Following the money
A High Court finding against an awardwinning fund manager stirs up the murk of sharemarket manipulation.
A High Court finding against an awardwinning fund manager stirs up the murk of sharemarket manipulation. by Jonathan
Underhill
It is unlikely anyone watching the stock market on May 27, 2014, and several weeks later, on July 9, would have noticed anything out of the ordinary. The BusinessDesk newswire, which publishes a daily sharemarket report, noted that May 27 was a slow day with turnover of just $82 million thanks to national holidays in the US and the UK. Fisher & Paykel Healthcare rose 1.2% to $4.39 as 1.6 million shares changed hands, but didn’t rate a mention.
The July 9 report said New Zealand stocks were sold off, along with equities across the Asia-Pacific region. Investors were waiting for earnings season the following month. A2 Milk shares were unchanged at 69c on the day, with about 1.1 million shares traded. Again, it didn’t feature in the day’s market report.
But Chief High Court Judge Geoffrey Venning saw something unusual on both days in trading in both those stocks. The common theme was Mark Warminger, a former award-winning fund manager at Milford Asset Management, who Venning found in a March 3 judgment was guilty of market manipulation by carrying out trades that “created a misleading appearance”.
Venning’s judgment is the first in New Zealand to attempt to define the boundary between a legitimate trading strategy and market manipulation. It has been widely read by commercial lawyers and financial market participants. The court has yet to determine a penalty in what was a civil case with no substantive victims and little obvious profit.
Although some people call Warminger an outlier, others say his behaviour wasn’t far outside the norms of a highly competitive industry in which funds report their performance on a daily basis, especially given the uncertainty about what constitutes market manipulation.
In reaching his decision, Venning leaned on the role of purpose in determining whether the line had been crossed, saying that “the purpose of the trade may be the key factor that distinguishes culpable manipulation from a trade made for genuine reasons”.
That’s because there can be “legitimate indirect or collateral motives” for trades rather than the old adage of buy low, sell high. Such motives could include “price or volume discovery and positioning” – such as a small trade that acts as a fishing expedition to try to flush out how much stock is available or wanted at what price.
The stakes are high. Warminger alone managed $669 million of investments, some on behalf of the NZ Superannuation Fund. Milford, in total, manages about $3.5 billion for 20,000 clients. All up, New Zealanders had about $37 billion in KiwiSaver as at the end of 2016. At their average 1.28% fee, that would mean fund managers were competing for nearly $500 million of income a year in that market alone.
MUMBLE MUMBLE
Few brokers or fund managers are willing to speak publicly about the case while it is open to appeal. They may also feel shy in a market so small that six degrees of separation overstates the gap between the players and where illiquidity leaves the market “more susceptible to manipulation”, as Venning says.
In taking the case, the Financial Markets Authority (FMA) acted on a referral from the NZX market surveillance team, which had spotted an odd movement in Xero shares on June 23, 2014, it described as “an interruption to a declining price trend” involving “the buying and selling of the same security in a matter of minutes through different brokers”.
The surveillance team identified a direct market access-enabled (DMA) client of Macquarie Securities, which turned out to be Milford, and the user at Milford was Warminger. The DMA facility allowed him to enter orders directly into the trading system, although technically he was trading through Macquarie.
Using DMA, he had placed buy orders for small quantities of Xero stock, which had the effect of nudging up the price. Then, through a different broker, he sold a bigger parcel of Xero off-market at a higher price. The surveillance team began taking a wider look at Warminger’s trading and the FMA ended up taking 10 examples to the High Court, and obtained judgments in two.
DMA? Off-market? About now, the ordinary person might be bewildered by market jargon. But capital markets are one of the building blocks of an efficient economy and trust in the integrity of trading is vital to its success.
A 400-year-old institution where buyers and sellers meet to trade, the stock market remains a bustling, noisy, chaotic venue where the mood can swing from euphoric to desperate, even in these days of computerised trading. It has spawned legends such as Warren Buffett and villains like Jérôme Kerviel, whose unauthorised trading in stock futures cost French bank Société Générale about €4.9 billion in 2008.
It is easy with hindsight to sift through the vast record of trading – the data, the email trails, the phone records, the digital fingerprints – that can throw up unusual trading patterns, but in the organic, rolling maul of the market, as one trader says, people can do dumb things and some behaviour can be baffling.
Add to that high-frequency traders – computers driven by algorithms that can transact in milliseconds to chase micromargins across millions of individual trades – along with the vast “dark pools” now operating in major stock markets, and the “ping-pong” trading of Warminger, whom no one calls dumb, could almost seem slow motion.
He was caught by the 99-word section 11B of the Securities Markets Act 1988 (now subsumed into the Financial Markets Conduct Act), which prohibits false or misleading trading and refers to people who ought to know the effects of their actions or omissions, such as a professional investor.
In the organic, rolling maul of the market, people can do dumb things and some behaviour can be baffling.
However, it wasn’t until this judgment that the courts have tried to put meat on the bones of 11B. Last month, the NZX also spelt out its expectations of market participants in a market-conduct note that gives examples of what it sees as market manipulation. The guidance, which is out for submissions, came almost three years too late for Warminger. Until it is bedded down, the trading community will tread carefully.
“Inherently, the market understands what intentional market manipulation is and all firms have strong policies to identify intentional behaviour,” says James Lee, managing director and head of securities at First NZ Capital. “Where the market will be looking for clarity is around the concept of non-intentional, where the effect is subjective and visible only with the benefit of perfect hindsight.”
Lee gave evidence for the FMA during the hearing and declined to comment specifically on the case. He says so long as there is ambiguity in the rules, firms will “continue to err on the side of caution”.
Off-market trading, or crossings, are trades negotiated directly between or within brokerages as opposed to on-market trading via what’s known as the central order book, and is now where most of the trading action occurs. About two-thirds of all NZX stock trades are off-market – way higher than in other jurisdictions. Although these must be subsequently reported through the trading system, critics say they rob the market of liquidity and price discovery.
Critics include Milford’s Brian Gaynor, who declined to be interviewed, but wrote in December that off-market transactions put market participants “at a huge disadvantage compared with brokers”, who may have substantial private wealth operations and can generate commissions on both sides of an off-market trade. In a small, illiquid sharemarket such as New Zealand’s, “a handful of brokers completely dominate” the market, he wrote.
Retail investors, the mums and dads, are typically just price-takers, but they’re smaller fry in a more equitable market than it once was.
“Much has been learnt from the excesses and crash of the New Zealand equities market in the 1980s and the subsequent collapse of myriad listed companies, and more recently the failure of so many finance companies from 2008 onwards,” says Philip King, chairman of the Institute of Finance Professionals and an executive at Fletcher Building. “At the end of the day, New Zealand has to compete for capital on the world stage, and a well-structured, wellregulated financial marketplace is critical. Fortunately, we have that.”
The judgment is also being scrutinised in the UK and Australia, such is the lack of case law on the topic. It took the FMA two years to build a case, which speaks volumes about the difficulty of the task.
PRACTICE DOESN’T MAKE PERFECT
What is market manipulation again? Dionigi Gerace, of the faculty of business at the University of Wollongong, wrote in a 2014 paper about manipulation on the Hong Kong Stock Exchange. It is “among the oldest and most harmful practices in global sharemarkets” and “victimises individual investors, erodes public confidence in market integrity and undermines market efficiency”.
Gerace notes the difficulty of defining the concept and adds that the effectiveness of the law “must be called into question if manipulation cannot be defined with precision”.
Milford reached a $1.5 million settlement with the FMA in June 2015 and avoided being hauled through the courts as a party to Warminger’s misdeeds.
The settlement allowed Milford to deny liability while saving it from what would have been a time-consuming, costly and brand-damaging court case.
It did have to acknowledge inadequate oversight of its star fund manager, who accepted the Institute of Finance Professionals New Zealand (Infinz) award when Milford was named top fund manager for the fifth straight year in 2014, and tightened its trading systems and controls as part of a process reviewed by PwC.
Venning has reserved his decision on imposing a financial penalty on Warminger, but Roger Wallis, a Chapman Tripp corporate and securities law specialist, said the case was never about fining the fund manager. Rather, it was about testing the limits of the law and providing some definition of when legitimate trading steps over the line into market manipulation. And it was about signalling to the market that the regulator was prepared to take action.
“The fact that they took action two years ago probably got them 60% of the way there even before the judgment came out,” Wallis says. “The Milford situation, I suspect, would now be pretty rare.”
Market manipulation is “among the oldest and most harmful practices” and “erodes public confidence”.