The new Market Abuse Directive what it means for investment trust share buybacks

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1 Stop Press 14 July 2005 The new Market Abuse Directive what it means for investment trust share buybacks 1 Issues 1.1 The EU Directive on Insider Dealing and Market Manipulation (the Market Abuse Directive ) aims to harmonise market abuse rules across the EU. It came into force on 1 July 2005, at the same time as new Listing Rules. 1.2 In addition to a revised market abuse regime, the Market Abuse Directive introduced an express safe harbour for specified share buy-back activities. This safe harbour can be used in respect of buy-backs by investment trusts compliance with the requirements of the safe harbour will protect against the possible commission of market abuse. 1.3 It is likely to be difficult for some investment trust buy-backs to fall within the safe harbour, because it imposes significant restrictions as to purpose, price and volume and its criteria are cumulative. 1.4 Where share repurchase activities do not fall within the safe harbour, that is not to say that they will constitute market abuse The FSA has said that non-compliance with the buy-back safe harbour, as set out in Regulation 2273/203/EC (the Regulation ) in itself is not market abuse The amendments to the Listing Rules provisions on share buy-backs have explicitly been made on a basis that allows issuers to elect whether or not they comply with the safe harbour or will continue just to comply with the constraints imposed under the Listing Rules. The Listing Rules allow buy-backs to be conducted at a maximum price which is 105% of the latest five day average (i.e. the pre-1 July provision) or at the maximum price formula specified in the safe harbour The AITC has released a note in which it discussed what it considers accepted practices and advised that its interpretation of the new rules is that common investment trust share repurchase activities, which, as a consequence of a reduction of capital, seek to address liquidity issues and discount volatility, will not amount to market abuse. This is attached. Following discussions with the Financial Services Authority ( FSA ), regarding this note, the AITC confirmed to us on 7 July 2005, that the FSA had raised no issues of concern regarding any of the contents of the note regarding share repurchases. Since the FSA can only issue guidance further to a consultation exercise, this is probably as much comfort as it is possible to obtain from the FSA 1.5 It is unlikely that share buy-back programmes that did not constitute market abuse under the previous regime will constitute market abuse now. However, if not conducting buybacks in accordance with the safe harbour, it may still be necessary, depending, in particular, on the share price effects of the buy-back and how the share repurchase activity is conducted, to consider whether the elements of one of two market abuse A /0.0/11 Jul 2005

2 offences may apply to the activities 1. This is especially so where buy-back instructions are unusual and/or constitute a departure from normal practice. It may also be necessary to consider whether the specific defence to the first offence is available. 1.6 Certain aspects of the AITC s note and the fact that it has been reviewed by and discussed with the FSA are helpful, in particular: given that, in relation to the first market abuse offence: it is necessary for its commission that the price of the shares should be considered to be secured at an abnormal or artificial level, it is helpful that the FSA have reviewed and not raised any issues with the AITC s comments that adopting strategies to address typical liquidity concerns are beneficial to shareholders and indeed assist in the orderly functioning of the market ; as there is a defence to the first head of market abuse where buy-back activities are carried out for legitimate reasons and in conformity with accepted market practices on the London market, it is helpful that the FSA have reviewed and not raised any issues with the AITC s comments that share buy-backs by investment trusts are part of an accepted practice by which Boards tackle issues relating to an imbalance between the supply and demand for the company s shares ; given that, in relation to the second market abuse offence, much ultimately turns on how the regular user (e.g. the FSA) would view the behaviour in question, it is helpful that the FSA have reviewed and not raised any issues with the AITC s comments that, because typical share buy-back activities are conducted in a transparent environment, they are unlikely to create a misleading impression of the demand for an investment trust s shares and therefore unlikely to constitute market abuse. 1.7 While comfort can be taken from the discussions held by the AITC with the FSA, it will continue to be the case that even if conducting a buy-back in accordance with the Listing Rules, the safe harbour is likely to be considered a guide to acceptable conduct. The greater the extent to which a buy-back meets criteria which, if not strictly complying with the conditions of the Regulation, seek to stay as close to them as possible, the less likely it is to be considered abusive. We recommend that the practical points suggested below should therefore be considered for any investment trust buy-back. 1.8 As well as complying with limits directed at avoiding market abuse, investment trusts will, of course, also continue to have to comply with the limits imposed under the terms of their shareholder authorities and the ABI in effecting share buy-backs The Market Abuse Directive makes it a civil offence for an investment trust or its brokers, amongst other things, to: create false or misleading impressions regarding the supply, demand or price of shares or secure the price at an abnormal or artificial level, subject to the defence that the transactions are for legitimate reasons and in conformity with accepted practices (s118(5) FSMA); otherwise mislead or distort the market, in the view of the regular user (s118(7) FSMA). The ABI guidelines on share buy-backs have not changed and the form of the authorities that are taken by investment trusts are unlikely to change. A /0.0/11 Jul 2005 Page 2 of 5

3 2 Action points regarding compliance with the legal framework 2.1 Compliance with the following practical guidelines, which, if not strictly complying with the conditions of the Regulation, seek to stay as close to them as possible, should help ensure that a buy-back conducted under the Listing Rules is not considered abusive. 2.2 Purpose The Regulation requires that the sole purpose of the buy-back programme must be to reduce the capital of the issuer (in value or in number of shares) or to meet obligations arising from debt financial instruments exchangeable into equity instruments or employee share option programmes. For investment trust buy-backs to satisfy the sole purpose condition, it will be necessary to be able to demonstrate that the purpose of the buyback is to benefit ongoing shareholders by buying in excess capital so that the buy-back activities are therefore a mechanism for the long term capital management of the investment trusts. In light of the variety of reasons for which buy-backs are conducted by investment trusts it is most unlikely that the sole purpose test will ever be met. Clearly, however, it will help if the pre-dominant purpose or purposes are directed at long term factors which the board believes will benefit the company and its shareholders as a whole rather than any short term price objective. While views on best market practice are being formulated, the following action points and criteria are suggested: the purpose of the buyback should be as clear as possible and ideally should be documented in the board resolution approving the buy-back. legitimate secondary purposes of a buy-back, alongside long-term capital management, may be considered to be 3 : enhancing net asset value ( NAV ) for remaining shareholders; improving liquidity; minimising, so far as achievable, discounts which investment trust boards regard as too wide, in absolute or relative terms; helping to narrow discount volatility; and eliminating overhang caused by an imbalance of buyers and sellers. the buy-back should at least have a purpose that is not price support and the way the buy-back is implemented should seek, so far as possible, to minimise the pricing impact of what the investment trust/its brokers are doing in the market. having a cut-off point by reference to a particular discount to NAV may be acceptable as long as the purpose is still to achieve most efficient use of capital over the long term. 3 These typical consequences are listed in the AITC note. A /0.0/11 Jul 2005 Page 3 of 5

4 investment trusts should review guidance on share buy-backs looking to ensure that instructions given to brokers can be documented as directed to long term capital management and the other legitimate purposes outlined above, rather than achieving price effects. 2.3 Pricing: the Regulation provides that the price for the buy-back must not be higher than the higher of the price of the last independent trade and the highest current independent bid 4. In light of the regular user test we consider the answer on pricing issues lies in what develops as perceived best practice for investment trust buy-backs. Guidelines should be set which, if not strictly complying with the pricing limits, seek to stay as close to them as possible 5. Until such time as a regular user view develops, we recommend that investment trusts and brokers should monitor the market in their shares and be alert to situations where continuing with their normal buy-back activity could give rise to unacceptable price effects and or distortion. Unusual buy-back instructions and/or departure from historic practice and/or what will emerge as best practice for investment trusts is likely to need to be closely scrutinised. 2.4 Quantum: the issuer must not repurchase more than 25% of the average daily volume (in the 20 days preceding the date of purchase), but in cases of extreme low liquidity 6 this can be increased to 50% if the issuer informs the FSA and discloses via an RIS. 2.5 Market notification: the issuer must ensure it has in place mechanisms to fulfil trade reporting obligations to the Financial Services Authority 7. The mechanisms must record each transaction relating to buy-back programmes, including the names and numbers of instruments bought, dates and times of transactions, transaction prices and the means of identifying the investment firms concerned in the buy-back activities. We recommend public disclosure by no later than the end of the market session following the buy-back transaction in question. This is more stringent than the requirements of both the Regulation, which only requires public disclosure no later than the end of the seventh daily market session in question, and the Listing Rules. 2.6 Satisfying the additional conditions of: the Regulation, and the Companies Act 1985, namely requiring compliance of the buy-back authority with s166 of the UK Companies Act 1985, are unlikely to present particular difficulties in practice. 3 Trading in the investment trust s shares while buy-backs are ongoing 3.1 The position, under the Listing Rules, in relation to trading in shares during buy-back programmes, including close periods, is unchanged from the pre-1 July position As to whether this condition can be satisfied, a lot depends on whether the investment trust is trading through the order book or off-market. For example, looking to execute a trade over a day by reference to a limit of the volume weighted average price over that day may be an acceptable alternative benchmark of what is best practice. The definition of extreme low liquidity varies depending on specific circumstances and the Code of Market Conduct advises that the FSA is contacted for specific guidance on this point. LR A /0.0/11 Jul 2005 Page 4 of 5

5 3.2 The general rule 8 is that during the course of a buy-back the issuer cannot engage in: the selling of its own shares; trading during a closed period ; and trading where the issuer has decided to delay the public disclosure of inside information. This prohibition does not extend to banks dealing on behalf of clients or selling own shares where there are Chinese walls in place The concept is retained that, for investment trusts, it is possible to continue buying shares in a close period as long as the investment trust has announced NAV on a weekly or more frequent basis 10. Granting of permission is still at the FSA's discretion. If you have any queries, please contact Matthew Middleditch, Tim Shipton, John Lane, Anne Kirkwood or your usual Linklaters contact. Matthew Middleditch tel: matthew.middleditch@linklaters.com Tim Shipton tel: tim.shipton@linklaters.com John Lane tel: john.lane@linklaters.com Anne Kirkwood tel: anne.kirkwood@linklaters.com This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts at Linklaters. Linklaters. All Rights Reserved 2005 Please refer to for important information on the regulatory position of the firm. We currently hold your contact details, which we use to send you special reports such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this special report or other marketing communications, please let us know by ing us at marketing.database@linklaters.com New Code of Market Conduct EU, para 1 of table. The exceptions are in new Code of Market Conduct, para 2 of table and new LR LR and A /0.0/11 Jul 2005 Page 5 of 5