Calculating pecuniary penalty maxima under the FMCA*

In Financial Markets Authority v Zhong,[1] in relation to multiple breaches of the market manipulation provisions of the Financial Markets Conduct Act 2013 (FMCA), the High Court recently considered how to calculate the applicable maximum penalty under the formula prescribed by s 490 of the FMCA, and in particular whether gains made from contravening conduct should include unrealised gains.

 Financial Markets Conduct Act 2013 – penalty provisions

Section 489 of the FMCA provides that the FMA may apply for a pecuniary penalty order where a person has contravened a civil liability provision. In determining the appropriate penalty, s 492 provides that the court “must have regard to all relevant matters”, including specified matters listed in that section.

Section 492 largely adopts the penalty considerations set out in s 42Y of the Securities Markets Act 1988 (SMA).  Deterrence is not expressly set out as a factor.  However, in FMA v Warminger, the High Court recognised that “deterrence must be a relevant consideration” when determining a pecuniary penalty.[2]  This approach was confirmed in FMA v ANZ Bank Ltd, where Muir J held that deterrence was captured as a factor by the need to consider the purposes of the FMCA.[3]  Indeed, Muir J stated deterrence will always be a relevant consideration, and it may be the overriding objective.[4]

In the context of other civil pecuniary penalty regimes, the courts have highlighted the need to set penalties at a level where they are not seen as a financially acceptable risk when compared to the potential gains from the misconduct.[5]  The courts have emphasised this also applies to the FMCA.  In ANZ, Muir J stated:[6]

I accept the FMA’s submission that, to achieve deterrence, it will generally be appropriate for the starting point to be substantially higher than the gain obtained. This ensures that penalties are set at a level where they are not seen merely as a cost of doing business and sends appropriate signals to the market in terms of the importance of compliance with the Act. Again I revert to this issue in my discussion concerning deterrence.

This principle was repeated in FMA v Cigna Life Insurance New Zealand Ltd where the Court held that “a starting point should also be significantly above the net gain to meet deterrent aims”.[7]

The approach to fixing pecuniary penalties

In the two pecuniary penalty cases for market manipulation under the SMA, FMA v Henry[8] and FMA v Warminger, the High Court adopted a penalty-setting approach analogous to that taken in determining penalties under the Commerce Act 1986 and in criminal sentencing matters.  The Court also took the same approach in determining penalty in relation to the third and fourth defendants in the Zhong proceeding.[9]

In those cases, the Court proceeded by:

·         determining the maximum penalty;

·         establishing a starting point, in light of the relevant factors bearing on the contravenor’s culpability, and by reference to the applicable maximum penalty; and

·         adjusting the starting point by applying an uplift or a discount on the basis of any considerations personal to the defendant.

Determining the maximum penalty

Sections 385 and 490 of the FMCA provide that the maximum penalty for a single breach of a market manipulation provision by an individual will be the greater of:

·         the consideration for the relevant transaction;

·         if it can be readily ascertained, three times the amount of the gain made or the loss avoided by the person who contravened the provision; or

·         $1 million.

Unrealised gains

At issue in Zhong was whether the second option above - three times the amount of the gain made by the person who contravened the provision – included unrealised gains.  The evidence was that each 10c move in the share price of the relevant stock in that case, Oceania Natural Ltd, led to an approximate $1.6 million mark to market gain for the Zhong Family Trust.  However, the defendants never realised those gains before the company went into liquidation. 

Using the unrealised gains from the various beaches led to a total maximum penalty of $48.58m for Mr Zhong and a total maximum penalty of $48.02m for the second defendant, Ms Ding.  If the default maximum penalty of $1m was used, the total maximum penalty for Mr Zhong would have been $6.2m and $7m for Ms Ding.

The FMA argued that a purposive approach for insider trading and market manipulation contraventions should focus on the gain at the date of the transaction, not whether in fact that mark to market gain was subsequently realised.  As one of the key purposes of pecuniary penalties is deterrence, setting the maximum with regard to the mark to market gain or loss would be a further disincentive to engage in prohibited conduct. 

This point was alluded to in the Law Commission’s review of pecuniary penalties:[10]

We consider that linking a maximum penalty to three times the commercial gain resulting from the breach can be a useful formulation, particularly where deterrence of breach for financial benefit is sought. The approach is accepted as an effective deterrent against those who would make a rational decision to breach with the intention of making a profit or avoiding a loss. It has been designed with a specific purpose and with specific offenders in mind. In addition, arguably there can be little objection to this approach on the grounds of uncertainty about the potential penalty – the persons targeted are likely to be in a position to calculate their maximum possible liability.

Assessing the gain made on the basis of both realised and unrealised gains is consistent with US securities law dealing with disgorgement of profits obtained from both insider trading and market manipulation.[11]  For example, in one US market manipulation case,[12] Securities and Exchange Commission stated:

We consider that the amount of disgorgement was properly computed on the basis of [defendant’s] profits, realized and unrealized, at the time it completed its participation in the [stock] manipulation. Disgorgement is an equitable remedy. A manipulator is not relieved of its disgorgement obligation simply because it chooses, for whatever reason, to retain manipulated securities until their subsequent drop in price dissipates some or all of the manipulator's ill-gotten gains.

Decision

In his decision, Robinson J concluded that unrealised gains should be included in the assessment of maximum penalty under ss 385 and 490 for four key reasons:

1.    Effective deterrence: The penalty formula is intended to ensure that the maximum penalty exceeds any gains unlawfully obtained, or the prospect of any such gains.  It would undermine the purpose of the pecuniary penalty regime if readily ascertainable unrealised gains made, or losses avoided, were excluded from the maximum penalty calculation.

2.    Motivation: Not all instances of market manipulation are motivated by the realisation of short-term trading profits. There are other reasons why a market participant might seek to manipulate a company’s share price. For example, a shareholder might wish to increase the valuation of the company in advance of a future capital raise, or to strengthen the shareholders’ and/or the company’s hand in negotiations with third party lenders. In each of these scenarios the share price is manipulated for some benefit other than short-term profit taking. The gain is unrealised but immediately advantageous. 

3.    The formula would be redundant for wash trades: Wash trading refers to trading activity where a person is directly or indirectly both the buyer and seller of a particular financial product.  When a person executes a wash trade there is no change in beneficial ownership of the traded product, they do not realise any trading gain (it’s a wash).  But there is still a direct benefit to their misconduct if the market value of the contravenor’s shareholding increases.  It would defeat the purpose of the penalty formula, including the need for deterrence, if the unrealised gains arising out of wash trades were excluded from the calculation of the maximum penalty.

4.    Overall discretion: When a court turns to stage two of the penalty setting process and sets an appropriate starting point, it will invariably take into account both the defendant’s realised and unrealised gains in assessing the nature and extent of the misconduct.  In that way, the court still factors into its penalty assessment that the gains were not ultimately realised.

* This article has been published in the New Zealand Law Journal - [2024] NZLJ 286.

[1] [2023] NZHC 2196 (15 August 2023). I acted for the FMA in this case.

[2] Financial Markets Authority v Warminger [2017] NZHC 1471 at [35] & [36].

[3] Financial Markets Authority v ANZ [2021] NZHC 399 at [44].

[4] Financial Markets Authority v ANZ [2021] NZHC 399 at [45].

[5] Department of Internal Affairs v Ping An Finance (Group) New Zealand Co Ltd [2017] NZHC 2363, [2018] 2 NZLR 552 at [92].

[6] Financial Markets Authority v ANZ [2021] NZHC 399 at [55].

[7] Financial Markets Authority v Cigna Life Insurance New Zealand Ltd at [58].

[8] Financial Markets Authority v Henry [2014] NZHC 1853.

[9] Financial Markets Authority v Zhong [2022] NZHC 480 at [57] and [58].

[10] New Zealand Law Commission, “Pecuniary penalties – Guidance for Legislative Design”, NZLC R133 at [16.36].

[11] See eg SEC v. Shapiro 494 F.2d 1301, 1309 (2d Cir.1974); SEC v Commonwealth Chemical Securities Inc 574 F.2d 90, 102 (2d Cir.1978). 

[12] In re L C Wegard & Co, SEC Release No. 34–40046, 67 S.E.C. 552, 1998 WL 275929 at [6] (SEC May 29, 1998) aff'd, 189 F.3d 461 (2d Cir.1999).