Capital Markets Law
by Klaus J Hopt
1. Concept, functions and sources of capital markets law
Capital markets law (the European term for securities regulation) regulates the capital market. This seems self-evident, but both concepts are controversial. In legal terms, the capital market can be described as the part of the financial markets where participations in companies or other fungible securities (including unincorporated securities and derivatives) like bonds or investment parts are traded. The prototype of a capital market is the stock exchange, yet even this term has become controversial because of recent technical innovations like multilateral trading facilities (MTF). The prototype of capital markets law is stock exchange law (exchanges). Capital markets law in a wider sense includes, eg company law, banking law and tax law. Yet a narrower concept is preferable. Capital markets law in the narrow sense contains only those rules which deal with the constitution of the capital markets. This includes stock exchange law as well as the rules dealing with the transactions on the primary market (between issuers, banks and investors) and on the secondary market (between investors and the various sorts of financial intermediaries). Capital markets law is therefore different from company law insofar as it is a typical cross-sectional law which includes public law as well as private law. It is sometimes even enforced by criminal law.
Modern capital markets law has its roots in US securities regulation. With its history, its codification in the famous statutes of the 1930s—in particular the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Company Act and the Investment Advisers Act of 1940—and by the activities of the Securities and Exchange Commission (SEC), securities regulation has become a prominent area by itself and has served as a model for capital markets laws all over the world including, for example, Japan. In continental Europe, the first country to follow suit was Belgium in 1935; France followed later with its Commission des Opérations de Bourse (COB 1967, now the Financial Markets Authority AMF) while Germany developed its capital markets law only much later under the influence of European law (Securities Transactions Statute 1994 with a capital market supervisory body, BaFin, and the Takeover Statute 2001). In the 1990s the countries of Middle and eastern Europe followed the trend.
Capital markets law has the function of creating the conditions and legal framework for a well-functioning capital market. This means the promotion of allocational efficiency of the capital market, which can only be achieved if there is adequate information, operational efficiency to allow the transactions to be speedy and cheap and institutional efficiency which is based on the confidence of the market participants. This confidence depends on sufficient investor protection. Particular challenges for capital markets law result from the informational asymmetry between the parties to the market transactions and the conflicts of interest of the banks and other financial intermediaries. In law, one distinguishes the regulation of the primary market and of the secondary markets. But there are transition phenomena between both of them, such as the initial private placement of securities if it is intended to be followed by the distribution to the public; and there are functional interdependencies, in particular the fact that both markets require the confidence of the market participants.
The central regulatory mechanism of capital markets law is disclosure, namely the rules on transparency of the capital markets. Capital market transparency complements traditional accounting and company law transparency and includes, for example, disclosure by prospectuses, disclosure of participations above a certain threshold and instant disclosure of events that are expected to influence the stock price of a security. The constitution of the capital markets is regulated by stock exchange law for the stock exchanges and by takeover law for the market for corporate control. There is a wide field of rules for investment products, such as the law on investment companies and specific rules for financial intermediaries such as stockbrokers, banks, analysts and rating agencies. Today much of this is regulated by European law.
2. European harmonization
European harmonization of capital markets law had already begun by the end of the 1970s. In the beginning, this harmonization was concentrated on stock exchange law (exchanges). Several directives followed each other in quick sequence: the directive coordinating the conditions for the admission of securities to official stock exchange listing of 5 March 1979 (Dir 79/279); the directive coordinating the requirements for the drawing up, scrutiny and distribution of the listing particulars to be published for the admission of securities to the official stock exchange listing of 17 March 1980 (Dir 80/390); the directive on information to be published on a regular basis by companies whose shares have been admitted to the official stock exchange listing of 15 February 1982 (Dir 82/121); and the directive on the information to be published when a major holding in a listed company is acquired or disposed of 12 December 1988 (Dir 88/627). The directive on the admission of securities to the official stock exchange listing and on information to be published on those securities of 28 May 2001 (Dir 2001/34) has consolidated and complemented these four earlier directives. This directive was in turn complemented and modified by the Transparency Directive of 15 December 2004 (Dir 2004/109). In the meantime, a large number of further European directives have made the European capital markets law one of the areas of European law where harmonization has advanced the most, at least insofar as it is much ahead of European company law. A collection of texts and leading cases on European company and financial law compiled in 2007 contains no less than 34 entries (up to autumn 2006). These cannot be described here in detail. Instead, three particularly important directives shall be presented briefly: the Market Abuse Directive of 2003 (Dir 2003/6), which contains the prohibitions against insider trading and market manipulation; the Markets in Financial Instruments Directive of 2004 (MiFID, Dir 2004/39); and, also from 2004, the Takeover Directive (Dir 2004/25).
3. Regulation of insider trading and market manipulation
Insider transactions refer to the buying and selling of financial instruments in the widest sense by board members or other persons who have privileged access to information relating to the company and its shares and other securities and use that information in acquiring or disposing of such instruments. The use of such privileged information ahead of the stock exchanges and the general investors is considered to be unjustified by nearly all modern legal orders. Even apart from a possible cheating of the individual investor, insider trading is harmful for the stock exchange and the capital market since it enlarges the gap between the buy and sell offers and encroaches upon the confidence of the investors. This is even truer of market manipulation.
Directive 2003/06 of 28 January 2003 on insider trading and market manipulation (market abuse) has replaced the directive on insider trading of 1989 (Dir 89/592) and has reformed the law of insider dealing and regulated the law on market manipulation for the first time. Persons who possess inside information are prohibited from using that information by acquiring or disposing of, for their own account or for the account of a third party, financial instruments to which that information relates. This particularly concerns trading by board members and shareholders of the issuer, but under certain conditions also employees of the issuer. These persons are also prohibited from disclosing inside information to any other person unless such a disclosure is made in the normal course of the exercise of their employment, profession or duties. Apart from these so-called primary insiders, the prohibition also applies to secondary insiders, ie those persons who knew or ought to have known that the information they received was inside information.
The concept of market manipulation is much more controversial—legally as well as economically—and is defined and regulated by the directive in a complicated manner. In simplified terms, market manipulation means transactions or orders to trade that give false or misleading signals as to the supply of, demand for or price of financial instruments, or which secure the price of one or several financial instruments at an abnormal or artificial level (unless the action is legitimate and conforms to accepted market practices on the regulated market concerned) or which employ fictitious devices or any other form of deception or contrivance. Dissemination of false rumours or of wrong or deceptive information is also market manipulation.
These rules are broad and have to be filled with detail, and the European Commission has done so in several legal instruments. It has allowed exceptions for share buy-back programmes and stock price stabilization measures. Furthermore, it has defined in more detail what is to be considered inside information and market manipulation and what needs to be disclosed publicly in this context. Detailed rules concern the fair presentation of investment recommendations and the disclosure of conflicts of interest. The concept of accepted market practices and the drawing up of lists of insiders have also been regulated in some detail.
4. Regulation of the market for financial instruments
The directive on markets in financial instruments of 21 April 2004 (Dir 2004/39; Markets in Financial Instruments Directive, MiFID) is the basic law of European financial market regulation. It has replaced the Investment Services Directive of 10 May 1993 (Dir 93/22, ISD), which was completely outdated, and has brought far-reaching reforms. These reforms concern in particular the reach of the directive, market transparency for trading platforms and the legal bases for transactions in financial instruments.
The MiFID contains, to begin with, rules on the authorization and operating conditions for investment firms. Among these are rules as to the suitability of shareholders and members with qualifying holdings, the membership of an authorized investor compensation scheme, the initial capital endowment and the organizational requirements. Particular rules deal with multilateral trading facilities (MTF).
Then, the operating conditions for investment firms are spelled out. Among these are rules on conflicts of interest, provisions to ensure investor protection—such as conduct-of-business obligations when providing investment services to clients and taking all reasonable steps to obtain, when executing orders, the best possible result for the client (best execution)—and rules on market transparency and integrity, among which there are post-trade and pre-trade disclosure rules.
Among many other rules of the directive, the rules establishing rights of investment firms in the internal market and rules on regulated markets should be mentioned. The regulated market is a fundamental concept of capital markets law that is defined in the directive with applicability for other directives as well. Above all this, there is the supervision by the competent authorities of the Member States who are required to cooperate with other authorities in the same and in other Member States.
When dealing with the MiFID, the Lamfalussy rule-making procedure in the European Union must be kept in mind. This is a four-stage procedure which led to the following parallel legal instruments: (1) the MiFID, which is a framework directive enacted by the European Parliament and the European Council; (2) implementation regulations and directives which fill this framework; (3) a common supervisory practice by the CESR (Committee on European Securities Regulators, representatives of the national supervisory offices); and (4) supervision of a uniform transposition and observation of the legal rules by the European Commission. Examples of implementation rules are, among others, the Implementation Directive of 10 August 2006 and the Regulation of 10 August 2006 concerning the implementation of the MiFID as regards record-keeping obligations of investment firms, transaction reporting, market transparency, admission of financial instruments to trading and certain definitions.
The MiFID has been transposed into German law by the MiFID Transformation Act of 16 July 2007 (‘FRUG’). This law completely changed the Stock Exchange Act and reduced the size of the latter from 64 to 52 articles as a consequence of the now uniform regulation of the admission of securities to listing instead of the former separation of the official trade and another lower regulated segment. Furthermore, the Securities Transaction Act (WpHG) has been changed considerably. The reforms of the latter concern the reach of the statute, the transparency requirements for trading platforms and the legal conditions for transactions in financial instruments.
5. Takeover regulation
A functioning market for corporate control is indispensable for the internal market and for (external) corporate governance. Takeovers contribute to better use of synergies and help to control the management of listed companies with dispersed ownership. It is therefore important that—after decades of birthing pains—the directive on takeovers of 21 April 2004 (Dir 2004/25) finally saw the light of day with rules that are less than ideal, but in toto at least acceptable.
The content of the directive—in particular concerning the procedure, the takeover bid prospectus and transparency, the mandatory bid rule and the legal conditions for the formation of the bid price—cannot be described here in detail (takeover law). The German Takeover Act was enacted before the EU directive came about and has since been amended to conform to the directive. In the present context, it is enough to take up two basic questions, namely the anti-frustration rule in connection with the breakthrough rule and the option regime including reciprocity.
The directive starts in Art 9 with a strict anti-frustration rule for the board of the target. From the moment the board of the target receives the official information concerning the bid, and until the time when the result of the bid has been made public or the bid lapses, defensive measures (actions which may result in the frustration of the bid) are to be decided upon by the general meeting of the shareholders. This meeting can be called at short notice, though not less than two weeks. Defensive measures that are to be decided upon by the general meeting are, in particular, the issue of any shares which may result in a lasting impediment to the bidder acquiring control of the target. Exceptions to the anti-frustration rule are the search for alternative bidders (white knights) and decisions which the board has taken before the above-mentioned time period and which form part of the normal course of the company’s business and have not yet been partly or fully implemented.
The anti-frustration rule is complemented by the breakthrough rule of Art 11. Restrictions on the transfer of securities provided for in the articles of association or in contractual agreements between holders of the target company’s securities—as in the case of many name shares—do not apply in such a takeover. Similarly, voting caps and other restrictions on voting contained in the articles of association or in contractual arrangements also do not apply if the general meeting makes its decision on the defensive measures. But most important of all, following a bid, if the bidder holds 75 per cent or more of the capital-carrying voting rights, none of the aforementioned types of restrictions apply. This means that requirements of consent, voting restrictions and special rights to appoint or dismiss board members can thereby be set aside.
The option regime of Art 12, which stems from a compromise proposal by Portugal, allows the Member States to not adopt the provisions laid down in Art 9 and/or Art 11 (opting out). Yet in this case the Member States shall nevertheless grant the companies which have their registered offices in their territory the option, which shall be reversible, of applying Arts 9(2) and (3) and/or Art 11. Such an opting in needs the authorization of the general meeting of the shareholders of the target by a qualified majority. Member States may exempt companies which have opted in from not applying the option regime if they be- *come the subject of an offer launched by a company which does not apply the same articles (‘reciprocity rule’).
Germany, to take one example for the transformation laws of the Member States, has decided to opt out. The German Takeover Act does provide for an anti-frustration rule as the general principle, but then, contrary to Art 9, allows the management board to take defensive actions with the mere consent of the supervisory board without asking for a resolution of the general meeting of shareholders. The breakthrough rule, too, is optional under German law. If a company opts in, then the reciprocity rule may apply. Details on the transformation of the Takeover Directive can be found in the Commission Staff Working Document of 21 February 2007. The European Commission is not satisfied at all with the transposition of the directive in most of the Member States and is about to state its conclusions in this regard in the examination report it is required to draw up according to Art 20, five years after the enactment of the directive, ie by 2011.
Holger Fleischer and Hanno Merkt, ‘Empfiehlt es sich im Interesse des Anlegerschutzes und zur Förderung des Finanzplatzes Deutschland das Kapitalmarkt- und Börsenrecht neu zu regeln?, Gutachten F und Gutachten G’ in Ständige Deputation des Deutschen Juristentages (ed), Verhandlungen des vierundsechzigsten Deutschen Juristentages, vol I (2002); Eberhard Schwark (ed), Kapitalmarktrechts-Kommentar (2004); Kerstin Stünkel, EG-Grundfreiheiten und Kapitalmärkte, Die Auswirkungen der Grundfreiheiten auf die Integration der Sekundärmärkte (2005); Susanne Kalss, Martin Oppitz and Johannes Zollner, Kapitalmarktrecht, vol I: System, vol II: Europäische und österreichische Rechtsquellen des Kapitalmarktes (2005); Stefan Grundmann and Florian Möslein, European Company Law, Organization, Finance and Capital Markets (2007); Klaus J Hopt and Eddy Wymeersch (eds), European Company and Financial Law, Texts and Leading Cases (4th edn, 2007); Klaus J Hopt, Rüdiger Veil and Jörn Axel Kämmerer (eds), Kapitalmarktgesetzgebung im Europäischen Binnenmarkt (2008); Niamh Moloney, EC Securities Regulation (2nd edn, 2008); Reinier Kraakman and others, Anatomy of Corporate Law (2nd edn, 2009); Wolfgang Groß, Kapitalmarktrecht (4th edn, 2009).