How to disclose conflicts of interest under the Market Abuse Regulation
After more than five years of investigations, German prosecutors stopped proceedings regarding a short selling attack and the accusation of market manipulation against speculative investor Carson Block. (See also the blog post from Christie and Liptrap (2020) on whether the issuer has a private right of action for the alleged price manipulation.) Through his hedge fund Muddy Waters, Carson Block attacked the German publicly listed ad-firm Stroeer in April 2016 (see here for further information). Muddy Waters published a research report expressing serious concerns about Stroeer’s balance sheet practice. Moreover, they also claimed that the actual key figures, such as organic growth and operating cash flow, were significantly lower than the figures reported by Stroeer. The German prosecutors, along with the German Federal Financial Supervisory Authority, BaFin, had serious concerns about the effectiveness of the disclaimer, which was used by Muddy Waters in the research report in order to avoid civil and criminal liability (the full report can be read here).
This case raises the general question of what the legal requirements are under the Market Abuse Regulation for the disclosure of a conflict of interest due to holding a position in a financial instrument whilst simultaneously disseminating a research report about that financial instrument. This conflict of interest is often related to pump and dump schemes or, more recently, short selling attacks. The latter refers to situations where a short seller induces others to sell so that he or she can make profit before the stock rises again, much like when a stock promoter induces others to buy so that he or she can sell at a profit.
The European legislator addresses this kind of behaviour primarily in Article 12 (2) (d) of the Market Abuse Regulation (MAR) No 596/2014, which provides that the conflict of interest must be disclosed ‘in a proper and effective way’ (cf also Article 20 MAR, which regulates investment recommendations and obliges the producer of an investment recommendation to disclose a conflict of interest). Surprisingly, the law does not explicitly state how to disclose the conflict of interest in order to avoid the accusation of market manipulation. As far as the author knows, there is no case law on this topic, neither under the Market Abuse Regulation, nor under the former Market Abuse Directive.
The special focus of this blog post is: How can someone who disseminates investment advice about a financial instrument disclose information about his or her conflict of interest whilst avoiding the accusation of market manipulation? What information must specifically be disclosed in order to avoid such an accusation?
The answer can only be found when we consider the regulatory intention behind Article 12 MAR (Market manipulation). Market manipulation distorts the price mechanism and leads to an inefficient allocation of capital (cf Kahan (1992), Kyle and Viswanathan (2008)). Therefore, it is obvious that the application of Article 12 MAR seeks to preserve the functionality of capital markets (cf according to Article 1 MAR the regulation should ‘prevent market abuse to ensure the integrity of financial markets in the [European] Union and to enhance investor protection and confidence in those markets’).
Capital markets can only function when all publicly available material information is instantly reflected in the share prices. (This is, in other words, the so‑called semi-strong form of the well-known Efficient Market Hypothesis by Fama.) The other condition is that the information is correct and that the share price reflects the fundamental value. The Market Abuse Regulation attempts to incorporate this theoretical construct through the concept of the so‑called ‘reasonable investor’ (cf Article 7 (4) MAR).
We have to ask ourselves which information a reasonable investor needs for making a rational investment decision and—in our case—for noticing any conflict of interest. The answer to this question requires not only correct and complete information about external facts in the research reports, such as balance sheet figures and financials (cf information-based market manipulation in Article 12 (1) (c) MAR), but also information about internal facts like the intent of the analyst or activist short seller.
With this in mind, the following solution could be a step in the direction of legal certainty:
- A person (eg analyst, activist short seller), who is voicing their opinion about a financial instrument or its issuer must disclose their identity and the identity of any other person responsible for the production of the investment recommendation (cf also Article 2 of Commission Delegated Regulation No 958/2016). By disclosure of their identity, a reasonable investor can evaluate the credibility of the analyst or activist short seller and—vice versa—the analyst or activist short seller can earn their reputation.
- The analyst or activist short seller must disclose whether they hold a long or a short position. Additionally, the analyst or activist short seller must disclose how large their position is and consequently the exact amount of the position (eg 0.75 % of the total issued share capital). It seems justified that a reasonable investor can assess the extent of financial interest before they make an investment decision. In the case of activist short sellers, it is, in my opinion, insufficient to disclose their short position only according to Article 6 of the Short Selling Regulation (SSR) No 236/2012. Instead, they must also disclose their holding of a short position in the disclaimer itself, when disseminating a research report. A reasonable investor should be able to get their information from one source.
- Finally, a reasonable investor needs to know whether the analyst or the activist short seller has the intent to sell or buy the financial instrument after their recommendation has been made. This information is necessary because a typical pattern of a pump and dump scheme or a short selling attack is that the position held in the financial instrument will be closed right after the price rises, or rather falls (see eg Mitts (2019); Mitts (2020); Coffee (2020)).
In summary, in order to avoid the risk of triggering the application of the Market Abuse Regulation, investors who disseminate investment advice about a financial instrument should follow the steps indicated above. These steps can also serve as an inspiration for any future legislative initiative in this field, which would bring about much-desired legal certainty.
Marcel Vollmerhausen is a research assistant at the University of Mannheim (Germany).
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