Cum-ex trading: FCA sharpens regulatory gaze

The FCA has, for the first time, issued a penalty in relation to cum-ex trading dividend arbitrage and withholding tax (WHT) reclaim schemes. The FCA fined Sapien Capital Ltd (Sapien Capital), a corporate finance advisory and brokerage firm owned by Sanjay Shah, £178,000 for failings that led to the risk of facilitating fraudulent trading and money laundering. The original fine of £236,740 was reduced due to serious financial hardship.

Background

The FCA's enforcement action is part of increasing regulatory focus in the area of cum/ex dividend arbitrage cases, and WHT schemes. Cum-ex is a trading method used to engineer multiple refunds for WHT paid on a dividend. Typically, company shares are sold or swapped prior to a dividend payment in order to produce two tax refunds in respect of just one underlying withholding tax payment. The FCA referred to the trading as "purported" as it has found no evidence of ownership of the shares by the Solo Clients, or custody of the shares and settlement of the trades by the Solo Group. The FCA considers that this, coupled with the high volumes of shares purported to have been traded, was "highly suggestive of sophisticated financial crime".  As of February 2021, the FCA was investigating 14 firms and eight individuals.

In June 2017, the FCA issued Market Watch 52 which looked at activities of inter-dealer brokers, settlement agents and custodians involved in trading European equities around ex-dividend dates. The FCA highlighted concerns around the use of dividend arbitrage to support fraudulent WHT reclaims. It set out processes for firms to follow in monitoring existing business, taking on new business and in accepting new clients, as well as regulatory rules. In April 2021, the High Court dismissed a 1.5 billion claim brought by the Danish Customs and Tax Administration (SKAT) against Solo Capital Partners LLP (see our briefing here) on policy grounds. Whilst the judge dismissed the case, SKAT has now been granted the right to appeal.

What did Sapien Capital do? 

Sapien Capital executed purported OTC equity trades to the value of approximately £2.5 billion in Danish equities and £3.8 billion in Belgian equities (Solo Trading) for a number of clients without having adequate systems and controls to identify and mitigate the possibility of being used by clients to facilitate fraudulent trading and money laundering. The clients were off-shore companies, including entities incorporated in the BVI and Cayman Islands previously unknown to Sapien Capital. They had been introduced to Sapien Capital by the Solo Group, authorised firms owned by Sanjay Shah providing clearing and settlement services. 

The Solo Trading consisted of two phases:

• purported trading conducted when shares were cum-dividend, in order to demonstrate apparent shareholding positions that would be entitled to receive dividends, for the purposes of submitting WHT reclaims; and
• the purported trading conducted when shares were ex-dividend, in relation to the scheduled dividend distribution event which followed the cum-dividend trading, in order to reverse the apparent shareholding positions taken during cum-dividend trading.

The FCA found no evidence of ownership of the shares by the Solo Clients or custody of the shares and settlement of the trades by the Solo Group.

Breaches

The FCA found that Sapien breached Principle 3 of the FCA Principles of Business because it failed to take reasonable care to organise and control its affairs responsibly and effectively with adequate risk management systems. Its policies and procedures were inadequate in that they failed to: 

• give adequate guidance on how to conduct risk assessments and what factors to consider;
• set out adequate processes and procedures for enhanced due diligence (EDD);
• set out adequate processes and procedures for transaction monitoring including how transactions are monitored, and with what frequency; and
• set out adequate processes and procedures for how to identify suspicious transactions.

The FCA also found that Sapien failed to act with due skill, care and diligence as required by Principle 2 of the FCA Principles of Business by failing to properly assess, monitor and manage the risk of financial crime associated with the clients and the trading. In particular, it failed to:

• properly conduct customer due diligence by failing to follow procedures set out in the its policies;
• gather information to enable it to understand the business that the customers were going to undertake, the likely size or frequency of the trading intended or the source of funds;
• undertake and document a risk assessment for each of the clients; and
• complete EDD, despite the fact that none of the clients were physically present for identification purposes and a number of other risk factors were present, including that each of the 40 entities disclosed that they had a net worth of less than €2 million but were purportedly going to execute 25 trades of €100 million.

The FCA found the breaches to be particularly serious because Sapien Capital onboarded clients over a three month period and some of these clients came from jurisdictions which did not have AML requirements equivalent to those in the UK. Sapien was willing to cut corners to obtain business. It did not review and analyse the KYC materials provided or ask appropriate follow-up questions to red flags in the KYC materials. Even after a number of red flags appeared, Sapien failed to conduct any ongoing monitoring.

This looks to be the first outcome across a number of other investigations which the FCA has in train.  The focus on this area, both by regulators and enforcement authorities across Europe, and by the courts, makes this an area to watch for financial institutions in the UK and beyond.  

Authors: David Capps, Jake Green, Ruby Hamid, Victoria Padley, and Bisola Williams