BaFin: Market manipulation – Pre-arranged trades and wash sales 

BaFin has published an article with important information for investors regarding Market manipulation – Pre-arranged trades and wash sales.

Trading securities to gain would-be tax advantages could boomerang back to investors if the transactions involve pre-arranged trades or wash sales.

Such practices are considered a form of market manipulation: under section 20a of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG) it is prohibited to initiate transactions or issue purchase or sell orders that have the potential to generate false or misleading signals affecting supply, demand or the exchange or market price of financial instruments or to create an artificial price level. Pre-arranged trades and wash sales are actionable forms of market manipulation.

Pre-arranged trades and wash sales

Pre-arranged trades are buy and sell orders that are for substantially the same volume and price and are undertaken or given by different parties acting in collaboration, unless such transactions were disclosed in a timely manner in accordance with the applicable market.

A wash sale is a transaction where the buyer and the seller are one and the same person, i.e., where the purchase or sale of any securities does not involve a change in the beneficial ownership of those securities.

Pre-arranged trades and wash sales are prohibited because they unlawfully influence the process of price determination on the exchange. They give the market the misleading impression that the ensuing trade is the result of uniting independent buyers and sellers in line with free-market principles of supply and demand. In actuality, however, pre-arranged trades or wash sales do not involve independently operating investors. Instead, one or several persons arrange a trade at a specific market price which is not transparent to the market beforehand.

Such manipulative practices create, among other things, the impression of an active and liquid market in the relevant securities. Other investors falsely rely on exchange prices being determined by the free market interplay of supply and demand from independently acting market participants.

Tax motives

Investors who attract the attention of BaFin, the public prosecutor’s office and the courts in executing such securities transactions often cite tax motives. Their objective, they argue, is to reduce their tax burden by selling securities at a loss in order to obtain a tax benefit. Investors sometimes also argue that such a transaction made sense because, despite share price losses they generally still believed in the relevant investment and therefore wanted to hold on to it.

Regardless of whether any such transaction might be relevant for tax purposes, it is still a prohibited transaction under securities law.

Special case: Asset managers

Asset managers are also among those who execute such prohibited transactions. They execute the manipulative securities transactions for the securities accounts of their customers on the basis of powers of attorney. There are several variations of this.

For example, one or several securities accounts of the one and the same customer could be affected, between which trades are executed back and forth, so that the orders or transactions do not involve any change in beneficial ownership. However, securities accounts of different customers may also be used for pre-arranged trading. It is irrelevant whether one individual or several employees of the asset manager executed the pre-arranged trades for the various customers, because even “pre-arrangements with oneself” constitute a breach of the prohibition against market manipulation.

If such actions result in a manipulated market price, this would constitute a criminal offence under section 38 (2) of the German Securities Trading Act (WpHG). If BaFin becomes aware of any indications of any such actions, it is obligated to report these to the competent public prosecutor’s office. It may also take supervisory measures under the German Banking Act (Kreditwesengesetz – KWG) or the German Securities Trading Act (WpHG), if the asset manager is subject to its supervision.

Forfeiture order

If criminal proceedings are instituted, this may result not only in penalties, but a forfeiture order may be issued as well. This means that the market manipulator would be required to forfeit the assets gained by virtue of its actions.

In such cases, the no-netting principle will usually apply: the assets arising directly from the manipulative transaction would be forfeited in full and the investor would have no claim to consideration or other expenses.

Source: BaFin

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