purpose. Full stop. Here the experts appear to have strayed well beyond their field of expertise,’ Justice Litton NPJ said. ‘However, the witnesses in the present case went further than that. They gave their opinions about the purpose or purposes with which the appellants acted,’ Justice Gleeson NPJ respectively said. The statements by the expert witnesses about the traders’ purpose were held to be inadmissible.
Jill Wong, Counsel, Hong Kong
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