Regulators have long been aware of the risks posed by market soundings to the integrity of markets. By definition, market soundings involve the disclosure of confidential information to a limited circle of market participants. This will likely include details of the imminent placing of securities, together with confidential information about related corporate activity (e.g. restructuring or merger) – each of which may amount to inside information in their own right.
Why market soundings carry risk
In the latest edition of its market conduct newsletter, Market Watch 75, the Financial Conduct Authority (FCA) shares its observations about the functioning of market soundings. It recognises that these play an important role in the efficient functioning of financial markets and price discovery by allowing issuers and their advisers to gauge investor interest in potential transactions. However, there are also elements of market soundings that are vulnerable to market abuse.
One example, given by the FCA, exposes the potential for the practice to be misused: cases where firms are trading in relevant instruments after they have been asked to participate in market soundings but before inside information is disclosed. The FCA strongly suspects that this is not a coincidence and that recipient firms are making “educated guesses” as to the identity and nature of the inside information. It is not impressed by explanations such as “portfolio rebalancing” where they have sold instruments immediately after the initial contact and then buy back the same quantity of the instrument in the subsequent placing – insider dealing by any other name.
The FCA reminds…
In Market Watch 75, the FCA reminds buy and sell-side firms, the likely parties to market soundings, of the main features of the market soundings regime (as previously discussed in Market Watch 51 and 58).
For Disclosing Market Participants (“DMP”), generally issuers and their advisors, it is as follows:
- An assessment of whether a market sounding includes inside information;
- Standardised procedures and scripts to communicate information to Market Sounding Recipients "MSR" (typically buy-side firms) without the potential for preferential treatment;
- Obtaining formal consent from the MSR to receive the market sounding;
- Informing MSRs that they are prohibited from using the information to trade or attempt to trade relevant instruments; and
- Making records of the communications with, and the information provided to, MSRs.
- Making their own assessment of whether they possess inside information upon receipt of the market sounding, including consideration of any other information already in their possession;
- Making a record of the market sounding and their own inside information assessments; and
- Establishing arrangements to limit the internal flow of inside information on a need-to-know basis.
The FCA also recommends a number of measures for firms, to minimise the risk of insider dealing or unlawful disclosure:
- DMPs need to take particular care with market soundings in sectors with a limited number of issuers and other circumstances where MSR’s may easily deduce the identity and nature of the market sounding;
- DMPs need to carefully consider the standardised information and scripts used in initial outreach to MSRs;
- MSRs should consider putting in gatekeeper arrangements to receive the initial request – someone in Compliance or another non-investment role to minimise the risk of contamination;
- MSR staff who receive and process market soundings, should receive proper training on the required internal procedures and the Market Abuse Regulation (MAR) prohibitions on unlawful use of inside information; and
- Both DMPs and MSRs should seek to minimise the time interval between initial contact and consent to receive inside information, hence reducing the risk of insider dealing.
A further point worth noting (although this was not explicitly covered by the FCA), is that firms declining to receive a market sounding should consider whether they have nonetheless received inside information (especially in combination with other information in their possession). Investment professionals are often extremely good at guessing the identity of issuers in these scenarios. This also underlines the point about insulating investment teams from such information.
Market Watch 75 closes with a sharp warning: “Firms and their employees should be aware of the breadth of information that the FCA can request and which is available to us when reviewing trades, communications and documentation relating to soundings. We will intervene when we have reason to suspect behaviour detrimental to confidence in, and the fairness of, UK markets.”
In other words: “We know market abuse is happening during market soundings and will not hesitate to take enforcement action where we have clear evidence of wrongdoing.”
Cosegic is available to assist firms review and enhance their controls and procedures around market soundings and other wall-crossing events.
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