9.2 Ethical Considerations in Securities Underwriting and Trading

Securities underwriting and trading involve complex ethical considerations. Investment banks must balance their profit motives with fair dealing and market integrity. Key issues include preventing market manipulation, ensuring fair order handling, and providing accurate disclosures to investors.

Ethical practices in securities markets are crucial for maintaining investor trust and market efficiency. Regulations aim to prevent deceptive practices like pump-and-dump schemes and front-running. Proper disclosure of material information and adherence to best execution principles are essential for ethical conduct.

Market Manipulation and Unfair Practices

Deceptive Practices in Securities Markets

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• Market manipulation involves intentionally distorting securities prices or trading volume to create false impressions and mislead investors
• Pump and dump schemes artificially inflate the price of a security through false and misleading positive statements to sell the cheaply purchased security at a higher price (microcap fraud)
• Front-running occurs when a broker executes trades for their own account ahead of their customers' trades to benefit from the expected price movement caused by the pending orders
• Engaging in manipulative and deceptive practices undermines the integrity and efficiency of securities markets, eroding investor confidence

Ensuring Fair Dealing and Price Stability

• Fair dealing principles require that all clients be treated fairly and equitably, without giving preferential treatment or taking advantage of certain clients
• Investment banks and broker-dealers must establish policies and procedures to prevent manipulative practices and ensure fair dealing among clients
• Price stabilization involves supporting the price of a security during a public offering by engaging in permissible activities (overallotment, buybacks) to prevent or slow a decline in the security's price
• Stabilization activities must be disclosed in the offering prospectus and are subject to specific rules and restrictions to prevent market manipulation

Short Selling and Order Handling

Short Selling Practices and Regulations

• Short selling involves selling borrowed securities with the expectation of buying them back at a lower price to profit from the price decline
• Naked short selling occurs when a short seller sells shares without first borrowing them or ensuring they can be borrowed, potentially causing failed trades and market disruption
• Regulations require short sellers to locate shares to borrow before executing a short sale and impose restrictions on short selling during significant price declines (uptick rule)
• Abusive short selling practices, such as spreading false rumors to drive down prices, are prohibited and subject to enforcement actions

Best Execution and Order Handling Requirements

• Best execution requires broker-dealers to seek the most favorable terms reasonably available for customer orders, considering price, speed, likelihood of execution, and other relevant factors
• Order handling rules require broker-dealers to establish and enforce written policies and procedures designed to obtain best execution for customer orders
• Broker-dealers must not interject a third party between the customer and the best available market without meaningful added value or service
• Order handling rules also require broker-dealers to disclose their order routing practices and any payment for order flow arrangements to customers

Disclosure and Material Information

Prospectus Disclosure Requirements

• A prospectus is a legal document that provides detailed information about a securities offering, including the issuer's business, financial condition, risks, and terms of the offering
• Securities laws require that a prospectus contain all material information necessary for investors to make informed investment decisions
• Material information is any information that a reasonable investor would consider important in making an investment decision or that would significantly alter the total mix of available information
• Omitting material information or making false or misleading statements in a prospectus can result in liability for the issuer, underwriters, and other participants in the offering

Greenshoe Option and Overallotment

• A greenshoe option, also known as an overallotment option, allows underwriters to sell additional shares (typically 15% of the original offering) at the offering price to cover overallotments
• Overallotment occurs when underwriters sell more shares than the issuer initially offered to meet excess demand and stabilize the price in the aftermarket
• The greenshoe option provides flexibility for underwriters to manage the offering process and helps stabilize the price of the newly issued securities
• If the greenshoe option is exercised, the issuer receives additional proceeds from the sale of the extra shares, but if not exercised, the underwriters cover the overallotment by buying back shares in the open market