Compliance: Theory and Practice in the Financial Services Industry

4. Market Conduct Rules

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Outline

	Market Misconduct
	Order Record Requirements
	Order Precedence and Allocation Rules
	Dealing with Clients as Principal
	Dealings for or with Employees
	Short Selling

Market Misconduct

In ASIC v Soust, the former managing director of a company who purchased shares in his mother's name on 31 December 2007, shortly before the close of the market for the calendar year, with a view to increasing the market price of the company's shares and thereby earning a larger bonus under his service contract, was found to have engaged in market manipulation in contravention of CA s1041A (and also s1041B).

In R v Manasseh and Austin, the defendants were charged under the predecessors to ss1041B(1), (2)(a) and (3) and convicted at first instance for implementing a series of purchases and sales of shares between various trust companies which held the shares in question on trust for persons associated with the defendants. On appeal, the NSW Court of Criminal Appeal rejected an argument by the defendants that the convictions should be set aside because they were not dealing as principal and that the persons who should have been charged were the trust companies concerned who owned the shares. The court held that the predecessor to s1041B(1) applied to a person who engaged in the proscribed conduct even though that person so engaged by dealing in the securities of another with or without the authority of that other. The court, however, quashed the convictions because the Crown had failed to identify the persons who were the beneficial owners of the shares before and after the transactions for the purposes of the predecessor to s1041B(2)(a) and to identify the persons or their associates who held interests in the shares before and after the transactions for the purposes of the predecessor to s1041B(3).

In Endresz v Whitehouse, above, after the transaction in question, the ASX wrote to Emu Hill and queried it about the fluctuations in its share price. E, who you will recall was the chairman of Emu Hill and a director of its major shareholder CTC, responded on behalf of Emu Hill without referring the matter to his fellow directors. He said that the board of Emu Hill was not aware of any information not known to the market that would explain the movement in its share price. The letter set out various generally known factual matters about the earlier takeover of Emu Hill by CTC and then expressed the opinion that the price movements were the result of the market’s reappraisal of the company in light of those developments. The letter also stated that CTC had purchased the 2.7m shares needed to clear the market the day before so that the 4m transaction could go through at the desired price "in the ordinary course of trading on the ASX". It did not mention the fixing of the price or the 4m transaction. E was charged and convicted at first instance of breaching the precursor to s1041E. On appeal, E tried to argue that he had answered the ASX query as chairman of Emu Hill and not as director of CTC and was precluded from disclosing in the letter information that was confidential to CTC. The court rejected this argument, saying that some of his answers included information that could only have been known to CTC. E had also included matters of opinion, such as the comment about market reappraisal and, having opened up these matters of opinion, he was obliged to give complete and honest answers. Held that E’s appeal should therefore be dismissed.

In R v Wright, W, a director of Wattle Gully Gold, authorised a letter to the ASX saying that the company’s consulting geologist had reported significant ore reserves in the company’s uranium lease and that at current values the reserves were worth $160m. As a consequence, the market price of Wattle Gully traded up from 8 cents to 12 cents. In fact the report had referred to possible reserves and contained nothing to justify the $160m valuation. Further, the geologist had said in the report that he did not consider the deposits to be economically recoverable. A few days later a correcting letter was sent to the ASX and the price fell back to 8 cents and subsequently even lower. W and the company were convicted of breaching the precursor to s1041E, with W jailed for 12 months and the company originally fined $20,000. Subsequently on appeal, the company’s fine was reduced to $500 as the court did not see any point in punishing the innocent shareholders in the company. An appeal by W against his conviction and jail sentence, however, was rejected.

In ASC v MacLeod, M, an independent consulting geologist, issued a report to Cambridge Gulf Exploration NL on the results of exploration it had undertaken in WA with a view to diamond mining. He said that based on sampling tests and the current price of diamonds, the company’s annual profits could be expected to be US$1.374b. The company issued the report to the ASX and its share price climbed dramatically. The size of the sample that had been taken was not adequate to draw the conclusions that the geologist had and, as it transpired, the company did not make anywhere near the level of recoveries or profits that the geologist had predicted. He was convicted as first instance by a magistrate of breaching the precursor to s1041E. That decision was set aside and the charges dismissed on appeal by a Commissioner of the Supreme Court of Western Australia. ASC then appealed the dismissal to the Full Court of the Supreme Court of Western Australia. The Full Court held that the geologist’s statement about the level of profits was a statement as to the future; therefore the precursor to s769C kicked in and the geologist had the onus of showing that he had a reasonable basis for making that statement. He didn’t and so it was therefore deemed to be misleading. Further it was clearly material and, on the evidence, one that was likely to induce people to buy shares in the company. The test to be applied when considering whether a person knew or should have known something was materially misleading was an objective one and, on that standard, the geologist should have known that his statements would have induced people to buy shares. Accordingly, the Full Court found that he was properly convicted of breaching the precursor to s1041E and reinstated his conviction.

That decision was subsequently set aside by the High Court on technical grounds (namely, that the ASC did not have the authority to bring the appeal to the Full Court): see MacLeod v ASIC [2002] HCA 37.

"Dishonest" is defined in s1041F(2) to mean: (a) dishonest according to the standards of ordinary people; and (b) known by the person to be dishonest according to the standards of ordinary people.

Note that s1041F(3) gives this section an extended operation in relation to certain dealings in superannuation and RSA products.

In NCSC v Monarch Petroleum NL, a bogus letter on Monarch Petroleum letterhead and purporting to be from its chairman was delivered to the Perth Stock Exchange and read out over the floor loudspeaker system in the usual way. It referred to a possible takeover of the company by a "large Australian company" and to a potentially valuable oil discovery. This caused a run on the company’s stock and a dramatic increase in its share price. The company secretary, upon hearing the news, informed the NCSC that the letter was a forgery. The NCSC applied to have sales on the exchange declared void. The order was made. It was held that whoever had published the forged letter had committed an offence under the precursor to s1041F and that enlivened the jurisdiction of the court to grant injunctions where an offence had been committed.

Note that the Government proposes to increase the criminal penalties for market manipulation. In the case of an individual, the new penalty will be imprisonment for 10 years and/or a fine equal to the greater of: (a) 4,500 penalty units; or (b) if the court can determine the total value of the benefits that have been obtained by one or more persons and are reasonably attributable to the commission of the offence, 3 times that total value. In the case of a body corporate, the new penalty will be a fine equal to the greatest of: (a) 45,000 penalty units; or (b) if the court can determine the total value of the benefits that have been obtained by one or more persons and are reasonably attributable to the commission of the offence, 3 times that total value; or (c) if the court cannot determine the total value of those benefits, 10% of the body corporate’s annual turnover during the 12-month period ending at the end of the month in which the body corporate committed, or began committing, the offence.

In Australian Securities & Investments Commission v Soust [2010] FCA 68 ASIC, the managing director of Select Vaccines instructed his broker to purchase Select Vaccines shares in his mother's name in the last hour of the last day of trading for the 2007 calendar year with the intention of increasing the Select Vaccines share price on the ASX in order to secure the payment of the short-term performance bonus under his service contract. The amount of the bonus was linked to the market price of Select Vaccines shares on that day. It was found that he had engaged in market manipulation in contravention of ss1041A and 1041B and had also breached his director’s duties to Select Vaccines under ss181(1) and 182(1).

This rule applies only to cash market products. See also ASX Market Rules Guidance Note 1 - Prevention of Manipulative Trading and note the statement in that Guidance Note: "ASX interprets the phrase "no change in beneficial ownership" in light of the Corporations Act. This means ASX regards a transaction as involving no change in beneficial ownership if a person, or that person’s associate, had an interest in the [cash market products] before the transaction, and has an interest in the same [cash market products] after the transaction."

ASIC has said that it will seek to follow the published interpretations contained in pre-existing ASX Market Rules guidance notes, including Guidance Note 1, but will look to review them and issue replacement ASIC Guidance Notes in due course (see ASIC Regulatory Guide 214 - Guidance on ASIC market integrity rules for ASX and ASX 24 markets, at para 57-58).

This means that you need to include filters in automated order processing systems designed to prevent manipulative trading (eg to stop people buying and selling the same stock or marking the close).

Curiously, there currently is no penalty prescribed for breaching MIR 5.8.2.

Click here for a copy of ASX Business Rules Guidance Note 8/00 - Trading Practices. ASX also issued a convenient Summary of ASX Business Rules Guidance Note 8/00.

The maximum penalty prescribed for breaching MIR 3.1.2 and 3.1.3 is $1,000,000. The maximum penalty prescribed for breaching MIR 3.1.12 is $100,000.

MIR 3.1.12(1) does not prohibit: (a) a transaction where both sides are taken by the same market participant where the ultimate clients are different; (b) a transaction where both sides are by the same entity but acting in different capacities; or (c) a transaction where each side is for a different division of the same market participant entity which is trading separately and for different purposes (MIR 3.1.12(2)).

MIR 3.1.12(3)-(5) impose a requirement on market participants to report certain wash trades to ASIC and to maintain a register of other wash trades that are not required to be reported to ASIC.

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Order Record Requirements

The financial services licensee must keep the records for at least 5 years after the particulars are created (CR r7.8.19(5)). Records relating to instructions given by a client to deal in financial products must be kept in a manner that makes the records identifiable separately from records relating to instructions to deal in financial products on the financial services licensee’s own account (CR r7.8.19(4)).

Under CR r7.8.19(3), if a financial services licensee transmits for execution on a financial market outside Australia and the external Territories instructions to deal in financial products and it is not reasonably practicable for the financial services licensee to set out the date and time of execution of those instructions in its records, the financial services licensee must set out the date and time as precisely as is reasonably practicable.

This obligation applies to a market participant who receives instructions to enter into a market transaction on behalf of a person (a "client"), whether or not a trading message corresponding to those instructions is entered into or matched on a trading platform (MIR 4.1.1(1)).

The maximum penalty prescribed for breaching MIR 4.1.1 is $100,000.

MIR 4.1.7 provides that a market participant who instructs another trading participant to enter into a market transaction on behalf of a client does not have to comply with (e)-(j) above in respect of that instruction. Instead, they must maintain sufficiently detailed records in respect of the instruction showing: (i) the name of the person who received the instruction; (ii) the name of any person who passed the instruction on between the person who initially received the instruction and the person instructing the trading participant to enter into the market transaction; (iii) the name of the person who instructed the trading participant to enter into the market transaction; and (iv) the time the person instructed the trading participant to enter into the market transaction.

This obligation applies to a market participant who makes a decision, or gives instructions to, enter into a market transaction on its own account, whether or not the market transaction is executed (MIR 4.1.2(1)).

The maximum penalty prescribed for breaching MIR 4.1.2 is $100,000.

MIR 4.1.8 provides that a market participant who instructs a trading participant to enter into a market transaction on its behalf does not have to comply with (c)-(f) above in respect of that instruction. Instead, they must maintain sufficiently detailed records in respect of the instruction showing: (i) the name of any person who passed the instruction on between the person who initially gave the instruction or made the decision and the trading participant instructed to enter into the market transaction; (ii) the name of the person who instructed the trading participant to enter into the market transaction; and (iii) the time the person instructed the trading participant to enter into the market transaction.

MIR 4.1.5 provides that a trading participant may meet certain of its obligations under MIR 4.1.1 and 4.1.2 by relying on records maintained electronically as set out in MIR 4.1.6.

The maximum penalty prescribed for breaching MIR 5.5.3 is $1,000,000.

These records have to be maintained for 7 years (MIR 5.5.4).

MIR 5.5.3 and its predecessors have often been interpreted as a rule prescribing IT system requirements (ie how orders being processed through the participant's internal trading systems can be matched against bids/offers being submitted into the ASX's trading platform and the resultant executions). However, I believe that the requirement in this rule for a trading participant "at all times" to be able to link a trading message back to an order has broader compliance ramifications.

For example, it seems to me to prevent a DTR from submitting a "fictitious" bid/offer into the ASX trading platform that the DTR does not intend to execute (eg a bid/offer away from market that the DTR intends to cancel if and when the market starts to move towards it). Even if the DTR has an order in the relevant product and discretion as to the price at which it is executed, you can't really say that the bid/offer in question "corresponds to" that order (in terms of the requirement in paragraph (b) above) when there was never any intention to execute the order at the price bid/offered.

Similarly, it is common practice for brokers to aggregate careful discretion and VWAP (volume weighted average price) orders received from clients prior to the open of trading, to execute them as a "bunched order" over the course of the trading day and then to assign an average price for the executions to the clients participating in the bunched order. That is seen to have the advantage of ensuring that all clients get the same price. MIR 5.5.3 requires a broker to be able to link each trading message back to an order at all times. So if a broker is going to bunch orders in this manner, to comply with this rule, it should use a VAR ('various') or similar code when it transmits the bunched orders for execution to the ASX to signify that the transmission relates to a number of clients, and have proper (upfront) records identifying which clients are participating in the bunched orders and in what proportions. If they don't, then it seems to me that the only proper manner to execute the orders is to do so initially on principal account and, when the resultant executions are allocated to the clients to satisfy their orders, to do so in compliance with the principal trading rules. Note that to help avoid disputes with clients over this type of trading, a broker really should include in its client agreements a provision entitling it to bunch orders and to assign average prices.

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Order Precedence and Allocation Rules

This section is complemented by CR r7.8.18(3), below, which basically says that if a licensee wants to deal in financial products on its own account and the person who is going to effect that dealing is aware of instructions of a client to deal in the same products at or near the market price, then they cannot transmit the instructions for the principal order until the client order has been transmitted.

The word "associate" here takes its meaning from ss11, 13 and 15 of the Corporations Act. It includes directors and secretaries of a company, partners of a partnership, related bodies corporate, and certain trusts.

In other words, the client order precedence rules in the Corporations Act do not operate where the market integrity rules or operating rules of the relevant market provide otherwise. As we saw earlier, CR r7.8.18(3) – restricting the execution of principal orders where there is an extant client order at or near the market price – also does not apply if the market integrity rules or operating rules of the relevant licensed market otherwise provide (r7.8.18(1)).

Both the ASX and the ASX 24 markets have their own client order precedence rules that effectively displace the operation of s991B(2) in relation to those markets (see below).

CR 7.8.17(2) provides that s991B(2) also does not apply to a transaction if, at the time that the instruction is issued, the financial services licensee is not a participant in the licensed market on which the particular financial product is being traded. This exclusion, however, does not apply if: (a) the financial services licensee deals, or has dealt, in a financial product traded on that market on its own behalf (whether directly or through an agent or other representative) or on behalf of a client; or (b) an associate of the financial services licensee is a participant in that market mentioned in that subregulation.

CR r7.8.18 has been made pursuant to CA s991C, which authorises the making of regulations imposing requirements relating to the order in which instructions are to be transmitted to a market and market dealings are to be allocated, and prohibiting the disclosure of instructions in specified circumstances.

CR r7.8.18(6) defines a reference to the transmission by a financial services licensee of instructions to deal in a class of financial products as a reference: (a) if the financial services licensee has direct access to the licensed market on which the instructions are to be executed - to the transmission of the instructions to that licensed market; or (b) if the financial services licensee has access to the licensed market on which the instructions are to be executed only through another financial services licensee - to the transmission of the instructions to that other financial services licensee.

To the extent that paragraph (2) above requires "at market" orders to be transmitted in the sequence they are received, it basically codifies the common law position: see Constable v Meyer (1972) 3 DCR(NSW) 41. In that case, a client (M) telephoned his broker and asked the market price in T. He was told that there was a buyer at $1.30 but no seller. M asked the broker to buy him 2,000 shares in T at market ASAP. The order was handed to a floor operator along with an order from another client to buy 2000 shares. The floor operator bought 4,000 shares at prices from $1.65 to $2.00. He informed the broker of the purchases, who then advised M that his order had been filled but that the broker at that stage did not know at what price. M was told that the market had jumped to between $1.80 and $2.00, whereupon he asked the broker to buy him another 3,000 shares. The floor operator came back with a number of purchases at the end of the day for M and other clients. In accordance with firm practice, the operator allocated the original 4,000 purchase to M and the other client at an average price for the total purchase. The balance of purchases for the rest of the day were allocated to M and the remaining clients also at an average price for the total balance. M rejected the purchases as not being in accordance with his instructions and the broker then sued M for payment. The District Court of NSW was held that where a stockbroker is instructed by a number of clients to buy shares at market price in a rapidly rising market, its duty to those clients is to execute their commissions as expeditiously as possible and strictly in the order in which they are received. The broker had failed to do that in this instance and so judgment was entered for the client and the broker did not get paid.

Note the words in italics in r7.8.18(1) above. Both the ASX and ASX 24 Market Integrity Rules contain provisions dealing with client order precedence and so rr7.8.18(2)-(4) will not apply to dealings on the ASX and ASX 24. That is quite fortunate as there are real problems with the drafting of rr7.8.18(2)-(4).

In the first place, the phrase "near the market price" is altogether vague. How far away from the current market price must an order price be to not be "near the market price"?

For example, suppose the current market asking price is at $1.01 and the client wants to buy at 99¢. If this is considered to be "near the market price", r7.8.18(3) would require the client buy order to be transmitted to the market at 99¢ before any house order. But that would not stop the house then transmitting a buy order at $1.00 and taking price priority over the client. On that scenario, the regulation would seem to have achieved little.

Suppose further that the house order at $1.00 gets filled and then the market drops so that the client order at 99¢ is also filled. R7.8.18(4) would seem to require that the $1.00 execution be allocated to the client and the 99¢ execution be allocated to the house!

For what it is worth, my view is that the phrase "at or near the market price" needs to be interpreted having regard to the manner in which markets normally operate and reflect the fact that, at any point in time, there is usually a bid-ask spread in the market (ie there is no single "market price" as such). In my view, a buy order should be considered to be "near the market price" if it is equal to or more than the current bid price but less than or equal to the current ask price and a sell order should be considered to be "near the market price" if it is less than or equal to the current ask price but equal to or more than the current bid price. To illustrate, suppose the market price for a financial product is bid 99¢ /ask $1.01. An "at market" buy order would be processed at $1.01 (the current asking price). Conversely, an "at market" sell order would get processed at 99¢ (the current bid price). In my view, any buy order from and including 99¢ up to and including $1.01, and any sell order from and including $1.01 down to and including 99¢, should be consider "near the market price" since that represents the potential range of executable market transactions at that point in time.

That said, the clearly safer course for any licensee to follow who receives an order to buy or sell a financial product at a particular price (as distinct from a "careful discretion" or "best price" style order) is to transmit the order to the market as soon as it is received, regardless of how close it is to the current market price. That way,  if the market price moves rapidly in favour of the order, the licensee won't face any issues with the timing of the transmission of the order.

Leaving aside the ambiguities arising from the phrase "near the market price", r7.8.18(4) assumes that the licensee has complied with r7.8.18(3) and not transmitted house orders before client orders. But what if the licensee makes a mistake in this regard? R7.8.18(4) would seem to prevent the licensee re-allocating the trades to cure the breach.

R7.8.18(5) arguably applies to trading on the ASX as it is not otherwise covered by the ASX Market Integrity Rules or Operating Rules. The ASX 24 Market Integrity  Rules prohibit participants from disclosing any information about orders unless otherwise permitted or required under the Market Integrity Rules or the law (MIR 3.1.7) and that is probably sufficient to displace r7.8.18(5) from operating in relation to transactions on the ASX 24 market. However, both r7.8.18(5) and ASX 24 MIR 3.1.7 are unnecessarily wide. On their face, they would seem to prevent a trader responding to a request from his own Compliance or Legal Department for information about a client trade.

The maximum penalty prescribed for breaching MIR 5.1.3 is $1,000,000.

Under MIR 5.1.2, the following are not regarded as orders on a market participant's own account: (a) an order placed by a life insurance company registered under the Life Insurance Act (or equivalent State legislation) on behalf of a statutory fund; or (b) an order placed by a controller or a related body corporate of the market participant or of a controller on behalf of clients of, or funds managed by, them or their related bodies corporate.

Compare this definition with the definition of "connected person" used in ASX MIR 5.4 for the purposes of requiring the participant to monitor and approve certain trades on behalf of employees and employee controlled entities (see below).

The ASX Market Integrity Rules define "employee" of a market participant to include "a director, employee, officer, agent, representative, consultant or adviser of that market participant, or an independent contractor who acts for or by arrangement with a participant" (ASX MIR 1.4.3). It seems clear that the words "who acts for or by arrangement with a participant" only apply to independent contractors. Accordingly, it would seem that the inclusive reference to "employee" in this definition means a person who legally stands in an employer/employee relationship with the participant. Many brokers are part of a larger corporate group and the persons who work in their business are often employed by another entity in the group. Technically, therefore, these persons are not employees of the participant in the normal legal sense. However, they are probably caught by the expanded definition of "employee" on the basis that they are agents or representatives of the participant.

Note that the expressions "responsible executive", "controller", "immediate family", "family company" and "family trust" also have defined meanings under the ASX Market Rules (see MIR 1.4.3).

It follows from this definition of "prescribed person" that a participant needs to be able to identify orders that come from a prescribed person (especially employees and their immediate family and family companies and family trusts) and label them as such in its order management system. This means having an employee trading policy that extends to the immediate family and family companies and family trusts of employees and that requires these accounts to be properly disclosed.

MIR 5.1.4(2) provides that for the purposes of (c) above, a reference to a market participant giving preference to an order of a client over an order on the market participant’s own account, means that from the time of receipt of the order until it is fully executed, the market participant does not enter into, on its own account, a market transaction for the same products on the same terms unless: (a) the products are allocated to the client in accordance with MIR 5.1.6(c); or (b) the products are allocated to the client pursuant to an allocation policy previously disclosed to the client, to which the client consents, under which the market participant may buy or sell (and be allocated) the same products on its own account.

This effectively means that a broker can’t execute house or employee orders while it has an extant client order unless it does so pursuant to an allocation policy previously disclosed to the client, to which the client has consented. That could be a real problem if the broker were trying to cover a balance sheet exposure. It is therefore critical that brokers who trade on their own account have an allocation policy which acknowledges that they can execute principal orders at the same time as client orders and that they get client consent to that policy. Clearly, the best way to do that is for brokers to build the required consent into their client agreements. However, some institutional clients are reluctant to sign formal client agreements and so it would be wise to have a separate short-form consent for them to sign in lieu.

MIR 5.1.4(3) provides that for the purposes of MIR 5.1.4(2), a limit order which cannot be executed owing to price differences is not on the same terms.

Under MIR 5.1.4(4), a market participant must keep a record of any consent given by a client for the purposes of (c) above.

One point to note. The effect of (c) and (d) above is that a broker may have to postpone an employee trade to a client trade. Brokers should include a proviso to that effect in their employee trading policy.

The maximum penalty prescribed for breaching MIR 5.1.5 is $1,000,000.

Again, in light of (e), brokers should include a proviso in their employee trading policy to the effect that an employee trade may have to be postponed to a client trade.

The maximum penalty prescribed for breaching MIR 5.1.8 is $20,000.

Click here for a copy of ASX Market Rules Guidance Note 11 - Client Order Priority.

ASIC has said that it will seek to follow the published interpretations contained in pre-existing ASX Market Rules guidance notes, including Guidance Note 11, but will look to review them and issue replacement ASIC Guidance Notes in due course (see ASIC Regulatory Guide 214 - Guidance on ASIC market integrity rules for ASX and ASX 24 markets, at para 57-58).

The maximum penalty prescribed for breaching MIR 5.8.4 is $100,000.

The maximum penalty prescribed for breaching MIR 3.1.4 and 3.1.16 is $100,000. The maximum penalty prescribed for breaching MIR 3.1.5, 3.1.6 and 3.1.17 is $1,000,000.

MIR 3.1.4 does not apply to pre-negotiated business under MIR 3.3.1 or block trades under MIR 3.4.1. It also does not apply to (a) orders that cannot be transmitted to the trading platform such as "market on close", "stop loss" or "market if touched"; (b) "at best" orders, provided these orders are transmitted to the trading platform at such time as the market participant forms the view that the best price may be achieved; and (c) orders where client instructions preclude immediate transmission unless those instructions would cause the market participant to breach the MIR (MIR 3.1.4(3)).

Under MIR 3.1.5(2), orders may be transmitted and executed outside of the sequence in which they are received where they are aggregated under MIR 3.1.6.

MIR 3.1.6(2) provides that the only types of orders which, when received, may be aggregated for placement into the trading platform, are: (a) all futures or options orders received when the market is neither open, nor in the pre-opening phase; (b) spread or custom market orders received during the pre-opening phase of the market; (c) all futures or options orders received and recorded at exactly the same time; (d) orders that, by definition, cannot be entered upon receipt, for example "market on open" or "market on close"; and (e) orders negotiated under Part 3.3 of the MIR (pre-negotiated business).

For the purposes of MIR 3.1.16 and 3.1.17, the clients of a full participant which is a corporation include a related body corporate or a division of the participant which is separate from its futures division.

MIR 3.1.16(3) permits a market participant to allocate out of sequence where: (a) orders are aggregated under MIR 3.1.6; (b) the market participant uses either of the volume weighted average method or the percentage method to allocate the trades on a pro rata basis; (c) the market participant has advised, in writing, each client whose orders may be allocated out of sequence of their method of allocation; and (d) the market participant has retained a record of the advice sent to the client while the client remains a client of the market participant and for a period of 5 years after that client ceases to be a client of the market participant.

Under MIR 3.1.16(4), a market participant must notify ASIC in writing prior to adopting or changing its policy of allocating orders on one of the pro rata methods set out in MIR 3.1.16(3)(b).

There is an exclusion in MIR 3.1.15(3) for a representative who executes a trade to cover an error trade. Note that for these purposes, "client" includes a related body corporate of the participant or a division of the participant which is separate from the participant’s futures division (MIR 3.1.15(4)).

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Dealing with Clients as Principal

Note this does not apply to sales or purchases of securities or interests in managed investment schemes by issuers under the fund raising provisions in Chapter 6D or Part 7.9 (CR r7.8.20(1)).

The breadth of the expression "able to be traded" has been narrowed by CR rr7.8.20(1A) and (1B). Prior to the introduction of those regulations, there was a concern that a licensee might not know whether a particular financial product is able to be traded on a financial market on which the licensee was not a participant or did not have access through a third party. CR r7.8.20(1A) provides that subject to r7.8.20(1B), s991E(1) does not apply to a transaction if, at the time of the transaction, the financial services licensee is not a participant in the licensed market on which the particular financial product is being traded. CR r7.8.20(1B) provides that r7.8.20(1A) does not apply if: (a) the financial services licensee deals, or has dealt, in a financial product traded on that market on the licensee's own behalf (whether directly or through an agent or other representative) or on behalf of a client; or (b) an associate of the financial services licensee is a participant in the market mentioned in that r7.8.20(1A).

Note that this section only applies if the other party to the trade is a non-licensee. A broker who trades on-market in the ordinary course will be trading with the broker on the other side, who will of necessity be a financial services licensee. So this rule will not apply in practice to a broker selling as principal on-market to another broker, whether or not that broker is acting for a client. Most institutional investors will also be financial services licensees. So this rule will therefore generally only apply in practice to a broker who crosses on-market with principal one side, non-institutional client the other or who trades off-market as principal with a non-institutional client.

It is a good idea for a broker to include a form of disclosure and consent in its client agreements and to have a separate short form disclosure and consent to be signed by those institutional clients who may not wish to sign a client agreement.

The assumption underlying this prohibition is that if you are dealing as principal you are likely to be making a margin on the transaction and it is unfair for you to charge commission as well.

Again, it is a good idea for a broker to include a form of authorisation and consent in its client agreements and to have a separate short form authorisation and consent to be signed by those institutional clients who may not wish to sign a client agreement.

These rules apply where a market participant enters into a market transaction with a client as principal, except where the client is a market participant or a participant or member of a recognised stock exchange (MIR 3.2.1).

The maximum penalty prescribed for breaching MIR 3.2.2 is $100,000.

A reference to dealing on behalf of a substantial holder means that the relevant product is, or will be on the execution of the transaction, beneficially owned by the substantial holder (MIR 3.2.5(2)). This includes products that appear, or would appear, as assets on the balance sheet or consolidated balance sheet of that substantial holder's assets and liabilities (other than a life insurance company registered under the Life Insurance Act or the equivalent Act of a State where the products are held for or on behalf of that life insurance company's statutory funds) (MIR 3.2.5(3)).

Note that MIR 3.2.6 requires market participants to keep a register of the persons referred to in paragraphs (a)-(e) of MIR 3.2.5, with a maximum penalty for breach of $100,000. The purpose of this presumably is to have a register that DTRs can look at before executing an order to see whether or not it is a principal order. This is pretty unrealistic in the context of the large corporate groups nowadays (the list of related bodies corporate caught under (e) will often run into the thousands and will change on a daily basis).

The maximum penalty prescribed for breaching MIR 3.2.3 is $100,000.

The maximum penalty prescribed for breaching MIR 3.2.4 is $100,000.

"Prescribed person" is defined in MIR 1.4.3. It includes (amongst others) employees, directors and partners of the participant and related bodies corporate of the participant.

In relation to (b) above, the market participant must keep a written record of the consent given by the wholesale client and send a copy of the record to the client as soon as practicable (MIR 3.2.4(2)).

For a sample clause that addresses the requirements of this Market Integrity Rule, see the notes on Jones v Canavan in lecture 9.

This disclosure technically is only required where a client specifically requests it, which seems rather silly. Most brokers would (and those that don’t should) include this disclosure as a matter of course in their client agreements governing automated order processing.

Again, for a sample clause that addresses the requirements of this Market Rule, see the notes on Jones v Canavan in lecture 9.

See generally, SFE Practice Note 3 - Taking Other Side of Client Order (included in course reading materials).

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Dealings for or with Employees

In the case of a body corporate, "employee" includes officer (s991F(4)).

In relation to s991F(1), CR r7.8.20A provides that a financial services licensee and one or more employees of the financial services licensee may, on their own behalves, jointly acquire a financial product if it is a risk insurance product as defined in CA s761A. Presumably this in intended to relate primarily  to directors and officers insurance and to permit joint acquisition of such insurance policies.

CR rr7.8.21(5) and (6) attempt to define what is meant by "able to be traded on that market" for the purposes of s991F(3). CR rr7.8.21(5) provides that subject to r7.8.21(6), s991F(3) does not apply unless: (a) the particular financial product that is acquired or proposed to be acquired is a financial product traded on a market in which the financial services licensee is not a participant at the time of the acquisition or the proposed acquisition; or (b) the particular financial product is a derivative the value of which is derived from a financial product mentioned in paragraph (a). In turn, r7.8.21(6) provides that r7.8.21(5) does not apply if: (a) the financial services licensee deals, or has dealt, in a financial product traded on that market either on the licensee’s own behalf (whether directly or through an agent or other representative) or on behalf of a client; or (b) an associate of the financial services licensee is a participant in the market mentioned in r7.8.21(5).

Note that the exemption in (b) above only applies to the acquisition of fully paid shares. It does not apply to the acquisition of partly paid shares or interests in managed investment schemes.

CR r7.8.21(1A) also provides that s991F(2) does not have effect in relation to a financial services licensee that gives credit in good faith to a person employed by the financial services licensee or a person related to the financial services licensee to enable the person to acquire an insurance product in relation to a credit facility provided by the financial services licensee to the person (eg mortgage insurance provided in relation to a credit facility).

Note that many brokers form part of a larger corporate group and the persons who work in their business are often employed by another entity in the group. So technically they would not be caught by s991F(3). It is not quite clear what r7.8.21(2) is directed to, unless it relates to those groups that have more than one broker within the group (eg one that acts for institutional clients and another that acts for retail clients). In any event, the requirement in para (b) seems unduly restrictive for companies within the same group.

CR r7.8.21(4) effectively excludes from the prohibition in s991F(3) an employee of a financial services licensee whose employment is not directly connected with the licensee’s business of dealing in financial products on the relevant licensed market. The Explanatory Statement for the regulations adopting this provision (the Corporations Amendment Regulations 2003 (No 8) SR 282/2003) stated: "Persons whose employment is directly connected with a licensee's business of dealing in financial products on a licensed market would include persons employed as dealers/traders on the market, employees in the 'back office' (eg. settling and recording trades) and employees with management responsibility for the licensee's activities on that licensed market. The requirements of subsection 991F(3) will continue to apply to such employees."

For these purposes, "connected person" is defined to mean, in effect, an employee or a company or trust controlled by an employee (see ASX MIR 5.4.1 and the definition of "controlled trust" in MIR 1.4.3). Compare this to the range of officers, employees and associated family members, companies and trusts that are caught by the definition of "prescribed person" in MIR 5.1.1 in determining when an order is placed on the participant's "own account" and therefore attracts client order precedence rules (see above). An ASX participant will need to monitor whether an order it receives is on its own account and so a good case can be made that its employee trading policy should extend to the broader definition of "prescribed person" used in MIR  5.1.1 rather than the narrower definition of "connected person" above.

As mentioned above, the expression "employee" includes "a director, employee, officer, agent, representative, consultant or adviser of that market participant, or an independent contractor who acts for or by arrangement with a participant" (ASX MIR 1.4.3). Many brokers are part of a larger corporate group and the persons who work in their business are often employed by another entity in the group (usually the holding company or a separate service company). A person who is employed in this way technically will only fall within this rule if they act as an "agent" or "representative" of the broker. Notwithstanding this, many (if not most) Australian financial services groups that include an ASX broker apply these requirements across the entire group and oblige all group employees, even those not involved in the broking business, to comply with an employee trading policy. Typically this will require employees, their immediate family and family companies and family trusts to maintain their broking accounts with the house broker and to seek prior approval from Compliance to transactions in those accounts. In addition to ensuring compliance with MIR 5.4.2 for broking staff, this also facilitates the monitoring of compliance with Chinese walls requirements across the entire organisation.

For these purposes, "associate" is not specifically defined and therefore takes its Corporations Act meaning (MIR 1.4.2). "Relative" means a spouse, parent or remoter lineal ancestor, son or daughter or remoter issue, or brother or sister of that person (MIR 1.4.3).

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Short Selling

"Section 1020B products" means: securities; managed investment products; foreign exchange contracts that are neither derivatives nor immediately settled exchanges of currency (as per s764A(1)(j)); and other financial products prescribed by the regulations: s1020B(1). Warrants have been prescribed for these purposes (CR r7.9.80B).

Under s1020B(7), the expression "sell" has an extended meaning. A person who: (a) purports to sell s1020B products; (b) offers to sell s1020B products; (c) holds himself, herself or itself out as entitled to sell s1020B products; or (d) instructs a financial services licensee to sell s1020B products, is taken to sell the products.

On its face, s1020B(2) applies to brokers selling securities on behalf of their clients. If the client doesn’t have the securities and the broker doesn’t know and doesn’t have reasonable grounds to believe that the client has the securities, then the broker breaches by selling on behalf of the client. It would therefore be wise for a broker to include a warranty in its client agreements that unless the client instructs otherwise, whenever they place a sell order with the broker, they will be taken to have represented that they have a presently exercisable and unconditional right to vest the securities in the buyer.

As an example of something that happens from time to time – a client places an order to buy 100,000 shares over the course of a day. The broker, because of market conditions or through carelessness or whatever, only manages to buy 95,000 by the close of trading. Rather than send out a confirmation for a partial fill, the remaining 5,000 are credited to the client’s account and debited to the broker's error account, with a market trade placed the next day to buy 5,000 to cover the short in the error account. Unless a stock borrowing arrangement is put in place to cover that short, this is a clear case of short selling in breach of s1020B(2).

Another example of something that has been known to happen (but shouldn't!) - a broker who knows that a client is interested in selling a parcel of shares but does not have an actual order from the client to sell, sees a brief opportunity emerge in the market to make a favourable sale. He executes a sell order in the hope that when he presents it to the client, the client will accept it. If the client doesn’t, the broker will enter into a reversing purchase and write any difference to the error account. Again, unless a stock borrowing arrangement is put in place to cover that short, this too is a clear case of short selling in breach of s1020B(2).

See generally ASIC Regulatory Guide 196 Short selling.

CA s1020B(4) allows a seller to sell products acquired through the purchase agreement even though the seller may not have a presently exercisable and unconditional right to vest the products in the buyer because, at the time of sale, the purchase agreement to acquire the products has yet to complete (ie it is still conditional on payment of the purchase price and delivery of title and transfer documentation).

There is a formula in CO 09/1051, para 6 for working out the amount of coverage provided by ETOs.

In relation to the last bullet point, ASX Business Rules Guidance Note 11/97 correctly said that a short sale covered by shares that will be issued in the future under company issued options constitutes an unlawful short sale because at the time of sale all that the seller has is a contractual right against the listed company for the allotment of securities in the future through the exercise of the options. That is not a "presently exercisable and unconditional right to vest the shares in the buyer". In addition, the short sale will also amount to a contravention of ASX MIR 5.10.1 because, at the time of the sale, the securities dealt with will not have been admitted to official quotation. Official quotation can only be applied for after the options have been exercised and shares have been allotted. These breaches will arise even if the seller is able to fulfil its settlement obligation by having the options converted and the shares admitted to official quotation by the time settlement is required. By extension, the same reasoning will apply to other convertible or converting securities.