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 CHAPTER 24

lVfARKET ABUSE AND INSIDER DEALING

Summary of investment frauds

The principal securities frauds are: 24-01

e deceitful misrepresentation or non-disclosure-see chapter 23,

111 market manipulation and the like--explaincd in this chapter, and
@ insider dealing-also explained this chapter.

Sources of law The law on market fraud and abuse is built up in tiers from 24-02
the general to the specific.

@ General--common law or codified rules concerning fraud, civil or

criminal, eg conspiracy to defraud, obtaining money by deception,
dishonest concealment of material facts.
@ Specific-securities statutes creating criminal ofTenccs, cg Fisma 200
s 397; the US Securities Exchange Act of 1934 s 15, Rule 1065, the EU
Market Abuse Directive 2003 and ancillary legislation ("Mad").
@ Regulatory statutes--rules which create administrative ofTences which
are a half-way house between the criminal and the civil. These rules are
brought in to make it easier for the regulator to bring perpetrators to
account: the essential protections of the criminal law are relaxed to
case convictions. Sec para 20 04.

The review in this chapter does not necessarily make a distinction between
the administrative offences and the criminal offences.

Whistle-blowing Rules requiring market participants and exchanges posi- 24-03

tively to report market manipulation or insider dealing to the regulators are
common. Thus in the EU under Mad 2003 Member States must require that
"any person professionally arranging transactions in financial instruments
who reasonably suspects that a transaction might constitute insider dealing
or market manipulation shall notify the competent authority without
delay." See art 6(9).

Market manipulation
What is market manipulation?

Market manipulation is a course of conduct intended to rig or distort the 24-04

price of securities with a view to deceiving other users of the market in order
to make a profit or avoid a loss.
 7

392 REGULATION OF INTERNATIONAL FINANCE MARKET ABUSE AND INSIDER DEALING 393

Examples of market manipulation by a spirit of prophecy, divine who would be the purchasers on a
subsequent day." After spending some time in jail, the admiral
24-05 Composite example A typical composite case involving the many example. concerned subsequently helped liberate Chile, Peru and Brazil,
of market manipulation is as follows (based on an article in the Yale La~ was elected to the British House of Commons and was considered
.Journal of 1937): for employment in the Crimean War when he was nearly 80. He
was buried in Westminster Abbey, but not for services to the law
The manager of a pool of dealers acting in concert contracts an option of market manipulation.
with outsider dealers in the market to buy the targeted stock at the current The first English reported case or fraud on a market appears to be
market 1:mcc: Members of the pool purchas_e th_e stock 111 the market and
in 1369, but one imagines that there were plenty of cases in
also sell 1t, with the purchase orders prcdom111atmg. They form a nng with
the purchases and sales going around a circle, so as to create an various regions for centuries before that.
appearance of independent active trading. Up goes the price. Large In Anon (1369) Jcnk 49 (Case xciii); 145 ER 36, an alien spread a
holders of the stock who arc members of the pool agree to withhold sal~s false rumour in the Cotswolds that there was a market glut of
of their stock in the market. More push up on the price. Members of th~ wool overseas and overseas traders would buy no mor;. The
pool also agree with purchasers either to share losses or to guarantee the
sale _p_rice so that the insider purchasers arc safe and hence willing to object was to cause the price to fall. Held: criminal falsity. The
part1c1patc. Members of the pool then arrange for the sprcaditH; of alien was fined, ransomed and imprisoned. Publishing a false-
publicity about the stock. The directors are persuaded to make bullish hood which may occasion detriment to the public, cg that the
statements about prospects. The brokers put about "buy" recommenda- coin is debased, is a crime. Salus populi est s11pre111a !ex.
tions in their tip sheets. Financial journalists arc paid to publish glowing
reports and to suggest an impending bid or increased dividends. Thi~ In the English administrative case of Jncligo & Bonnier, FSA
publicity has little foundation in fact. The price or the stock goes up even December 21, 2004, the managing partner of Indigo made a
more. The operator then exercises its option which was fixed at the lower statutory disclosure to a London listed company that Indigo had
original market price. The pool carefully unloads the optioned stock into acquired an increasingly large shareholding in the company. In
the market, making profits over its option price. The price subsides. As a fact Tndigo had instead acquired contracts for differences with an
final triumphant sting, the pool has also sold short into the market ic has investment bank relating to the company's shares under the terms
sold stock which it does not own. When the price collapses, the pool buys or which it was expressly stated that [ndigo would not obtain
in at the collapsed price, delivers the stock under the short sales and ownership of the shares but merely benefit from changes in price.
makes further profits because the buy-in price is now below the short sale The FSA held that these disclosures were likely to give regular
price. W ondcrful. users a false impression of the demand for the company's shares
as the impression was created that shares had been acquired
The only problem is that practically every step in this ingenious operation whereas in fact they had not.
is a serious criminal fraud.
Some of the clements of the operation arc: @ False maintenance of the price by guarantees, indemnities or loss- 24-07
sharing agreements unknown to the market and so distorting of the
@ A conspiracy to defraud which the market docs not know about. pncc.
® Dishonest statements of financial prospects with a view to deceiving
@ Fictitious or "wash sales" so as to create a misleading appearance of
purchasers.
active trading, ic of genuine demand as opposed to a mirage. There is
no real change of ownership. @ False recommendations by financial .iournalists and others holding the
stock with a view to deceiving and making a profit ("scalping").
24-06 @ False rumours with intent to deceive and to induce others to purchase.
The notion of fraud on a market is not new. In the leading Supreme Court case or SEC v Capital Gains
Research B11rca11, 375 US 180 (1963) an investment advisory firm
Jn R v De Berenger (1814) 3 M&S 67; 105 ER 536, the accused
bought securities in a listed stock on the New York Stock
bought up government bonds at the time of the Napoleonic wars,
Exchange and then sent out to approximately 5,000 subscribers
and then spread rumours in London and Kent that Napoleon
one of its special recommendations or special bulletins containing
was dead and that peace would soon be made. The price of' the
a financial analysis of the particular company without disclosing
bonds shot up and the accused sold them, reaping a profit. Held:
the firm's position in the stock. There was a small market rise and
criminal conspiracy. Lord Ellcnborough CJ said: "it is a fraud
the firm within a few days sold its stock at a profit. Held: this was
levelled against all the public, for it is against all such as may
a fraud under the fnvestmcnt Advisers Act of 1940. It was irre-
possibly have anything to do with the funds on that particular
levant that the advice may have been honest since the aim of the
day. It seems to me also not to be necessary to specify the per-
rule was to prevent this type of con0ict of interest.
sons, who became purchasers or the stock, as the persons to be
atTcctcd by the conspiracy, for the defendants could not, except In Zweig v Hearst Corporntion, 594 F 2d 1261 (9th Cir I 979) a
 394 REGULATION OF INTERNATIONAL FINANCE MARKET ABUSE AND INSlDER DEALING 395

newspaper columnist published a highly favourable dcscripf of the issued share capital with no prospect of settling these sales.
of a corporation. It was alleged that the newspaper descriJ)tJion About 250 retail investors were adversely affected by the short
. d matcna . I m1sreprcscntat1ons
. . 011
con tame ma d c to t l1e columnist selling and the stock exchange intervened to suspend trading in
6
insiders of the corporation. The column was published after thy the company's shares. lfrlcl: the short selling was market
columnist had purchased 5,000 shares of the firm's stock at : manipulation. This was because market users normally expect
substantial discount from the market price. After the colun/ that a seller will be able to settle transactions in a timely fashion.
appeared, the price of the firm's stock rose swiftly. J-fC'lc/: this w, 11 If sellers cannot settle transactions in a timely fashion or at all
a fraud and the columnist was subsequently held liable to perso~s because they have sold short beyond the level for which they have
who alleged that the price at which they bought the securities w,/ a reasonable settlement plan, then this distorts the market for
significantly affected by his recommendation. The case w'./ those shares at the point of sale because the expectation of timely
decided under the anti-fraud Rule I 0b-5. 's delivery on the part of investors who trade in that market and
buy shares will not be met. The result is similar to the US prin-
In the English administrative case of Isaacs (FSA, February 28
ciple that a short seller must "locate" securities for delivery.
2005) Isaacs visited the house of a friend who was an employee of
a Lo!1clon listed comp~my and came across copies of minutes
Investors expect the value of an investment to be determined by (a) the
showmg expected profits. Isaacs posted anonymous opinions
public correct disclosure, not lies or fibs or concealed information, and (b)
relating to this information on an internet bulletin board with the
market forces of supply and demand, as opposed to artificial rigging. There
intention of thereby ramping up the price of the shares and
is a blurred line between a legitimate commercial rationale for the trans-
consequently the value of shares which he already held and those
action and manipulation by buys and sells intended deliberately to change
be bought subsequently. J-fC'ld: his behaviour constituted the
administrative offence of market abuse. In another case jour- the price.
nalists were convicted for scalping.
In Scott v Bro11'11, Doffing, McNab & Co [1892] 2 QB 724, brokers and a
24--08 @ A short sale with an intent to deceive and induce others to buy. Short client agreed to buy shares of a projected company on the stock exchange
selling is selling a security which the seller docs not yet own in the hope at a premium to induce the public to believe that there was a real market
that the price of the securities will go down. Typically the short seller in the shares and a real premium. Held: the contract was illegal.
sells securities, borrows the securities concerned to deliver to the buyer
and then buys the securities later at a lower price to repay the bor-
rowed securities. Short selling on its own is not usually prohibitccl--- Comers, market timing, false markets
cven if speculative, it creates liquidity and there is nothing intrinsically
wrong with selling an asset with a view to buying it in when delivery These are other examples of market manipulation. 24--W
has to be made. In most jurisdictions, short selling may be market
manipulation if the seller sells securities which he docs not own and has Corners (abusive squeezes) Corners are attempts by dealers to monopolise 24--11
not contracted to buy with the deliberate intention of forcing clown the an investment and then to sell only at abnormally high prices to those who
price with a view to buying them up cheaper later so as to satisfy the have contracted to sell to third parties and are therefore desperate to buy.
short sale contract. The speculative short seller is forced into a corner. A corner is also known as
Hence the following jingle is not quite true: an "abusive squeeze"--it distorts the market price. This may be an unlawful
manipulation of the market.
"HC' that sC'!ls what isn't his'n The problem is that market forces of supply and demand may create a
Must buy it back or go to prison." tightness in the market. Also, having a significant holding of a security is not
in itself an abusive squeeze.
Obviously if short sellers talk down the price of a security by false
rumours, innuendos and gossip, falsely implying that the security is over- Market timing An example is as follows: 24--12
valued, then this is clearly an abusive market manipulation.
A naked short sale is a situation where a seller sells securities which it has In R v SffuritiC's and Fut111"C'S Authority Ltd, C'X p FlC'urosc [2001] EWHC
not yet borrowed from a third party lender so that its position is uncovered. Admin 292, JP Morgan had written an option for a customer under which
the bank would have to make a substantial payment of around £500,000 if
24-09 @ The distinction between a legitimate short selling and market distortion both the FTSE I 00 and the S&P 500 share indices were higher at the end
is illustrated by the UK FSA decision Evolution BC'eson Gffgory Ltd v of the month. The S&P 500 index was substantially higher but the FTSE
Christophff Potts (November 12, 2004). 100 was hovering around the strike or contract price level. On the last
trading day of the month, in the last six seconds or trading, the index
In this case the head of market-making at a firm engaged in short dropped to below the strike level. Starting in the last eight minutes oC
selling of the shares of a London traded company. The firm trading, Fleurose entered waves of sale orders totalling over£ 11 million
established short positions in the company equal to 252 per cent on the five companies which had the highest stocks in the FTSE I 00. The
 3% REGULATION OF INTERNATIONAL r:INANCE MARKET ABUSE AND INSIDER DEALING 397

bank accepted that this conduct breached the London Stock Exchan Jn Basic_ v Levinson, 485 US 224 (1988) the Supreme Court decided that
rules against attempts to manipulate an index value. The bank was fincg{ compa111cs ~trc not free to deny the existence of negotiations leading to a
The regulator held that the actions amounted to misconduct. The trad~i merger until there is an agreement in principle as to the price and struc-
was suspended. ture of the ~ransaction. The court held that the parties had to apply a test
of materiality which involved "a balancing of both the indicated prob-
ability that the event will occur and the anticipated magnitude of the
24-13 Churning Churning occurs when a securities broker engages in excessiv event in light of the totality of the company activity."
trading in disregard of his customer's investment objectives for the purpos:
of generating commission business. In the administrative action of E.ON AG SEC Release No.43372, the SEC
brought and settled civil administrative fraud charges again E.ON AG,
In Charles Hugh_es & c;o v SEC, 139 F 2d 434 (2d Cir 1943)_, the customers formerly l~nown as Veba AG, which was Germany's third largest indus-
were almost entirely smglc women or widows who knew little or nothing trial holdmg company and a company listed on the New York Stock
about securities. The dealers called up Mrs Furbeck on the telephone and Exchange for issuing materially false denials over the course of a month
~fld her of '\'.'wonderful" sto~k she should buy,_or th/,lt there was another concerning merger negotiations with Viag AG, another German com-
marvellous buy or somcthrng that was def1111tcly beyond the usual" pany .. '( eba denie? press _reports that it was engaged in merger
The prices which Mrs Furbeck and other customers paid for sccuritie; negotiat1ons with V1ag when 111 fact the two companies had entered into a
purchased in this manner ranged from 16 per cent to nearly 50 per cent confidentiality agreement, retained investment bankers and legal advisers,
over the market value. In those cases the dealer had already bought the exchanged financial forecasts and engaged in high level talks concerning
securities concerned so that there was no risk to the dealer. At no time did proposed deal structures, valuation methods, corporate governance and
the dealers reveal the true market price of any securities. Held: the dealers other merger issues. E.ON consented to the entry of a cease and desist
built up the confidence of the investors so that the failure to reveal the order. Sec also another SEC administrative case involving a foreign firm
mark-up was both an omission to state a material fact and a fraudulent Eric John Watson SEC Release No. 34-44034.
device. The natural implication in the untutored minds of the purchasers
was that the price asked was close to the market. The fraud lay in the fact In the European Union Mad 2003 provides that Member States must ensure
that there was a concealment in circumstances where there was an implied that "issuers of financial instruments inform the public as soon as possible
duty to disclose. of inside information which directly concerns the said issuer".

Churning is a borderline administrative oITence.

Exemptions for stabilisation and buy-backs
24-14 False markets It is believed that virtually all the major stock exchanges
rcq uire a listccl company to disclose to the public through the press any Stabilisation Stabilisation is the making of bids or offers by lead managers 24--15
material information which would reasonably be expected to afTcct the value during the primary distribution to maintain the price. Strictly it may run
of securities or influence investing decisions. The objective is to ensure that counter to market-rigging or insider trading prohibitions. However, the
markets do not trade on the basis of out-of-date information. For example, need to stabilise highly volatile prices in an initial distribution is a greater
an investor purchasing a security may complain that they would never have priority and hence is commonly permitted, cg as in the USA and EU.
bought if they had known of the adverse undisclosed event. Similarly an
investor selling a security may complain that they would never have sold a Buy-backs A buyback is a purchase by a company of its own shares. A 24-16
security if they knew of the good news on the way. company may decide to buy back its own shares for various reasons such as
The question of what information is material and when announcements to discourage takeover bids, to pay shareholders more cash or to establish a
should be made, cg pending merger negotiations or a new contract or of a better balance between supply and demand for its securities.
drop in earnings, can only be considered on a case-by case basis. If an
announcement is made without firm facts, this may mislead the market just Further reading 011 market abuse and market manipulation: LPIF vol 7
as much as the withholding of a material change which is a hard fact. chapter 20.

In Financial !11d11strial Fund t' McD01111cl! Douglas, 474 F 2d 514 ( I 0th Cir
1973) a mutual fund sued for losses of $700,000 on its purchase of the Insider dealing
stock of the company. The fund alleged that the company had withheld
an announcement of reduced earnings when the relevant facts were
available to it. Held: there was no pr~of that the company had unduly Meaning of insider dealing
delayed its announcement.
!ns_ider dealing (sometimes called insider trading) occurs where a privileged 24-17
In State Teachers Retirement Board v Fluor Corpn, 654 F 2d 843 (2d Cir insider, such as an officer or professional adviser, who has unpublished
1981) the court held that a company had not violated Ruic l Ob 5 by
withholding announcement of a pending contract until all facts were material price-sensitive information about securities gained by virtue of his
available and failing to request the New York Stock Exchange to suspend rela~ionship with the company, exploits that information to make a profit or
trading in the stock until an announcement could be made. avoid a loss by dealing in the securities, the price of which would have been
 398 REGULATION ()I,' INTERNATIONAL FINJ\NCL' MARKET ABUSE AND INSIDER DEALING 399

materially altered if the information had been disclosed. The rot t' · able to monitor banks. The law discourages enterprising investigation---
example is inside knowledge by a director or a company or a takeover/ t~c thc results just have to be handed over to the public.
made by this company r~r '.1 target at a high price: _they secretly bu/o/ ,. The rules necessitate Chinese walls in financial firms which split busi-
shares or the target. The mstdcr must not deal: abstain or disclose. c
nesses and arc difficult to keep in place.
The rules arc more important in relation to equities where prices arc 111 .
sensitive to financial conditions. But the principles impact upon bonds
of course upon convertibles or other bonds with an equity clement. Thnc
t~ '[he reality is that the pros have resoundingly won the day internationally.
also impact on derivatives related to those assets. ey Nearly all countries with capital m,ll'~?ts have insider deali1_1g )egislatio'.1. Sec
Insider dealing is often both a criminal ofTcncc and an administrative J\l[aps ol World Financial Lcrn 1, LPIF vol 8. In the EU, ms1dcr dealing 1s
o!Tence. outlawed by Mad 2003, and in the US by the general fraud Rule I Oh 5.

Insider dealing under the general law

Policies of insider dealing
:Misrepresentation principles arc or little assistance for trades injuring third 24-19
24-18 The policies in favour of outlawing insider dealing include: parties on anonyn'.ous st~ck cx~hanges. !he hallmar)<. of the insider is that
he is completely silent. Silence 1s not 1111sreprcscntatton. The countcrparty
® Equality and non-discrimina~ion between invcsto1_·s---thc level playing. docs not know who he is dealing with and is not induced to enter into the
field. Insiders have an unfair advantage which ts seen as unjust. In transaction by the trader. Unlike a face-to-face transaction, the dealer
practice some investors will always be better informed than others. cannot make a direct cnq uiry of his counterparty or rely on the normal
misrepresentation or non-disclosure rules. The non-statutory principles
@ Insiders should not be able to misappropriate information which docs must therefore rely on liability for the misuse of confidential information for
not belong to them.
which there is ample authority.
@ Investors will have less confidence in markets if they think the cards are
stacked.
Specific regulation outside insider dealing statutes
@ A ban forces more immediate disclosure so that insiders can deal--
hence markets do not trade on false or out-of-date information. This Apart from specific insider dealing statutes, there arc other statutory rules 24-20
can be achieved by disclosure obligations. which impinge on the subject.

The policies said to be against insider dealing include: Reports of officer holclings Many jurisdictions require insiders, such as 24-21
directors, to disclose their shareholding in the company in a public register,
@ Over-criminalisation of commercial law: the misuse of information or cg EU Mad 2003, Ontario, the US. The result is that dealings by insiders arc
the breach or a fiduciary duty is treated as theft or fraud. Insider known to the public and may be taken as an indication of the insider's view
trading legislation is effectively a criminalisation of the normal duty or of the company's financial situation. Note that these reporting requirements
fiduciaries not to use confidential information of a clients or their arc to be distinguished from those requiring a specified percentage of ben-
principal for their own benefit. The use by a fiduciary or confidential eficial shareholdings to be notified a rule intended to avoid surprise
information for the benefit of the lid uciary personally often gives rise in takeovers.
many jurisdictions to a claim for compensation. An example is as
follows: Listing and other codes Listing codes generally require an issuer promptly 24-22
In A!!cn v Hyatt (1914) TLR 444. the directors were negotiating to publicise any significant new factors affecting the company's securities
an amalgamation with another company and induced individual and to maintain the utmost secrecy in the meantime. The main object is to
shareholders to give them options to buy shares at par hy saying avoid false markets but the cfTcct is to narrow the possibilities of insider
that this would assist negotiations. The directors exercised the dealing-the information is public so that traders do not have to abstain.
options and made a profit. Held: the directors were accountable
for the profit because they had held themselves out as willing to Liability for short-swing profits The US renders certain insiders absolutely 24-23
act as agents in the negotiations and were thus in a fiduciary liable for short-term profits, regardless of whether or not based on insider
relationship imposing a duty of full disclosure. information. This is because of the likelihood of quick profits on the basis
of insider information. The Securities Exchange Act of 1934 s 16(b) makes
@ The complexities of the law chill information flows -nobody can say insiders (directors, ofliccrs and principal IO per cent shareholders) account
anything except formally. The market is less able to carry out its task to their corporation for any profit received on securities listed on a national
of monitoring issuers and forecasting insolvencies. Analysts arc less exchange which is sold within six months of the acquisition or the security.
 400 REGULATION OF INTERNATIONAL FINANCE MARKET ABUSE AND INSIDER DEALING 401

The insider is liable for these "short-swing" profits regardless be difficult question is where to draw the line, especially as regards casual
intention to use inside information to make a gain. ! 'dcrs such as the alert financial printer, the capitalist-minded cleaning
Other examples are: China (six months); Japan (six months); Korea ( . tO~'y or the waiter who overhears a conversation in a caf6. The test is
months); Mexico (three months); Sweden (three months); Taiwan (six montI~~) Ia .; ally whether the insider is in a specially privileged position in relation
110 1
~hc company and therefore bound by fiduciary duties. There is also a fine
fi1
e between insider information and independent research (which should be
Main prohibitions in summary .ncouraged).
c In the European Union, Mad 2003 catches those who possess the infor-
Jtl'ltion by virtue of their being (broadly) directors and the like, shareholders
24-24 The usual prohibitions are three in number: ,dd those having access by virtue of their "employment, profession or
ju tics". Sec art_ 2( I). The potential list of in~iders might include co1~1pany
® Dealing. An insider takes advantage of unpublished price-sensitive crnployces, aud1t?rs, lawye_rs, bankers, se~u_nty analysts, brokers, prmters,
information by acquiring or disposing of securities for his own account government offic1als, suppliers, tax authont1es, and regulators.
or for the account of a third party.
In the United States, case law has caught ofiiccrs, employers and brokers
® Inducing/procuring. The insider recommends or procures or induces a but not an employee of a financial printing firm: sec Chiarella F US, 445
third party to acquire or dispose of securities. This is aiding and US 222 (1980) (not criminal, but the employee had to disgorge profits).
abetting an offence and is intended also to catch deals by associates. It But in SEC v Materia, 745 F 2d 197 (2d Cir 1984), a printshop employee
also catches individuals who arrange for their controlled companies or was held liable. Apart from that case, the US test is whether the employee
brokers or family members or employees to deal for them, and those was, as is likely, subject to a confidentiality duty, cg under his contract of
who finance deals, or advise on them. employment, so that he misappropriated the information.

® Tipping. An insider discloses inside information (sometimes with

intent) to a third party otherwise than in the proper performance of his Tipping
ofiicc, employment or profession, or a tippee tips another tippee. The
reason is that the tippee is likely to trade on the basis of the infor- Tipping is communicating insider information. The tipper must be an insi- 24-26
mation. Tipping is a breach of confidence. der with inside information. Tipping is generally prohibited because it
involves a breach of confidence and because it gives the tippee an unfair
The effect of being an insider or tippcc is that one cannot deal until the advantage over other market participants. Companies cannot effectively
information is publicly discloscd---"abstain or disclose". In many cases an give research analysts unpublished information about the company, ic all
insider relies on the issuer to perform its duty to disclose since most insiders information must be publicised first.
will be bound by a duty of confidence.
All three offences are caught by Mad 2003. In Elldnd v Liggett and Myers, 635 F 2d 156 (2d Cir 1980), the court held
that certain information given by corporate officers to analysts about
24-25 Insiders There are usually three classes of insider: (I) true insiders-such as earnings could reasonably be expected to be used by the tippcc for trading
directors; (2) quasi-insiders or temporary insiders--those having occasional advantages--which it was---and therefore the officers could be liable. The
privileged access by virtue of a business relationship, such as professional court held that a "pre-release review of the reporting of analysts is a risky
activity, fraught with danger" because the company has to steer between
advisers, lawyers, auditors and financial advisers; and (3) tippces-- those misleading stockholders by implied approval of analyst reports and
who are given information by an insider and know that it is confidential. tipping.
There arc different approaches to tippee liability. Sub-tippees are generally
caught. In SEC v Dirks, 463 US 646 (1983), a securities analyst was told by a
An example of an architect being an insider is shown by a French case. retired middle level employee of the Equity Funding Corporation of
America that there was a massive fraud in fictitious insurance policies
within the corporation. The analyst confirmed the allegations with spe-
In the French Carrefcmr case (Paris Tribunal de Grande Instance, October cified employees and disseminated the information to institutional
15, 1976, Dalloz 1978, II, p 381 ), an architect working on a construction investors whom he knew were likely to and in most instances did sell their
project for a supermarket saw the chairman emerge into the waiting-room holdings. He also informed the outsider auditors and the Wall Street
with the chairman of another company which he had read in a press Journal. The US Supreme Court held that Dirks was not liable. The
article was interested in a shopping store. He bought shares in the other company employee had not breached a fiduciary duty and therefore the
company. A joint supermarket venture between the two companies was analyst as tippee was not implicated in improper conduct.
announced and the architect profited from a rise in the shares. He was
convicted of insider dealing since he had acquired privileged information In the French Pechiney case (Court de Cassation, October 26, 1995,
in a work context. The case seems very borderline-this was a hunch, Bulletin Joly Boursc March April 1996, p 120), Pcchincy was negotiating
guesswork, not a specific tip. a takeover of a US company Triangle. A government officer involved in
 MARKET ABUSE AND INSIDER DEALING 403
402 REGULATION OF INTERNATIONAL FINANCE

the negotiations leaked the deal to a tippcc who tipped two sub-ti expected to cause the share price to rise further if they were also
All the tippccs dealt. Held: the tipper was convicted since he had kiees.: published.
ingly permitted third parties to trade. An adviser to the target who ti;ow. I the Ea11x-D11111ez case (Paris Court of Appeal, March 15, 1995, BuH.
a friend was also convicted by the Paris Court of Appeal. Ped, / ly Boursc, May June 1995 p 181), !l director sold shares on be~alf of his
Insiders who talk to their lawyers, accountants, etc. arc not tipping sit
;fe following a directors Jun~~ which rcve~d~':1 losses. He claimed that
Jrcss reports had already publicised the poss1b1hty of losse~. Held: he was
this is in the course of their job. Possibly suppliers, lenders, potcnt'.e~ 1 nvictcd. The press reports were mere forecasts and the dlJ'ector sold by
transferees of loans, labour representatives, potential merger partne:~ ·. ~~ason of the precise information at the lunch.
underwriters and credit reference age_ncies may be legitimate tippccs if
chsclosurc was normal or necessary 111 the proper course of the job, an I
th~ . I the English administrative case of Arif Mohammed v FSA, Financial
J~rviccs and Markets Tribunal decision of Ma1:ch 29, 2005, I':1ohamm<::d
provided that the recipients agree confidentiality: agreements often rcqui/ was an auditor employed at an ac~ountants hrm and was mvolvcd 111
them not to deal. T_hey will still become insiders and th?rcforc L~na?lc to de,~ auditing the accounts of a London hsted com~any. He purchased sharE:s
or tip others. Consider whether banks selling a loan might be t1pp1ng if they · the company at a time when he knew from 111s professional tasks that 1t
disclose insider information to the proposed transferee. ~~as finalising a probable sale of the division. The tribum~l uphel~ the
FSA's decision that this dealing was market abuse on the basis of a m1~usc
of information. Mohammed argued that he had no~ traded ?1: ~he basis of
Inside information inside information because tl?e sale o_f the particular d1vis1on ?f the
company in question _was sub~ect to widespread rumours. ~h? tnbunal
24-27 Information must be material Generally inside information is that which is held that in order for mformation to be available to tl:ic public 1t must be
likely to have a significant e/Tect on the price of securities if it were public or precise i1_1 nature and rumours w_ould not be sufficient. Therefore the
the price of related derivatives. Typical examples are proposed take-over information was not generally available.
offering and financial bad or good news.
One problem is drawing a line between specific information and mere ff a passenger on a train passes a burning factory, calls a br~kcr a1_1d tells
hunches based on rumours or guesswork and research or fact-finding on them to sell shares in the factory's owner, the_ passenger_ 1s act_mg on
commercial or economic trends or businesses. Mad 2003 requires the information which is generally available since it 1s m~ormation which has
information to be "precise'' and related to one or more issuers or financial been obtained by legitimate means, ie through obscrvat10n of a public event.
instruments (but not the economy generally). Sec art I ( I). Another problem is the degree of publication. Information ough~ to be 24-28
disseminated to the market before the insider deals, otherwise the 111s1der
Re Cad.1· Roher ts & Co, 40 SEC 97 ( 1961 ). A broker was told by directors could publish and then act immediately before the market could absorb the
that the dividend would be cut. The broker sold the company's stock for information.
his clients before the information was made public. Held: the broker was In the US case law holds that the market must have had time to digest the
liable notwithstanding that he had a conf1icting duty to do his best for his information. The better advice is that for heavily traded stocks it might be
clients.
appropriate to wait for a day. For thinly-traded stocks, a longer delay may
SEC F Texas Gulf Sulphur Co, 40 l F 2d 833 (2d Cir 1968). In this SEC be appropriate. . .
administrative decision, officials and employees of a company made Where the information is particularly important, 1t may be desirable for
substantial profits in company stock after learning that an unpublicised the issuer to apply for a trading halt in its securities to give investors time to
exploratory drill on the company's property showed promise of extra-
react to the news.
ordinary ore discoveries. They were liable.
Investors Management Co, 44 SEC 633 (1971). An aircraft manufacturer
told a broker/dealer, who was acting as a principal underwriter for a
debenture issue, that current earnings would be much less than a pre- Securities covered by the prohibitions
viously published forecast. The dealer's underwriting department told the
sales department which told major institutional clients who sold large
amounts of stock before the information became public. Held: the dealer Outside the US, the tendency is to limit the insider trading prohibition to 24-29
was liable. publicly available or listed securities, and to derivatives. related to those
securities, cg Mad 2003. This limitation results from a desire to narrow the
In the Netherlands, in the FlexOl'it case (noted in Mark Stamp, Linklatcrs,
lntemational Insider Dealing, City and Financial Publishing 2005 p 319), criminalisation to markets involving the public. . .
an insider knew that a takeover or other cooperation between Flexovit The inclusion of non-traded private derivatives related to traded sccunt1es
and another company was planned. At the time a report, based on is usual. The reason is that otherwise an insider could avoid the prohibiti~n
rumours, was published about these moves and the share price of Flcxovit by taking out an option to buy the shares they expect, say, to shoot up Ill
moved up 18 per cent. After this report, the insider bought shares of price.
Flexovit. Held: insider dealing. The specific information which the insider
had was more powerful than the published rumours and could be
 404 REGULATION OF INTL'RN/\TIONAL FINANCE MARK.ET ABUSE AND INSIDER DEALING 405

Sanctions and enforcement In the case of Pariente/ N_af (Paris Court of Appeal, October 26, 1999,
Bulletin Joly Boursc, April- May 2000, p 153), the manager of a company
24-30 Sanctions may be criminal, administrative, civil or all of these. sold some of his s!rnres in the company while kno_wing that profits would
fall short of previous forecasts. The manager said that he h,!d. sold the
Any form of sanction runs into the difliculty of identifying the insicl . ,
· · I · · · · ~ ci <lnd shares in order to repay substantial bank loans. He had previously sold
o.,bt a'.'.1m_g t 1c_ ncc~ssary discovery, especially !f the_ msider arranged th ~ome of his shares when he was allowed to do so under a shareholders
t1c1nsdct1on fiom ctbroad through a bank which raises the bank sccre e '.1grecmcnt and had only sold 20 per cent of his holding. Held: on the facts,
defence against foreign subpoenas. · cy ~l~c insider inforrnatio!1 was not the determining reason for the deal and
A problem with civil liability arises from the fact that there is oftci the manager was acquitted of the cnm111al offence. But he was fined under
relationship bct_wccn the insider dc,~lcr and their counterparty in the mai:k~o the administrative offence: sec Paris Court of Appeal, May 13, 1997. As
It 1s not pract1cablc to show which counterparty dealt with the ins'c! t: regards the administrative offence the courts in France have treated the
amongst _the many transactions which may l:ave tak~n place between \1~~ need to repay loans or other side reasons as not a good reason for insider
tune_ th_c ms1dcr dealt and the time the ms1dc mformat1on became public. If dealing.
the ms1dcr w~rc to be hable for loss~s to_ all coun~crpartics in the market
(usually the cl1ffcrcncc between the price with and without the informatio ) Equality ?f _info~mation . It is_ often t'.ot insider dealing where the person 24-36
then the liability could be vast and disproportionate to the offence. n, with the 111s1de mformat1on discloses 1t to another person and then enters
Civil damages arc a_vailablc, for example, in the US (three times the into a dealing with that pcrson--thc defence is often referred to as the
amount_ of the profit gamed or the loss avoided by the illegal transaction), in "equality of information" defence. Underwriters can trade between them-
Austraha, Korea, Hong Kon?_ and. Ontario normally the difference selves on the basis of shared insider information. This may also protect loan
bct_wcc1~ the pnce of the secuntics with and without publication of the transfers. The recipient should be under a confidentiality obligation.
111s1dcr mformation. In Australia the regulator can take action on behalf of
mvestors. Stake-building am! takeovers Stake-building is the buying of shares by a 24-37
company and those acting for it in advance of a takeover to build up a large
holding. Stake-building is often protected, as in the EU, but the scope of the
Negative profits exemption is intricate.

24-31 Generally, where an insider holding securities is influenced not to sell In the takeover battle in France for Louis Vuitton-Moct Hennessey in the
because of inside information and thereby avoids a loss, it is impracticable late 1980s, rival camps dealt in the shares of the target while they were in
to impose habd1ty because of the difficulty of proving intent to sell which possession of insider information about an increase in the profits of the
was subsequently doused by the inside information. So an investor can target. The regulator concluded that the deals were stake-building and no
cancel an order to sell once he hears of the oil strike. prosecutions were brought (Bull. COB no 225, May 1989, pp 4-6).
fn Caisse Centra/e de Credit Coopc;ratif (Paris Court of Appeal, Septem-
ber IL 200 I, Bulletin COB no 360 September 200 I p 9), a company,
Exemptions knowing of an offer for a target, bought a large block of shares in the
target prior to the announcement of the offer. The company said that this
24-32 Usually a number of transactions arc exempted from the insider dealing was part of a strategy of forming a partnership with the target as a
prohibitions. defence to the bid from the third party. Held: insider dealing under the
administrative offence. The court viewed the strategy with scepticism, cg
there was no evidence of consultation with the target. In any event, very
24-33 Stabilisation and buy-backs Sec para 24 15. compelling evidence was required as to the company's interests to justify
insider dealing.
24-34 Disclosure in the normal course of duties Sec para 24 26.
Managed accounts If a client who is an insider has mandated an invest- 24-38
24-35 For_cecl. tra~ing or alternative legitimate reasons Dealing pursuant to an ment manager to manage an investment account in the discretion of the
obhgat1on 111curred before the transactor acquired the insider information is manager and the manager deals in securities concerning which the client has
often exempted -the deal was not influenced by the insider information. inside information, then both the manager and the client should escape
This would usually protect underwriting commitments. liability since the manager is not an insider and the client is not trading by
~~metirncs, h:ading w_hilc in the possession of inside information may be virtue of the inside information.
lcg1tnnate even if there Is no legal obligation to trade if the insider proves Similarly a broker who deals for a client who has inside information is not
that he would have acted in the same manner even without the knowlcdue of liable if they do not know that the order is based on insider information. ff
inside information, as in the case of pre-programmed trades. b
the broker has inside information but the client docs not, the broker can
In France, the alternative reason must normally be one of necessity or execute a specific order from the client but must not inform the client of the
very compelling.
inside information or influence the deal.
 406 REGULATION OF INTERNATIONAL FINANCE

24-39 Chinese walls It is almost invariably a defence that there is a Cl ·

between those who know the information and those who trade. If ~rese W·
105
trade are not aware of the price-sensitive information by reason 0 f , c.w
· II ti h' · · · · · · · · · . d Chi
CHAPTER 25
wc1 , 1en t 1s 1s not 111s1der tradmg 111 many Jtmsd1ctions: see para ~se
22 8,.
24-40 Territorial scope Sec LPIF vol 7 para 26 070. FINANCIAL SUPERVISION AND
CAPITAL ADEQUACY
Practical policies for companies
24-41 For directors and employees, points to consider as a protectio 11 .
. . i er dea1mg
111s1.c · me. I ude: education; minimum periods between bu ·ag·iinst '
selling the company's shares so as to encourage long-term invesi1~~; ai~d fhis chapter deals with the financial supervision of banks and investment 25-0l
11 firms-often called prudential supervision---with the primary focus on
op~o~e? t~ :l10rt-~ermprofit-taking; no short sales or trading in option~ ~s
de11~c1tives mvolvmg the company s shares; closed black-out period ~ commercial banks.
dealmg before announcement of interim or final results and befoi· s fot for some of the key difTcrcnccs between banks and investment firms as
· ·1- e ot11er regards risk, see para 2024.
s1g111 1cant announcements; limiting internal information flows· com I
d t·r. t· . , pu sory The main heads of financial supervision arc:
a va1:~e no l!lca 1.011 to a compliance officer of dealings in the com , ,
secur'.t1e:; no trad1n.g in the securities of companies with which the coi~ai:y 8
has s1g111ficant dealings (large suppliers customers liccncees)· •rnd Cl P ny • capital adequacy, ic how much capital a bank must have compared to
walls. , .' . ' ' 1mese
its exposures,
N~ unp\1blis.hed price-scnsitiv~ in(orn:ation should be given to analysts.
. ~de~ I 1cqu1'.·cs issuers to mamtam hsts of persons who have access t0 e liquidity, ie readily available cash and securities owned by the bank
111s1de mformatJon. See art 6. and access of the bank to borrowings to repay its deposits and loans
and to meet its obligations to lend,
Further reading 011 insider dealing: LPIF vol 7 chapter 21. Sec also Mark e large exposures, ic concentration of risk by reason of large loans to a
?amp (ed) lntcn.zat'.011.al ~nsidcr Dc~11i1:g (2~05, City & Financial Publishing) single group (often there is a 25 per cent limit), and
dncl IOSCO, fn.11(/c, t1 achng: Ho11 1 p11·1sd1ct1011s arc regulated (March 2003).
• systems and controls, ie the procedures the bank must put in place to
For questions and seminar topics, sec the end of' chapter 25. monitor its risks.

There is a huge array of capital liquidity and other financial resource 25-02
requirements which varies according to the type of entity which is being
regulated--whether a bank (debtors to customers), a securities broker, a
custodian (holds asset on trust), an investment bank or an investment
adviser (docs not hold clients assets, is not a debtor to clients).
The main difference is between commercial banks which take deposits
from the public and make loans on the one hand and investment banks on
the other which do not take deposits from the public and do not generally
make loans but hold securities.
For investment firms and others which do not have bank-type exposures,
the aim of prudential requirements. is merely to enable the firm to conduct
an orderly wind-down or transfer of its business and its client assets and
money if that becomes necessary. The focus, therefore, is on non-capital
financial requirements such as professional indemnity insurance and the
segregation and holding of client moneys and securities on trust. Capital
requirements, tend to have as their purpose the limited aim of ensuring that
minimum financial resources arc available to meet administrative costs for a
number of weeks only. By contrast the object of bank prudential supervision
is to ensure the solvency of the bank so far as possible and also to ensure
that the bank has sufficient cash to pay its obligations as they fall due
(liquidity).

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