Are Wash Trades and Matched Orders Now Illegal?
A recent decision of the Court of Appeal opens up the possibility that market participants crossing securities with themselves or their associates in the market may be regarded as engaging in market manipulation. In this article, we review the Court of Appeal’s reasons for judgment and assess its impact.
The decision of the Court of Appeal in HKSAR v Fu Kor Kuen (CACC 179 of 2010, December 23, 2010) suggests that wash trades are inherently manipulative and may undermine a statutory defence which is critical to legitimizing washed trades and matched trades. If this is correct, the decision is highly unsatisfactory, leaving market participants who engage in wash trades and matched trades for legitimate and non-manipulative commercial reasons potentially open to criminal prosecution.
The Securities and Futures Ordinance (“SFO”) creates a number of market manipulation offences, including false trading. The penalties are harsh – on indictment, a person guilty of false trading may be imprisoned for 10 years and fined HK$10 million – and the courts are increasingly willing to hand down significant prison terms.
Elements of False Trading
In simplified terms, under the SFO, false trading occurs where a person does anything with the intention that, or being reckless as to whether, it has or is likely to have the the effect of:
- creating a false or misleading appearance of active trading in securities traded on an exchange;
- creating a false or misleading appearance with respect to the market for, or the price for dealings in, securities traded on an exchange.
Statutory Deeming Provision
Under the SFO, there is a deeming provision which provides, in simplified terms, that a person is regarded as engaged in false trading if he:
- enters into any transaction (“wash trade”) of sale or purchase of securities that does not involve a change in the beneficial ownership of them; or
- makes an offer (“matched trade”) to purchase securities at a price that is substantially the same as the price at which he has made, or he knows that an associate has made, an offer to sell the same or substantially the same number of them and vice-versa.
The effect of the deeming provision is that a person is regarded as engaged in false trading if he enters into a wash trade or matched trade whether or not the wash trade or matched trade in fact has, or is likely to have, the effect of creating a false or misleading appearance of active trading in securities, or with respect to the market for, or the price for dealings in, securities.
The SFO then establishes a statutory defence which, in simplified terms, provides that where a person is charged with false trading through a wash trade or a matched trade, it is a defence for the person to prove that the purpose of the wash trade or matched trade or, where there is more than one purpose, the purposes of the wash trade or matched trade, did not include the purpose of creating a false or misleading appearance of active trading in securities or with respect to the market for, or the price for dealings in, securities.
Court of Appeal Decision
In HKSAR v Fu Kor Kuen and others, the defendants day traded derivative warrants, all issued by the same issuer, on the Stock Exchange of Hong Kong to profit from a rebate scheme. To do so, they first bought derivative warrants from the issuer at an early stage of a trading day, then placed buy and sell orders repetitively against each other at around the same price during the trading day to generate substantial trading volume. This was because under the rebate scheme, the more trading volume the defendants generated, the more rebate they would receive from both the issuer and their own broker which would more than offset their trading transaction costs, resulting in an almost risk-free profit. Before the end of the same trading day, the defendants disposed of the derivative warrants, at around the same price they had bought them from the issuer at the beginning of the trading day, either to the issuer, a third party or a combination of the two.
The prosecution claimed that as the defendants’ trades dominated the market turnover, they intended to create a false and misleading appearance of active trading in the warrants or were reckless as to whether it had or was likely to have that effect.
The District Court convicted both defendants for false trading. The defendants appealed and the Court of Appeal dismissed the appeal against conviction.
Whilst market observers may agree with the Court of Appeal’s decision, the decision leaves some uncertainty as to whether all wash trades are criminal and whether the statutory defence is available for wash trades and matched trades. It is thus, for example, not clear whether following the decision, a taxpayer who transfers securities from one of his companies to another of his companies for tax planning reasons is guilty of false trading.
False or Misleading Appearance
The false trading offence refers to a false or misleading appearance of active trading or with respect to the market for, or the price for dealings in, securities or futures contract. The Court of Appeal held that the term “false or misleading appearance” seeks to ensure that the market reflects “the forces of genuine supply and demand”. It did not go on to explain what was meant by “genuine supply and demand”, simply affirming the District Court trial judge’s determination that because the two defendants traded with each other frequently and at the same price, their trades were not “real” and therefore their trades had the effect of creating “...a false or misleading appearance” of active trading.
It is not clear from the Court of Appeal’s decision whether all wash trades now inherently create a false or misleading appearance of active trading because it is difficult to see how such trades could ever reflect genuine forces of supply and demand.
On the basis that the requisite elements of false trading under the charging provision in this case had been satisfied, the Court of Appeal went on to find that it was not necessary to consider the statutory defence.
Availability of Defence
The Court of Appeal appears to have taken the view that because the defendants could be found to have engaged in false trading under the charging provision without relying on the deeming provision, it was not necessary to consider the statutory defence. It is not clear whether this is correct.
On its face, the statutory defence provision provides that the statutory defence is available where “a person is charged with an offence..... in respect of a contravention of [the false trading charging provision] taking place through the commission of [a wash trade or matched trade as referred to in the deeming provision]”. In other words, on its face, the statutory defence provision appears to provide that the statutory defence is available to a person being charged for false trading under the charging provision as long as his acts constitute a washed trade or a matched trade as referred to in the deeming provision. The statutory defence provision does not provide that the statutory defence is available only when the defendant is charged for false trading pursuant to or by relying on the deeming provision. Therefore, it does not seem to be correct to say that the statutory defence need not be considered if the deeming provision is not invoked. Such an interpretation would deprive a defendant who has carried out a washed trade or a matched trade of the statutory defence merely because the prosecution elects not to rely on the deeming provision.
Meaning of Defence
The Court of Appeal neither considered whether a “purpose”, which is the term used in the statutory defence provision, is the same as an “intention”, which is the term used in the charging provision, nor did it clarify whether a person could ever have the requisite “intention” under the charging provision but not have a “purpose” under the statutory defence provision. However, the Court of Appeal did confirm that a person intends a result where an act will almost certainly produce a result and he knows this.
Where a person does something with a commercial motive as well as the intention that, or being reckless as to whether, it has or is likely to have the effect of creating a false or misleading appearance of active trading, it does not seem to be correct to say that the purpose of the person’s act is for or includes creating a false or misleading appearance of active trading. If “purpose” under the statutory defence provision refers to the commercial motive, it is vital to distinguish it from “intention” under the charging provision. As in the example above, a taxpayer may, as part of a tax plan, transfer securities from one of his companies to another of his companies knowing full well that the transfer would increase trading volume without any genuine supply and demand. He clearly intended to increase trading volume because he knew that his transfer would increase trading volume. However, this does not mean that the purpose was to increase trading volume. His purpose was clearly to improve his tax position.
Having said that, in this case, the District Court trial judge held that the defendants, as day traders who bought derivative warrants from the issuer at the early stage of a trading day, ran the risk that they would be unable to exit the market before the end of the same trading day unless the defendants were sure that someone would buy the warrants at the end of the trading day. On the basis that an active liquid market would be easier to exit than an illiquid market, the trial judge held that the defendants wanted to create an active liquid market and consequently, at least one of their purposes was to create a false or misleading appearance of active trading in the warrants market. Thus, in this case, the statutory defence was not successfully proved even though another purpose may have been to profit from the rebate scheme.
The state of law following the Court of Appeal’s judgment in HKSAR v Fu Kor Kuen is unsatisfactory. The decision opens up the possibility that wash trades inherently create a false or misleading appearance of active trading in the market and hence, the possibility that such trades are criminal. At the same time, it appears that it is not possible to defend an allegation of false trading arising from a wash trade or a matched trade based upon a legitimate commercial motive for the trade.
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