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. (2nd 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 non- public 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 10b-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 10b-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

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)? Conclusions