Preemptive subscription rights and "market" orders: beware of the price difference, which can be very large when placing an order for highly illiquid securities

Facts

Mr B wanted to take part in a capital increase of a company in which he already held shares and in respect of which he had been allocated preemptive subscription rights.

However, instead of exercising the preemptive rights he already held to subscribe new shares, Mr B wanted to buy additional preemptive rights on the market.

The investment services provider (ISP) with which Mr B placed his order imposed a minimum order entry threshold of €100 for penny stocks. When he placed his buy order, the price of the preemptive rights was shown as €0.0004. This double circumstance led Mr B to place a buy order for 250,000 preemptive rights so that his order amounted to the theoretical price of €100 (250,000 x €0.0004 = €100).

Moreover, he took the risk of placing this order as a "market" order. As I explained in my May 2017 online diary, such a “market” order ensures full execution of the desired quantity. Until it is fully executed, the order will stay in the order book until a counterparty is found or it expires. However, this type of order provides no control over the execution price.

While he intended to place an order for €100, Mr B's order was executed two days later for a total amount of €174,366.90, which was debited from his securities account with this ISP.

It was in these drastic circumstances that Mr B asked me to intervene in order to obtain compensation from his ISP, criticising it for not having blocked his order and believing that he had not been informed of there being such a risk.

Investigation

As a first step, I got in touch with the ISP in question to ask for its comments.

This initial contact gave me a clearer picture of the chronology of events and the circumstances under which Mr B's order was executed.

In particular, the institution forwarded me the security operation notice that had been sent to Mr B informing him of the forthcoming capital increase, the fact that he held preemptive subscription rights as a shareholder of the company, and the terms and conditions of participation.

I then contacted the market operator Euronext, which informed me that several market buy orders, including that of Mr B, had caused such a price difference that trading in the preemptive subscription right was reserved for 48 hours, which is unusually long. In other words, because the price difference was too wide, the security could not be traded during this period.

As the theoretical execution price, calculated on the basis of the orders in the order book, remained at around €0.66 for two days, Euronext finally resumed trading in this instrument, and the order was therefore executed at €174,366.90.

Finally, Euronext told me that it had tried to contact the retail desk of Mr B's investment services provider before trading resumed, but without success.

Following these explanations, I went back to the intermediary to ask it to send me the questionnaire that had led it to consider Mr B to be “competent” in complex products, as well as his client profile, and to send me screenshots of the various warning windows that appeared when he placed the market order to buy the preemptive rights.

The questionnaire completed by Mr B and sent to me by the intermediary, although quite old, showed that he had good knowledge of financial matters, but no experience.

I also asked it to tell me whether Mr B had placed market orders previously and whether he had ever taken positions in preemptive rights in the past.

Finally, I asked it why Mr B's order had not generated an alert when the order was placed and while it was pending execution, given the nature of the stock, the lack of liquidity, the type of order placed (“market") and the existence of a price reservation for 48 hours.

Recommendation

First of all, I decided to remind the investment services provider of the applicable legislation, and in particular:

• Article 314-3 of the AMF General Regulation, which states that "Investment services providers shall act honestly, fairly and professionally, with due skill, care and diligence, in the best interests of clients and the integrity of the market. More specifically, they shall comply with all the rules pertaining to the organisation and operation of trading platforms that they use.”
• Articles 8106/1, 8106/2 and 8106/3 of the Euronext Rulebook, which require members to set up an internal control system that includes "pre- and post-trade risk management controls which are appropriate to the nature, scale and complexity of the Member’s business on the Relevant Euronext Market Undertaking”. Each Member must ensure “that it has appropriate arrangements in place to vet orders prior to their submission to the Central Order Book, irrespective of whether such orders have been submitted manually or electronically [...]; and to monitor the positional and financial risks inherent in the business it conducts.”

In the light of the information I had, it appeared to me that the market order placed by Mr B ought to have generated an alert to the investment services provider under its obligations to safeguard the interests of the retail investor and preserve the integrity of the market, insofar as:

• it involved a particularly large number of preemptive subscription rights (250,000),
• to take part in the capital increase of a company whose penny stock was, by its very nature, highly volatile,
• it was a major contributing factor to a price reservation that lasted for 48 hours.

I told the institution that, in my opinion, the integrity of the markets had not been preserved, since the disputed order had contributed, very significantly, to the reservation of the price of the preemptive right for 48 hours.

This reservation mechanism suspends the execution of orders to allow the parties concerned to consider whether to maintain their respective orders.

I reminded it that information such as the "reservation of trading", "adjustment of static or dynamic collars" and "theoretical execution price" had been made available to market members in real time by Euronext. 

To this end, I reminded it that Article 67(1)(c) of the delegated regulation on markets in financial instruments (MiF II) stipulates that “Investment firms shall satisfy the following conditions when carrying out client orders: [...] inform a retail client about any material difficulty relevant to the proper carrying out of orders promptly upon becoming aware of the difficulty.”

As the reservation had lasted 48 hours, I told the investment services provider that it should have informed Mr B of the potential consequences of his order, reminding him that he could cancel it.

I told the provider that the situation in which Mr B found himself, i.e. having to pay the sum of €174,000 to cover his debit, could have been, or rather should have been, avoided, while pointing out that my reasoning was based on an analysis of shared responsibility, since Mr B had acknowledged that part of the fault should be attributed to him.

I also reminded Mr B that this situation could have been avoided if he had acted more prudently:

• if he had placed a limit order instead of a market order.

  I noted that information about the different types of orders had been provided by the investment services provider at the time the order was placed.

  In addition, consulting the order book should have alerted him to the fact that the preemptive subscription right was highly illiquid and that his market order would very likely result in a substantial price difference.

• if he had carefully read the securities operation notice sent to him by his investment services provider before the capital increase.

  I found that this document was very clear and concise in its explanation of how to exercise his preemptive rights, and that careful reading would probably have enabled Mr B to avoid the situation he found himself in.

After an initial discussion as regards the amount, in light of the assessment of the concept of loss of opportunity, the investment services provider agreed to increase its initial proposal, at my request, to a lump-sum compensation of €115,000 (representing approximately 2/3 of Mr B's loss), which I considered satisfactory.

The institution has also told me that it has now changed the way it takes orders for preemptive rights to ensure that such orders cannot be repeated. Clients can no longer enter market orders to buy preemptive rights by remote banking. They are now required to enter a price limit for orders for this asset class.

Lessons to be learned

Investment services providers must ensure that they have adequate means for examining client orders in order to preserve the integrity of the markets and to serve the best interests of their clients.

These "filter matrices" must be sufficiently fine-tuned to enable them to detect orders that are likely to lead to very large or even disproportionate price differences, as was the case with Mr B's order, and to protect their clients at the same time. It is fortunate that this ISP took this dispute as an opportunity to stop accepting market orders for preemptive rights and now only accepts limit orders for preemptive rights by remote banking.

Investors, for their part, need to be particularly careful about the types of orders they place when they wish to buy preemptive rights, which are often highly volatile securities, because the consequences of a market order can be tragic if their orders remain authorised.

This dossier once again highlights the advantages of mediation: it is free for all parties, fast and confidential.

It makes it possible to avoid lengthy and costly legal proceedings, while finding a solution in law and in equity, where appropriate for both parties. In the case of Mr B, only a few months elapsed between the disputed order and the proposal for compensation that was accepted by the investment services provider and the client.