Part II: What Is Meant by Market Manipulation and Should it Be Regulated?
39. This part of the document looks at what is meant by the term market manipulation and considers arguments for and against regulating market manipulation. It describes specific practices which are likely to come under this heading.
40. There is no generally accepted definition of the term market manipulation. Although manipulation is prohibited under a number of statutes in overseas jurisdictions, it tends not to be defined precisely.
"Manipulation is difficult to define, but manipulative practices and schemes are usually readily identifiable."2
41. Market manipulation generally involves an attempt to interfere with the operation of the market. Various commentators have described it as "conduct intended to induce people to trade a security or force its price to an artificial level" or "deliberate interference with the free play of supply and demand in the securities markets". Commentators have also suggested that the inability to define the term market manipulation reflects conceptual confusion. It has been described by the United States Supreme Court as "virtually a term of art".
42. The traditional approach to regulation of market manipulation has been for the statutory requirements of offences to include proof of the intent of the offender. There has been much debate about whether deception and intent are a specific requirement of manipulative conduct. A possible definition, using an effect rather than an intent or purpose based test, is:
"Conduct likely to mislead or deceive market participants concerning the value and/or trading volume of a security".
43. Some market manipulation offences in overseas jurisdictions require proof of the intention of the manipulator. This may depend on the level of sanction, with a criminal offence requiring proof of intent, whereas a civil liability will result if there is no proof of intent required. If motive or intent is required for a definition of manipulative conduct, proving the offence becomes much more difficult. The discussion document entitled Reform of Securities Trading Law: Volume Three: Penalties, Remedies and the Application of Securities Trading Law considers the inter-relationship of criminal and civil penalties at paragraphs 162 to 166.
44. There are two ways of looking at the harm which may be caused by manipulative conduct.
- It may be seen as a wrong against the people who are directly affected, that is those who trade on the basis of the false information concerning the value or trading volume caused by the manipulative conduct. Taking this approach leads to manipulative conduct being seen as a form of fraud; or
- It may be considered a wrong against the market. Those who advocate this approach argue that manipulative conduct undermines public confidence in markets, as investors are unable to rely on the integrity of the market.
45. The view of the harm caused by manipulative conduct will determine the type of legislation that is implemented. If the purpose of the legislation is to prevent damage to confidence in the market, legislative provisions are likely to be different than if it is seen as a problem affecting individuals.
Questions for Submissions
- Should market manipulation be viewed as a private wrong or a wrong against the market?
- What definition of market manipulation should be adopted for any law that is introduced in New Zealand?
- Should the concept of market manipulation focus on the purpose or the effect of the conduct? What are the reasons for your view?
Should We Regulate Market Manipulation?
46. If we believe that market manipulation is occurring in New Zealand, then the issue that needs to be addressed is whether it has a positive or a negative impact on financial markets and whether we need to legislate against it.
47. Market manipulation is regarded by some commentators as essentially a type of fraud. It involves the creation of a false impression of trading activity or price movement or of market information. The existence of such a false or misleading impression leads to a reduction in market efficiency as trading decisions are not made on financial fundamentals. Commentators have argued that market manipulation undermines public confidence in markets as investors are unable to rely on the integrity of the market. This then has detrimental impacts on the level of competition and liquidity of securities markets.
48. It has been argued that investors require higher risk premiums from issuers of securities in a market where manipulative practices are not regulated and where disclosures may not be relied upon. Where the cost to issuers of raising capital is increased, there will be a negative impact on the economy wide level of investment. Hence it may be more difficult for issuers to finance investment projects.
49. Some commentators argue that all investors in a market should be on an equal footing and that fair prices in a market result from all investors having an equal opportunity to obtain and evaluate public information relevant to their trading decisions. Manipulative practices result in investors receiving misleading information. Accordingly, it is argued that prohibitions on manipulative practices promote market efficiency through allowing investors to have confidence that the information they obtain is based on accurate disclosures and genuine trades.
50. Historically, regulation of market manipulation was formalised in the United States in the 1930s. It was considered by the Congress that there was a link between manipulation of securities prices leading to excessive speculation and the stock market crash of 1929 and the depression of the 1930s. Regulation was considered necessary to ensure investor confidence in the integrity of the securities markets.
51. The rationale for enacting market manipulation law in other countries is similar. In many countries, regulation of market manipulation is seen as part of the wider regulation of financial markets and as contributing to the overall objectives of ensuring an efficient market and promoting confidence in the market. A number of jurisdictions, however, also have as an aim the protection of investors from manipulative practices.
52. Regulation aimed at the prevention of market manipulation focuses on maintaining the integrity of the market price of securities or of derivatives contracts. Regulation attempts to ensure that market prices are not distorted by manipulative activity and to prevent false or misleading information being released into the market. Thus rules imposing disclosure requirements may be seen as a tool for preventing manipulation.
53. The European Council and the United Kingdom regime argue that insider trading and market manipulation are two forms of market abuse, as they both result in some investors being disadvantaged by the conduct of others. There has been debate over the principles promoted in these regimes that confidence in a market requires that all investors are able to have:
- equal access to information;
- confidence in the price setting mechanism; and
- confidence that public information is not false or misleading.
54. The European Council in its proposal for a directive on insider dealing and market manipulation commented that:
"Fair prices result from individual analysis by investors of all public information. Prices resulting from manipulation are set at another level, creating economic advantage solely for the manipulators, but damaging the interests of all other investors".3
The Alternative View Regarding Regulation of Market Manipulation
55. There appears to be a widespread acceptance among commentators that manipulation undermines market efficiency through distorting prices and resulting in an inefficient allocation of resources. This differs from the situation with insider trading, where opponents of regulation argue that insider trading makes securities markets more efficient by communicating earlier to the market the existence of inside information. The misleading nature of the information disseminated as a result of manipulative conduct will not provide the correct signals to investors for resources to be allocated to their highest value uses.
56. The arguments of opponents to market manipulation regulation relate mainly to difficulties in defining and detecting manipulative conduct and in enforcing legislation.
57. Some commentators have argued that manipulation in financial markets should not be prohibited.4 The reasons for this view may be summarised as follows:
- The lack of an objective definition of manipulation;
- Some manipulative conduct, principally disclosure based manipulation, is a form of fraud and does not need to be considered under the concept of manipulation;
- Trade based manipulation is difficult to identify;
- There is a low probability that trade based manipulation can succeed; and
- Enforcement of prohibitions on manipulation is likely to be costly.
58. Opponents of market manipulation law consider that the various approaches to defining market manipulation are flawed. Manipulative conduct has sometimes been defined as being designed to:
- Interfere with the free play of supply and demand;
- Induce people to trade; or
- Force a security's price to an artificial level.
59. Commentators have said that the concept of "interference" is unhelpful as, like manipulation, it is undefined. The fact that conduct induces people to trade is seen as too broad, as "it includes value-maximising exchanges in which the transaction makes each party better off"5. Conduct which has the effect of forcing a security's price to an artificial level might catch trades where the trader genuinely believes that prices will move in one direction, but the trader turns out to be wrong.
60. On this basis commentators argue that there is no objective definition of market manipulation, with the result that the definition must be subjective, focusing on the intent of the trader. The problems which have arisen from the requirement to prove the intent of the manipulator are discussed in paragraphs 129 to 144 of this paper.
61. Fictitious transactions such as wash sales or matched orders are designed to mislead market participants that trading is taking place when in fact no transactions are taking place. Hence it is argued that this is a form of fraud. A similar argument can be made as regards false or misleading statements.
62. The argument of the opponents regarding actual trades where the trader has a manipulative intent is that in most cases individual trades will not affect price. Taking into account transaction costs, they argue that manipulative trades are not likely to be profitable. It has been argued that "there is no compelling reason to be concerned about such trading because it is likely to be self deterring."6
63. 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.
"Because manipulative intent is hard to identify, a rule prohibiting manipulative trades is expensive to administer and deters some appropriate and beneficial trading.7"
Market Manipulation Practices
64. 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.
Disclosure Based Market Manipulation
65. Disclosure based market manipulation generally involves a person releasing information that misleads the market and in this way materially affects the price of shares.
66. An example is where a person disseminates unrealistic, unsubstantiated or incorrect data, projections or evaluations. The manipulator then uses the demand generated by the false information to sell their own shares. This is sometimes known as "hype and dump" or "pump and dump".
67. Another example would be 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.
68. As discussed in Part I, developments in technology have impacted on 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. New technologies have provided many investors with a multitude of information about their investments, often at no charge. In recent years, many investors have begun to search the Internet for information about their investment options.
Trading Based Market Manipulation
69. Some of the specific trading practices which may be considered as market manipulation are described below.8 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.
70. The objective of these forms of manipulative conduct will normally be to make money. Ways in which this objective may be achieved include:
- Influencing the price or value of a security so that the manipulator can buy at a lower price, sell at a higher price, influence takeover bids or combat competitive transactions;
- 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 offers; and
- Influencing someone to subscribe for, purchase, or sell assets.
Matched Orders
71. A matched order occurs when a person buys a security with a low turnover and subsequently places contemporaneous buy and sell orders for that security. These orders will be for substantially the same number of securities at substantially the same time and at substantially the same price. The aim of this is to convey an appearance of renewed interest in the security to attempt to induce others to buy the security. The intention is that enough new investors are attracted by the apparent increase in activity so that the price of the security rises. The manipulator is then able to sell the security and make a financial gain.
Pools
72. A pool is essentially the same type of practice as a matched order, but involves more than one person colluding to generate artificial market activity.
Wash Sales
73. A wash sale involves a person, either directly or indirectly, being both the buyer and seller of securities in the same transaction, that is there is no actual change in ownership of the securities. The manipulator will undertake frequent trades hoping to attract other investors who note the increased turnover in the security. The manipulator aims to gain financially through creating a small price differential between the buy and sell rates of the security in question.
Runs
74. A run involves a person creating activity in a security by successively buying (or selling) that security. The intention is that the increased activity would, in the case where the person is buying, attract others to buy and push up the price. At that point, those organising the run would then attempt to sell out at a financial gain. This is sometimes known as "pumping and dumping."
Corners
75. A corner is where a person buys up a substantial volume of a security knowing that other market participants will be forced to buy from him at a higher price. An example of this would be where the other market participants hold short positions in the security which must be settled. A similar practice is the "abusive squeeze" where a person takes advantage of a shortage in an asset by controlling the demand side and creating artificial prices.
Market Stabilisation
76. This involves trading in a security at the time of a new issue in order to prevent a decline in the price of the security. This would normally involve issuers, underwriters or those participating in an offering of securities trading to avoid the failure of the offering.
Marking the Close
77. Marking the close is making a purchase or sale of a security near the close of the day's trading in an effort to alter the closing price of the security. This might be done to avoid margin calls (when the trader's position is not self-financed), to support a flagging price or to affect the valuation of a portfolio (called "window dressing"). A common indicator is trading in small parcels of the security just before the market closes.
Parking and Warehousing
78. These involve a person holding shares which are actually controlled by another person whose identity is not disclosed, sometimes through nominee or fictitious accounts. While the failure to disclose a change in shareholding may be dealt with under Part II of the Securities Amendment Act 1988, these trading practices may be used to conceal matched orders or wash sales.
Computerised Program Trading
79. A market practice which has been linked to market manipulation is computerised program trading. This is a strategy mainly used by large institutional investors. It uses computer programs which determine the timing of transactions, for example if there is a discrepancy between the price of a futures index and the shares included in the index. It is likely to influence the price of securities, but may not be caught by market manipulation laws as it is not likely that an element of intent to induce trading or to mislead others could be proven. Trading programs themselves are not manipulative.
Short Selling
80. Another trading practice which is sometimes considered manipulative is short selling. Short selling is defined as the sale of securities where, at the time of sale, the seller does not own the securities.
81. Short selling is used when a person considers that the price of a security will fall. A person will make a profit if he sells at the current price and purchases later at a lower price. Arguments for and against regulating short selling are discussed at paragraphs 170 to 175. Short sellers generally need to deposit with the broker the amount of cash needed to purchase the shares they are shorting in order to short sell.
Incidence of Market Manipulation
82. There is very little data available on the incidence of market manipulation in New Zealand. Commentary referring to market manipulation has tended to be in the context of discussions on public confidence in the sharemarket.
83. The New Zealand sharemarket underwent particular scrutiny for its poor performance in the years following the 1987 sharemarket crash.
"A 1992 public opinion survey indicated that the New Zealand public held the share market in very low esteem. A total of forty-four per cent of respondents believed that the share market was manipulated compared to sixteen per cent who did not, and forty percent said they had no opinion. When asked `do you think all investors are treated fairly or do you think big investors can manipulate the market?', a total of seventy seven per cent said that big investors can manipulate the market and only three per cent stated all shareholders were treated fairly."9
84. More recently, media attention was drawn to market manipulation following an investigation by the Securities Commission into trading in the shares of Fletcher Challenge Limited10 which found conduct involving a person releasing information "to cause a movement in the price of FCL shares by which he could profit". The Commission commented "The question arises whether actions of this sort are better recognised by the law as deliberate attempts to manipulate a market".
85. The 1974 Report of the Senate Select Committee on Securities and Exchange, known as the Rae Report, is the major detailed study in Australia on the conduct of stock market manipulation.
86. The Rae Report noted that:
"the deliberate manipulation of the market for listed shares on the organised exchange has at times been widely practised in Australia. Although this manipulation has been known to prominent market traders, the practices have seldom been exposed publicly. They have not been effectively regulated."11
87. The United States is the jurisdiction where market manipulation has received the most attention. Legislation to deal with market manipulation was introduced in the 1930s, following massive sharemarket losses suffered by the public during the Depression. After the 1987 sharemarket crash, there were a number of high profile cases involving insider trading and market manipulation.
"The widely publicized criminal prosecutions of Michael Milken, Drexel Burnham Lambert, Ivan Boesky, Dennis Levine, Boyd Jefferies, the GAF Corporation and James Sherwin, Salim "Sandy" Lewis, Paul Bilzerian, and others all involved allegations of manipulation of securities markets."12
88. The most recent focus of the United States Securities and Exchange Commission is on Internet investment fraud, including pump and dump schemes.
"In its fourth nationwide Internet fraud sweep, the Securities and Exchange Commission today announced 15 enforcement actions against 33 companies and individuals who used the Internet to defraud investors by engaging in pump-and-dump stock manipulations."13
89. The International Organisation of Securities Commissions (IOSCO) has published a report entitled "Investigating and Prosecuting Market Manipulation."14 This report includes an annex containing 13 examples of manipulation cases in various jurisdictions. These cases were investigated in the United States, France, Australia, Hong Kong, Portugal and Greece
Questions for Submissions
- Do you believe market manipulation exists in New Zealand?
- Should we regulate market manipulation in New Zealand?
- What are the reasons for your view?
- If you are in favour of regulating market manipulation, what do you think the policy justification for our market manipulation legislation should be?
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