MARKET MANIPULATION AND CORPORATE-FINANCE - A NEW PERSPECTIVE

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.