FCA’s latest MarketWatch newsletter sets out the results of its review of dividend arbitrage, a process which involves placing shares in alternative tax jurisdictions around dividend dates, with the intention of minimising withholding taxes (WHT) or generating WHT reclaims.
The review focused on the activities of a number of inter-dealer brokers, settlement agents and custodians involved in trading European equities around ex-dividend dates. FCA wanted to assess the risks of any practices being market abuse and whether custodians issuing tax vouchers, and/or shareholders were entitled to WHT rebates. The review included considering the role of management oversight, the seniority of the MLRO and internal systems and controls.
FCA concluded that most firms complied with their regulatory obligations. But some had not done proper due diligence to enable them to identify the financial crime risks posed by fraudulent dividend arbitrage transactions where the purpose of the transaction was to make illegitimate WHT reclaims. Examples of transactions which could be used inappropriately include:
- off-shore funds instructing share transactions through UK broking firms;
- OTC execution for stock trades;
- back to back securities lending agreements;
- the use of OTC derivative instruments to hedge stock trades;
- share transactions, where the volume traded may represent a significant proportion of the free float;
- potential connection between the owners of the off-shore funds and firms involved in custody, settlement and clearing ;
- poor transparency as to the source and availability of funds supposedly being used to fund the trading;
- a lack of transparency as to the source of stock needed to fulfil a trade; and
- a lack of realistic assessment of whether some of the institutions involved in the trading have sufficient financial standing to trade and/or clear and/or settle trades in the volumes being arranged.
FCA has stressed the importance of firms having effective due diligence procedures to help identify and mitigate these risks for both new and existing clients. This system must be overseen and managed by senior management, and systems and controls must cater for the possible need to make reports under POCA, MAR and the general Principle 11 requirement that would lead to the need to report to FCA suspicious trading activity even where not covered by the SARs regime or MAR.