The purpose of this paper is twofold. First, we review the market mani
pulation literature in the context of corporate finance and study its
implications for financial management. Second, we provide a new perspe
ctive on corporate finance theory, viewing the corporation as a ''mani
pulator'' of its share value. This second motivation provides a unifyi
ng framework for corporate finance and it provides some new insights.
We define manipulation to be the process of trading the firm's shares
in a manner such that the share price is influenced to the advantage o
f the trader. There are three types of manipulation: (i) action-based,
i.e., manipulation based on actions that change the actual or perceiv
ed value of the assets, (ii) information-based, i.e., manipulation bas
ed on releasing information or spreading false rumors, and (iii) trade
-based, i.e., manipulation based on size of orders when buying or sell
ing. We analyze the growing literature on market manipulation from a f
inancial management perspective, based on the following three maintain
ed hypotheses: (i) the corporation maximizes the wealth of price-takin
g shareholders; (ii) no agency problems exist between the price-taking
shareholders and the management of the firm; and (iii) the corporatio
n is an entity whose activities influence the prices of its bonds and
equities, i.e., it is a ''manipulator'' of its shares in the sense of
the above definition. The first hypothesis is a refinement of the stan
dard assumption. The second hypothesis concerning agency costs is impo
sed for convenience. Its relaxation is the subject of subsequent resea
rch. Finally, the third assumption is a reasonable description of corp
orate behavior.We derive two propositions. The first proposition is th
at the corporation should manipulate its share price to maximize price
-taking shareholder wealth. As a corollary to this proposition, existi
ng corporate finance theory can be deduced. For example, action-based
manipulation yields the theory of capital budgeting, and the real effe
cts of financial structuring decisions, i.e., Modigliani and Miller. I
nformation-based manipulation includes the signalling theories for deb
t/equity optimality, i.e., Ross, and Leland and Pyle, and dividend pol
icy, i.e., Bhattacharya, and Miller and Rock, as well as asymmetric in
formation models like Myers and Majluf. Finally, trade-based manipulat
ion yields the market-completeness models of Green and Jarrow, and oth
ers. Our second proposition is that the corporation should act in a ma
nner so as to minimize the manipulation of its shares by others. This
follows because manipulation by others reduces the price-taking shareh
olders' wealth as they either buy at prices which are too high or sell
at prices which are too low. The application of this proposition gene
rates new insights into corporate finance. First, the corporation need
s to guard against action-based manipulation by others. The papers by
Vila and Bagnoli and Lipman study the takeover market for a firm's sha
res, and show how it can be manipulated. Fishman and Hagerty look at t
he mandatory disclosure requirements for insiders and show how manipul
ation opportunities are generated by these provisions. Actions that th
e corporation can undertake to avoid these situations are discussed. S
econd, the corporation needs to guard against information-based manipu
lation by others. The papers by Vila and Benabou and Laroque give exam
ples of such manipulations. The corporation can protect itself from th
is type of manipulation by releasing firm-specific information, both g
ood and bad news, in a timely fashion. Honesty is the best policy in t
his regard. Third, the corporation needs to guard against trade-based
manipulations. Models of this type of manipulation include Hart, Jarro
w, Chatterjea and Jarrow, Cherian and Kuriyan, Allen and Gorton, and G
erard and Nanda. This type of manipulation occurs when there are asymm
etries in the buying and selling of shares. A corporation should smoot
h its equity purchases/sales over time to minimize these occurrences.
This implies that there are benefits to low debt/equity ratios, bank l
ines of credit, and stable dividend patterns. These benefits suggest t
hat them may be an optimal intertemporal liability structure for the f
irm. This analysis, however, awaits subsequent research. For a listing
of the references included in this executive summary, the reader is d
irected to page 208 of this issue.