Stock market regulation: Safeguards interest of investors?

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“The setting up of the Securities Council alone will not result in the development of the capital market. The balanced development of the market in the long run would depend on the creation of the right climate, the right inducements and the right incentives”

- Ronnie de Mel

As correctly stated by Ronnie de Mel when presenting the Securities Councils Bill in 1987, the right climate, appropriate inducements and incentives can be identified as the cornerstones in achieving the mission of the Securities and Exchange Commission of Sri Lanka (SEC) in promoting, developing and maintaining a capital market that is fair, efficient, orderly and transparent.

There is consensus about the importance of the right climate in achieving the aforementioned. ‘The right climate’ has many facets. This article will focus on regulation on stock market offences, a facet subjected to much controversy across global stock markets.

The need of appropriate regulation is felt than ever before as global financial markets are closely interwoven. Misconduct in a market would trickle down to the rest and thereby escalate the possibility of financial collapse/turmoil. The financial crisis in the USA is a classic example where deregulation was proved unsuccessful.

Asymmetric information is an inherent characteristic in capitalism. If we are to minimize the adverse impact asymmetric information holds towards the interest (hard-earned money) of the majority of the investors, it is important for the regulator to facilitate a level playing field that promotes an efficient price discovery mechanism. This could undoubtedly be achieved through appropriate regulation.

Hence, it is vital for investors to inculcate the correct attitude towards regulation. A wide knowledge of market offences and its dynamics will reiterate the important role of regulation in safeguarding the interest of the investors.

Insider dealing What is insider dealing?

Rajaratnam receives longest prison term in history for insider trading

Hedge Fund founder Raj Rajaratnam sentenced in Manhattan federal court to 11 years in prison for insider trading crimes
Published on - October 13, 2011

Preet Bharara, the United States Attorney for the Southern District of New York, announced that Raj Rajaratnam was sentenced in Manhattan federal court to 11 years in prison stemming from his involvement in the largest hedge fund insider trading scheme in history. Rajaratnam was the managing member of Galleon Management, LLC (“Galleon”), the general partner of Galleon Management, L.P., and a portfolio manager for Galleon Technology Offshore, Ltd., and certain accounts of Galleon Diversified Fund, Ltd. He was convicted on May 11, 2011, of all 14 counts of conspiracy and securities fraud with which he was charged, following an eight-week jury trial. It is the longest sentence to be imposed for insider trading in history.

Manhattan U.S. Attorney Preet Bharara stated: “Two years ago, Raj Rajaratnam stood at the summit of Wall Street, commanding his own financial empire. Then he was arrested, tried and convicted by a jury. Rajaratnam stood convicted 14 times over of felonies, his empire exposed as a web of fraud and corruption that entangled many. Today, Rajaratnam stood once more and faced justice which was meted out to him.

From 2003 to March 2009, Rajaratnam repeatedly traded on material, non-public information (“Inside Information”) pertaining to upcoming earnings forecasts, mergers, acquisitions and other business combinations. As the evidence at trial showed, the inside information was given as tips by insiders and others at hedge funds, public companies and investor relation firms.

It is a sad conclusion to what once seemed to be a glittering story. We can only hope that this case will be the wake-up call we said it should be when Rajaratnam was arrested. Privileged professionals do not get a free pass to pursue profit through corrupt means. The message is the same for everyone no matter who you are or how much money you have—obey the law or face the fate of those who don’t.”

Source: http://www.fbi.gov/

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, non-public information about the security that is price sensitive.

The offence occurs when any person who buys/sells stocks based on price sensitive information before the information is released to the investor community in a fair manner. The most important factors are procession or access to price sensitive information, sufficient grounds to know that such information is unpublished and misusing it.

An insider is an individual who has access to price sensitive information of a company. In general, the following instances can be considered as probable situations of insider dealing.

Corporate officers, directors and employees who traded the corporation’s securities after learning of significant, confidential corporate developments that are not made public.

Friends, business associates, family members and other of such officers, directors and employees, who traded the securities after receiving such non-pubic information.

Anyone who gets to know about non-public information as a result of business or professional relationship and trades based on such information.

Other persons who received this information through a person who has access to such information and traded based on such information.

It is important to bear in mind that there can be variations in defining the offence in various jurisdictions. It could take many dimensions based on the circumstance and facts. See the sketch of the basic process of insider dealing.

What is the penalty?
According to Section 33A of SEC Act No.36 of 1987, any person who contravenes any provision of this part of the act (section on insider dealing) can be guilty of the offence if convicted after a summery trial by a magistrate. The convicted individual will be liable for a fine not less than Rs.1 million or to imprisonment of either description for a term not less than two years and not exceeding five years or to both such fine and imprisonment.

Market manipulation What is market manipulation?
The SEC rules, 2001 (Rule 12 and 13) define market manipulation as follows:

Rule 12: No person shall create, cause to be created or do anything that is calculated to create a false or misleading appearance or impression of active trading or a false or misleading appearance or impression with respect to the market for or the price of any securities listed in a licensed stock exchange.
Rule 13 (specifically for wash sales): No person shall by means of purchase or sale of any securities that do not involve a change in the beneficial ownership of those securities or by any fictitious transactions or by any other means, create a false market in any securities listed in a licensed stock exchange.

In simple market manipulation could be understood as an intentional or willful conduct designed to deceive or defraud investors by controlling or artificial affecting the price of securities through misleading information or through market activity.

Generally the following elements must be established to prove the offence
nOne or more persons must affect a series of actions/transactions in a security (pump and dump/wash sales/matched orders, etc.)
nThese actions/transactions must either create actual trading in such security or cause a rise or decline in the price of such security.
nShould operate as an offence in the market.

What are the types of market manipulation?

Canadian man charged in first federal securities fraud prosecution involving ‘layering’

Published on - January 13, 2015

WASHINGTON—A Canadian man was arrested for allegedly orchestrating a large-scale, international stock market manipulation scheme in the first federal prosecution of securities fraud involving a high-frequency trading strategy known as “layering,” U.S. Attorney Paul J. Fishman for the District of New Jersey announced.

Aleksandr Milrud, 50, of Ontario, Canada, and Aventura, Florida, is charged by complaint with one count of conspiracy to commit securities fraud and one count of wire fraud. FBI agents arrested Milrud at his residence in Aventura this morning. He is scheduled to appear this afternoon before U.S. Magistrate Judge John J. O’Sullivan in federal court in Miami.

“As our complaint shows, illegally manipulating markets to cause even small price changes can yield large gains when done on a massive scale,” U.S. Attorney Fishman said. “The defendant and his far-flung network of conspirators operated an international scheme in which they generated millions of dollars in illicit profits for themselves with artificial trade orders executed at high speeds.”

“As alleged in the complaint, Mildrud was the engineer behind a sophisticated, international, groundbreaking market manipulation scheme that utilized an illicit, high-speed trading strategy to execute trades,” said Special Agent in Charge Aaron T. Ford of the FBI in Newark, New Jersey. “The losses to investors due to this innovative fraud could be in millions. The FBI will continue to identify and investigate frauds such as this one, in order to ensure a level playing field for all investors.”

Source: http://www.fbi.gov/

Theory spells out various types of market manipulation. No one could ever spell out all types as it would depend on the situation and techniques used. Given below are some of the most important types.

Ramping
Share ramping is a form of illegal market abuse, involved in taking up the price of particular shares in order to mislead the market.

Marking the close
By placing orders or executing trades shortly before the close of trading to influence or set the closing price.

Pump and dump
A scheme that attempts to boost the price of a stock through recommendations based on false, misleading or greatly exaggerated statements. The perpetrators of this scheme, who already have an established position in the company’s stock, sell their positions after the hype has led to a higher share price.

Bid support
Bid support, as a form of market manipulation, involves multiple bids for small amounts of a particular stock being placed just below the highest bid price posted by market makers. This has the effect of absorbing sell orders and creating an artificial floor for the stock, while giving the impression that plenty of buyers are waiting in the wings.

Wash sales
“Selling and repurchasing the same or substantially the same security for the purpose of generating activity and increasing the price.

What is the penalty?
According to Section 51 (2) of the SEC Act No.36 of 1987 any person found guilty of market manipulation shall be liable on conviction after summary trial by a magistrate to of imprisonment of either description for a period not exceeding five years or to a fine not less than Rs.50,000 and not exceeding Rs.10 million or to both such imprisonment and fine.

Front running
In front running, a trader will take a position in equity just before a client takes a position that will cause the stock to move in a predictable way. The most common example of front running is when an individual trader buys shares of a stock just before a large institutional order for the stock which will cause a rapid increase in the stock’s price is executed. The crucial point is for the trader to be aware of the institutional order. to It can also be obtained illegally, such as when the research analysts of an investment bank pass insider information to the brokerage arm of the business, or when an advisor takes a position in a stock before convincing a client to make a large investment in that same security.

This is considered as a serious offence even in Sri Lanka. The SEC rules, 2001 (rule 14) define front running as follows:

Rule 14: No person shall directly or indirectly trade in securities of a company ahead of a significant purchase or a sale of securities of that company for his client with the intent to profit by trading in such securities thereafter.

What is the penalty?
According to Section 51 (2) of the SEC Act No.36 of 1987 any person found guilty of front running shall be liable on conviction after summary trial by a magistrate to of imprisonment of either description for a period not exceeding five years or to a fine not less than Rs.50,000 and not exceeding Rs.10 million or to both such imprisonment and fine.

Other
Apart from the aforementioned a few of the other offences under the SEC Act No.36 of 1987 are noteworthy.

(1)Section 51(1)(a): Any person who contravenes any provision of the Securities and Exchange Commission of Sri Lanka Act (SEC Act) or any requirement imposed or regulations or rules made under the Act shall be guilty of an offence.

(2) Section 51(1)(b): Any person who furnishes or produces for the purposes or requirements of the SEC Act, rules or regulations, any information, return, document or statement which is untrue, incorrect or misleading shall be guilty of an offence.

(3) Section 51(1)(c): Any person who willfully obstructs any member of the Commission or any officer of the Commission in the performance of his legitimate duties shall be guilty of an offence.

(4) Section 50A: Any person who threatens or intimidates or makes any derogatory remarks or publishes any statement with a view to bringing disrepute or defaming the reputation of any member of the Commission, the Director General or any other officer or servant of the Commission in the course of discharging his duties shall be guilty of an offence.

(5) Section 30: Anybody corporate or individual who uses the words “stock exchange”, “stock broker” or “stock dealer” without first having obtained a license from the SEC shall be guilty of an offence.

(7) Sections 27, 28(2) & 29: Prohibited conduct of licensed stock exchanges, licensed stock brokers and licensed stock dealers.

(9) Section 28(1): Prohibition on off-the-floor trading (dealing in listed securities except in accordance with the trading procedure of the stock exchange).

(10) Section 46A(4): Every person who fails to appear before the Commission when required to do so/ refuses to answer any question put to him/ gives false answers/ fails to produce any document in his possession when required to do so is guilty of an offence.

Wrap up
The core spirit of market offences as well as relevant regulation is creating a level playing field for investors with the aim of promoting an efficient, fair and orderly market. Hence, it is advised that investors focus more towards the spirit of regulation and follow ethical practices when investing in the market.

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Stock market regulation: Safeguards interest of investors?

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