JP Markets asks SCA whether regulator was right to shut it down when it wasn’t insolvent

JP Markets was an extraordinary South African success story. Founded in 2016 by Justin Paulsen, then just 29 years old, JP Markets grew into an online broking powerhouse with more than 300 000 clients, generating annual profits running to hundreds of millions of rands.

Between 20 000 to 30 000 of these clients were active in the market on a regular basis. JP Markets offered clients the possibility to invest in a type of derivative called Contracts for Difference or CFDs, which track the price movements of actual financial instruments without having to own the underlying asset. Clients could pick from more than 500 instruments, from forex to indices and individual stocks.

We know JP Markets was hugely profitable because the company’s various bank accounts reflect a balance of R258 million, while claims against the liquidated company total around R40 million. That makes Paulsen the largest claimant against the liquidated estate.

What we also know is that Paulsen is not accused of stealing or misappropriating a cent of clients’ money.

There were complaints from customers who lost money due to a technical glitch during in a ‘trading halt’ in March 2020 when the Covid crash was in full bloom, but there were no complaints from those who made money during the same event. And even if JP Markets was to repay all clients who lost money during this event, it would account for a fraction of the company’s available cash reserves.

So how is it that a company this profitable was shut down in July 2020 by the Financial Sector Conduct Authority (FSCA)?

Gerhard van Deventer, head of the FSCA’s investigations unit, says the issue of JP Markets’s solvency is not the issue, rather that it was in violation of the law and its licensing obligations, and that the regulator was forced to act to protect the interests of clients.

Paulsen also asks why only he was shut down and not other online brokers doing exactly the same thing.

The FSCA replies that 16 others are being investigated, but cannot provide more details at this stage (see the full FSCA reply below).

Paulsen’s questions are about to be answered by the Supreme Court of Appeal (SCA), following an appeal lodged by JP Markets and its 100% shareholder Paulsen against the FSCA and the final liquidation order granted on September 7 by the South Gauteng High Court.

The FSCA says it took this draconian step because it believed JP Markets had contravened certain financial sector laws, “including but not limited to running an unlicensed over-the-counter derivatives provider (ODP) business”, according to an FSCA press statement issued on July 8, 2020.

FSCA’s regulatory powers in the spotlight

The SCA court filings lodged by Paulsen raise some interesting questions about the limits of the FSCA’s regulatory powers.

JP Markets had a Category 1 FSP (Financial Services Provider) licence, which allowed it to provide advisory and intermediary services in respect of derivative instruments and deposits.

Paulsen is challenging the standing of the FSCA to seek an order for its final winding up on two principal grounds:

1. That it flies in the face of the Companies Act, which allows for the winding up of solvent companies only under strict circumstances, such as when creditors believe it is just and equitable to do so. This, says Paulsen, is clearly inapplicable in the case of JP Markets, and the FSCA does not have standing in terms of the Companies Act to take the actions that it did.
2. The second ground for appeal is that the FSCA says it was investigating JP Markets, but had not concluded its investigation. The Financial Advisory and Intermediary Services (Fais) Act, read together with the Financial Sector Regulation (FSR) Act, makes allowance for the liquidation of a financial services provider only after an on-site inspection or an investigation.

The high court’s reading of this law was that an investigation need not be completed, it need only be underway.

The FSCA, in its heads of argument, has asked the SCA to apply a ‘purposive interpretation’ to the issue of the investigation and “interpret the section (of the act) with its clear purpose to protect the interests of clients and members of the public and to protect the integrity and stability of the financial sector”.

The FSCA’s court papers argue that the regulator must act even if an investigation is ongoing, particularly where theft of funds may be an issue.

Blindsided

The issue of the investigation, whether complete or not, is relevant to JP Markets, since Paulsen and his attorney Darren Hanekom (also involved in representing clients of the Africrypt crypto scheme) believed they were assisting the FSCA with its requests for information until they were blindsided by the rush to court for a final winding up order.

Read: Meet the 29-year-old South African unravelling the multi-billion-rand Africrypt theft

Paulsen says he is not entirely sure what triggered the FSCA’s sudden zeal to close it down, but suspects it had to do with a host of complaints relating to a trading halt in March 2020.

“This was at the start of the Covid-19 panic and markets around the world went into a tailspin, prompting a trading halt on most major markets. For technical reasons, JP Markets continued to trade during this trading halt, so we had people who lost money and people who made money during this period.

“This was an error on our part, and we had to go back to clients – both the winners and the losers – and inform them that trades made during that period would have to be reversed. That, of course, upset a lot of people, but we had to do it.”

A question of time

There is no question that JP Markets was issuing forex CFDs, and that it did not have a licence for this as required by the Financial Markets Act. But Paulsen argues that this was a new requirement at the time and he was endeavouring to bring himself within the ambit of the law by engaging with the FSCA, when he was suddenly shut down.

Says Van Deventer: “JPM paints a picture of a legitimate business that was doing well, but suffered from a few electronic glitches and being hampered by the lockdown regulations. Failing this, it was a healthy and legitimate operation that had business longevity.

“This is unfortunately not correct. JPM conducted the business of an ODP [over the counter derivatives provider] without having the required licence in contravention of Section 111(1) of the FSR Act, which is a criminal offence.

“One needs to appreciate the difference between an FSP licence [which JPM possessed] and an ODP licence. An FSP licence relates to advice and intermediation only. The FSP is never exposed to market risk. This means that the licence requirement for an FSP is in many ways much lower. It must be borne in mind that OTC derivatives were a significant contributor to the 2008 financial crisis. OTC derivatives are by nature high risk financial products that can easily obscure the full extent of the risk and loss.” (See the full FSCA reply below.)

The FSCA suspended JP Markets’s FSP licence in June 2020, though the company continued to trade because it believed the licence suspension precluded it from conducting new business, but not from wrapping up unconcluded trades, according to Paulsen.

Withdrawal delays

Another batch of complaints received by the FSCA apparently had to do with delays in processing requests for withdrawals.

JP Markets built its name on honouring requests for withdrawals within hours of a client making a request. This was in stark contrast to others in the same business who often processed withdrawal requests once a week or every few days. Paulsen explains the delays in March 2020 were caused by the Covid lockdowns and the shift to remote working for back office admin staff.

At its peak, JP Markets employed 78 staff, most of whom were suddenly expected to continue working from home.

“That process of moving to remote working caused some admin delays, as it did with most businesses across the world at the time,” says Paulsen.

Why CFDs are regulated

There’s a good reason why CFDs are regulated in most countries, and it has to do with the risks of things going wrong.

You can purchase CFDs on currencies, commodities, indices and individual stocks like Apple, for example.

A CFD on Apple gives you the benefit of any price movement of the stock, but you never actually own the stock, so you don’t get dividends or voting rights.

Here’s another potential problem: the exchange issuing the CFD is the counter-party. If you lose on a trade, the exchange wins, and vice versa. That means in addition to taking a bet on the direction of the stock price, you are also taking a bet on the financial soundness of the exchange.

Paulsen hopes his case sets legal precedent in SA in determining the bounds of regulatory reach. If he wins the case, a substantial damages claim is likely to eventuate. If he doesn’t, he plans on taking it all the way to the Constitutional Court.

The FSCA replies

Why the FSCA brought the application

The Authority is constrained to comment in detail due to the fact that the matter is subject to an appeal before the Supreme Court of Appeal and to be heard on 21 September 2021. Our omission to comment on all the issues raised must not be interpreted as an admission as to its correctness. It is evident that you have accessed the court judgment of the South Gauteng High Court (High Court) that was delivered in favour of the Authority. This detailed judgment sets out the facts of the matter. Further, the papers filed before the SCA clearly sets out the competing arguments. We trust the court papers will be of assistance to you.

JP Markets (“JPM”) paints a picture of a legitimate business that was doing well, but suffered from a few electronic glitches and being hampered by the lockdown regulations. Failing this, it was a healthy and legitimate operation that had business longevity.

This is unfortunately not correct. JPM conducted the business of an ODP provider without having the required licence in contravention of section 111(1) of the FSR Act, which is a criminal offence.

One needs to appreciate the difference between an FSP licence (that JPM possessed) and an ODP licence. An FSP licence relates to advice and intermediation only. The FSP is never exposed to market risk. This means that the licence requirement for an FSP is in many ways much lower. It must be borne in mind that OTC derivatives were a significant contributor to the 2008 financial crisis. OTC derivatives are by nature high risk financial products that can easily obscure the full extent of the risk and loss.

We have evidence wherein JPM requested the platform operator to assist with (fabricated) reasons why JPM do not have to pay out (legitimate) winnings of clients. The platform operator was requested to change the bid–offer spread of identified profitable clients to restrict profitability because JPM stood on the opposite side of the transaction and would benefit from this strategy. It further delayed honouring the withdrawal requests of clients without substantiation.

The FSCA took this into account when it decided to apply for the liquidation of JPM.

JPM was not insolvent

The issue of insolvency is not relevant in the present case.

The FSCA has the statutory power to apply to the High Court for a liquidation order to protect the interests of the clients of the provider. It is not about assets and liabilities, it is about protecting the public. But this power of the FSCA does not go unchecked – we still have to convince a High Court that it is the appropriate remedy. In this instance the High Court held that it was an appropriate remedy in order to protect the interests of the clients of JPM and for the integrity and stability of the financial sector.

Paulsen was not accused of misappropriating clients’ funds

I should perhaps put this in perspective – the FSCA has jurisdiction to investigate breaches of financial services laws, not fraud and theft. So we do not make findings in this regard. We can say, however, that Paulsen did not act in the best interest of his clients by inter alia preventing them profiting from their transactions.

Was it (the ODP licence) a new requirement at the time?

The requirement for an ODP licence is a relatively new part of the FSCA legislative framework, and a very necessary one.

You will note from our papers that we explain the risks of OTC derivatives and the compelling reasons to regulate it. There was extensive public consultation before the ODP regulations were brought in operation. JP Markets had sufficient time to submit an application. The Regulations in terms of the Financial Markets Act for ODPs were published in February 2018 already, but applicants were given an automatic exemption until 14 June 2019 to apply. If they applied before 14 June 2019, they were permitted to conduct business until the outcome of their application is known.

Did they allow clients to wrap up or conclude trades only?

JPM was allowed to close out existing positions but was prohibited from conducting new business. The suspension terms were clear and it was brought under the attention of the attorneys of JP Markets that their client must cease with new business. JP Markets (Paulsen) chose to ignore this and continued to conduct new business.

Why was JPM “shut down” and no other brokers?

We can do no better than to quote the High Court when it stated: “…the assertion that other unlicensed ODPs have not been pursued by the applicant cannot constitute a basis for explaining why the respondent need not be licensed or why the applicant should be excluded from pursuing what remedies may legitimately be available to it in discharging its statutory regulatory mandate”.

The prejudice or potential prejudice to clients based on complaints received required intervention. However, I should point out that at least 16 other entities are currently the subject of an investigation on the basis of possible unlicensed ODP business, details of which cannot be disclosed at this stage.

Justin Paulsen replies

We will let the SCA decide the matter based on the evidence presented to it.

The one point I would take issue with is the FSCA’s comment that it has evidence “wherein JPM requested the platform operator to assist with (fabricated) reasons why JPM do not have to pay out (legitimate) winnings of clients.”

The FSCA clearly misunderstands the information we presented to it, and your readers may gain the impression from this we were working against our own clients in the background by altering the bid-offer spread. This is certainly not the case. We had algorithms to flag suspicious trades, which is common industry practice, where we suspected a client was trying to violate the terms and conditions of using our platform, such as by collusive or risk-free prohibited trading. Most exchanges around the world battle to flag and stop this kind of abusive practice. The number of clients we flagged for this was nominal. We nevertheless paid them out in full but asked them not to trade with us in future.