Market Abuse The EU and US Approaches Compared

Market Abuse: The EU and US Approaches Compared Guido Ferrarini, Professor of Business Law, University of Genoa; Vice-Chairman, European Corporate Governance Institute (ECGI)

1. Insider Dealing: Four Elements 2. The Insider Dealing Prohibition 3. Market Manipulation 4. Preventive Regulation 5. Conclusions

Insider Dealing Inside Information • General – the use of non-public information is allowed provided it is not price-sensitive – role of financial research • 4 Elements – precise information • Rumours are not covered • Definitions Directive Art 1(1)

• Non-public information – SEC v. Texas Gulf Sulphur Co. (2 nd Cir. 1968) • Corporate Information/Market Information – coming from within the company (dividend increase) or from the market (takeover)

• Price-sensitive information – likely to have a significant effect on price – reasonable investor’s test • Basic Inc. V. Levinson (US Sup. Ct. 1988)

• Insiders – Primary v. Secondary Insiders – Primary Insiders • broad notion (Article 2(1)) – directors and managers – employees and advisors – shareholders • focus on the “status, profession or activity giving access to inside information” • new category: criminal insiders

• Secondary Insiders – Art. 4 MAD: “any person. . . who possesses inside information while that person knows, or ought to have known, that it is inside information” – Analogy with the “tippee” concept under US Law; however • a tip is not required • a breach of fiduciary duty is not required

• Comparison with US Law – the EU definition reflects the US equal access theory • Cady, Roberts and Co. (SEC 1961) – the ‘disclose or abstain’ duty applies to anyone who has access to information intended to be available only for a corporate purpose and not for the personal benefit of anyone

• Comparison with US Law – the EU definition does not require a breach of fiduciary duty • United States v. Chiarella (US 1980) – Chiarella was a printer by trade handling announcements of takeover bids – He traded in the stock of target companies exploiting confidential information – The Court held that Chiarella did not violate § 10 (b) as he was not under a duty to disclose before trading

• Comparison with US Law • United States v. Chiarella (US 1980) – The Court refused to recognize a general duty between all participants in market transactions to forgo actions based on material, non-public information (equal access theory) – The Court held that Chiarella was not liable as he was not a fiduciary of the shareholders who sold shares in the target companies to him (fiduciary duty theory)

• Comparison with US Law • Dirks v. SEC (US 1983) – Dirks (broker-dealer) received material nonpublic information from ‘insiders’ of a corporation with which he had no connection – He disclosed this information to investors who relied on it in trading the corporation’s shares

• Comparison with US Law • Dirks v. SEC (US 1983) – The SEC argued that a tippee ‘inherits’ the duty to disclose or abstain – In the Court’s opinion » a similar rule could have an inhibiting influence on the role of market analysts » however, tippees are not always free to trade » It is necessary to determine whether the tip constitutes a breach of the insider’s fiduciary duty

• Comparison with US Law – the EU definition does not require corporate information to be misappropriated • United States v. O’Hagan (US 1997) – O’Hagan was a partner in a law firm representing the bidder in a tender offer – He did not work on the bid, but traded on the relevant information

• Comparison with US Law • United States v. O’Hagan (US 1997) – Opinion of the Court: » A person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information, is guilty of violating § 10 (b) and Rule 10 b-5

• Comparison with US Law • United States v. O’Hagan (US 1997) – Opinion of the Court: » The misappropriation theory outlaws trading on the basis of non-public information by a corporate ‘outsider’ in breach of a duty owed not to a trading party, but to the source fo the information (O’Hagan traded in breach of a duty of trust and confidence owed to his law firm and to its client)

The Insider Dealing Prohibition • Article 2(1) – prohibition of trading – intent is not required • Article 3(a) – prohibition of tipping – also recommendations are forbidden

The Insider Dealing Prohibition • Article 4 – these prohibitions also apply to secondary insiders • compare Dirks v. SEC • impact on analysts: inhibiting influence?

The Insider Dealing Prohibition • US Law: Intent is required – Ernst & Ernst v. Hochfelder (US 1976) • The 1934 Act was intended to protect investors against manipulation of stock prices • The words ‘manipulative or deceptive’ used in conjunction with ‘device or contrivance’ strongly suggest that & 10 (b) was intended to proscribe knowing or intentional misconduct

Market Manipulation Types: a) Transaction – based manipulation (i) Transactions giving false or misleading signals as to the supply of, demand for or price of financial instruments (fictitious transactions) • wash sales (no change in ownership of financial instruments) • improper matched orders (entered into by colluding parties)

(ii) Transaction securing the price of one or several financial instruments at an abnormal or artificial level (market power manipulation) • corner or squeeze (dominant position over the supply of or demand for a financial instrument)

- Comparison with US Law US cases require to demonstrate - an artificial price - causality - intent ¨ CFTC: intent is the essence of manipulation ¨ Reference to intent distinguishes manipulation from legitimate market activity

the MAD does not require intent for market power manipulation - could the mere accumulation of a large position be held as manipulative? - could the “accepted market practices” defense be used? (iii) transactions which employ fictitious devices or any other form of deception or contrivance example: trading at the end of the day (to affect the closing price)

b) Information-based manipulation - Dissemination of information. . . giving false or misleading signals as to financial instruments • scalping (recommending a financial instrument after buying it) • Special regime for journalists

- Comparison with US Law • the equivalent provision is section 10(b) of the 1934 Act (see also SEC Rule 10 b-5) making unlawful the use of any “manipulative or deceptive device” in contravention of Commission rules • Ernst & Ernst v. Hochfelder (US 1976) - the SEC argued that the effect on investors is the same regardless of whether the conduct is negligent or intentional - the Court argued that the words manipulative etc. make unmistakable a congressional intent to proscribe “intentional or wilful conduct”

Preventive regulation • Timely disclosure of inside information – Art. 6(1) MAD • “corporate information” – Art. 2 Definitions Directive • “upon the coming into existence of a set of circumstances or the occurrence of an event, albeit not yet formalised”

• When is an event ripe for publication? Basic v. Levinson (US 1988) – preliminary merger discussions can be material – it is not necessary that an “agreement-in principle” has been reached – Judge Friendly’s approach adopted: balancing the indicated probability of an event and the anticipated magnitude of the same

Conclusions • Insider Dealing – US approach (R. Kraakman): • Extended discussion of the concept of fraud • Displacement of the equal access theory by the other two theories • Assertions about the fairness or efficiency of informational disparities in the market

Conclusions • Insider Dealing – US approach (R. Kraakman): • Together, the fiduciary duty theory and the misappropriation theory reach most conduct that would be condemned under the equal access theory

Conclusions • Insider Dealing – EU approach: • It is based on the equal access theory • The scope of the insider dealing prohibition is potentially broader than in the US approach • Financial analysts find a potentially narrower field of action in the EU approach

Conclusions • Market Manipulation – US approach: • Reference to intent distinguishes market power manipulation from legitimate market activity • Fictitious transactions are a form of fraud

Conclusions • Market Manipulation – EU approach: • No reference to intent • Unclear connection with fraud

Conclusions • Market Manipulation – EU approach: • Questionable under the principle nullum crimen sine lege (Article 7 Human Rights Convention) • Does the Directive’s definition lack specificity given that intent is the essence of market manipulation (CFTC approach in the US)?