Financial regulation & ethics

Seminar 7: securities market regulation: disclosure, transparency and market integrity

Securities markets: function

Primary market (IPO)
Raising new capital- equity or debt Cash-out for founders

Secondary market
Trading of securities following IPO Liquidity for investors (note liquidity premium)

Securities markets: typology

Organised and unorganised (OTC) Regulated and unregulated
Regulated Hybrid
Multilateral trading facilities (eg Chi-X) Dark pools

Unregulated (eg OTC)

Dealing systems: order-driven and quote driven

Market regulation: overview

Economic efficiency as an objective: 3 forms Allocative efficiency: capital
Regulatory policy: disclosure & market integrity

Informational efficiency: prices

Regulatory policy: transparency

Operational efficiency: transaction cost

Regulatory policy: competition and transparency

Disclosure: rationale
Sunlight is said to be the best of disinfectants; electric light the most efficient policemen Louis Brandeis Other Peoples Money [1913] Disclosure by issuers and informed decision making by investors Link to the ECMH share prices reflect public information

Disclosure: timeline
IPO

(Listing and/or raising capital: publication of prospectus)

On-going (material developments, shareholder approvals)

Periodic (Annual, Interim, Quarterly reporting)

Disclosure: rules and process (1)

IPO disclosure
Standardised disclosure as per FSA Handbook. Residual disclosure: A prospectus must contain the necessary information to enable investors to make an informed assessment of: the assets and liabilities, financial position, profits and losses, and prospects of the issuer of the securities; and the rights attached to the securities. (FSMA 2000 s87A(2) )

Disclosure: rules and process (2)

Periodic disclosure
For listed companies, disclosure is more extensive than for other companies Annual report plus responsibility statement Interim report Quarterly report or interim management statement Corporate governance statement

Disclosure: rules and process (3)

On-going disclosure Issuers of financial instruments shall inform the public as soon as possible of inside information which directly concerns said issuers (Article 6 of the EU Market Abuse Directive) Link to the prohibition on insider trading

Disclosure: liability rules

Liability as ex ante incentive for disclosure Inadequate disclosure (meaning) IPO potential liability
Issuer The directors of the issuer Professional advisers accepting responsibility for parts of the prospectus

Periodic and on-going disclosure

Issuer only Protect directors (encourage information flow to the market)

Transparency: concept and relevance

Transparency and informed decision-making
Ex-ante prices and terms Ex post prices and terms of completed transactions

Transparency and market efficiency link to price formation Transparency and market structure regulated and other (eg OTC) market segments

Transaction reporting (to regulators)

Applies to any financial instrument admitted to trading on a regulated market in the EU
Any trading of such instruments in any location is covered (eg OTC)

Investment firms must report details of transactions to the regulator as quickly as possible and no later than the close of the following working day

Trade reporting (to market participants)

Current EU regime covers only shares Markets must provide:
Pre-trade information: bid-offer spreads and depth of trading interest (size); on a continuous basis Post-trade information: price, volume, time on a continuous basis

For other asset classes (e.g. sovereign bonds, derivatives) member states make their own rules and transparency remains poor (action required)

Disclosure of substantial shareholdings

Rationale: inform shareholders who controls the company Rule: disclose any shareholding above 3% and subsequent changes that exceed 1% Rule applies also to derivative positions that provide equivalent economic rights to the underlying shares

Market integrity: concept and relevance

Market integrity:
Fair and equal access to information by investors Investor confidence in market operation (pricing, allocation of capital)

Relevance:
Encourage investment (esp. equity) Minimise the cost of capital

Insider dealing
Concept: using inside information (not yet public) for personal gain Inside information: temporary character (pending disclosure) Legal prohibition

Yes: fairness, investor confidence, cost of capital [Consensus view] No: prices adjust more quickly to correct level if all information is reflected in the price [Minority view]

Market manipulation
Concept: conduct that results in prices being set at an artificial level. Examples
Sham transactions (no change of real ownership, creating a false sense of liquidity) Price positioning (eg heavy buying of shares to move an index at a particular time) False announcments by issuers to support their share price

Legal and regulatory controls over market integrity

Criminal law
Individuals only Intent required Evidence and burden of proof are problematic

Regulatory sanctions
Firms and individuals No intent required Burden of proof lower (civil law) Financial penalties

Short-selling
Concept: sell X today @ 100p, hoping to buy X next week @ 90p to deliver to the buyer. Risks: market instability, use for abusive purposes (e.g. false rumours) Regulatory response
Crisis measure: prohibition Longer-term: disclosure of short positions to the market

Recommended reading
MacNeil, An Introduction to the law on Financial Investment 2nd edition (2012) Ch 8, 12 and 13 Herbert Smith, Market Abuse Update 6(1) Law and Financial Markets Review 68-77 (2012) MacNeil, Insider trading and $64 million questions (Editorial) 5(4) Law and Financial Markets Review 253-255.