By Dr T Padma., LLM., Ph D (Law)
Both for developed and emerging stock markets, the possibility that the markets can be manipulated, is an important issue for both the regulation of trading and the efficiency of the market. Manipulation can occur in a variety of ways, from insiders taking actions that influence the stock price (e.g., accounting and earnings manipulation) to the release of false information or rumors in Internet chat rooms.
Establishment of Regulator
A major initiative of regulation in India was establishment of a statutory autonomous agency, called SEBI, to provide reassurance that it is safe to undertake transactions in securities. It was empowered adequately and assigned the responsibility to (a) protect the interests of investors in securities, (b) promote the development of the securities market, and (c) regulate the securities market. Its regulatory jurisdiction extends over corporate in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market.
Therefore, to fight against these manipulators, the SEBI should strong enough to play a proactive and vigilant role by introducing stringent measures designed to provide greater deterrence, detection and punishment to the persons involved in price manipulations. It should introduce greater transparencies, keep a check on sudden abnormal trends in the market, prior to corporate announcements viz. mergers, takeovers, monitor the trading patterns and undertake swift investigations in case of a spurt of buying or selling activity in the market, take stringent action against the guilty to act as deterrence for others. At the same time, it is the prerogative of companies to strictly adhere to the code of conduct prescribed by SEBI, and ensure good corporate governance in order to protect the overall interest of investors against unfair and inequitable practices of price manipulations.
Despite regulations, at times SEBI is finding it difficult to frame manipulators because of the nature of the offence. Identifying the manipulators and then proving the charges is an onerous task due to the heavy burden of proof involved in each case. Although SEBI has implemented laws against price manipulations trading mechanism, yet the number of offenders actually brought to book is dismal. In fact, many a time SEBI has been unable to detect instances of manipulations. SEBI Regulations do stipulate safeguards like initial and continual disclosures by listed companies etc. but there is room for improvement. Manipulation of the share markets is considered to be a serious economic offence.
Share Market Manipulations
The Stock Market Scams of 90’s affected millions of small investors across the country. Fly-by-night operators entered the primary markets and through Initial Public Offers (IPOs), collected hundreds of crores and vanished! The irony is that the whereabouts of over 100 companies are still not known either to SEBI or to the other investigating agencies. Even those companies, which did not vanish, used the people’s money for purposes other than for which it was collected. As a result, the value of their shares plummeted resulting in heavy losses to the investors.
Insider trading has the dangerous potential of market manipulation and misuse of un published price sensitive information by a privileged few insiders who are in possession of such information. This kind of malpractice defeats the very principle of fair and ethical business practices, besides spelling a doom for the common and small investors. The Capital Markets in India have been victims of this malady for years and more particularly when liberalization attracted small investors to the markets. Instances of artificially jacking up prices of shares and thereby inducing gullible people to buy them are also common. People have lost heavily on account of frauds of this nature committed by unscrupulous market players.
To prevent stock manipulation through spreading rumours, SEBI has issued regulations relate to Fraudulent and Unfair Trade Practices (FUTP) relating to the securities market known as SEBI (FUTP) Regulations, 2003.
According to Regulation 12, the SEBI has the power by an order, for reasons to be recorded in writing, in the interests of investors and securities market to take the following action against an intermediary:
(a) issue a warning or censure;
(b) suspend the registration of the intermediary; or
(c) cancel of the registration of the intermediary.
Recent Initiatives by SEBI
SEBI has also issued vide its circular dated 23/03/2011 ordered a new set of Code of Conduct, including restricting access to Internet forums for employees, for market intermediaries to ensure that unsubstantiated news, which could distort normal functioning and prices of stocks, are not circulated. This comes in the wake of observations by the Regulator that unauthenticated news related to various scrips are circulated in blogs, chat forums or e-mails by employees of broking houses and other intermediaries in violation of rules.
Penal provisions under other Laws
White Collar Crimes are not a new phenomenon in India. Even one and a half century ago, when the Indian Penal Code was enacted, punishment was provided for Cheating (Sec.420), Criminal Breach of Trust (Sec.409), Counterfeiting of Coins (Sec. 232), Making and Selling of Adulterated Drugs (Sec. 274&275), Fraudulent use of Weights and Measures (Sec. 265), Counterfeiting Govt. Stamps and their sale (Sec 255 and 258), Making and Selling of Fake Goods (Sec. 481 to 489). Soon after the introduction of currency notes in our country, counterfeiting of the currency led to addition of section 489-A and B in the Indian Penal Code in the year 1955. But what has changed in the past few decades is the magnitude and enormity of economic crimes owing to the development in technology and improved means of transport and communication and their use by the perpetrators of these crimes.
Position in US
In April 2008, the US Securities Exchange Commission (SEC) brought a well publicized enforcement action involving rumor-mongering. The agency claimed that Paul Berliner, a propriety trader at the Schottenfeld Group, had spread the false rumor that a target company’s board had agreed to a reduced buyout price. The agency also claimed Berliner had profited from the rumor by shorting the stock and covering those sales as the price of the stock fell. Berliner allegedly spread the rumor through instant messages to 31 traders and other securities professionals.
The rumor spread across Wall Street and was reported in the media. The price of the stock Berliner shorted fell from $77 per share to as low as $63.65 per share, a 17 percent decline. Berliner quickly settled with the SEC, agreeing to disgorge all profits ($26,129), pay a $130,000 fine, and submit to a lifetime bar from association with a broker-dealer.
Meaning of Rumor Mongering
In US, there is little prior case law concerning what the government would have to prove if a false rumor case like Berliner actually proceeded to trial.
According to the complaint in Berliner’s case, the purposeful spreading of false information violates §17(a) of the Securities Act and §9(a) (4) and §10(b) and Rule 10b-5 of the Exchange Act. Essentially, all these claims require the SEC to prove that the defendant:
(1) made a material misrepresentation;
(2) with scienter;
(3) in connection with the purchase or sale of securities.
Essential Elements to establish Rumor Mongering
In a false rumor case, SEC would require to prove that:
(i) first, the rumor was inaccurate;
(ii) second, the market was impacted by the rumor; and
(iii) third, the defendant knew or should have known that the rumor was inaccurate.
These elements would seem to present challenges to prosecution and potential help to defendants.
Many rumors are either accurate or believed so. In a case that could be the 20-year-old cousin of Berliner, In re Olympia Brewing Company, the main defendant, a general partner of an investor partnership, was sued for using short selling to depress Olympia Brewing Company’s stock price.
During dinner, the defendant informed a writer for Barron’s that he believed that the company was “going down,” that its stock price was too “high” compared to the company’s “fundamentals,” and that it was “the biggest rig he ever saw.” The court dismissed the case because the SEC failed to prove that information was inaccurate.
In Olympia, there was no evidence that the defendant’s conclusions about the company were wrong. On the other hand, in the Berliner case, the SEC’s charge was that Berliner’s rumor was false. The inaccuracy of his rumor would have been easier to prove at trial because the defendant claimed meetings took place that in reality had never occurred and were never contemplated.
Necessity of a Clear Market Impact
Although the government could argue that it does not have to prove that the false rumor actually impacted the market price of a stock, a court is less likely to find a defendant liable if a defendant’s scheme to manipulate a stock price had no chance of succeeding. In private actions, where reliance is an essential element of the offense, it has been recognized that reliance must be reasonable, and unsubstantiated observations of bystanders are not sufficiently reliable to support a claim of reasonable reliance.
Practically, given its limited resources and current motivation to stabilize the market, the SEC is unlikely to act, in the absent an actual market impact. For example, in the Berliner complaint, the agency alleged that Berliner’s actions caused a stock price to plunge 17 percent in 30 minutes.
Must Defendant Personally Profit?
In Berliner, the government alleged that the defendant spread the rumor so that he would profit from his short position.
While that case involved rumor-mongering in connection with short selling, in analogous cases, the agency has also successfully prosecuted research analysts who benefited in other ways because their recommendations were followed.
In SEC v. Johnson, the defendant was a research analyst who wrote reports giving a “buy” rating to various public companies that he held stock in. After the price of one company fell to $24 per share, the defendant made a private statement that he would not buy the company’s stock unless it fell to $12, yet a few days later the defendant again gave the stock a “buy” rating. At the same time the defendant was making his “buy” recommendation, he sold all of his shares in the company he was recommending. He also had a financial interest in two other companies he recommended.
The defendant was found liable by a jury of violating §17(a), §10(b) and Rule 10b-5, was enjoined from trading for five years, and ordered to disgorge $1,868,796 and pay $125,000 in civil penalties. On a motion to overturn the verdict, the court commented that the decision was a “close call” but upheld the jury’s decision. The court held that a jury could find that the defendant’s specific financial interests in the stock were material, and that his contradictory actions of recommending stocks as a “buy” while simultaneously making private derogatory statements concerning the stock and selling his own financial stake for a profit should have made the defendant realize he was acting improperly.
It is worth noting that while Berliner also personally profited from his recommendation, unlike in Johnson, Berliner’s financial decision to short-sell was in accordance with his public recommendation.
In contrast to this case, two other SEC cases, against posters of fake online messages, alleged no financial motives for spreading false rumors. In both cases, the postings affected the price of a company’s stock, but neither involved a claim that the defendant profited from the impact of his postings on a stock’s price, as was the case in Berliner.
In Moldofsky, the defendant was convicted of a criminal violation of Rule 10b-5, and in St. Heart, the defendant settled.
These cases involved clear misstatements: One defendant used multiple “screen names” and postings to create the illusion of a widespread acceptance of the rumor, while the other involved a misrepresentation that the defendant was the president and CEO of a large company that had filed a $20 million suit against another company. In both of these cases, there was no allegation that the defendant personally profited.
Judicial Approach - Free Speech Vs Gossip
The SEC’s drive to prevent gossip could have a grave impact on the efficient dissemination of information in the market, which in turn could affect the efficiency of the market, and even implicate First Amendment free speech considerations. This crackdown could deter legitimate behaviour—disseminating truthful insights—which the law should protect and encourage.
The US Supreme Court has recognized there in First Amendment protection for commercial speech. Of late, the courts have crafted an exception from the First Amendment for speech related to commercial transactions. There is a serious question, however, whether the investigation of rumors oversteps the limitations of this exception.
Even though rumors can be characterized as “commercial speech,” it has been clear that the First Amendment protects such speech since Virginia State Board of Pharmacy v. Virginia Citizens Consumer Council which observed that in a free enterprise economy “the free flow of commercial information is indispensable.” Under Central Hudson Gas & Electric Corp. v. Public Service Commission courts deciding commercial speech cases are required to examine:
(1) whether the speech at issue concerns lawful activity and is not misleading,
(2) whether the asserted governmental interest is substantial; and, if so,
(3) whether the regulation directly advances the governmental interest asserted and
(4) whether it is not more extensive than is necessary to serve that interest.
With respect to the first part of the test, observations about the value of securities are not only “lawful” but vital. In Dirks v. SEC the US Supreme Court noted that imposing liability for making such statements “could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market.”
In a few instances, the courts have skirted the issue of First Amendment protection for commercial speech by narrowing the SEC’s enforcement authority based upon factual issues or restrictive statutory construction. Nonetheless, these cases reflect judicial sensitivity to the First Amendment limitations on the SEC’s authority.
For example, SEC v. Siebel a case involving the agency’s Regulation Fair Disclosure (Reg FD), probably could have invoked First Amendment protection, but instead the court decided the case on the facts. In Siebel, the CEO of Siebel Systems made comments to a group of private investors the SEC claimed were materially different than a public statement he made earlier.
Finding that the comments were merely worded differently, not materially altered, the judge chastised the SEC, stating that “applying Regulation FD in an overly aggressive manner cannot effectively discourage full and complete public disclosure of facts reasonably deemed relevant to investment decision making.” Furthermore, excessive scrutiny “has a potential chilling effect which can discourage, rather than encourage public disclosure of material information.” However, the case did not address the First Amendment grounds upon which the commercial speech could have been protected.
A similar concern with First Amendment protections arose in the case of Lowe v. SEC. The Commission attempted to enjoin an unregistered publisher of investment material from continuing to publish its newsletters. Justice Byron White, concurring in the result but not on the merits, said that advisory speech not protected by licensing should be constitutionally protected under the First Amendment, and that the court should not engage in “constitutional avoidance” by dismissing cases on statutory or factual interpretation grounds. Justice White stated that “at some point, a measure is no longer a regulation of a profession but a regulation of speech.”
Justice White argued that even though the speech may not be considered fully protected under the First Amendment, “even where mere ‘commercial speech’ is concerned, the First Amendment permits restraints on speech only when they are narrowly tailored to advance a legitimate governmental interest.” Even though the stated governmental interest was the protection of investors from “scoundrels and swindlers” the measures taken were “extreme.”
The Court’s commercial speech cases have “consistently rejected the proposition that such drastic prohibitions on speech may be justified by a mere possibility that the speech will be fraudulent.” Justice White’s words in Lowe strike a resonant chord with the current SEC investigations into rumor-mongering. Simply because rumors and gossip could be used for market manipulation for personal gain does not mean that the agency should be allowed to prohibit dissemination of good faith opinions and beliefs about companies.
Efficient markets require the free dissemination of information. The flow of information, when communicated responsibly, is an essential element of efficient markets. Rumours are legitimately circulated through the financial system for a variety of reasons. It is customary for market participants to discuss rumours when accounting for the source of market volatility; when offering an objective assessment of a rumour’s likelihood to a client; and when attempting to better understand observable market behaviour.
At times, it is virtually impossible not to discuss rumors in fielding investor questions about the causes of otherwise unexplained market volatility. In such circumstances, the ability to freely discuss rumors with investors or other market professionals for the purpose of debunking them can be enormously helpful to investors and issuers alike, and highly beneficial to the efficiency of the market. On the other hand an excessively zealous crackdown on rumors could inhibit the flow of information in the market and thereby make the markets less efficient. Therefore, it is all the more required that diligent market analysis and its dissemination should be encouraged.
[Published in Supreme Court Journal/ Weekly January, 2012]
 SEC v. Berliner, Civil Action No. 08-CV-3859 (S.D.N.Y.), SEC Litigation Release No. 20537 (April 24, 2008).
 SEC v. Monarch Funding Corp., 192 F.3d 295, 308
 In re eSpeed Inc. Sec. Litig., 457 F. Supp. 2d 266, 281 (S.D.N.Y. 2006).
 SEC v. Johnson, 2006 WL 2053379, 11 (S.D.N.Y. 2006).
 SEC v. St. Heart, Civil Action No. 01-CV-00695 (D.D.C.), SEC Litig. Rel. No. 16947, (filed March 29, 2001); United States v. Moldofsky, No. 00 CR. 388, 2002 WL 313858819 (S.D.N.Y. 2002) (denying motion to preclude imposition of sentence of imprisonment).
 Virginia State Board of Pharmacy v. Virginia Citizens Consumer Council, 425 U.S. 748 (1976)
 Central Hudson Gas & Electric Corp. v. Public Service Commission, 447 U.S. 557 (1980)
 Dirks v. SEC, 463 U.S. 646 (1983)
 SEC v. Siebel, 384 F.Supp.2d 694 (S.D.N.Y. 2005)
 Lowe v. SEC, 472 U.S. 181 (1985)