Insider Trading and Market Manipulation: Overview White Collar - - PowerPoint PPT Presentation

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Insider Trading and Market Manipulation: Overview

White Collar Crime and Serious Fraud Conference 2nd July 2010 New Zealand Governance Centre

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 strong focus on information asymmetries and disclosure.  Accurate disclosure has an important role to play in investment

decisions, as well as a further role in the price setting process and in the prevention of market abuse.

Interference with the price setting process :

 damages investor confidence  adversely affects investor confidence in the fairness, honesty

and integrity of the market. This may distort the choices made by investors, scares investors away from the market and raises the cost of capital for issuers.

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Market Abuse

Insider dealing involves traders who know something other traders do not, and who take advantage of that information asymmetry.

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Market Abuse

Market manipulation traders manipulate the market by:

• disseminating false or misleading information
• engaging in trading activity that gives a false impression as to

the demand for or liquidity of a particular security.

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• 2. Prevalence of Market Abuse

 Some studies indicate that market abuse may be quite prevalent.  Attracts a lot of media attention.  The U.S. Securities and Exchange Commission (SEC) prosecutes

• ver 50 cases each year. Many of the cases are settled out of court.

The SEC and several stock exchanges actively monitor trading, looking for suspicious activity.

 In 2006, Britain’s Financial Services Authority estimated insider

trading may have occurred in 29% of UK takeovers in the six years to 2004.

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Concept of insider trading

 The basic principle behind the New Zealand’s original insider trading

regime was that an insider who obtains price-sensitive information by virtue of his or her position as an insider should be prohibited from dealing in securities or tipping until the information is published

• r otherwise reflected in market prices.

 Under the regime introduced in 2006, a person no longer becomes

an insider because of his or her position in or connection with the entity that the inside information pertains to. Rather, a person becomes an insider because of a connection with the inside information itself.

 While insider trading regulation is no longer based on the fiduciary

principle, fiduciary obligations and obligations of confidence under the common law and the Companies Act 1993 remain in place.

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Characteristics of new legislation

 A person who overhears inside information in passing, and then

trades on that information may be just as liable to prosecution under the legislation as the company director who learns of inside information by virtue of their office.

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Key features of insider trading provisions

 An insider is defined not by reference to a relationship with a public

issuer, but by reference to a relationship with “inside information”.

 Broadens definition of persons to “outside insiders”.  In previous provisions possession was the trigger and there was no

requirement that the insider knew the information was inside information.

 The introduction of the mental state of a person as an element both

narrows the class of potentially liable persons and adds an element that will be evidentially difficult to establish.

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 If complexity was the principal shortcoming of the pre-2006 regime,

it seems highly improbable that the new provisions have cured that deficiency.

 The prohibited actions remain basically unchanged. An “information

insider” must not trade, (SMA 2006, s 8C) disclose the information, (SMA 2006, s 8D) or advise or encourage others to trade. (SMA 2006, s 8E)

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Market Abuse: Market Manipulation

White Collar Crime and Serious Fraud

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• 1. Introduction

 MED- “Market manipulation is a deliberate attempt to interfere with

the free and fair operation of the market.”

 Market manipulation impedes securities markets from operating as

independent pricing mechanisms and thus can be regarded as the enemy of market efficiency and investor confidence.

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 While insider trading involves taking advantage of information

asymmetries, market manipulation involves providing misleading information to the market – creating information asymmetries.

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Crimes Act 1961, s 240

 "Every one is liable to imprisonment for a term not exceeding 5

years who conspires with any other person by deceit or falsehood or

• ther fraudulent means to defraud the public, or any person

ascertained or unascertained, or to affect the public market price of stocks, funds, shares, merchandise, or any thing else publicly sold, whether the deceit or falsehood or other fraudulent means would or would not amount to a false pretence as hereinbefore defined.“

 A conspiracy is an agreement between two or more person. Offence

is complete as soon as agreement is reached.

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R v Adams

 Crown alleged that Mr Hawkins and Mr Darvell conspired by deceit,

falsehood and other fraudulent means to affect the public market price of shares in Equiticorp Holdings Limited in that they agreed to dishonestly support the company's share price.

 Although the Crown was able to establish that both defendants had

misled the press and the NZSX, the Crown failed to establish that this conduct resulted from any concerted action between the two accused that amounted to a conspiracy for the purposes of section 257.

 This section is targeted at preventing conspiracy, but does not cover

fraudulent conduct carried out by an individual.

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NZSX Code of Conduct

 Avoiding misleading or deceptive acts or representations

Member Firms and their representatives shall refrain from any action which would hinder or disrupt the fair, efficient and orderly functioning of the market. Member Firms shall not communicate groundless or false information or rumours and may not undertake any activities, including advertising, which are misleading or deceptive or would mislead or deceive others about the true state of the market. Member Firms and their representatives shall not engage in any manipulative practices such as trades which involve no change in beneficial ownership, or which falsely indicate activity. The NZSE will not discourage new trading strategies provided they are not prohibited by law (such as insider trading) and they do not diminish the fairness, openness or efficiency of the market.

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• 2. Overview of Market Manipulation Practices

 The practices which are generally considered to come within the

ambit of market manipulation are of two main types:

 Disclosure based manipulation. This occurs where a person

disseminates false or misleading information which has the effect of misleading other participants about the value or trading volume of a security.

 Trade based manipulation. This is the buying or selling of a

security by a person which misleads or deceives other participants about the value or trading volume of that security.

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2.1 Disclosure Based Market Manipulation

 Disclosure based market manipulation generally involves a person

releasing information that misleads the market and in this way materially affects the price of shares.

 An example is where a person disseminates unrealistic,

unsubstantiated or incorrect data, projections or evaluations. The information could also relate to more general political and economic affairs.

 The manipulator then uses the demand generated by the false

information to sell their shares. This is sometimes known as “hype and dump” or “pump and dump” – because once the price has risen, the manipulators dump the securities.

Example

 A person, such as an investment advisor, purchasing a security

before recommending it to others, with the intention of selling it at a profit after the recommendation has resulted in an increase in price.

 Conversely, “slur and slurp” involves the price of securities being

talked down, allowing the manipulator to buy at a lower price. When this takes place over the Internet, it is called “cyber-smear”.

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Early example

 In R v De Berenger (1814) 105 ER 536, not so “noble” members of

the English aristocracy conspired with De Berenger. De Berenger was to appear in Dover as a French officer who would bring the (false) news of Napoleon’s death. Upon De Berenger’s disguised appearance as a French officer bringing the news, City stockbrokers and the public started buying government debt notes pushing their price appreciably higher, while the members of the syndicate

• ffloaded their holdings, as originally planned, at considerable profit.

The discovery of the scheme meant criminal conviction of its perpetrators, who were stripped of their titles and removed from public office.

Early example

 Nathan Rothschild, the banker, was known for maintaining a

network of communications between Continental Europe and Great Britain thanks to a system of carrier pigeons. He allegedly deceived the City by spreading the rumour that Napoleon was winning the battle of Waterloo (18 June 1815), after which his agents openly sold government securities (called “consuls”). Simultaneously, he was covertly purchasing large quantities of the same securities, taking advantage of the depressed price caused by the false

• rumour. Wellington won the battle.

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Other examples

 A Canadian listed company, Bre-X, which was later declared

bankrupt, filled the headlines of the global financial press with the false news that it had discovered one of the world’s biggest gold deposits in Indonesia, leading it stock price to skyrocket. In March 1997, the price of Bre-X shares dropped from over $280 per share so rapidly that it caused the Toronto Stock Exchange computer system to crash. In May 1997, the stock was de-listed.

 Developments in technology have increased the potential for these

types of practice as they have changed the ways in which information can be disseminated. For example, the use of the Internet creates opportunities for information, whether accurate or inaccurate, to be widely disseminated almost instantaneously.

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Comparator Systems Corp

 Comparator Systems Corp (CSC) was a small company trading on

NASDAQ’s Small Cap Market. In May 1996, a false rumour circulated that CSC had developed a system for fingerprint recognition, which purportedly could be integrated with a credit card

• system. A rumour on the Motley Fool chat room (www.fool.com) for

investors suggested that MasterCard would soon adopt the company’s technology. CSC’s market capitalisation increased from $36 million to $1 billion in one day. It was eventually discovered that the technology had been stolen from British researchers and the MasterCard rumours were false. CSC’s stock price dropped and the company was de-listed and went bankrupt later that year.

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Trading Based Market Manipulation

 Some of the specific trading practices which may be considered as

market manipulation are described below. These fall into the general categories of artificial transactions and price manipulation. There are many variations on the practices and the terminology used to describe them.

 The manipulative conduct will normally involve:

 Influencing the price or value of a security so that the

manipulator can buy at a lower price, sell at a higher price, or influence takeover bids

 Influencing the price of a derivative contract or the underlying

asset

 Influencing the price of a security underlying an index  Influencing the price of a security in connection with takeover

• ffers

 Influencing someone to subscribe for, purchase, or sell assets

 The manipulative conduct will normally involve:

 Influencing the price or value of a security so that the

manipulator can buy at a lower price, sell at a higher price, or influence takeover bids

 Influencing the price of a derivative contract or the underlying

asset

 Influencing the price of a security underlying an index  Influencing the price of a security in connection with takeover

• ffers

 Influencing someone to subscribe for, purchase, or sell assets

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Contract-based Manipulations

 The most effective forms of trade-based manipulation are those that

aim to influence the value of financial contracts or commercial deals, whose outcome or profitability depend on reported market prices. The trader’s profit does not come from the manipulated stock as such, but from the conclusion of an agreement or settlement of contracts influenced by the manipulated price.

 Companies may agree to redeem securities or convert bonds to

shares on the occurrence of agreed conditions. The value of such agreements is usually dependent on the market price, which creates incentives for manipulation.

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US v Milken

 The market price of a company’s stock (Wickes) was allegedly

manipulated in April 1986 by a brokerage (belonging to Ivan Boesky), under the instructions of Michael Milken (the inventor of junk bonds), acting for the company’s bankers Drexel, Burnham Lambert.

 Boesky’s firm was requested to buy enough Wickes’ stock so that

the market price moved to the price threshold (US$6.125) required to trigger the redemption clause contained in an issue of 8 million shares, convertible into preferred stock, which Wickes had arranged in April 1985.

 Wickes wanted to avoid paying dividends to the holders of the stock.

Drexel stood to gain substantial fees from the redemption of the stock and guaranteed Boesky’s firm their losses from subsequent sale of Wickes stock, purchased for this purpose. The market price declined after 23 April, the day Boesky’s firm bought Wickes’ stock. The firm incurred losses upon selling its holdings in Wickes, the intended purpose of the scheme.

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 In many firms, the tenure of senior management and a substantial

portion of their remuneration are tied to the market performance of the company stock. The same is true of fund managers’ bonuses. Thus, on certain occasions, a short-lived manipulation of market prices may translate into a substantial bonus.

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• 3. Disclosure Based Manipulation under the

Securities Markets Act 3.1 Basic Rule

 Section 11 of the Securities Markets Act 1988 (2006) is closely

modelled on s 1041E of the Corporations Act 2001 (Cth).

 While there are a couple of differences, the cases decided under the

Australian provision illustrate what conduct is likely to breach s 11.

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Australian Example- R v Wright; R v Wattle Gully Gold Mines NL

 W was a director of a listed company. He authorised the sending of

a letter to the stock exchange which contained the following statements: “The company’s consulting geologist has submitted a preliminary report in respect of the Thatchers Soak uranium deposit Western Australia and such report indicates there is a minimum of 2,750,000 tons of ore reserves averaging 1.6 lb per ton uranium. On present day values such reserves would be worth in the vicinity of $160,000,000.” In fact, the consulting geologist’s report had referred to possible reserves of 2,750,000 tons averaging 1.6 lb per ton, and contained nothing to justify the statement that the value of reserves would be in the vicinity of $160,000,000. Furthermore, at the trial the Crown alleged that the term “ore reserves” was misleading because it means economically recoverable deposits, yet the consulting geologist did not consider the deposits economically recoverable.

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W was convicted for the offence of disseminating information known to be false or misleading in a material particular and likely to have the effect of raising the market value of the company’s shares (under the equivalent of SMAA 2006, s 11). There was no evidence that he had profited from this. He was sentenced to one year’s imprisonment. The company was convicted

• f the same offence and fined $20,000. W and the company each
• appealed. W’s appeal was dismissed, but the company’s fine was

reduced to a nominal amount.

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• 4. Trade Based Manipulation

 The legislative history does not contain any details of the extent of

market manipulating trading in the New Zealand market. It is simply assumed that the fact that few market manipulating practices have been detected is because such conduct is designed to be difficult to detect.

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North v Marra Developments Ltd

 Stockbrokers sued their client company for remuneration for

professional services. The defence was that the agreement under which the fees were claimed was illegal.

 Pursuant to the agreement in question the brokers had set about

raising the market price of the client’s shares by purchases on the stock market. Their purpose was to facilitate the client’s takeover bid for another company (involving an exchange of shares) and to diminish the client’s own vulnerability to a takeover. It was held that the agreement, and the carrying out of the scheme, involved illegality in that the conduct was contrary to the s 11B equivalent. Hence no fees could be recovered by the brokers.

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Australian Example- Endresz v Whitehouse

 A director of CTC, Mr Endresz, approached the liquidators of

Rothwells, with a proposal that CTC purchase Rothwell’s holding of shares in Emu Hill Gold Mines NL. Rothwell owned 50% of the shares in Emu Hill. The liquidator agreed to the sale and in the following year CTC purchased a further parcel of shares in Emu Hill from a third party.

 Following this later purchase, the director instructed a broker (“the

selling broker”) to sell a bundle of CTC’s shares in Emu Hill. A different broker (“the buying broker”) was then instructed to purchase the same amount of shares in Emu, on behalf of CTC. The purchase price was not payable until three months after the date of the contract, whereas the proceeds of the sale were obtained at the time of sale.

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 After the transaction occurred, ASX wrote to the board of Emu Hill,

inquiring about the fluctuation in the price of its shares. Endresz replied, in his capacity as chairman of Emu Hill, without reference to the Board. In this letter, he advised that the board of Emu Hill was not aware of any information, not known to the market, which would explain the movement in share price. He also expressed the opinion that movements in the price of Emu Hill shares were the result of the market’s reappraisal of the company in the light of generally known facts concerning the takeover of that company. The letter also stated that CTC had purchased the shares in the ordinary course of business on the stock exchange.

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 Endresz was charged and convicted of creating a false or

misleading appearance of active trading in Emu Hill shares under the equivalent of SMAA 2006, ss 11B and 11C(1), and making a false or misleading statement likely to have the effect of maintaining

• r stabilising the market price of shares in Emu Hill under equivalent
• f SMAA 2006, ss 11.

 Endresz appealed.  In relation to the sale and purchase of the same shares, the Court

held that it was not possible, having regard to the expense to be incurred by the transaction (such as payment of duties and commission), to conclude other than that its purpose was to create a false and misleading impression of the market.

 Endresz argued that he had replied to the ASX letter as chairman of

Emu Hill and not as a director of CTC. His duty of confidentiality to CTC precluded his answering a letter on the basis of any knowledge he had gained purely as an officer of CTC.

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 The Appeal Court found that there was no doubt that Endresz knew

• f all the relevant facts, either in his capacity as a director of CTC,
• r, in his capacity as director and chairman of Emu Hill.

 The only issue was whether he was entitled to have excluded from

his answer to ASX any matter which he knew solely by reason of the fact that he was a director of CTC. When his letter was examined, it could be observed that it had included matters that could not have been known to Endresz as a director or chairman of Emu Hill.

 Furthermore, although he had gone into the matters that could not

have been known to Emu Hill, he had done so selectively.

 He also included matters of opinion in his letter, such as that “market

perception of the group... has led to an overall reappraisal”. These expressions of opinion gave what could only be described as a false

• r misleading appraisal in material particulars of the events leading

to the increase in the price of Emu Hill shares — events which Endresz had complete knowledge. Having opened up these matters

• f opinion, he was obliged to give complete and accurate answers.

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• 5. General Dealing Misconduct

 In relation to any dealing in listed or non-listed securities, a person

must not engage in conduct that is misleading or deceptive or conduct that is likely to mislead or deceive: SMAA, s 13(1)

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 This provision applies to a wider range of dealings than the other

market manipulation provisions, since it applies to all dealings in all types of securities, whether listed or unlisted – s 13. (Some unlisted securities may be exempted by regulation – s 49D.)

 The wording of section 13 resembles the wording in s 9 of the Fair

Trading Act 1986. It is inevitable in New Zealand that when interpreting the terms “misleading” and “deceptive” and the term “likely to mislead or deceive” the Courts will pay close attention to the way the equivalent provisions Fair Trading Act provisions have been interpreted by the courts.

 The Act allows the Securities Commission to work with the

Commerce Commission.

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 Enforcement of prohibitions on manipulation is likely to be costly.

Some commentators argue that the lack of an objective definition of manipulation increases enforcement costs.

 Another concern is that, if the law is drafted too broadly, it may

prohibit conduct which might otherwise be considered efficient. If market manipulation law were to have the effect of deterring trading unnecessarily, market efficiency would be reduced.