by Harald Baum
Attempts to influence prices of securities, commodities or their derivates traded on an exchange or other marketplace to one’s own advantage are as old as these institutions themselves. The same is true for the efforts to curb such ‘abusive’ behaviour. In spite of these regulatory endeavours, manipulative practices are well documented through the centuries at all international market places from London to Paris and from New York to Vienna or Frankfurt. In modern legal language these practices are referred to as ‘market manipulation’. Under EU legislation market manipulation comprises one of the two forms of market abuse; the other one is insider dealing. Precise legal definitions, however, are lacking. Instead, most modern laws work with enumerations of criteria and examples to differentiate between allowed and forbidden practices having a potential to influence prices.
The multitude of forms and manifestations in which manipulative behaviour may occur are the main reason for the persistent difficulties in regulating these activities. In order to systemize the phenomenon most modern commentators differentiate between three phenotypes of activities that can be used to directly or indirectly influence and distort market prices.
The various forms of information-based market manipulation constitute the first phenotype. A widely used practice of this kind is the dissemination of false or misleading information about an issuer in the form of incorrect or misleading balance sheets, business reports or notifications. Another example is the spreading of rumours with a potential to influence investment decisions. A third variant is the misuse of privileged information, which, legally, is sometimes referred to as insider trading. An example is the so-called ‘scalping’, a practice where the actor, eg a finance journalist, publishes an unfounded buy recommendation that leads to a rise in prices of securities he had acquired before and can now sell for a profit.
The second phenotype consists of various forms of trade-based market manipulation. This group covers fictitious as well as genuine transactions. The classical forms of this kind of manipulation are fictitious trades with no economic effects for the actor as no genuine change in actual ownership takes place. These orders are aimed at creating the artificial impression of trading activities, liquidity and trends in order to raise prices. The buyer and seller may be identical (‘wash sales’), or two or more colluding market participants enter buy and sell orders at the same time for the same quantity and price that do lead to formal changes in ownership but that result in an economically neutral outcome (‘matched orders’/’circular trades’). In the case of trade-based manipulations undertaken by genuine trades, economically relevant transactions do take place. Such activities are very difficult to distinguish from normal transactions in the form of, for example, buy orders legitimately carried out as stabilization measures or in the context of a share buy-back programme. As no objective criteria exist, a differentiation between these allowed and forbidden activities has to be based on subjective criteria, namely the actor’s intent to manipulate. A highly controversial example are ‘short sales’ where a seller who does not own the pertinent financial instruments or commodities at the time of the sale, but hopes to acquire these for a better price later at the time he has to fulfil his obligation, speculates on falling prices. As short sales contribute to the information efficiency of financial markets they are, so far, mostly not banned in general as a form of market abuse but are only temporarily prohibited during a financial crisis.
The third phenotype is made up by action-based market manipulations. The term refers to activities, other than the dissemination of false or misleading information, that aim at distorting the inner value of financial instruments. The actor hopes to complete profitable transactions at (temporarily) distorted prices. Examples for this are acts of sabotage relating to products or production facilities of the issuer of those instruments.
b) Similar institutions
Market manipulation has to be distinguished from speculation and insider dealing. Whereas the insider ‘only’ makes use of an already existing information asymmetry, a person engaged in market manipulation actively distorts the formation of prices of financial instruments. A speculator on the other hand neither distorts prices nor uses inside information, but rather acquires financial instruments based solely on public information while expecting a future change in prices advantageous to him. As speculation enhances the efficiency of financial markets it is, as a rule, not prohibited.
2. Regulation in a comparative perspective
Because market manipulation is typically aimed at distorting prices, it is more or less universally regarded as detrimental to the information efficiency of financial markets. Reduced information efficiency impairs the function of the market in allocating and supplying capital with negative consequences for issuers in need of funding and the public looking for investment possibilities. Accordingly, a general international understanding has developed that market manipulation needs to be curbed by prohibition in order to protect confidence in the reliability of price formation and the integrity of the market. Thus, the predominant regulatory aim is more the protection of the market function and less a direct protection of individual investors. Regardless of this general understanding, the scope of application and the actual form of the prohibition of market manipulation (still) differ significantly in the various jurisdictions.
a) National laws
The greatest differences exist with respect to sanctions. Some jurisdictions make market manipulation a criminal offence. This is true, for instance, in Switzerland. Article 161bis of the Swiss penal code (StGB), adopted in 1997, prohibits the dissemination of misleading information aimed at influencing prices for one’s own advantage as well as trade-based manipulations in the form of wash sales or matched orders. Violations are sanctioned by imprisonment of up to three years or monetary penalties. Other jurisdictions do without a criminalization. The Austrian Stock Exchange Law, for example, qualifies a forbidden market manipulation (as a rule) only as an administrative offence sanctioned with a fine and a surrender of profits; also a temporary professional suspension is possible (§§ 48a, 48c, 48q BörseG).
Most jurisdictions apply a mixture of sanctions. According to an inquiry undertaken in 2008, some 25 out of 29 European countries surveyed had put into effect a combination of different sanctions. British courts were the forerunners in the fight against market manipulation. The first pertinent decision dates from 1814 (Rex v De Berenger 105 Eng Rep 536). The court condemned an information-based manipulation under the applicable common law as a conspiracy to rig the market. Today, the marked manipulation is regulated in Part VIII (ss 118 ff) of the Financial Services and Markets Act 2000 (FMSA). To put the statutory definition in more concrete form, the Financial Services Authority has published a code of conduct, the FSA’s Market Conduct Handbook, that distinguishes between information-based, trade-based, and other forms of manipulation. Monetary fines or a public announcement of the incriminated behaviour are alternative sanctions for violations. Besides these, a surrender of profits can be ordered and civil claims are possible. Additionally, the general prohibition of misleading statements and practices applies (s 397 FSMA).
The well-developed US securities regulation offers a highly differentiated and flexible catalogue of graded administrative, penal and civil sanctions. These range from supervisory administrative (disciplinary) measures like, for example, a professional suspension, a surrender of profits, civil penalties or criminal sanctions (fines or imprisonment of up to 10 years). Furthermore, regardless of actions by the authorities the victims of market manipulation have either express or implied private actions to sue the persons involved for damages. The most important pertinent regulation has since the 1930s been found in the two central federal capital markets laws, the Securities Act (SA) of 1933 and the Securities and Exchange Act (SEA) of 1934. Section 9 SEA stipulates a specific prohibition of trade-based as well as of information-based price manipulations for trading in listed securities. Because of practical difficulties with the high demands of proving a manipulative intent, the general antifraud provision laid down in s 10(b) of the SEA of 1934 and rule 10b-5 thereunder has gained increasing practical importance. Furthermore, s 17(a) SA stipulates a general prohibition of fraudulent behaviour and the dissemination of misleading information when offering securities. This prohibition includes market manipulation. Special provisions provide for exemptions for legitimate activities such as, for instance, the buy back of securities by the issuer (‘safe harbours’).
Though a prohibition of ‘market price manipulation’ had already been an element of German law for some time, since 2002 it has followed the threefold modern distinction mentioned above and differentiates between three types of prohibited manipulative behaviour: information-based manipulation, trade-based manipulation and other deceptive practices (§ 20a of the Securities Trading Act (WpHG)). A mixture of criminal sanctions and monetary fines apply to violations of these prohibitions (§§ 38, 39 WpHG). After the model of the US law, under certain preconditions safe harbours allow for market stabilization measures and a buy-back of shares. But in stark contrast to the US regulation, under German law it is next to impossible for victims of market manipulation to sue the persons involved for damages.
b) International efforts
The brief comparative overview shows that, so far, no coherent international practices or standards in fighting market manipulation have been developed. A report titled ‘Investigating and Prosecuting Market Manipulation’, prepared by the Technical Committee of the International Organization of Securities Commissions (IOSCO) in 2000, is nothing more than a first, albeit important step in this direction. It analyses on a broad comparative basis internationally used techniques of market manipulation and formulates some general recommendations for fighting manipulation. Of special interest is the formulation of suggested minimum standards and procedural rules that would allow an international cooperation in investigating and prosecuting market manipulation. Activities on the level of the European Union have corresponded with these efforts undertaken by IOSCO.
3. Genesis and core elements of the European regulatory regime on market manipulation
The European Commission put the subject ‘market manipulation’ on its agenda for the first time in 1999 and made the fight against it part of its Financial Services Action Plan. Simultaneously the (former) Forum of European Securities Commissions (FESCO) set up an expert group to investigate these matters. The group published its first report in 2000 and, with respect to the fragmented and mostly ineffective fight against market manipulation in the individual Member States, it urgently recommended a joint action based on shared standards within the EU against these practices. A couple of reports followed, first by FESCO and later on by the (former) Committee of European Securities Regulators (CESR), an entity that had taken over the former’s tasks in 2002. These reports laid the groundwork for the Market Abuse Directive of 2003 (Dir 2003/6).
b) Regulatory architecture
The Market Abuse Directive of 2003, slightly amended in 2008 (Dir 2008/26), was one of the centrepieces of the Financial Services Action Plan. It provides for an amended regulation of insider dealing and a new regulation of market manipulation. Both practices are grouped together under the term ‘market abuse’. The directive was one of the first directives drafted within the framework of the simplified legislative proceedings introduced in 2002, the so-called comitology or Lamfalussy procedure. According to the directive’s character as a framework directive it only regulates basic principles and leaves technical issues to be addressed by implementing measures on the second level of the comitology procedure. In 2003 and 2004 the Commission adopted three implementing directives (Dir 2003/124, 2003/125, 2004/72). Also in 2003 the Commission adopted a regulation implementing the Market Abuse Directive (Reg 2273/ 2003) that supplements these three directives. Article 8 of the regulation stipulates exemptions from the prohibition of market manipulation of high practical importance for buy-back programmes and for legitimate price stabilization measures (‘safe harbours’). On the third level of the comitology procedure CESR has published three sets of guidance and information on the operation of the Market Abuse Directive between 2005 and 2009. Of special interest in this context are the first set of guidance on market manipulation of 2005 (CESR/04-505b) and the third set of guidance on market manipulation of 2009 (CESR/09-219).
c) Central regulatory elements
This complex regulatory regime on the ‘prohibition of market manipulation’ aims to create a framework for ensuring the integrity of Union financial markets and enhancing investor confidence in those markets. Integrity and public confidence are regarded as basic requirements for an integrated and efficient financial market (2nd, 11th and 12th recital). According to Art 5 of the directive, Member States have to ‘prohibit any person from engaging in market manipulation’. Furthermore, the Member States have to set up the institutions necessary to achieve this goal.
The central question is what kind of behaviour should be regarded as ‘market manipulation’. The European legislature gives a complex answer to this question spread over the three regulatory levels of the comitology procedure. On the first level, in the context of the directive’s general legislative definitions, Art 1(2) qualifies three different types of practices as market manipulation in the form of ‘basic definitions’: (a) ‘[T]ransactions or orders to trade which give, or are likely to give, false or misleading signals as to the supply of, demand for or price of financial instruments, or which secure, by a person, or persons acting in collaboration, the price of one or several financial instruments at an abnormal or artificial level, unless the person who entered into the transactions or issued the orders to trade establishes that his reasons for so doing are legitimate and that these transactions or orders to trade conform to accepted market practices on the regulated market concerned’; (b) ‘transactions or orders to trade which employ fictitious devices or any other form of deception or contrivance’; and (c) ‘dissemination of information through the media, including the internet, or by any other means, which gives, or is likely to give, false or misleading signals as to financial instruments, including the dissemination of rumours and false or misleading news, where the person who made the dissemination knew, or ought to have known, that the information was false or misleading’. The definitions are followed by a brief enumeration of examples of incriminating practices.
On the second level of the comitology procedure the Commission’s first implementation directive (Dir 2003/124) provides supplementary explanations in the form of a non-exclusive enumeration of forbidden practices. Article 4 of that directive deals with manipulative behaviour related to false or misleading signals and to price securing; Art 5 deals with manipulative behaviours related to the employment of fictitious devices or any other form of deception or contrivance. Article 2 of the Commission’s third implementation directive (Dir 2004/72) regarding, among others, accepted market practices aims at unifying the supervisory practices within the Union by providing a non-exclusive catalogue of factors to be taken into account by the national authorities when considering market practices.
In addition to this, on the third level of the comitology procedure CESR’s first set of guidance on market abuse of 2005 provides further explanations—again in the form of enumerations of examples—of what should be regarded as ‘accepted market practices’ and what ‘types of practices CESR members would consider to constitute market manipulation’ (CESR/04-505b). CESR’s third set of guidance on market abuse of 2009 discusses safe harbours in the form of stabilization measures and buy-back programmes allowed under the Market Abuse Directive (CESR/09-219).
A certain contrast is obvious between the detailed efforts to define and explain manipulative behaviour and practices and the rather short regulation of sanctions in Art 14 of the Market Abuse Directive. According to this provision the Member States are only obliged to ensure that appropriate administrative measures can be taken or administrative sanctions can be imposed against persons responsible for non-compliance with any of the directive’s provisions. The measures have to be effective, proportionate and dissuasive. The important issue of private actions by the victims of market manipulation for damages is not, however, dealt with in the Market Abuse Directive.
In sum, one may be rightly impressed with the highly differentiated regulatory regime on market manipulation which is spread over three levels of the Lamfalussy procedure. Not only flexibly attuned to the needs and reality of financial practice, it strikes a noteworthy balance between framework principles and implementing measures. On the other hand, however, the danger of an increasing assumption of legislative tasks by the executive branch of the EU bureaucracy cannot be ignored. For good reasons, this concern was a central one in the discussion on the adoption of the Lamfalussy procedure in 2001.
Louis Loss, Fundamentals of Securities Regulation (2nd edn, 1988); Technical Committee of the International Organization of Securities Commissions, Investigating and Prosecuting Market Manipulation (2000); Guido A Ferrarini, ‘The European Market Abuse Directive’ (2004) 41 CMLR 711; Emilios E Avgouleas, The Mechanics and Regulation of Market Abuse (2005); Jan Eichelberger, Das Verbot der Marktmanipulation (2006); Edward J Swan, Market Abuse Regulation (2006); Indre Waschkeit, Marktmanipulation am Kapitalmarkt (2007); Niamh Moloney, EC Securities Regulation (2nd edn, 2008); Barry Rider, Kern Alexander, Lisa Linklater and Stuart Bazley, Market Abuse and Insider Dealing (2nd edn, 2009); Financial Services Authority, Market Conduct Handbook (as amended).