Chapter 16

• Jurisdiction: United States

Chapter 16 Market Manipulation

What Is Market Manipulation?

Section 9 of the 1934 Act prohibits the manipulation of security prices, and Section 10(b) of the 1934 Act prohibits "any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe." In fact, the word "manipulate" appears throughout the securities laws. See, e.g., Section 9: "Manipulation of Security Prices"; Section 10: "Manipulative and Deceptive Devices." Manipulation is "virtually a term of art when used in connection with securities markets." Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). But what exactly is it?

Common wisdom is that market manipulation led to the enactment of the Securities Exchange Act of 1934 and, as noted above, the word "manipulation" shows up in many sections. For example, Section 2 of the Securities Exchange Act provides: "National emergencies, which produce widespread unemployment and the dislocation of trade, transportation, and industry, and which burden interstate commerce and adversely affect the general welfare, are precipitated, intensified and prolonged by manipulation and sudden and unreasonable fluctuations of security prices and by excessive speculation on such exchanges and markets."

The purpose seems to be to make sure that securities markets be free of conduct that "interferes with the 'natural' forces of supply and demand."¹ But what, exactly, is manipulation and what distinguishes it from ordinary trading?

Those questions have plagued courts, prosecutors, and scholars for decades and have still not been satisfactorily resolved.² Most examples of market manipulation that are prosecuted today—and there are relatively few—are accompanied either by clearly unlawful activity or false statements. In "pump and dump" schemes, for example, stock purchases are accompanied by optimistic but false statements about a stock made by the pumper that are designed to inflate the price of the stock just before the pumper becomes a dumper. But does lawfully purchasing a stock on an open market and without any accompanying false statement solely for the purpose of causing the market price to rise constitute unlawful market manipulation? What if the purchaser wanted the price to increase for the purpose of squeezing the short sellers? Is that an improper purpose? And if it is, can it render an otherwise perfectly lawful purchase of stock unlawful market manipulation? To put that question in a historical context, it is worth recalling that noted Yale law professor J. William Moore wrote in 1934—the year the Securities Exchange Act was enacted—"The term 'manipulation' may, in short, be applied to any practice which has as its purpose the deliberate raising, lowering, or pegging of security prices. Buying and selling in themselves do, of course, affect price, but in a free and open market this is a natural consequence and not their preconceived purpose. Manipulation leads to an artificial and controlled price" (emphasis added).³

Even though the words "manipulative" and "manipulate" occur throughout the federal securities and other laws, relatively few cases have been brought under Section 9 of the 1934 Act, in large part because until the Dodd-Frank Act, Section 9 was limited to securities traded on national exchanges. Instead, prosecutors seemed to favor Section 10(b) of the 1934 Act, which prohibits "any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe," and Rule 10b-5, which prohibits the use of "any device, scheme or artifice to defraud" or engaging "in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any purpose."

The SEC is not the only federal agency that investigates and charges market manipulation, however. The Commodity Futures Trading Commission, for example, enforces its rule, Prohibition on the Employment, or Attempted Employment, of Manipulative and Deceptive Devices—Prohibition on Price Manipulation.⁴ Dodd-Frank added additional provisions to the proof of intent component to the market manipulation language that was already contained in the Commodity Exchange Act, including a fraud provision.⁵ The Federal Trade Commission and the Federal Energy Regulatory Commission enforce rules against market manipulation that are similar to the 1934 Act's Rule 10b-5.⁶

Why do we even care about market manipulation, especially if it takes place through open market purchases? Conventional wisdom holds that market manipulation interferes with pricing consistent with the normal supply and demand forces in the market. In theory, efficient markets "impound" all publicly available information about a stock in the stock price. In a "perfectly efficient" market (the "strong-form efficiency," which doesn't actually exist in reality), the market price closely resembles the true value of the stock. In a manipulated market, by contrast, the market price has been "artificially" moved in one direction or the other and is unrelated to the true value of the stock. Sanjay Wadhwa, at the time an Associate Director of the SEC's Enforcement Division in the New York Regional Office and currently SEC Deputy Director of Enforcement, said that "the fair and efficient functioning of the markets requires that prices of securities reflect genuine supply and demand. Traders who pervert these natural forces by engaging in layering or some other form of manipulation invite close scrutiny from the SEC." That may be so, but "close scrutiny" rarely results in prosecutions—much less successful ones.

Part of the reason may be that there is no satisfactory definition of market manipulation. The statute does not define it. The SEC's attempt at rulemaking simply refers back to Section 9. In the Hochfelder case, 425 U.S. 185 (1976), the Supreme Court made it clear that although the 1934 Securities Exchange Act was intended "principally to protect investors against manipulation of stock prices," manipulation cases (there an attempt to defraud investors into investing in non-existent "escrow" accounts) nevertheless required proof of intent. "There is no indication that Congress intended anyone to be made liable for such practices unless he acted other than in good faith." But what if the improper intent is accompanied by conduct that is otherwise lawful? Keep this question in mind. We will return to it below. It is very important.

The word "manipulative" as used in Sections 10(b) and 15(c)(1) has never had any precise meaning. Although there is a short definition in the SEC's Investor.Gov website ("Market manipulation is when someone artificially affects the supply or demand for a security (for example, causing stock prices to rise or fall dramatically)"), the question still remains what constitutes "artificially" affecting supply and demand? Timothy Snider called it a "murky miasma of questionable analysis and unclear effects."⁷

Open questions abound: What is "interference" with supply and demand? Is purchasing or selling a stock on an open market "interference"? What if a broker releases a positive report on a company, the clients buy, and the price goes up? Is that an interference with supply and demand or is that just the normal operation of the market? What about "day traders" who trade for the purpose of driving the price up and then sell at the end of the day? What is "forcing a security's price to trade at an artificial level"? Is there a difference between an artificial and non-artificial price? What if the purpose of the manipulation is to "restore the stock to its true value"? If you are finding it difficult to answer those questions, you are not alone. The most common response is the equivalent of Justice John Paul Stevens's definition of pornography in Jacobellis v. Ohio (378 U.S. 184 (1964)): "I know [manipulation] when I see it."⁸

According to Professor Louis Loss, there is no satisfactory definition. Although there is a definition in the SEC's "fast answer" website, it is neither a legal definition nor a statement of SEC policy. Neither the Securities Exchange Act nor the Commodity Exchange Act attempts to define the term. "The law governing manipulations has become an embarrassment—confusing, contradictory, complex, and unsophisticated."⁹

Is manipulation "interference with supply and demand" as Professor Nagy suggests? What does "interference" mean? What about "inducing people to trade"? What if a broker releases a positive report on a company and the clients buy the stock and the price goes up? Can intent alone make an otherwise lawful practice unlawful? What about forcing a security's price to trade at an artificial level? Is there a difference between an artificial and a non-artificial price? What if the purpose of the manipulation is to "restore the stock to its true value"?¹⁰ There are no good answers to most of these questions.

Elements of Manipulation

The traditional elements of a manipulation prosecution are thought to be the following:

• a manipulative act,
• damage,
• reliance on an efficient market free of manipulation,
• scienter,
• "in connection with" purchase or sale of a security, and
• the use of mail or national exchange.

Even though these elements have been recently reiterated by the Second Circuit Court of Appeals, the theoretical basis for them remains elusive. In particular, can a "manipulative act" be based on intent alone if the underlying act is lawful? We examine that question below.

The Theoretical Basis for Prohibiting Manipulation

In 1991 in the Harvard Law Review, Professor Daniel Fischel (later Dean of the Chicago Law School) and David Ross, a Ph.D. candidate, tried to define manipulation as trades made with "bad intent."¹¹ They concluded that trades that meet the following criteria are manipulative:

• the trading is intended to move prices in a certain direction,
• the trader has no belief that the prices would move in this

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