Shariah Principles for Islamic Capital Markets and the Regulation of Market Abuse in UK and the US: Common Grounds, Divergences and Proposal for Reform A thesis submitted to the University of Manchester for the degree of PhD in the Faculty of Humanities 2012 Kabir Ahmed School of Law 1 List of Contents List of Contents…………………………………………………………………........2 Abstract………………………………………………………………………………7 Declaration…………………………………………………………………………...8 Copyright Statement…………………………………………………………………8 Dedication……………………………………………………………………………9 Acknowledgements………………………………………………………………….10 List of Statutes………………………………………………………………………11 List of Cases………………………………………………………………………....13 List of Abbreviations………………………………………………………………...14 Chapter 1- Introduction 1.1- Introduction……………………………………………………………………..15 1.2- Research Questions …………………………………………………………….24 1.3- Structure of thesis……………………………………………………………….25 Chapter 2- Rationales for Prohibition of Market Abuse 2.1- Introduction……………………………………………………………………..28 2.2- Prohibition of Market Abuse…………………………………………………....28 2.3- Prohibition of Insider Trading…………………………………………………..28 2.3.1- Introduction……………………………………………………………....28 2.4- Insider Trading and the Efficient Pricing of Securities………………………....29 2.4.1-Information and the Stock Market………………………………………...29 2.4.2-The Impact of Insider Trading………………………………………….....30 2.5- Fairness as a Justification for Insider Trading Prohibition……………………...36 2.5.1-Fairness Requires Symmetrical Information to all participants…………..38 2.5.1.1- The Absolute Equality of Information…………………………..38 2.5.1.1- The Equal Access View……………………………………….....44 2.5.2- Fairness Requires No Breach of Fiduciary Duty…………………………46 2.5.3- Fairness Requires No Harm and Preservation of Investors Confidence….47 2.6- Prohibition of Market Manipulation…………………………………………….50 2.6.1- The Ethical Rationales for Prohibition of Market Manipulation ...............50 2.6.2- The Economic Rationales against Prohibition of Manipulation………….58 2 2.7- Conclusion………………………………………………………………………62 Chapter 3- US and UK Law of Market Abuse Part I - US Law on Market Abuse…………………………………………………..63 3.1- Introduction……………………………………………………………………..63 3.2- The Evolution of Law on Market Abuse………………………………………..63 3.3- The Origins of Federal Prohibition of Securities Fraud………………………...65 3.4- The Current Law on Market Abuse……………………………………………..66 3.4.1- Prohibition under Section 10(b)………………………………………….67 3.5- The Jurisprudence of Rule 10b-(5)……………………………………………...68 3.5.1- Equal Access Theory of Fairness….…………………………………….68 3.5.1.1- Cady Roberts & Co……………………………………………..68 3.5.1.2- SEC v Texas Gulf Sulphur Co………………………………….69 3.5.2- Classical Theory of Fairness…….………………………………………70 3.5.2.1- Chiarella v United States……………………………………….71 3.5.2.2- Dirks v SEC…………………………………………………….71 3.5.3- The Emergence of Misappropriation Theory of Fairness………………..72 3.5.3.1- United States v Newman……………………………………….72 3.5.3.2- United States v Carpenter……………………………………....73 3.5.3.3- United States v O’ Hagen………………………………………75 3.6- Prohibition under Section 14(e) ………………………………………………..76 3.7- Prohibition under Section 16……………………………………………………77 3.7.1- Section 16(a) - Reporting Obligation……………………………………77 3.7.2- Section 16(b) - The Short Swing Profit Rule …………………………...77 3.7.3- Section 16(c) - The Rule against Short Selling………………………….78 3.8- Prohibition of Selective Disclosure and Regulation FD………………………..78 3.9- Conclusion………………………………………………………………………78 Part II – UK Law on Market Abuse………………………………………………...80 3.10- Introduction……………………………………………………………………80 3.11- The Evolution of Law on Market Abuse…..…………………………………..80 3.12- The Current law ……………………………………………………………….82 3.13- The Criminal Law Offences…………………………………………………...83 3.13.1- Insider Dealing …………………………………………………………84 3 3.13.2- Misleading Statements…………………………………………………85 3.13.3- Market Manipulation…………………………………………………...86 3.14- The Regulatory Offences of Market Abuse under FSMA 2000………………87 3.14.1- Insider Dealing ……………………………………………………….88 3.14.2- Improper Disclosure……………………………………………………89 3.14.3- Manipulating Transactions……………………………………………..98 3.14.4- Manipulating Devices………………………………………………….90 3.14.5- Dissemination of Misleading Information….………………………….90 3.15- Offence of Encouraging Market Abuse……………………………………...91 3.16- Conclusion……………………………………………………………………91 Chapter 4- Shariah Principles for Securities Markets 4.1- Introduction……………………………………………………………………..92 4.2- The Origins of Islamic Finance……………….…………………………………93 4.3- Shariah Compliance of Modren Securities Markets...…………………………..94 4.4- The Emergence and Development of Securities Market …………………….....96 4.5- Key Principles and Prohibitions in Securities Markets………………………...101 4.5.1- Achievement of Falah…………………………………………………...104 4.5.2- Socio-economic Justice………………………………………………….106 4.5.3- Distribution of Wealth and Elimination of Exploitation………………...107 4.5.4- Social Solidarity and Egalitarianism…………………………………….109 4.5.5- Prohibition of Interest…… ……………………………………………..110 4.5.6- Prohibition of Gharar………………………………………………….. .114 4.5.7- Prohibition of Maisir…………………………………………………….117 4.5.8- Prohibition of Haram activities………………………………………….123 4.6- Conclusion……………………………………………………………..............124 Chapter 5- Contractual Structure of Financial Instruments in Islamic Capital Markets 5.1- Introduction……………………………………………………………………125 5.2- Equity Based Shariah Compliant Contractual Structures...……..……………..125 5.2.1- Mudarabah………………………………………………...…………….126 5.2.2- Musharakah……………………………………………………………...128 5.3- Debt Based Shariah Compliant Contractual Structures…...…………………...130 4 5.3.1- Murabaha………………………………………………………………..130 5.3.2- Deferred payment (Bai Bithman Ajil)…………………………………..133 5.3.3- Sukuk…………………………………………………………………....133 5.3.4.1- Sukuk Issuance and Secondary Market………..……………....138 5.4- Hedging and Risk Management in Islamic Capital Market……………………140 5.4.1- Introduction……………………………………………………………...140 5.4.2- Islamic Concept of Risk Management………………………………......142 5.4.3- Islamic Risk Management Products……………………………………..145 5.4.3.1- Bay- Salam……………………………………………………...145 5.4.3.2- Istisna…………………………………………………………...149 5.5- Conclusion……………………………………………………………………..151 Chapter 6- Shariah Perspective of Market Abuse and Prohibition of Abusive Speculation 6.1- Introduction……………………………………………………………………152 6.2- Philosophical underpinning of Shariah based Market Abuse Framework….....152 6.3- Prohibition of Insider Trading in Islam………………………………………..157 6.4- Prohibition of Market Manipulation in Islam……………………………….....161 6.5- Shariah Compliant Contractual Structures minimises Abusive Spculation …...168 6.6- Equity versus Debt based Products: Does Interest facilitates Abusive Speculation in Securities Markets? ……………..………………………………………….169 6.7- Shariah Principles and Market Abuse through Derivative Products.………….184 6.7.1- Introduction………..…………………………………………………....184 6.7.2- Non-Shariah Element of Derivatives……………………………………186 6.8- Does Non-Shariah Elements in Derivative Products Facilitate Market Abuse?.187 6.8.1- Deferment of Payment and Delivery Creates Excessive Gharar Leading to Market Abuse…………………………………………………………....188 6.8.1.1- Shariah Principles Reduce Market Abuse………………………189 6.8.2- Lack of Ownership, Possession and Delivery of Objects Facilitate Market Abuse…………………………………………………………………… 193 6.8.2.1- Do Short Sales Leads to Market Abuse……...............................196 6.8.2.2- Is there a Shariah Approach to Short sales which can Reduce Market Abuse?.............................................................................200 6.8.3- Derivative Speculation Contravenes Shariah and Facilitate Market 5 Abuse?.......................................................................................................205 Chapter 7- Critical Evaluations and Conclusion 7.1- Introductions………………………………………………………………….. 224 7.2- Comparison of Rationales of Prohibition of Insider Tradingin UK and US with Shariah Principles of Shariah…………………………………...…..........................224 7.3- Comparison of Rationales of Prohibition of Manipulation in UK and US with Shariah Principles …………………………………………...……………………..229 7.4- Conclusion……………………………………………………………………..233 Bibliography ……………………………………………………………………….237 6 Abstract Investor protection is the essence of Islamic banking and capital markets. Shariah aims to promote fairness in the exchange mechanism, prohibit abuse, exploitation and harm, protect investors and safeguard public interest. The purpose of this thesis is to explore and compare Shariah’s principles for investor protection from market abuse with the rationales and theories of prohibition underpinning the UK and US legal market abuse framework in securities markets. Shariah takes a completely different and a very comprehensive approach in combating market abuse. It takes a two pronged approach. Firstly , it propounds compliance and incorporation of ethical principles, Quranic proscription, and Prophetic commandments in the legal framework which prohibit market abuse before it occurs. Secondly, its unique contractual structures facilitate fair exchange. The product innovation incorporates ancient contractual structures as building blocks with inbuilt safety features to curb abusive speculation, manipulation and distortion in the price formation mechanisms. These principles and contractual structures successfully safeguarded the interest of participants in one to one transactions in barter based ancient markets in Mecca and Medina. The thesis analyses the validity of the aforementioned approach in regulating market abuse in impersonal trading in