Market Abuse: The EU and US Approaches Compared

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

2. Insider Dealing: Four Elements • The Insider Dealing Prohibition • Market Manipulation • Preventive Regulation • Conclusions

3. 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)

4. 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)

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

6. 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

7. 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

8. 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

9. 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

10. 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)

11. 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

12. 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

13. 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

14. 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

15. 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)

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

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

18. 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

19. Market Manipulation Types: • 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)

20. (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)

21. 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

22. 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)

23. 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

24. 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”

25. 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”

26. 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

27. 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

28. 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

29. 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

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

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

32. 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)?