THE METHODS TO PREVENT MARKET MANIPULATION ON SECURITIES EXCHANGES

1. THE METHODS TO PREVENT MARKET MANIPULATION ON SECURITIES EXCHANGES ASLI BASTURK Capital Markets Board of Turkey April 21, 2003

2. Introduction • The central economic function of markets is to create LIQUIDTY. • Investors face lots of kinds of risks on the process of trade. • Information is a valuable commodity in security market. • However, information can be gained lawfully or unlawfully.

3. Introduction (cont.) • The major objectives of securities regulation are open, honest and fair markets. • Most of the regulation of financial markets seeks to prevent manipulation. • Securities Act of 1933 • Securities Exchange Act of 1934

4. Introduction (cont.) • The problem of manipulation was attacked by Congress in a number of ways; • By specific prohibitions, • By giving the SEC rulemaking authority in certain areas, • By a general prohibition against any trading for a manipulative purpose. • The statutory scheme is a blend of fraud theories and open market concept developed in the English and American cases.

5. What is manipulation? • No satisfactory definition of the term exists. • No definition in the regulatory statutes. • Courts and commentators have suggested various formulations.

6. Definition of manipulation • Manipulation means anything in particular; it means conduct intended to induce people to trade a security or force its price to an artificial level. • Deliberate interference with the free play of supply and demand in the security markets. • Any price change that results from trading designed to produce such a price change is an artificial price.

7. Definition of manipulation (cont.) • The only definition that makes sense is subjective – it focuses entirely on the intent of the trader. Manipulative trades could be defined as profitable trades with “bad intent” – in other words, trades that meet the following conditions: • (1) the trading is intended to move prices in a certain direction; • (2) the trader has no belief that the prices would move in this direction but for the trade; and • (3) the resulting profit comes solely from the trader’s ability to move prices and not from his possession of valuable information. • Traders who trade with “good” intent – for the purpose of moving prices in the direction they believe prices will move – are not engaged in manipulation.

8. Manipulation as a white collar crime • The label “white collar crime” introduced by Edwin Sutherland in 1940s. • Aimed to foster an integrated analysis of ‘crime in the upper, or white collar class’. • Many white collar offences, like manipulation, are complex and heterogeneous acts.

9. The very first case against manipulation • Rex v. de Berenger, decided by the King’s Bench in 1814. • In this case, as a matter of criminal law, the concept of a free and open public market established.

10. Manipulation before the SEC • The pre-cases in the US arose in three contexts: • Criminal prosecution, • Litigation between manipulators, • Litigation between investors and manipulators. • The criminal attack on manipulation came under the mail fraud statute and special state legislation, primarily in New York. • In 1933 Judge Woolsey in the Southern District of NY adopted the open market theory.

11. The provisions of SEC statutes • The purpose of the various statues and rules prohibiting market manipulation is to prevent activities that rig the market and thereby to permit the operation of the ‘natural law’ of supply and demand. • The function of the SEC statutes has been to give a greater degree of definiteness to the concept of manipulation and to supply an enforcement and preventive mechanism .

12. Securities Act of 1933 • According to the provision of section 17 (a), it shall be unlawful for any person in the offer or sale of any securities or any security-based swap agreement by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly- • to employ any device, scheme, or artifice to defraud, or • to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or • to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

13. Assets Held by Insurance Companies • Insurance industry has a dominant role in the capital markets because off their role as the managers of pension funds and mutual funds and the main demander of long term bonds. • Insurance companies held assets; • Bonds • Mortgages • Stock • Real Estate • Other • Traditionally insurance companies heavily invested in fixed-income securities. Secondary preference for life/insurance companies is mortgages and for property/casualty companies is equities. But for the last years the boom in the stock market cause a shift toward equity-based securities for life/insurance companies.

14. The Regulation of Insurance Companies • Since the McCarran-Ferguson Act of 1945, insurance companies have been regulated by the states. • State regulations include firm solvency and product specification. • While regulations vary from state to state, they share at least the following goals: • Prevent insurer investment in speculative assets • Ensure that assets are not vulnerable to dramatic shifts in the economy • Restrict insurers from control beyond the influence of regulatory authorities • Achieve “social goals” • To promote a convergence of standards, the National Association of Insurance Commissioners (NAIC) was formed in 1871. This organization provides various services to the state commissioners and has developed the standardized examination system known as the “Insurance Regulatory Information System (IRIS)”.

15. Securities Exchange Act of 1934 • Section 9 • Section 10 (b) • Section 15(c)

16. Section 9 of 1934 Act • Outlaws manipulative practices in connection with the trading of exchange-listed securities and also provides a private remedy for investors injured by the prohibited manipulative conduct. . • Unlike most other provisions of the 1934 Act, section 9 is limited to securities traded on a national securities exchange and does not apply to the securities of the many registered reporting companies that are traded in the over the counter markets.

17. Section 9 of 1934 Act (cont.) • Section 9(a) expressly prohibits ‘wash sales’, ‘matched sales’, or any transactions entered into simultaneously where the purpose is to create ‘a misleading appearance of active trading’. The section also prohibits any exchange-based transactions that give the artificial impression of active trading as well as transactions entered into for the purpose of depressing or raising the price. • Section 9(e) of the Exchange Act contains an express remedy to redress damages incurred by investors who have been injured by illegal manipulative conduct with regard to those exchange-listed securities. Liability under section 9(e) is expressly limited to persons ‘willfully’ participating in the manipulative conduct; willfulness would seem to be an even stricter requirement than that of scienter which is required generally in suits under Rule 10b-5.

18. Section 9(a)(6) of 1934 Act • Section 9(a)(6) acts as a limitation on Section 9(a)(2) in that it excludes certain types manipulation _ “any series of transactions for the purchase and/or sale of any security registered on a national securities exchange for the purpose of pegging, fixing or stabilizing the price of such security”- from the general prohibition and subjects them to the Commission’s rulemaking authority. • Congress found the evidence as to the value of stabilizing operations was “far from conclusive”. And so it authorized the Commission “to prescribe such rules as may be necessary or appropriate to protect investors and the public from the vicious and unsocial aspects of these practices” .

19. Section 10 (b) of 1934 Act • Section 10 (b) of Securities Exchange Act empowers the SEC to promulgate rules prohibiting manipulative and deceptive devices and contrivances in connection with purchases and sales of securities. • Section 10(b), which is the general antifraud provision of the 1934 Act provides that it is unlawful “to use or employ (utilizing any means or instrumentality of interstate commerce), in connection with the purchase or sale of any security… any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

20. Section 10 (b) of 1934 Act (cont.) • The Commission has utilized this rulemaking power in a number of instances, with regard to a wide variety of manipulative and deceptive acts and practices and in Rule 10b-5 it fashioned its most encompassing antifraud prohibition. • The rule prohibits: • (1) Fraudulent devices and schemes, • (2) Misstatements and omission of material facts, • (3) Acts and practices which operate as a fraud or deceit .

21. Section 15 (c) of 1934 Act • The Commission is given the power to promulgate rules prohibiting brokers and dealers from engaging in ‘manipulative, deceptive, or otherwise fraudulent’ devices and contrivances .

22. Fischel and Boss’s arguments on manipulation • Fischel and Ross argue in their article that, the law’s efforts to prevent manipulation are misguided. They conclude that “the concept of manipulation should be abandoned altogether … Actual trades should not be prohibited as manipulative regardless of the intent of the trader.”

23. Steve Thel’sarguments on manipulation • Thel concludes that, much of the regulation of financial markets seeks to prevent manipulation. The law should not lightly abandon this quest, Fischel and Ross’ arguments notwithstanding. Manipulators can sometimes control prices with trades and by doing so they can reap profits, whether by taking advantage of preexisting contracts or by inducing other market participants to trade at manipulated price. • It is often hard to tell what motivates a particular trade, so rules that turn on intentions would be unlikely to prevent intentional manipulation. Objective rules may more accurately identify and prevent manipulative trading .

24. Article 47/A-2 of the CML • According to the article:“Real entities, the authorized persons of legal entities and those acting together with them all which trade capital market instruments in order to artificially affect their demand and supply, to give the impression of existence of active market, to hold the prices at the same level, to increase or decrease the prices.” • shall be punished with a prison sentence of from two to five years and a heavy pecuniary fine of from 10 billion TL up to 25 billion TL. If two or more of the cases specified in this sub paragraph are combined in the committing of the crime, then the minimum limit of the prison sentence is three years and the maximum limit is six years”.

25. Article 46 (i) of the CML • Beside these criminal provisions, Article 46 (i) of the CML authorizes the Board, “to take such measures needed to ensure the prevention of real persons or legal entities that are determined by the Board to have directly or indirectly participated in acts enumerated in the provision of subparagraph A of Article 47 of this Law from engaging temporarily or permanently in transactions on exchanges and other organized markets following the supervision, examination and auditing made in accordance with this Law”.

26. The CMB rule about prohibition to engage transaction on the exchanges and other organized markets. • This measure is applied to all the manipulators and insiders, and is also applied to other crimes like unauthorized broker-dealers. • With the authority given by the Law, the Board applies two major methods to prevent manipulators from engaging the same kind of exercises; • prohibition to engage transaction on the exchanges and other organized markets and • unlisted the securities that manipulators owned.

27. Conclusion • Much of the regulation of financial markets seeks to prevent manipulation. • The difficulty to prove manipulation as a crime in the courts is parallel to the most of the markets. • Since CML have the criminal and administrative provisions against manipulation in the Law, the Law does not have a similar rule like Rule 10(b)(5) of SEC. • To formulate classic manipulative conducts as fraud or to regulate manipulation with objective rules can not be the right solution for preventing manipulative conduct.