Market Manipulation and Insider Trading

Regulatory Challenges in the United States of America, the European Union and the United Kingdom

Ester Herlin-Karnell, Nicholas Ryder

• Publisher: Hart Publishing
• Year: 2019
• ISBN:
  9781509903092
• Edition: 1
• Topic: Law
• Subtopic: Financial Law
• Index: Law

The European Union regime for fighting market manipulation and insider trading – commonly referred to as market abuse – was significantly reshuffled in the wake of the financial crisis of 2007/2008 and new legal instruments to fight market abuse were eventually adopted in 2014. In this monograph the authors identify the association between the financial crisis and market abuse, critically consider the legislative, policy and enforcement responses in the European Union, and contrast them with the approaches adopted by the United States of America and the United Kingdom respectively. The aftermath of the financial crisis, ongoing security concerns and increased legislation and policy responses to the fight against irregularities and market failures demonstrate that we need to understand, in context, the regulatory responses taken in this area. Specifically, the book investigates how the regulatory responses have changed over time since the start of the financial crisis. Market Manipulation and Insider Trading places the fight against market abuse in the broader framework of the fight against white collar crime and also considers some associated questions in order to better understand the contemporary market abuse regime.

1

Introduction

I.Introduction

This book explores the phenomenon of market manipulation and insider trading, and how it is regulated and dealt with by the European Union (EU), the United Kingdom (UK) and the United States of America (US) respectively.

The ban on market manipulation in European law, for example, has its roots in the US, where the courts developed it based on the general common-law provisions on fraud.¹ The EU regime for fighting market manipulation and insider trading – commonly referred to as market abuse – was significantly reshuffled in the wake of the financial crisis of 2007/08, and a new Directive and Regulation were proposed in 2011 and subsequently adopted in 2014.² In all of the EU, US and the UK frameworks, the aftermath of the financial crisis, security concerns and increased legislation and policy responses to the fight against irregularities and market failures demonstrate that we need to understand the regulatory responses in this area in context. Specifically, the aim of this book is to investigate how the regulatory responses have changed since the start of the 2007/08 financial crisis, and to place the fight against market abuse within the broader picture of the fight against white-collar crime and the associated questions it raises in the context of the EU, US and the UK.

What, then, is market abuse? As stated, the notion of ‘market abuse’ is the umbrella label used to define insider trading and market manipulation. The insider trading ban, as Niamh Moloney explains, has several justifications. As she observes:

The first rationale for insider-dealing regulation has a micro focus. It characterizes insider dealing as a breach of the fiduciary relationship of trust and confidence (a related strand characterizes insider dealing in terms of the allocation of property rights), where one can be established, between, typically, the insider and the company concerned. The macro focus of the second theory (which has shaped the EU regime) is on market efficiency, and on the support of efficient price formation and deep liquidity.³

The definition of ‘market manipulation’ is somewhat more vague, however. In short, market manipulation may arise in circumstances where investors have been unreasonably disadvantaged, directly or indirectly, by others who have used information that is not publicly available to trade in financial instruments to their advantage (insider dealing), have distorted the price-setting mechanism of financial instruments, or have disseminated false or misleading information.⁴ In short, market manipulation can be defined as conduct that may misinform or deceive others into making ill-considered misleading investment decisions.⁵ ‘Market manipulation’ is a term that has been used in the broader sense as including ‘practices deemed harmful to the capital markets’.⁶ It has also been defined as an ‘unwarranted interference in the operation of ordinary market forces of supply and demand; an interference in the market’s normal price-forming mechanism’.⁷ For example, according to the definition provided by the UK Financial Services Authority, market manipulation encompasses three elements.⁸ First, it includes financial dealings that provide fictitious indicators to obtain the price of a monetary tool at a synthetic level. Secondly, it involves a series of contracts or orders to utilise fabricated devices or products. Thirdly, it incorporates the sharing and dispersal of information that provides false or misleading signals. Examples of conduct that amounts to market manipulation include providing false statements or transactions that could result in the fluctuation of share prices.⁹

Furthermore, market manipulation can also include ‘disseminating misleading information which moves the price of investments up or down’, or ‘improper use of market power’.¹⁰ Other instances of market manipulation include a process called ‘share romping’, as illustrated during the Guinness fraud in the 1980s.¹¹ Wayne Carroll stated:

Market manipulation is a general term covering a number of practices deemed harmful to the capital markets. Conduct that can lead to a violation of the market manipulation provisions extends from active trading to merely spreading information about a particular security or company. Market manipulation comes in many forms, whose number is limited only by human ingenuity.¹²

The EU Market Abuse Directive (MAD) offers a slightly different version.¹³ Article 5 defines market manipulation as (inter alia) someone entering into a transaction, placing an order to trade or any other behaviour which: gives false or misleading signals as to the supply of, demand for, or price of, a financial instrument or a related spot commodity contract; or secures the price of one or several financial instruments or a related spot commodity contract at an abnormal or artificial level.¹⁴

Moreover, in Article 8 of the Market Abuse Regulation (MAR), insider dealing (the common term in the EU context) – on the other account – is defined as arising

where a person possesses inside information and uses that information by acquiring or disposing of, for its own account or for the account of a third party, directly or indirectly, financial instruments to which that information relates.

However, whom exactly do market manipulation and insider dealing harm? For a long time there has been a scholarly debate on what is wrong with insider dealing and who exactly is harmed by it. Scholars have asked why insider trading is banned and what the justification is.¹⁵ The question asked is whether insider trading and market manipulation are unethical if no one is harmed by them.¹⁶ Who exactly is harmed? The traders themselves? While the answers to these questions remain somewhat obscure, for the EU legislator, for example, the most important reason for banning market manipulation and insider trading is the protection of consumer confidence and investors by ensuring integrity in the market and fairness. While these matters have been debated for a long time, as a result of the global economic crisis, concerns were raised again about the effectiveness of the regime and the need to update it in light of current circumstances. Clearly, the financial crisis appeared to trigger policy reforms in this area but, as this book explains, it was not the only trigger. The development of the EU’s fight against irregularities and criminal activity in the financial sector should therefore be seen in tandem with the EU’s attempts to save the economy by boosting investor confidence in the EU market and securing an honest market place.

On that broader background, as a response to the financial crisis, both the EU and the US have increasingly focused on the phenomenon of white-collar crime as one of its major causes. The next section will therefore introduce the financial crisis that started over a decade ago and which is still ongoing, and explain why it is still relevant for understanding the law on market manipulation and insider trading.

II.The Financial Crisis and the Fight against Financial Crimes: Some Hardcore Data

The 2007/08 financial crisis began within the conduct of numerous US mortgage lenders,¹⁷ who offered a variety of mortgages, including ‘prime loans’, ‘alt-A loans’ and ‘subprime loans’.¹⁸ In the lead-up to the onset of the largest financial crisis since the Great Depression, the growth of subprime loans was unparalleled, and by 2007 approximately 25 per cent of all US mortgages were subprime.¹⁹ The growth of subprime loans was assisted by the introduction of the Fair Housing Act 1968 and the Civil Rights Act 1968,²⁰ which both fuelled access to convenient credit.²¹ The collapse of the subprime market was accelerated by a process called securitisation,²² which seeks to provide finance to financial institutions by the sale of assets.²³ The impact of the 2007/08 financial crisis on subprime lenders was catastrophic, and it claimed many corporate casualties – New Century Financial,²⁴ Lehman Brothers,²⁵ the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, American Insurance Group (AIG)²⁶ and Bear Stearns.²⁷ It is interesting to note that prior to its takeover by the Government and JP Morgan, Bear Stearns shares were trading at $170.²⁸ The total losses from the collapse of the US subprime market surpassed $600 billion,²⁹ there was $20 trillion of lost wealth, 20 million people lost their jobs and 4 million US homeowners found their homes were repossessed.³⁰

The US response was led by the Federal Reserve and the Department of Treasury, who provided emergency ‘liquidity in the financial sector’.³¹ The Federal Reserve reduced US interest rates, increased access to short-term liquidity, created a weekly loan service and arranged the takeover of Bear Stearns.³² These actions were soon followed by the introduction of an over-abundance of legislative measures, including the Economic Stimulus Act 2008,³³ the Emergency Economic Stabilization Act 2008,³⁴ the Housing and Economic Recovery Act 2008,³⁵ the American Recovery and Reinvestment Act 2009,³⁶ the Fraud Enforcement and Recovery Act 2009³⁷ and the Dodd-Frank Wall Street Reform Act 2012.³⁸

In the UK, the corporate casualty list included Northern Rock, Bradford & Bingley, Lloyds TSB, HBOS and the Royal Bank of Scotland (RBS), who required emergency liquidity from the Bank of England. The legislative response to the 2007/08 financial crisis in the UK included the Banking (Special Provisions) Act 2008, the Banking Act 2009, the Financial Services Act 2010 and the Financial Services Act 2012. The last of these resulted in the creation of a new system of financial regulation in the UK, managed by the Bank of England, the Financial Conduct Authority (FCA), the Prudential Regulation Authority and the Financial Policy ...