Market misconduct - Victorian Court of Appeal redefines "artificial price" as outcome rather than purpose test

In DPP (Cth) v J M [2012] VSCA 21 (14 June 2012) the Victorian Supreme Court of Appeal revisits section 1041A of the Corporations Act 2001 (Cth), and the decision in Soust.

At issue was whether a price resulting from: 

1. a transaction entered into for the sole or dominant underlying purpose of setting a particular price (as contended by the Crown); or
   
2. a transaction reflecting an abuse of market power (as contended by the accused)

is an “artificial price” for the purpose of s.1041A.¹

Background to the case

The accused was a director and CEO of X Ltd, an ASX-listed company. The accused had an interest in $10 million shares in X Ltd through an associate Z ApS, funded through a margin loan. X Ltd shares and options were the collateral for the loan, the value of which securities had sharply declined by July 2006 triggering margin calls and requiring a top-up payment of $2 million. The Crown alleged that the accused had entered into an arrangement with family members who agreed to buy X Ltd shares, financed by the accused, to maintain the price of X Ltd. The accused faces several charges of market manipulation under s. 1041A and related charges of conspiracy.

In the course of the criminal trial (which is continuing), an issue arose as to the meaning of the term “artificial price” in s. 1041A. The trial judge referred the issue to the Court of Appeal for determination on a stated case basis. The Court of Appeal split 2-1 on the issue.

The Court of Appeal’s decision

In their joint judgment, Nettle JA and Hansen JA declined to deal with the issue of whether the accused’s purpose in taking part in the impugned transactions was manipulative (because this was a matter of fact still to be determined by the trial judge). However, they held that the term “artificial price” in s.1041A has a legal meaning. It signifies market manipulation by “cornering” or “squeezing” (US jurisprudential concepts which involve misuse of market power or domination to set or maintain prices at an artificial level). Accordingly, an “artificial price” under s.1041A is one which although it reflects the forces of supply and demand, results from one party having a monopoly or domination of the market for that security which takes unfair advantage of that market power to extract a price different to that which would have applied if there was adequate supply.

On this analysis, a contravention of s.1041A would require an assessment as to whether (i) the requisite domination or monopoly existed, (ii) an artificial price had been created by the exercise of that power, and (iii) the dominant party intended to bring this about.

In so finding, they expressly disagreed with part of the decision in ASIC v Soust² (followed by ASIC v AAT)³ for misapplying the test in North v Marra Developments⁴ to s.1041A, by conflating it with the test for s.1041B.⁵

The majority added that if the accused had been charged with s.1041C⁶ offences they might have answered the questions stated in the referral differently.

Warren CJ found that s.1041A could cover a wider range of manipulative conduct than the “cornering” or “squeezing” identified by the majority⁷, although noted it may be easier to prove a breach of s.1041A where such market power existed. His Honour held however, that irrespective of the underlying purpose of the impugned transaction, the provision could only be breached if the subsequent behaviour of other genuine market participants was affected. If it was not, then there might still be a breach, but it would be a breach of s.1041B (the creation of a false and misleading appearance as to price), not s. 1041A, provided the sole or dominant purpose of the accused in entering into the transaction originally had been to set or maintain the price.

Conclusion and implications

It is apparent from the judgment that the Court of Appeal had difficulty accepting that the price of a security could be “artificial” for the purpose of s.1041A in the Soust sense, presumably because another genuine counter-party in the market was prepared to accept it (making it a “real”, not artificial price) and transact at that price level and/or the offending counter-party had unfairly used market power to bring this about.

The Court of Appeal decision therefore represents a substantial revision of what had previously been thought to be the scope of the prohibition in s.1041A, displacing reliance upon the primacy of the purpose test which had been used to distinguish prices created by non-genuine trades from prices created by genuine trades, and giving primacy instead to the outcome of the impugned transaction or its subsequent market impact (if any).

Under the previous test “artificial prices” were determined by reference to the motivations of the accused ie whether the accused had entered into the transaction with the predominant purpose of setting or maintaining a market price (irrespective of whether another participant had been willing to buy or sell at that price), and by reference to retrospective or hypothetical market conditions ie by comparing the price at which the impugned transaction occurred with what the price would otherwise have been but for that transaction (in effect, a stripping out the relevant transaction to assess what price the market would have paid free of that interference).

Following the Court of Appeal's decision, it will no longer be sufficient to show that the accused’s sole or dominant purpose was to create or maintain a particular price to establish an “artificial price” for the purpose of s.1041A. Instead it will be necessary to show that: 

• there is clear evidence of market domination or market imbalance leading to “cornering” or “squeezing” (the joint judgment of Nettle and Hansen JA); and/or
  
• the subsequent conduct of genuine buyers and sellers was affected (Warren CJ).

An unintended consequence of this and the confusion stemming potentially from the Court of Appeal’s discussion of the applicability of other market misconduct provisions (ss.1041B and 1041C), is that practices which might previously have constituted a clear breach of s.1041A, such as propping, price setting, or price stabilisation (especially in relatively illiquid stocks due to the infrequency of trading generally), may be more difficult to prosecute in the absence of evidence of market power or follow-on trading. Despite the suggestions of the Court of Appeal, ss.1041B and 1041C may not neatly or easily plug this apparent gap as conventionally these sections have focused on market appearances (which can be created without any trading), multi-party manipulation (matched trades, wash orders, pooling or churning) or other forms of sham transactions.

It also leaves ASIC and the DPP with a conundrum. They may now frame their cases in three alternative ways by reference to ss.1041A, 1041B and 1041C to see which one the court in each case eventually favours or perhaps split their case into one involving manipulative appearances (to capture the accused’s motivation or predominant purpose in entering into the impugned transaction and also adducing expert evidence as to the market appearances created under eg s.1041B), artificial transactions (where there is evidence the accused has conspired with others to bring about a market effect and adducing also expert evidence of that effect eg under 1041C), and market domination (with expert evidence as to market power or market imbalances that the accused has taken unconscientious advantage of). The case also raises a question as to how a future court will distinguish legitimate “cornering” or “squeezing” activity eg in a short covering situation from apparently illegitimate practices of the same kind.

The conundrum for ASIC and the DPP is a very real one, as the schedule below illustrates, which shows the majority of recent convictions were obtained under s.1041A (many on remarkably similar facts to the the present case). It remains to be seen whether the DPP will seek to amend their indictment in this case to include grounds other than s.1041A when it returns before the trial judge for mention in August.

Schedule 1: ASIC enforcement statistics

1. This section prohibits a person from taking part in or carrying out a transaction likely to have the effect of creating an artificial price for a security or maintaining a price level that is artificial for the security ie. market manipulation.
2. ASIC v Soust (2010) 183 FCR 21. In Soust, Goldberg J had found that an artificial price “connotes a price created not for the purpose of implementing or consummating a transaction between genuine parties…but rather for a purpose unrelated to achieving the interplay of genuine market forces of supply and demand” and that the test was essentially the same as for s.1041B.
3. (2010) 187 FCR 334.
4. (1981) 148 CLR 42.
5. This section prohibits a person from creating a false or misleading appearance of active trading or in respect of the market for or price of a security ie. false trading or market rigging to make it appear as if more volume is being traded than is truly the case, and so includes matched trades and wash trades.
6. This section prohibits a person entering into a fictitious or artificial transaction or device which results in the price of a security being maintained, inflated or depressed or price fluctuations ie. false trading or market rigging through the use of sham transactions or conspiracies.
7. Interestingly however, generally the examples of other manipulative conduct used by Warren CJ involved similar predatory conduct in relation to market imbalances to that identified by the majority. The one exception was the practice of “marking the close” which Warren CJ said could also come within the provision, although not on the basis that the price so created was artificial, but on the basis that other participants altered their behaviour as a result. It should be noted that this practice typically also arises due to an imbalance between demand and supply which may be created by the offending counter-party, especially in less liquid stocks.