Market manipulation: the curious case of Mr Hobbs

In something of a reverse for the FSA, last month the Upper Tribunal directed that no action should be taken against Mr Hobbs, a trader whose conduct the FSA had decided was market abuse (manipulation) under s 118(5) of FSMA, and whom the FSA had proposed to fine and ban.  The Tribunal's decision is somewhat unexpected, in that the Tribunal decided to place no reliance on Mr Hobb's comment to his broker that he had created a false impression, dismissing this as mere boastfulness, or on a market participant's claims to have been misled.  In addition, the Tribunal concluded that Mr Hobbs' conduct had been carried out for legitimate reasons and in conformity with accepted market practices on the coffee futures market, even though it accepted that his trade was designed to fix the coffee options reference price at a level above $1750 (above the true market price).  

Facts

Mr Hobbs was a trader employed by Mizuho International plc (“Mizuho”) to carry out proprietary trading in LIFFE coffee futures and associated derivatives.  He was approved as an investment advisor (CF21).

On 15 August 2007, Mr Hobbs held 2050 September 2007 coffee future put options with a strike price of US$1750.  Mr Hobbs had begun the day with a short position of 564 September 2007 coffee futures which he had virtually closed out, having bought 802 futures and sold some 326 futures by 12:23 pm.

At 12.26 pm, and consistently with the trading range for the previous two hours, the bid-offer range for September 2007 coffee futures was US$1744-US$1746; so that the put options were "in the money" (ITM).  Trading prior to 9:45 am had been consistently at prices above US$1750.   Key determinants of the price of LIFFE coffee options include the price of LIFFE coffee futures, time, volatility and interest rates.

September 2007 coffee future put and call options were due to expire at 12.30pm on 15 August 2007, after which time they could no longer be traded. The coffee options reference price (CORP) was then due to be set by reference to trading in futures in the minute between 12.29pm and 12.30pm.  If the option holders did not give contrary instructions to the Clearing House before 1.15pm, then options that were ITM by reference to CORP would be exercised automatically, and those “out of the money” (OTM) would be abandoned.

At 12.26pm Mr Hobbs instructed Andrew Kerr, a broker with Sucden Ltd, to place a limit buy order, up to US$1757, for 600 lots of coffee futures ("the Trade"), “on the close”, shortly before 12.30pm.  Mr Kerr executed the Trade in the two seconds prior to 12.30pm.  This caused the price of September 2007 coffee futures to rise from US$1745 (at 12.29.57) to US$1757 (at 12.30.00), in turn increasing the volume weighted price of the September 2007 coffee futures traded in the minute between 12.29 and 12.30 to US$1752, and thus causing the CORP to be set at that level (above the US$1750 exercise price for the September 2007 US$1750 put and call options rather than below, as would otherwise have been the case).

The result of setting the CORP at that level was effectively to reverse the default positions (as to exercise and abandonment) of those put and call options - so that the call options were ITM by reference to CORP, and would be exercised at 1.15pm - in the absence of a countervailing instruction - whilst the put options were OTM by reference to CORP, and would thus be abandoned, unless the holders gave the Clearing House contrary instructions.

Within seven minutes of 12.30pm, the market price had fallen back to its pre-12.30pm level of US$1745.  There is of course clear authority that even a price movement of short duration can be manipulative: in IMC Securities BV v Stichting Autoriteit Financiële Markten, the CJEU confirmed that the Market Abuse Directive does not require a price to be maintained at an abnormal or artificial level for any minimum period in order for the price to be considered to have been fixed at an abnormal or artificial level.

At 1.01pm on 15 August 2007, Mr Hobbs elected to exercise 1,147 of the US$1750 put options that he owned.  Those options were OTM by reference to the CORP (US$1752), and would have expired at 1.15pm but for specific instructions given by Mr Hobbs to the Clearing House.  The effect of that exercise was to increase his short position, and to that extent nullify the effect of his earlier net purchases of futures on that day.  However, because by then the price of the coffee futures had settled below US$1750 (trading at around US$1745 – 1746), the put options were in fact ITM by reference to market value.

The decision

The FSA issued a decision notice finding that Mr Hobbs's conduct on 15 August 2007 constituted market abuse under s 118(5) of FSMA.  The FSA proposed that Mr Hobbs should be fined £175,000 and that an order should be imposed prohibiting Mr Hobbs from performing any function in relation to any regulated activity on the ground that he is not a fit and proper person.  Mr Kerr, meanwhile, settled the case the FSA brought against him on the basis of a £100,000 fine and a prohibition order.

Mr Hobbs referred the matter to the Upper Tribunal in August 2010.  It was accepted by both parties that the standard of proof to be applied was the ordinary balance of probabilities.

The Tribunal accepted that the central issue for it to determine was the trading rationale for the Trade - effectively, whether Mr Hobbs's purpose in effecting it was legitimate.  The Tribunal commented that "in determining whether a trade is legitimate or not, it may be necessary, in a particular case, to weigh all the observable features, including the implausibility of the success of the scheme, in assessing what could have been the purpose of the transactions”, although "if the elements of market abuse are present and the trade is not a legitimate one, then it cannot matter if the purpose of the market abuse was incapable of being achieved".

The FSA's case was that the Trade was an order to trade which gave a false and misleading impression as to the price of September futures (and the CORP), and secured the price of September futures (and the CORP) at an abnormal and artificial level.  The FSA asserted that the Trade was not made for legitimate reasons and not in conformity with accepted market practices – and argued that Mr Hobbs' intention was to manipulate the price with a view to inducing other market participants to behave in a way that would have enabled him to profit thereby.

Mr Hobbs, on the other hand, argued that his intention in entering into the Trade was simply to reduce his short position, although he also claimed that he was trying to conceal his true position from Mr Kerr.  Mr Hobbs had been in breach of his front office limits at the start of the day, and was keen to conceal the fact that he was unable to take on a particular size of position because of the risk limits he was subject to.

The Tribunal found Mr Hobbs to be an unsatisfactory witness, whose answers could not be accepted at face value.  It dismissed a comment Mr Hobbs made to Mr Kerr shortly after the Trade - "I created a false impression" - as merely seeking to boast about the effect of his trading.  So in giving weight to his evidence, the Tribunal looked for other evidence to support his account.

The Tribunal ultimately concluded that Mr Hobbs' concern had been to ensure that he was able to exercise and abandon the required number of put options, taking account of the procedure for automatic exercise and abandonment with a CORP set at US$1752, and that this was not part of any strategy to sell into a rising market, but rather to bring his book back into line with his own view of the market.

Taking all the evidence into account, the Tribunal concluded that the trade had been carried out "for legitimate reasons and in conformity with accepted market practices on the coffee futures market".  It considered that the trade was executed to address Mr Hobbs’ short position, by means of a limit order which simply accessed prices already in offer in the market, and could not be regarded as creating a false impression in the market.  Accordingly, the Tribunal found the FSA had failed to make out its case.

The Tribunal's approach to the limb of the test which refers to conformity with accepted market practices is somewhat unexpected.  The Tribunal found that the volume-weighted nature of the CORP anticipated that trades would take place in the last minute prior to 12.30pm on options expiry, and that there was no evidence of any market practice not to trade in that last minute.  Such evidence as was led indicated that in respect of the 12 option expiries between September 2006 and July 2008, no trades took place in the expiry minute of 8, of the 12, expiries.  However, the  Market Abuse Directive's provisions on accepted market practices would appear to contemplate something rather more positive and formal by way of "acceptance" than mere absence of evidence of a contrary practice in the market.

Interestingly, although the Tribunal felt that Mr Hobbs' statements that he was engaged in a strategy of confusion had been false, it was not satisfied that Mr Hobbs was not a fit and proper person, given its view that no market abuse had taken place.

Comment

The Tribunal accepted that Mr Hobbs' intention in placing the futures trade in the final minute of trading in the options was to fix the CORP at a level above $1750 (above the true market price), so that he could elect to exercise a portion of his 2050 put options and abandon the remainder, increasing his short position and bringing his book back into line with his own view of the market.

Yet Mr Hobbs could have achieved a similar overall position without purchasing the 600 futures contracts, simply by electing not to exercise some or all of his put options, notwithstanding the fact that they were in the money.  This might of course have advantaged his counterparties rather than him (the Tribunal's decision does not assess what profits or losses resulted from the intra-day trading).  However, the Tribunal appears to have believed that such an approach would not have enabled him the flexibility to later take a short view (as the liquidity in the market might not have supported going short by selling futures).

From the limited information contained in the Tribunal's decision, it seems at least a possibility that Mr Hobbs' true purpose may have been to impact the demand for coffee futures, rather than an attempt to fix the price artificially.

By reversing the default positions as to exercise and abandonment of September 2007 coffee futures put and call options, Mr Hobbs artificially placed those market participants who were put option holders - who would otherwise have relied on the Clearing House to exercise their puts automatically because they were ITM - in the position of having to actively contact the Clearing House to elect to exercise them because they were OTM by reference to the artificially fixed CORP.  It would also have forced market participants who were short in the options to revise their assumptions about what those long in the options would do.  An 18 minute delay in the announcement of CORP (not of Mr Hobbs' making) in fact considerably reduced the window within which participants could react to the unexpected position and provide instructions to the Clearing House.

It appears that between 27% and 28% of the US$1750 puts were abandoned, despite the market having moved below that strike price before 1.15pm.  It could be argued that the fact that Mr Hobbs had declined various offers to buy his put options might be consistent with a strategy of seeking to limit shorting demand after trading in the options ceased.  Manipulation of demand is also manipulative conduct within the scope of section 118(5) of FSMA.

That said, the decision suggests that the evidence before the Tribunal did not establish that the failure to exercise 27% of put options was due to a failure by put option holders to react to the reversal of the default position on the exercise of the options and the rebound in the market value by 12:37.  Some may, like Mr Hobbs, deliberately have allowed some or all of their options to lapse.  Nor does the decision make clear what proportion of call options were left to be automatically exercised at 1:15 even though they were by then OTM by reference to the market value.  Rather than instructing the Clearing House not to exercise his call options automatically, Mr Hobbs modified his initial instruction for the exercise of 997 puts to a request to exercise 1147 puts to take account of the automatic exercise of the 150 calls options.

This decision also produced the somewhat curious outcome that Mr Kerr, the broker who was merely executing Mr Hobbs' trade, has been fined and banned for market abuse (having settled the FSA's case against him), even though the trader who devised the trade which he carried out has been found not to have committed market abuse.   In future, others charged with accessory liability may prove less willing to opt for early settlement.