Chiming Kam, LLM Candidate, King’s College London
Introduction
Drafting new regulations is often regarded as the best solution to prevent the mistakes of yesterday such as the ones that led to the financial crisis of 2008. Among the significant number of texts enacted at the EU level (EMIR, MiFID2/MiFIR, etc.), the European Parliament and the Council recently adopted Directive 2014/57/EU on criminal sanctions for market abuse and Regulation No 596/2014 on market abuse on 16th April 2014. They repealed the previous market abuse legal framework (Directive 2003/6/EC) in order to strengthen the integrity of the financial markets and the protection of investors. To achieve this goal, the new legal instruments seek to harmonise the European provisions through all 28 Member States’ domestic laws.
Though it may be too soon to properly discuss the efficiency of the market abuse package, this article will selectively highlight some adverse foreseeable outcomes. Part I briefly defines the notion of market abuse. Part II discusses the efficiency, or lack thereof, of prohibiting the attempt to engage in market manipulation. Part III addresses the danger of regulatory arbitrage which arises from the Directive’s criminal sanctions’ provisions. Part IV considers whether the definition of ‘inside information’ makes the task difficult for issuers to decide precisely when inside information should be disclosed. Finally, Part V presents the example of the commodities’ market where a precise definition of inside information would have been useful.
I. What is Market Abuse?
Market abuse is a generic term that refers to two broad types of market misconduct:
- insider dealing; and
- market manipulation, encompassing price manipulation and dissemination of false information.
These actions seriously harm the integrity of the financial markets, thus placing investors on an unequal footing. Some of them may benefit from material non-public information to make profits at the expense of others who do not have access to this valuable information. Simply put, insider trading is the action of making investment or divestment decisions on financial instruments based on information that is not made public (inside information). With regards to market manipulation – which is a concept that is hard to define[1] – EU institutions have preferred to give examples of manipulation such as entering into a transaction that is likely to give false indications as to the demand for, or the price and supply of, a financial instrument, or entering into a transaction which affects the price of a financial instrument. The last market misbehaviour is the dissemination of false information, that is the act of publishing by any means information that gives, or is likely to give, false or misleading signals as to the demand for, or the price and supply of, a financial instrument.
II. The Prohibition of the Attempt to Engage in Market Manipulation
The former Directive on market abuse (MAD)[2] provided a legal framework to combat this at EU level. If the MAD Directive did not impose criminal sanctions for market abuse, it nevertheless provided for administrative sanctions. With the new Directive, not only all member States have to transpose criminal provisions into their national laws – most of them already do – but new offences are created, notably the attempt to engage in market manipulation. To achieve complete EU-wide harmonisation, Article 15 of the Regulation on market abuse (MAR) prohibits the latter offence[3]. Indeed, it is possible that an individual intends to manipulate the market by undertaking manoeuvres without eventually executing a transaction or sending a market order. Here, the European lawmaker implicitly refers to high frequency trading (HFT), which is the use of sophisticated techniques based on speed to rig the market. In addition, HFT is known to cancel 80% of the orders and only execute those that are profitable, which can amount to an attempt to engage in market manipulation. The criminalisation of this attempt is thus aimed to cover a wider range of activities that can be considered as a market manipulation.
Perhaps the scope of application is too broad because mere error, whether it comes from an individual or from a technical issue, may become a criminal offence. In that situation, mens rea or the intention of the individual is not present, which is required for an offence to be characterised as such. Therefore, Article 15 of the Regulation would regard some transactions as market manipulation even without proving intent. It should be noted that in the case of France, judges have rarely condemned individuals for market manipulation. It would be consequently and logically harder for judges to characterise the attempt to manipulate the market.
It should also be noted that under Article 16 of the MAR, persons professionally arranging or executing transactions shall detect and report suspicious transactions and orders, including any cancellation or modification, that could constitute attempted market manipulation[4] to the competent authority. Yet, this duty is not precisely defined for the simple reason that it is unclear what kind of behaviour constitutes an attempted market manipulation[5]. What should be reported? Orders that were cancelled or not executed? Alerts coming from the detection framework that were not considered as a suspicious transaction? Reporting a few of them may be regarded as insufficient by the regulator. Reporting most of them may be too cumbersome for both the regulator and the market professional. This lack of precise definition of an ‘attempted market manipulation’ is thus more likely to hinder any efficient detection framework imposed by MAR.
III. The Incomplete Harmonisation of the Market Abuse Criminal Regime
The Regulation on market abuse of April 16th 2014 did not come alone; the European lawmaker also adopted MAD II which sets up minimum requirements in terms of criminal sanctions for Member States. Each one of them must transpose into their national laws criminal provisions related to market abuse. However, because of the very nature of a directive, which imposes a goal to achieve to EU countries that freely decide how to implement the measures, it is arguable that not all Member States will adopt the same criminal sanctions, as the EU lawmaker only put in place minimum requirements. Indeed, criminal law is by essence a prerogative that belongs to the sovereignty of each State. Theoretically, the harmonisation may not be as complete as expected and this may result in regulatory arbitrage. Namely, a market participant would choose to be incorporated in an EU State with a laxer market abuse criminal regime because he knows that his profits would exceed the amount of the fine. There are actually Members States that do not provide for criminal sanctions yet and/or provide for meaningless fines. The Directive’s transposition by each Member State would be a step forward in harmonisation but all the national laws regarding market abuse will not equally be the same everywhere. This would lead to regulatory distortions among the Member States.
IV. The Imprecise Definition of Inside Information
Without inside information, there is no insider dealing. The definition of the former has not been modified since the adoption of the Directive of 23rd January 2003. Under Article 7 of MAR, ‘inside information’ is:
- information of a precise nature;
- which has not been made public;
- relating, directly or indirectly, to one or more issuers or to one or more financial instruments; and
- which, if it were made public, would be likely to have a significant effect on the prices of those financial instruments or on the price of related derivative financial instruments.
The core of the problem is related to the notion of ‘precise information’. According to Article 7 (2) of MAR, information shall be deemed to be of a precise nature if it indicates:
- a set of circumstances which exists or which may reasonably be expected to come into existence;
- or an event which has occurred or which may reasonably be expected to occur;
- where it is specific enough to enable a conclusion to be drawn as to the possible effect of that set of circumstances or event on the prices of the financial instruments or the related derivative financial instrument.
This definition of ‘precise information’[6] was interpreted by an EU Court of Justice decision in 2012[7]. The ECJ ruled that the intermediate steps of a protracted process which leads to a future circumstance or event should be regarded as precise information. Though this decision was meant to improve our understanding of the notion of precision, some practical concerns should be pointed out.
In practice, an issuer will have to determine precisely when a piece of information constitutes ‘inside information’ that is then required to be disclosed to the public; this is not always an easy task. Every issuer, from all the different sectors, has different standards that give him or her reasons to believe that he or she possesses inside information. This situation leads to difficult interpretation issues amongst issuers, when MAD 2/MAR seek harmonisation. Let’s take the ECJ decision as an example. When was Daimler to disclose the information? The day the chairman was thinking about tendering his resignation? The day the press release was prepared? The day the supervisory board accepted the resignation? It is consequently difficult from the issuer’s perspective to determine precisely when information becomes precise. Is precision certainty? Thinking about resigning shall not be precise then as the chairman may change his mind. Disclosing at this particular moment is dangerous for the issuer because it could disseminate false information at the end of the day if the information turns out to be wrong, which is misleading the market. Is rumour precise information? A negative answer should be given. The issuer has two options: either he discloses early information deemed as precise but not certain and he may face market manipulation allegations, or he discloses the information later and will breach the duty to inform the public as soon as possible pursuant to Article 17 of the MAR. Either way, the issuer may face sanctions due to the interpretation issues that arise from the notion of precise information.
V. The Example of the Commodities’ Market
Article 7 of the MAR provides for a definition of inside information in relation to commodity derivatives[8]. Once again, it lacks precision. The commodities market is the place where raw materials (wheat, rice, coffee, etc.) are traded and is not similar to the traditional financial markets that propose dematerialised financial instruments such as stocks or bonds. Article 17 of the MAR imposes a duty upon issuers to disclose inside information as soon as possible. However, it is hard to believe that commodities producers – the main market players – should be regarded as issuers, and thus bound to disclose inside information. Article 3 (1) (21) of the MAR states that an issuer is a legal entity governed by private or public law, which issues or proposes to issue financial instruments. A commodity is not a financial instrument within the meaning of the MiFID2/MiFIR[9] but the commodity derivatives are. So, with this in mind, who shall disclose inside information? We may think of the drafters of the commodity derivatives but, legally speaking, they cannot be regarded as issuers of financial instruments. Indeed, as already mentioned, the commodities market is by essence strongly different than financial markets. And as such, a commodity derivative, which is a contract, is not issued to the market (they are mainly traded OTC) not dematerialised, nor negotiable. For these reasons, there can be no issuer of derivatives and that is a significant issue for MAR.
Unfortunately, the Regulation does not precisely say what constitutes ‘inside information’ in the area of commodities, not to mention that commodities are different from one another. Indeed, there is no doubt that information that relates to the production of a certain commodity is necessarily similar to another. Raw materials may require different conditions of production, hence a litany of inside information to deal with. Moreover, each category of commodity may be divided into sub-categories (there are more than 4 types of cocoa and more than a hundred thousand for rice for instance), which is then harder to identify which inside information needs to be disclosed. That is why ESMA (European Securities Market Authority) will soon consult on proposed guideline in respect of inside information for commodity derivatives.
This Regulation was also aimed at covering this particular unregulated market, but its global size makes it difficult to supervise as there is no international regulator overseeing this market.
Conclusion
This article sought to identify some practical issues that may arise from the application of the new Directive and Regulation on market abuse. Without being exhaustive, they stem from the criminalisation of the attempt to engage in market manipulation, regulatory arbitrage and the notion of inside information. Of course, it remains to be seen how the market participants will face with these issues. However, no one can argue with the fact that this new set of texts is ambitious and constitutes a significant improvement of the previous market abuse legal framework. The scope of application now becomes broader for it takes into account recent market developments, such as the existence of new trading venues (e.g. organised trading facility) or the increasing use of high-frequency trading, referred to as ‘insider trading 2.0’ by the New York State Attorney General Eric Schneiderman. It is fair to say that the new ‘package’ will be able to strengthen the integrity of the financial markets and the protection of investors. Furthermore, regulators have increased scrutiny over banks’ market misconducts where some of them were sanctioned over allegations of market manipulation, especially in the foreign exchange market[10]. Finally, it shall also be borne in mind that even banks have anticipated the enactment of the European texts by placing into leave or having fired more than 30 traders for alleged stock manipulation, and by beefing up their compliance departments. These soft law measures have become of great importance in the financial industry, seeking less state intervention.
[1]D. Fishel and D. Ross, “Should the Law Prohibit “Manipulation” in Financial Markets?”, Harvard Law Review, Vol. 105, No 2 (Dec., 1991), pp. 503-553
[2]Directive 2003/6/EC of 28 January 2003 on insider dealing and market manipulation.
[3]Article 15, MAR: A person shall not engage in or attempt to engage in market manipulation.
[4]Together with insider dealing, attempted insider dealing and market manipulation.
[5] Stakeholders’ replies for the ESMA consultation paper on technical standards on the Market Abuse Regulation, available on www.esma.europa.eu
[6]Definition provided by Directive 2003/124/CE of December 22nd 2003
[7] EU Court of Justice, Markus Geltl v Daimler AG, 28 June 2012, C-19/11. Simply put, the facts were as follows. On 6 April 2005, the chairman of Daimler’s board of management was thinking about tendering his resignation. The next month, he discussed his intentions with the chairman of the supervisory board. On 10 July, Daimler prepared a press release, an external statement and a letter for the employees. On 27 July, the news was becoming official during a meeting in the supervisory board. A public announcement was made the day after. A stockholder, who sold his shares, brought an action to court to seek compensation for late publication of this information while the stock price was rising following the publication of the firm’s 2005 financial results.
[8]Inside information is, in relation to commodity derivatives, information of a precise nature, which has not been made public, relating, directly or indirectly to one or more such derivatives or relating directly to the related spot commodity contract, and which, if it were made public, would be likely to have a significant effect on the prices of such derivatives or related spot commodity contracts, and where this is information which is reasonably expected to be disclosed or is required to be disclosed in accordance with legal or regulatory provisions at the Union or national level, market rules, contract, practice or custom, on the relevant commodity derivatives markets or spot markets.
[9] Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments (MiFID II); Regulation No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments (MiFIR).
[10]In November 2014, the CFTC and the FCA respectively imposed penalties totaling 1.4 billion dollars and 1.7 billion dollars on 5 banks for alleged manipulation of foreign exchange rates. See the press releases (http://www.cftc.gov/PressRoom/PressReleases/pr7056-14#5 ; http://www.fca.org.uk/news/fca-fines-five-banks-for-fx-failings)