A Guide to Penalties and Other Consequences Upon a Finding of Liability for Market Misconduct
The Market Misconduct Tribunal (“MMT”) adjudicates cases of insider dealing, market manipulation and failure to disclose inside information. Though the MMT has no power to order the imprisonment of anyone found liable, the reputational and financial consequences of a finding of liability are significant. In this article, we provide guidance for listed companies and their directors, traders, research analysts and other market participants under investigation for market misconduct of the potential penalties and other consequences which may arise from a finding of liability.
Under the Securities and Futures Ordinance (“SFO”), the MMT is responsible for adjudicating allegations of misconduct (“market misconduct”), including (i) allegations of failures by listed companies and their directors to disclose inside information, (ii) allegations of the disclosure of false or misleading information, whether by listed companies and their directors or by others seeking to influence the market, (iii) allegations of trades undertaken to manipulate the market, and (iv) allegations of insider dealing.
Direct Consequences Of Liability
Though a finding of liability by the MMT is not a finding of criminal liability and cannot result in imprisonment, it may nevertheless cause serious reputational damage, carrying with it the stigma of quasi-criminal liability. Such a finding is typically followed by orders of the MMT which can include the following:
- Fines – Listed companies and their directors found liable for failing to disclose inside information on a timely basis may be subjected to fines of up to HK$8 million.
- Disgorgement – Market participants, whether traders, research analysts as well as listed companies and their directors, found liable for disclosing false or misleading information, market manipulation or insider dealing may be required to disgorge any profit made or loss avoided as a result of the misconduct.
- Disqualification – Market participants, whether traders, research analysts as well as listed companies and their directors, found liable for market misconduct may be disqualified from being a director of a listed corporation (or other specified corporation) or otherwise taking part in the management of a listed corporation (or other specified corporation) for up to 5 years.
- Cold Shoulder – Market participants, whether traders, research analysts as well as listed companies and their directors, found liable for market misconduct may be barred from dealing in Hong Kong in securities or futures contracts for up to 5 years.
- Costs – Market participants, whether traders, research analysts as well as listed companies and their directors, found liable for market misconduct may be liable to pay the Government its costs and expenses in relation to the MMT proceedings and to pay to the Securities and Futures Commission (“SFC”) its costs and expenses in relation to its participation in the MMT proceedings as well as its investigation of the conduct of such participants before or for the purpose of those MMT proceedings.
As may be evident from the foregoing, fines can be levied only in cases where listed companies and their directors have failed to disclose inside information on a timely basis. In principle, disgorgement orders form no part of the sanctioning regime for the failure to disclose inside information on a timely basis. However, where the failure arises from a disclosure that is materially incomplete or incorrect, it is at least theoretically possible for the SFC to institute MMT proceedings both for the failure to disclose inside information on a timely basis (an approach that can result in a fine) as well as for the disclosure of false or misleading information (an approach that can result in disgorgement).
An order for costs requires a person found liable to pay the costs of the Hong Kong government and the legal, investigative and expert costs of the SFC in the proceedings. Depending on the duration of the MMT proceedings and the complexity and contentiousness of the matters heard, it is easy to see that costs can be significant. Indeed, financial liability under cost orders can (and often does) exceed that under a fine or an order for disgorgement.
Costs under an order for costs are separate from the costs which a person found liable by the MMT will likely have also incurred in defending himself, including his own legal fees and fees for any experts retained to assist in his defence.
Although at first glance an order for disgorgement is straightforward, the MMT and the courts have defined 3 different tests for disgorgement: (i) the actual profit realized test, (ii) the notional profit test, and (iii) the notional loss avoided test.
Actual Profit vs Notional Profit
A key difficulty in practice is determining whether the actual profit realized test or the notional profit test should be applied. In insider dealing cases, the Court of Final Appeal has determined that the actual profit realized test applies where market prices have not yet reflected the inside information which had been exploited and the notional profit test applies where market prices have reflected such information.
In Re Dealings in the Shares of China Huiyan Juice Group Limited, shares were bought on inside information between August 7 to 29 and were sold on September 3 and 4. Though the inside information was released on September 3, the MMT found that the market had not fully digested that information until September 5. As a result, the MMT ordered disgorgement of the actual profit realized.
In contrast, for example, in Re Dealings in the Shares of Mirabell International Holdings Limited, shares were bought on inside information on February 21 and 22, the inside information was disclosed to the market on February 28 and the shares were sold on March 10 and April 21. The MMT found that the market had fully digested the inside information by March 3. As the sales took place after the market had fully digested the information, the MMT applied the notional profit test.
Under the notional profit test, the profit to be disgorged is calculated based on the price at the time the market fully takes into account the inside information. So, in the Mirabell case, even though actual sales took place on March 10 and April 21 at $5.80 and $5.83 per share, the profit to be disgorged was calculated based on $5.83, the two-day weighted average price over February 29 and March 3, the date on which the MMT found the inside information had been fully digested.
The application of the actual realized profit test and the notional profit test has not yet been conclusively determined by the courts outside of the insider dealing context. The SFC has sought in the past to seek disgorgement not of the actual profit but rather, the theoretical economic benefit that the person earned from his misconduct. The latter represents the maximum amount the person could have earned had he timed his trading perfectly.
Notional Loss Avoided
Like the notional profit test, the loss avoided test is based on the notional loss that would have been avoided. In insider dealing cases, the notional loss is determined based upon the volume weighted average price at the time the market had fully absorbed the negative inside information.
So, for example, in Re Dealings into the Shares of Chaoda Modern Agriculture (Holdings) Limited, an insider dealing case, shares were sold at an average price of $5.304 on June 16 whilst in possession of negative inside information. The inside information was released on June 18 and the MMT found that it had been fully digested by the end of June 19. The two-day weighted average price of June 18 and 19 was HK$4.551. Though disgorgement was not in fact ordered, the MMT calculated the loss avoided per share as being the difference in $5.304 and $4.551.
Because the actual realized profit test and the notional profit test are applied depending upon a finding by the MMT as to when inside information or the effect of market misconduct has been fully reflected into market prices and because the notional loss test requires a similar finding, MMT proceedings will typically include expert evidence as to the time at which inside information was fully digested or the time until which market misconduct distorted market prices. This is inherently a difficult exercise.
To illustrate the difficulty, assume that A owns a stock which he bought at $5 before coming into possession of inside information. Assume further that A came into possession of negative inside information and whilst in possession of such information, sold that stock at the then prevailing market of $10. Upon release of the inside information, the stock slid to as low as $7 over a period of 3 days. However, over that 3 day period, the market as a whole declined each day for a total decline of 15 per cent. By selling at $10, arguably, A avoided a loss of $3 but given the decline of the market as a whole, it might equally be argued that A only avoided a loss of $1.50, as the stock would have declined by 15 per cent. in any event to $8.50. Moreover, it might be argued that the inside information had been fully digested by the end of the 1st day after the release of the inside information and that, as a result, in calculating the loss avoided, no account should be taken of the decline in the price of the stock and the 2nd and 3rd day after the release of the inside information.
It can be readily seen that a person who is subject to an allegation of market misconduct faces some uncertainty in terms of liability under any order for disgorgement. It is possible that such a person may need to disgorge profit which exceeds his actual cash inflows from his misconduct but will not know if he will be required to do so until the MMT proceedings complete.
Secondary Consequences Of Liability
Quite apart from the orders which can be made by the MMT, a person found to have engaged in a market misconduct by the MMT may face civil action through the courts. Such a civil action can take the form of proceedings by investors themselves under a statutory right of action. Alternatively or in addition, such a civil action can take the form of court proceedings brought by the SFC. Whilst investors have yet to take advantage of the statutory right of action, the SFC routinely takes civil action on behalf of investors.
It will be self-evident that any court proceedings by which a person found liable for market misconduct is required to pay compensation to investors who suffered a loss as a result of the market misconduct may impose a heavy financial burden on this person. Depending on market turnover, this burden could, in dollar terms, easily exceed the burden of the orders of the MMT to pay a fine, to disgorge profit made or loss avoided or to pay costs.
Investor Action for Compensation
The SFO includes a fast-track mechanism for investors to seek compensation for losses resulting from market misconduct. Under this mechanism, findings of the MMT are admissible in court proceedings by which investors seek compensation to establish liability. Though a finding of the MMT does not bind a court, the admission of the finding relieves individual investors of the burden of undertaking the time and cost intensive forensic exercise to discharge their burden of proof.
Regulatory Action for Compensation
Whether it is because of a lack of awareness, the absence of a desire to incur costs or otherwise, in the almost 15 years since the statutory right of action was introduced for investors, no investors have taken advantage of it. This is not to say however, that persons found liable need not fear potential liability to compensate investors.
The SFO, s. 213 provides that where a person has engaged in market misconduct, the court may make an order “requiring the person to take such steps as it may direct, including steps to restore the parties to any transaction to the position in which they were before the transaction was entered into”.
The SFC has frequently relied upon the SFO, s. 213 to seek compensation for investors. Thus, for example, in SFC v Tiger Asia Management LLC, the SFC obtained a court order against Tiger Asia under s. 213, which required Tiger Asia to pay HK$45.2 million to around 1,800 investors affected by its insider dealing. Similarly, in SFC v Tsoi Bun, the SFC used s. 213 to obtain an order against a futures trader, Mr Tsoi Bun, requiring him to pay HK$13.7 million to around 500 investors affected by his market manipulation.
An unresolved issue is how the quantum of compensation is to be calculated in the absence of agreement between the SFC and the person found liable of a market misconduct. In SFC v Sun Min, Mr. Sun had been found by the MMT to have engaged in insider dealing. The SFC sought a compensation order under s. 213. Mr. Sun and the SFC agreed that Mr. Sun would pay as compensation to each counterparty who sold shares to him a sum equal to the difference between the sale price and the value of the shares once the inside information had been digested. Though the court granted an order in terms by consent, it queried whether this methodology of calculating the quantum of compensation was correct, noting that the compensation was neither in the nature of a disgorgement of Mr. Sun’s profit nor a restoration of any loss suffered by any given counterparty.
Timing of Compensatory Orders
Strictly speaking, a court applies s. 213 independently of the MMT. Thus, a finding of liability by the MMT is not a precondition to the court making an order under s. 213. It is open to a court to make an order under s. 213 if it is satisfied that a market misconduct may have occurred. Conversely, a finding of liability by the MMT is not itself sufficient to enable a court to exercise its powers under s. 213. The court will need to be satisfied that a market misconduct has in fact taken place.
A consequence of this independence is that a person who is the subject of allegations of market misconduct may be subjected to proceedings under s. 213 prior to or in parallel with the institution of MMT proceedings.
Having said that, compensation orders have often been ordered following findings of liability by the MMT.
Other Regulatory Action
It is possible that a finding of liability by the MMT (or indeed, the mere institution of MMT proceedings) may result in regulatory action beyond a mere order for compensation. First, s. 213 is not limited to ordering persons liable for market misconduct to restore parties to their original position. The courts have the power to make a number of orders including:
- an order to restrain or prohibit further market misconduct,
- an order for the person engaged in market misconduct to take such steps as the court may direct,
- an order declaring transactions to be void or voidable,
- an order directing a person to do or refrain from doing any act for the purpose of securing compliance with any other order made under s. 213, and
- any ancillary order which the court considers necessary in consequence of the making of any other orders under s. 213.
The courts have in fact used s. 213 to support compensatory orders by, for example, freezing assets of a person who is alleged to have engaged in market misconduct. The effect of a freezing order would be to ensure that assets are available for a compensation order which might be made in the event the person were found liable for market misconduct.
Secondly, where the market misconduct prejudices shareholders of a listed company, the SFO, s. 214 empowers the courts, on an application by the SFC, to make a number of orders including:
- an order to restrain the carrying out or to require the carrying out of any act,
- an order to disqualify the person wholly or partly responsible for the listed company having engaged in market misconduct from being a director of the listed company or any other company for up to 15 years, and
- any other order it considers appropriate, whether for regulating the conduct of the business or affairs of the listed company, for the purchase of the shares of any shareholder of the listed company or otherwise.
Though there is no specific precedent as yet of the use of s. 214 in conjunction with MMT proceedings, there have been proceedings under s. 214 involving listed companies and their directors who have failed to ensure “The courts have in fact used s. 213 to support compensatory orders by, for example, freezing assets of a person who is alleged to have engaged in market misconduct.” that shareholders have been given all the information with respect to the affairs of these companies that such shareholders might reasonably expect. Allegations of this type are not substantively different in nature than allegations of a failure to disclose inside information.
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