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To some, stock manipulation is like obscenity — they know it when they see it, but have difficulty defining it. This is particularly true when the alleged manipulation is based solely on real, arm’s-length trades. Take the example of Joe Stockbroker. Joe works at a small, somewhat disreputable brokerage firm, XYZ Securities Corp. XYZ has a history of bringing to market initial public offerings (IPOs) that are highly speculative. Like other brokerage firms that also act as underwriters, when XYZ brings a company public and that company’s stock price rises dramatically, XYZ’s reputation is enhanced. Also, in the aftermarket, XYZ sometimes buys and holds stock in the companies it takes public. Thus, XYZ may have a number of legitimate reasons for wanting to see the stock prices rise for those companies XYZ takes public. Joe and other brokers at XYZ recommend the IPOs underwritten by XYZ to many of their customers and thereby create demand, which causes the prices to rise dramatically shortly after the IPOs go effective. XYZ then touts the historical performance of its IPOs to potential issuers and potential retail customers, leading to yet more underwritings and more retail business. Do Joe and the other brokers at XYZ “manipulate” the prices of the IPO shares by recommending them to their customers? You may say “no,” but some regulators and prosecutors may say otherwise, particularly if they think XYZ is a disreputable firm. Why? Because the definition of “manipulation,” as set forth in an increasing number of cases, is imprecise and therefore capable of abuse in its application. The term “manipulation” is not defined by federal securities laws or regulations. However, because three opinions of the Supreme Court between 1976 and 1985 offer clear guidance as to the meaning of the term, it is somewhat surprising that lower courts have struggled to apply the Supreme Court’s holdings to specific manipulation cases. In Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199 (1976), the Supreme Court referred to “manipulation” as “virtually a term of art when used in connection with the securities markets,” adding: “It connotes intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities.” Four years later, in Chiarella v. United States, 445 U.S. 222, 228 (1980), an insider trading prosecution brought under � 10(b) of the Securities Act of 1934, the Court held that a person who trades on inside information does not commit a fraud on the person on the other side of the trade because “one who fails to disclose material information prior to the consummation of a transaction commits fraud only when he is under a duty to do so. And the duty to disclose arises when one party has information that the other [party] is entitled to know because of a fiduciary or other relation of trust and confidence between them.” Five years after Chiarella, in Schreiber v. Burlington Northern, Inc., 472 U.S. 1, 7-8 (1985), the Supreme Court held that under �� 10(b) and 14(e) of the Securities Exchange Act of 1934, the term “manipulation” requires either a material misrepresentation or a material nondisclosure. The Court held that where a hostile tender offer had been replaced with a friendly tender offer that provided for a smaller payout to certain shareholders (allegedly to “artificially” depress the stock price through collusion between current management and the offeror), there was no “manipulation” because there were no allegations of “misrepresentation, nondisclosure, or deception.” Id. at 12. When read together , Ernst & Ernst, Chiarella and Schreiber stand for the principle that “manipulation” is a specific subset of “fraud,” and there is no fraud (and therefore no manipulation) without either a materially false statement or a material nondisclosure under circumstances requiring disclosure because of a relation of trust. Sounds simple, doesn’t it? Not so fast. In United States v. Regan, 937 F.2d 823 (2d Cir. 1991), the U.S. Court of Appeals for the Second Circuit held that a manipulation in violation of � 10(b) occurred even though the government did not allege that the defendants made a misrepresentation or breached a fiduciary duty. The alleged manipulation was the short selling of an over-the-counter stock by a trader at the Princeton Newport investment firm at the request of a trader at Drexel Burnham, who had a motive to drive the price of the stock down. The court distinguished Chiarella (and its requirement that a duty to disclose be based upon some fiduciary relationship) on the basis that Chiarella was an insider trading case, whereas Regan was a market manipulation case. Id. at 829. The court in Regan found that “failure to disclose that market prices are being artificially depressed operates as a deceit on the market place and is an omission of material fact.” This language from Regan raises important questions. First, why did the trader at Princeton Newport have a duty to disclose anything to the marketplace in the absence of any fiduciary relationship, as is required by Chiarella? Essentially, the Second Circuit held, without explanation, that those who trade with a manipulative intent are a unique group. Apparently, they and only they have a duty to disclose their intent to the marketplace, even in the absence of a fiduciary relationship to anyone. This is curious, to say the least. The second question raised by the quote from Regan is: What does it mean that “prices are being artificially depressed”? In defense of the Second Circuit, it is not the only court to use the expression “artificial” to describe prices that are the product of a “manipulation.” The case books are filled with opinions that describe manipulation as causing an “artificial” price. Unfortunately, the case books are short on opinions defining the word “artificial” in this context. In fact, the Schreiber opinion noted the uncertainty created by using the word “artificial” as a legal standard and disapproved of its use. 472 U.S. at 12. By using the word “artificial,” the courts have avoided coming to grips with the problem of defining “manipulation”; they have simply substituted one undefined term for another. Four years after Regan, the Seventh Circuit rejected a claim based on “artificial price” in a civil manipulation case. The plaintiff alleged that the defendant had manipulated LTV stock when it made short sales of more LTV stock than existed in the world. The defendant’s traders had started selling LTV stock short after learning that a publicly available reorganization plan for LTV estimated that the post-reorganization shares of LTV stock would each be worth only 3 or 4 cents. When the plan was announced, the old shares were trading above 30 cents. Apparently, the defendant understood the complex reorganization plan better than the plaintiffs and shorted LTV until it fell to 3 cents a share. The district court dismissed the complaint, and the Seventh Circuit affirmed. Sullivan & Long Inc. v. Scattered Corp., 47 F.3d 857 (7th Cir. 1995). Chief Judge Richard A. Posner wrote that there was no manipulation because the defendant, “not being a fiduciary of the people it traded with,” had no legal responsibility to educate its buyers, and because there were “no representations, true or false, actual or implicit, concerning the number of shares that [the defendant] would sell short.” Id. at 860, 864. The court rejected the plaintiff’s claim that the defendant caused LTV’s price to trade at an “artificial level.” Regrettably, however, Judge Posner defined “artificially high or low prices” as “prices that do not reflect the underlying conditions of supply and demand” without explaining what this means or what the court meant when it found that the defendant’s short sales were made above the stock’s “true value.” Judge Posner’s imprecise definition of “artificial” prices is similar to definitions used by other courts. For example, in United States v. Russo, 74 F.3d 1383, 1394 (2d Cir. 1996), the Second Circuit upheld the following jury instruction in a criminal manipulation case involving stockbrokers who caused their customers to buy speculative stock: “In order to find an intent to manipulate the price of EAS and Lopat stock, you must find that the defendant you are considering intended to raise the price of the stock to, or maintain the price of the stock at an artificial level, that is, to a level above the investment value of the stock as determined by available information and market forces” (emphasis in original). The question, then, is: What is “the investment value of the stock as determined by available information and market forces”? After Russo, a Southern District of New York judge was asked to rule on the definition of “artificial” in another stock manipulation case. Citing Russo, he held: “[A] stock is trading at an �artificial level’ when it is trading at a level above what market forces would otherwise dictate.” United States v. Hall, 48 F. Supp. 2d 386, 387 (S.D. N.Y. 1999). This definition raises the questions: “what market forces?” and “are real trades made with the intent to raise prices not part of market forces?” The defendants in Russo and Hall argued unsuccessfully that there is no intent to manipulate if a trader or a stockbroker attempts to move the price of a stock to a point that represents the stock’s “true worth” — that is, the price that the stock should be trading at even if the defendants’ trades (or trades caused by the defendants) had not occurred. This formulation has support in Sullivan & Long, in which Judge Posner used the term “true value” to describe a price that was not “artificial” for LTV stock. But what is “true value”? The imprecise language in Sullivan & Long, Russo and Hall is similar to other expressions often used to describe the prices that result from a manipulation — prices that are not the product of “normal market forces” or “normal supply and demand.” However, defining an “artificial” price by using words like “normal” begs the question: what is “normal”? The inconsistency that results from this definitional problem is manifest in the case law. Although the Second Circuit concluded in Regan that a non-fiduciary who had made no material misstatements could be convicted of manipulation under � 10(b), the Second Circuit stated in dicta in United States v. Mulheren, 938 F.2d 364, 368 (1991), that it had “misgivings” about a theory of prosecution which posited that “when an investor, who is neither a fiduciary nor an insider, engages in securities transactions in the open market with the sole purpose of affecting the price of the security, the transaction is manipulative and violates Rule 10b-5.” ( Mulheren reversed a conviction for stock manipulation due to the inadequacy of evidence presented in support of the government’s theory.) We should now revisit our friend Joe Stockbroker. He is advising his clients to buy speculative stocks shortly after IPOs, and he has a personal motive in wanting to see the prices of those stocks rise. A regulator or prosecutor might argue that Joe is recommending the stock to take the price to an “artificial” level and is thereby attempting to “manipulate” the stock — particularly if, much later, the stock’s price plummets, leaving Joe’s customers much poorer. In pursuing Joe as an alleged “manipulator,” a regulator or prosecutor might describe what Joe is doing as attempting to move a speculative stock to a point that is higher than “the investment value of the stock as determined by available information and market forces,” and to a point that is not the product of “normal market forces” or “normal supply and demand.” However, such an argument would be wrong as a matter of law and unfair because, on these facts alone, Joe has not lied to his customers, nor has he failed to disclose to his customer any material facts that he was required to disclose. Until the courts come to grips with the fact that manipulation requires either materially false statements or material failures to disclose under circumstances involving fiduciary relationships, the securities industry — and particularly that part of the industry that sells speculative securities — will be unfairly at the mercy of regulators and prosecutors who do not understand what manipulation means. Lawrence S. Bader represented one of the appellants in Regan and Russo. He is a principal of Morvillo, Abramowitz, Grand, Iason & Silberberg, P.C. in New York City, where Daniel B. Kosove is an associate.

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