The Big Squeeze

On April 13, the Securities and Exchange Commission filed a complaint in the United States District Court for the Central District of California charging several defendants with manipulation of the stock price of GenesisIntermedia, Inc. (GENI). The complaint alleged that the manipulation scheme resulted in the misappropriation of more than $130 million, the collapse of several broker-dealers, and the largest bailout in the history of the Securities Investor Protection Corporation (SIPC).

SIPC was created by Congress in 1970 to insure investors’ funds which are under the control of financially distressed brokerage firms. SIPC achieves this by returning non-negotiable securities in the name of the investor to the investor, and by satisfying the rest of an investor’s claim up to $500,000; a maximum of $100,000 cash claim may be restored. In short, SIPC is the capital markets’ equivalent of the FDIC.

The scheme began with acquiring the capital: the principals of GENI wanted to raise cash quickly, based on the value of their company’s equity. They formed a holding company called Ultimate Holdings to unload the equity shares, and they approached Deutsche Bank Securities, Ltd. about trading the shares for liquidity. Deutsche would not accept the stock from anyone but a broker; therefore, the GENI principals through Ultimate Holdings approached Native Nations, a broker-dealer, to facilitate the transaction. Once Native Nations went to Deutsche, Deutsche approved the loan of money in exchange for shares.

The share price acted as an index by which to measure the appropriate measure of capital allocated to Ultimate Holdings. It had similarities to a revolving line of credit, in that funds distributed to Ultimate Holdings based on the security in the collateral were not distributed in one some based on market value or other valuation method at time of loan; rather, Ultimate Holdings’ debits and credits with the broker-dealers fluctuated with the ever-changing price of the shares. This is called being “marked to market.” Marked to market is essentially recording the price or value of a security to the market value of the security, rather than the book value of the security. It is a practice which originated in the derivatives market but has since been expanded to use in corporate accounting and banking. Its most notorious use occurred in the accounting practices of Enron.

The scheme’s structure provided an incentive for Ultimate Holdings and its actors to attempt to influence the price of the shares. The greater the price of the shares, the more money owed to them.

What would have been the exit plan? Could there ever have been a way in which they could have caught up? If they only expected to make money via the price of the shares, they could never have caught up. If their only source of income was the shares on which they owed money, their balance ultimately would have dropped to zero – or worse. How much of the market in those shares did they control?

They could have controlled the price of the shares via supply and demand, via perceived notions about the strength of the company – this last option could implicate price-earnings ratio, and other gauges of corporate health. Options on the shares?

If the shares are loaned, then how would the other parties make money? Deutsche would make money because the shares were ultimately in their possession. They would make money by having the ability to pledge or otherwise hypothecate the shares to another party. Assume for instance, they paid out to Ultimate Holdings (through “Native Nations”) $130 million for shares of GENI. They have paid the market value. If Deutsche then placed those shares on the open market, assuming they could, they market value is $130 million. They are no better off than they were before. However, they can make money on this if the shares go up between the time that they acquire them and the time that they transfer ownership. They simply have bought low and sold higher. However, there is a problem with this assumption as it relates to this problem. If the stock price rises, Deutsche is supposed to transfer that difference in value in the collateral to Ultimate Holdings. Therefore, Deutsche is still stuck at $0. Even the only scenario in which Ultimate Holdings is supposed to transfer cash back to Deutsche garners no measurable gain to the bank – the shares they hold as collateral have declined in value.

Where is the difference in value that makes this a profitable transaction for Deutsche? The first party to which they can turn is the open market. There will be no profit from buying low and selling high. However, for each transaction, there will be a fee (maybe even multiple fees). Those fees are where they can make a profit. Second, they can turn to Ultimate Holdings itself. While each party is arguably on equal footing (transferring to each other party a thing of equivalent value with a promise to maintain parity through subsequent cash transfers), one party is the lender and one party is the borrower. One argument favors Ultimate Holdings as the lender; after all, they did lend the shares to Deutsche, and Deutsche will ultimately be obliged to return those shares.

However, another argument militates in favor of Deutsche as the lender and Ultimate Holdings as the borrower. At first blush, this transaction looks simply like a cash loan from a large bank to a party (Ultimate Holdings) which needs cash and pledges assets (shares) as collateral in case of default. Even if this is viewed as something of a revolving credit line with regular cash transfers pegged to the value of the collateral, one party holds the collateral and the other party credits or debits cash to or from its account based on that collateral.

For the sake of simplicity and the likelihood of this being the correct course, assume that Deutsche was the lender and Ultimate Holdings the borrower. For a cash loan, a lender will generally require a payment of interest from the borrower for temporarily sacrificing present liquidity. This goes to the time value of money. (The time value of money is, roughly defined, how much more valuable money is today, rather than later. It is comprised of present value and future value, and the correlation between the two is defined as the discount rate. The discount rate is the rate earned from lending money for one year).

This path will permit Deutsche to make money on the transaction. In this stock-lending context, the fee is called a rebate. Alternatively, they could charge a flat fee for providing the service. Of course, the principal will, in this case, fluctuate, but fluctuating principal has never obstructed reliable, accurate calculation of interest.

Why would Ultimate Holdings engage in this sort of float? Ultimate Holdings arguably has nothing to gain. They lend their shares, and they receive cash. At some point in the future, Deutsche will demand repayment. Ultimate Holdings will have received, for example, $130 million, and they will repay $130 million. Even if the share values have increased, Ultimate Holdings will already have received its monetary benefit for that gain. They are stuck at $0. However, the principal that warrants the payment of interest of Deutsche (loss of liquidity) cuts both ways. Just as Deutsche has lost the value of playing with a certain quantity of money, Ultimate Holdings has gained the value of playing with a certain quantity of money (gain of liquidity).

Ultimate Holdings’ liquidity gain could not have occurred if they had merely held on to their own shares. The value of their shares is, other valuations excluded, the equity in their business. In accounting terms, equity in a business is the difference between assets and liabilities. However, if the equity in a business is not liquid, it is difficult – albeit, not impossible – to leverage that equity in further gains. In order to make those other gains, Ultimate Holdings had to convert that equity into liquidity. They could do this in a number of ways. Two simple ways are selling and lending. In this case, Ultimate chose to lend the shares. Why not sell them? First, selling shares of one’s own organization is not an easy process. If your organization is not in the business of issuing shares of stock, then economies of scale and marginal costs militate against the efficient issuing of shares by your organization; in terms of time, energy, and sheer money, it is a costly process.

The second problem with issuing one’s own shares is partially an offshoot of the first reason regarding cost – issuing equity means issuing securities. The industry of issuing securities is, by virtue of the Commerce Clause, and ultimately, the Securities Act of 1933 and the Securities Exchange Act of 1934 and the resulting authorities, a complex and, therefore, costly process. Errors in this process will not only hurt a company’s balance sheet; they could also result in civil action, criminal prosecution, and possibly the demise of the organization (unless you’re Google and you’re in Playboy).

Deutsche, by virtue of its position as a bank in the business of dealing in securities, and by virtue of its reputation and market presence essentially eliminates all of these concerns for a company situated as was Ultimate Holdings. Ultimate Holdings provided assets and received readily-available liquidity, from which they hoped to make money; Deutsche provided a service, receiving a fee, and received assets from which they hoped to make money.

So why lend the shares to Deutsche instead of selling them? If Deutsche sold the securities, Deutsche would have been in the position of an underwriter. This increases both its liability and its costs. Moreover, when Deutsche entered into the transaction, the shares were not worth very much Which makes more sense? Incur all the costs of underwriting service for a deal which is going to cost more than it is worth? Or simply exchange some short-term liquidity for a small, but profitable fee? The answer is obvious.

(Note: for purposes of this entry, Ultimate Holdings is the entity discussed; Ultimate Holdings was, as stated earlier, a holding company, a dummy company and alter-ego of the owners of GENI, the company whose shares were at issue).

Something else is worth noting: during its life as a public company, GENI lost approximately $160 million; it never turned a net profit. On its merits, therefore, GENI could not have issued its stock and expected to make a profit on its shares. Quite simply, any further investment by any investors would have amounted to throwing good money after bad; rational investors would not have poured money into the stock based on fundamentals. GENI’s share prices could move up only through irrationally positive perceptions about the stock, or through market manipulation. And move up it did. Between GENI’s IPO on June 14, 1999, and just prior to its collapse in September 2001, GENI’s share price rocketed up from $2.83 per share to $25.00 per share. (At the time of its collapse, the shares were virtually worthless – at pennies per share).

GENI tried both tacks. First, it paid a financial commentator to disseminate baseless, positive reports about the company, thereby driving up demand for the stock. Second, GENI itself attempted to manipulate the market; this second route was designed to limit supply, prop up the share price and, thereby, the stock float with Deutsche, thereby pumping cash into Ultimate Holdings, and back into GENI. Besides being fraudulent, the first tactic is not reliable per se. Even after the fraudulent reports have been disseminated, buyers still have to snap up the shares and boost the price. The second tactic is quite effective, and in some regards cannibalistic.

The second route worked this way: Ultimate Holdings and its related parties prevented Deutsche from lending the stock to other parties. Additionally, when Native Nations took stock back, they held onto it, and GENI and Ultimate Holdings even snapped up stock on the open market, using proceeds from the stock loans themselves, to squeeze supply, and conversely, to increase demand and the share price. These acts also had the effect of preventing other parties – i.e.: speculators – from selling short the GENI stock and driving the share price down (which would have forced GENI to return the loan money).

Besides being fraudulent, the scheme had no exit strategy. Every part of the scheme was designed to keep the price of GENI stock at a certain level. At first, the stock loan proceeds may have funded the actual activities enumerated in the GENI corporate charter. Such activities, in theory, could have led to actual profits, and thus created a way for GENI to pay back the loans, market its shares, and exit the scheme. By the time the company collapsed, however, any money GENI took in from the scheme was used to pay for the scheme – in short, the python feasted on its own tail, making a loop that drew ever tighter, until there remained no room from which to extricate oneself.

The above entry does not constitute legal advice.

For Sale – Independent, Untouchable, Incorruptible Research

By now, everyone knows the “O” lady. Sometimes, it’s about the office, sometimes, it’s about the gOOOOld, and sometimes, it’s about pretending that you’re not thinking about what you want her to do with that tennis racket.

Sometimes, however, it’s all about the market manipulation. Overstock.com has alleged that one research did just that, filing a complaint with the SEC. The complaint alleged that a stock-research firm, after researching Overstock’s stock, tweaked its conclusions about the online retailer’s future performance. Overstock alleged that the research firm, Gradient Analytics, Inc. made changes to its conclusions at the request of a hedge fund, Rocker Partners, LP.

Why does this matter, and what reason could any of the parties have for doing any of these things? First, research firms, or firms that are dubbed research firms are supposed to conduct independent research. Investment firms of various types and shades then pay these research houses for the independent research and make investment decisions accordingly.

Hedge funds purchase this research. More so than other parties buying up the product of research firms, however, hedge funds engage in riskier investment strategies. They are more highly leveraged than other investment firms, they buy and sell more derivatives than other firms, and they sell short on positions more often than other firms. In short, they pursue much riskier bets, and they put down more money on each one. If they win, they’re heroes, but if they lose, the result is catastrophic.

Add to this volatile mix the fact that research firms have high overhead. They receive money on the back end – that is, after they’ve performed the research; to do otherwise would compromise their independence (i.e.: research to order). Additionally, independent research is highly fungible. Further, good research is very expensive (e.g.: tens of thousands of dollars per year for a subscription). Each firm, in order to make the sale and get the order to make up for all the money they’ve already burned must distinguish themselves from other research firms. They must provide added value. Or they must provide less rigorous research for a lower price, and possibly open to manipulation. And yet another alternative in the research game was played by institutional investors channeling portions of commissions to research firms in the form of “soft dollars”– the better the institutional investor did, the better the research firm did.

Some parties are only too willing to pay for that added value – whether it comes in the form of adjusted results or a lower price. As with drugs that bind to the vacant nerve receptors of glassy-eyed addicts and compromise the receptors’ ability to bind with organic compounds, so too with hedge funds that are willing to pay a premium to research firms with vacant checking accounts, thereby compromising their ability to sell an untainted product to blind parties. Gradient, however, counters that no one would want a biased report, especially in light of the money firms are paying for those reports; second, it would be bad for independent research. This is a nice thought, yet it presupposes what it seeks to prove – “Bad things aren't done by good people, and we haven't done any bad things, so we must be good people.”

However, assuming the initial thesis is true, Overstock alleged that certain hedge funds paid Gradient extra money to alter their research conclusions to conform to the bet that the funds had made. The complaint alleges that the hedge funds had sold short shares of Overstock – to wit, that Overstock share prices would go down.

Why would the fund do this? The fund has already made the bet. However, success or failure of the bet rides on how the rest of the market perceives the stock. Essentially, because of the nature of a short sale, the fund needs a market where they can go at the appointed time of the short sale, and buy up shares cheaply. A short sale occurs when a party that does not own a stock borrows the stock from a party that does own it, and sells the stock to someone else for a given price; the short seller makes his money when the price of the stock drops by the time he must buy up that stock in the market and give it back to the party from whom he initially borrowed it; his profit is between the high price for which he sold the shares, and the low price for which he bought them up to repay the debt. A few notes regarding short selling. First, the potential for profit is very narrow. While a stock price can go up with no limit in theory, the share of a price can only go down so far – to $0. Further, because the profit is limited, short sellers must place a large amount of money on the bet. If the share price drops, as they bet, they recoup their costs and then make the profit in the difference between the advance sale and late purchase. If they lose, however, and the stock price jumps, they must purchase all of those shares for whatever price the market currently dictates. Liability is, therefore, infinite.

Another theoretical problem is that, while the bet is for share prices to decline, share prices generally increase. This, however, is offset by the fact that in the short term (which is how long the bet of a short sale lasts) stocks are equally likely to go down as go up. Further, if share prices do increase in the short term, they do not increase significantly, thereby limiting the loss.

A practical problem goes to the borrowing aspect of short sales. Because there is a loan of shares involved, there is, as in all other loans, interest charged. Overstock shares, for instance, commanded an interest rate of 24% on the loan. In the problem alleged by Overstock, the high interest rate does provide support for the allegation that research was fudged – not only did the Rocker fund have to win, they needed to win big.

If the rest of the market believes that Gradient’s research is an independent, good faith prediction that Overstock will go down, there will be a race to the bottom, to see who can unload Overstock shares the fastest. The hedge fund which paid for the report will have created its market and will succeed on its bet.

Can a hedge fund create a market? Absolutely. Because of the size of hedge funds and the capital they can throw around, the question is not so much, “Can a hedge fund create a market?” but rather, “How big will the market be?” Further complicating this problem, hedge funds, while regulated, are in the nascent stages of only minimal regulation. They are still largely opaque, scooping up large packets of capital from an increasing number of investors while revealing remarkably little about themselves in the process. The exchange is not quite even.

Short selling, like nearly all other capital market activity, is regulated. Doing so makes sense, particularly in light of the fact that short selling only works when stock prices decline; were everyone to sell short, stock prices would all be driven inexorably down, and with all share prices at $0, all equity would be lost. Markets would have failed. (Arguably, the need for regulation in place of the invisible hand means that markets have failed already anyway, but that is a topic for another day). As a result, Congress gave the SEC authority to regulate – but not entirely ban – short selling in Section 10(a) of the Securities Exchange Act of 1934. Under this provision, the SEC has promulgated four rules to regulate short selling.

Rule 3b-3 defines a short sale. A short sale is any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller. Rule 10a-1 prohibits a short sale in a falling market. A person may not effect a short sale of any exchange traded security, wherever traded 1) below the last reported price at which such security was sold, regular way; or 2) at the same price, unless that price is above the next preceding price at which a sale of such security, regular way, was reported. Put another way, short sales may not occur on a minus tick or a zero-minus tick. They may be made on a plus tick or a zero-plus tick. A plus tick occurs when the last previous sale price is lower than the price at which the short sale is effected. A zero-plus tick occurs when a short sale is effected at the same price as the last previous price, provided that price is higher than the preceding different sale price of the security. These rules are security specific; that is, the market may be going down, but as long as the security is on a plus tick or zero-plus tick, the short sale may be effected.

Rule 10a-2 prescribes the methods used in covering a short sale (when the short seller buys the necessary shares back to repay the original loan of shares). Rule 105 of Regulation M prevents manipulative short selling of securities in anticipation of a public offering of those same securities. Rule 105 applies to short sales during the five business days prior to the pricing of an offering; as to these short sales, it is unlawful to cover short sales of equity securities of the same class as securities offered for cash pursuant to a 1933 Act registration statement.

The accusation against Gradient is both bold and serious. It is accusing Gradient of pimping itself out, and violating the trust placed in it by market players, as well as violating its fiduciary duty, and a host of securities laws and regulations. If proven true, it could spell the end of the organization, and it would implicate various parties. It would also likely create the second tremor in securities research in five years – the first coming after the dot-com bust of the early 21^st century, when it was discovered that research and investment were bedfellows and outlooks were driven not by probing inquiry but by sales goals. After all, as recently as 2003, the major players on Wall Street agreed to overhaul a system plagued by conflicts of interest. So, is there evidence to support these allegations?

It is true that Overstock’s share prices have dropped precipitously since their public debut in 2002. Trading at more than $75 per share in 2004, they hovered in the low $20s in late February of this year. Analysts predict Overstock will lose $31 million this year, and its share price dropped 40% between October 2005 and March 2006. However, Overstock’s share price rose threefold during the time that Gradient covered it, and even after its long fall, is still higher than it was when Gradient began covering it. This weighs heavily against Overstock’s allegations. However, Overstock could quickly counter that the players in this game are sufficiently sophisticated that they could still corrupt the information, win the bet, and leave room above the original share price, thereby chipping away at Overstock’s allegations. Yet, other research firms complain of lawsuits which claim they filed negative reports on companies for which they never actually wrote reports; with a narrow profit margin already, strike suits (i.e.: nuisance suits) are sufficient to drive a research firm out of the market. Often, funds filing these suits are only after the sources used by the research firms.

Moreover, stock prices fluctuate wildly all the time, and this practice, of purchasing corrupt research to bet on a race that, for all intents and purposes has already been run, is easy to explain, and even easier to conceive and execute. Yet, other corporations with publicly held shares that do not perform exceedingly well, are not as quick to make these allegations. Why Overstock?

There is a second issue that made this case notable. The SEC, investigating these claims, subpoenaed two journalists from Dow Jones & Co (i.e.: The Wall Street Journal). Why subpoena journalists? Because, the theory goes, sources tell journalists material information about capital markets, market players and other interested parties, and journalists then share that information with their readers, listeners and viewers; in short, those wishing to manipulate the market are using the media as their tools to do so.

This manipulation and the subpoenas of journalists, in and of themselves, are not so uncommon as to merit attention; however, in the wake of the Judith Miller/Valerie Plame affair, increased public awareness and sensitivity to the issue will constitute a bigger story, sell more newspapers, and facilitate drumming up sympathy with journalists and against large, federal entities with subpoena power. Whether that sympathy is warranted or not is another matter.

Twenty days after the subpoenas were served, however, SEC Chairman Christopher Cox denied any prior knowledge of the subpoenas, promising an investigation into the investigation. Amid a debate that the SEC’s enforcement division operates too independently – “cowboys” come to mind – he reproved his staff publicly, although there was no mention in the media of his withdrawing the subpoenas – only that the SEC would not seek to enforce them at the time.

Complicating this story further, Biovail Corp., a pharmaceuticals firm, filed a lawsuit in February against SAC Capital Management, LLC, an $8 billion hedge fund, David Maris, a Bank of America Corp. research analyst, and yes, Gradient Analytics, the independent stock-research firm noted above. Like the Overstock allegations, this lawsuit also alleged that different parties had conspired to drive down the price of the Biovail stock. It is worth noting that Biovail’s stock did decline more than 50% between 2003 and spring 2004. As a result, the SEC subpoenaed Gradient with regard to communications between it and journalists and other parties. This would complement the subpoenas that the SEC had served on several financial journalists and then put on hold after media outcry. Banc of America Securities LLC responded by terminating research coverage of Biovail.

There are those who argue that if the stock is going down, it must owe to the market manipulation of a conspiracy between hedge funds in the analysts in their pockets. However, there are those who point out that rather than any conspiracy, these companies merely have poor fundamentals, and short sellers, as they have been in the past, most notably with the Enron stock, are right in their evaluations of a company’s fundamentals and correct in their predictions about the direction of its share price. Rather than any conspiracy, this is really a story about the success of the efficient free market hypothesis and a group of investors who fundamentally understand it and know how to apply it. Casting further doubt on the merits of the Biovail suit (and, collaterally, on the Overstock suit), is that Biovail tried the same tactic in 1996; they did not lose, nor did they win – they settled out of court, with Biovail agreeing to invest in the hedge fund that was the target of the suit.

Further, as some writers have been bold enough to point out, hedge funds, since their entry to the market, have been traditional and convenient scapegoats for the rise and fall of financial markets and those who negotiate their waters. Again, nodding to their relative opacity, this is not entirely surprising, nor given their dazzlingly brilliant returns over the past decade – like money, envy is green, and a powerful motivating force. Moreover, insiders assert that the allegations are not entirely without foundation: hedge funds are bold in publicizing their predictions, and according to some analysts, have even pressured them to write reports that coincide with funds’ strategies. Such reports are called “hatchet jobs.”

Strangely enough, Gradient has already fired the analysts at issue.

The above does not constitute legal advice.

For Honor or Money

In his History of the Peloponnesian War, Thucydides intoned “My work is not a piece of writing designed to meet the taste of an immediate public, but was done to last forever.” In “Pericles’ Funeral Oration” in Book Two, Thucydides accomplishes that, and while Pericles’ acclamation for the honored Athenian dead eschews commerce for nobler topics, his words are as appropriate in this contemporary journal as they were more than two millennia ago:

“One’s sense of honor is the only thing that does not grow old, and the last pleasure, when one is worn out with age, is not, as the poet said, making money, but having the respect of one’s fellow men.”
-from Thucydides, History of the Peloponnesian War, Book Two, tr. Rex Warner, Penguin Classics 1954.

Reach Out and Cheat Someone…

Did you hear the one about the long-distance call that actually paid for itself? A long time ago, in an overtly monopolistic telecoms environment that might have been an impossibility. Even now, it would be difficult, but if the party at one end of the line has a plan, and the party on the other end of the line has nothing but good news, it is a real possibility.

On March 21, the SEC announced that it had filed a civil injunctive action against A.B. Watley Group, Inc., and eleven individual defendants in the Eastern District of New York. One of the defendants was a former broker at Merrill Lynch, and the other ten were day traders and management at A.B. Watley, a broker-dealer. The SEC charged all defendants with violations of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. They charged one individual defendant with aiding and abetting violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Finally, the SEC charged all defendants except for Watley with aiding and abetting A.B. Watley’s violations of Section 15(c) of the Securities Exchange Act of 1934. The complaint sought disgorgement of illegal profits, penalties, and an injunction against future violations against the defendants, in addition to officer and director bars against three other individual defendants.

There are two questions that need answering – first, what did the defendants do to warrant such special treatment, and second, what does the above mean?

What Does the SEC Complaint Allege?

The SEC alleges that A.B. Watley, Inc., several of its employees, and several employees of other, larger firms conspired in a fraudulent scheme to trade ahead. Day traders would call brokers they knew at larger firms, such as Citigroup Global Markets, Lehman Brothers, Inc., and Merril Lynch, Pierce, Fenner & Smith, Inc. The brokers at the larger firms would pick up the phones and leave the phone connection open; as a result, the day traders at Watley could hear the background noise at these larger firms. Normally, background noise is not premium content; normally, however, there is not a squawk box in the background.

A squawk box is used to broadcast customer orders to buy and sell large blocks of securities. This would regularly be material, nonpublic information. Brokers at each of the larger firms would receive this information about fairly significant trades by institutional investors, trade accordingly, and their respective institutions would profit. Any person, institution or other party not privy to this trade would not benefit from this trade – at least not directly.

However, the confidence in which such squawk box orders are kept and the propriety of that information are compromised when another party is there to hear them – or when that party can hear them over the phone. Traders at Watley would use the open phone line to listen to the orders coming over the squawk boxes. After overhearing the orders in the background at the larger firms, Watley day traders would trade ahead of the brokers at the other, larger firms. Trading ahead is defined as trading from one’s own account even thought there is a public order that offsets the account.

(Normally, activity defined as trading ahead is confined to activity conducted by specialists. This is a natural corollary of the structure of markets. In stock markets, each stock has a market that is made by a “market maker” or “specialist.” The specialist is the sole person – or one of the few people – who deals with that particular stock on the market. Something else should be noted: in a perfect market, when someone purchases a stock, the price of the stock goes up; when someone sells the stock, the price of the stock goes down. When an investing party wants to purchase or sell shares of Stock A, he must go to the specialist in Stock A with his order, and the specialist will place the actual order for him. Further, because the investor is buying or selling the stock based on the most current information available, the assumption is that the specialist is going to be placing the order based on the same information available to the investor. If the specialist purchases or sells the stock on his own account before he places the order for the investor, there are several problems: first, he is no longer a neutral party, contrary to his original representation; second, as a market participant – instead of a neutral party – he is trading on information that is not available to the investor, i.e.: that the price of the stock is about to go up or go down; third, he places the investor’s trade in a market that is now less favorable to the investor than the market that existed when the investor approached the specialist (share price has gone up or down in a manner not envisioned by the investor); and fourth, he has not acted for the investor’s benefit, for which he was paid, but has acted to the investor’s detriment, for which he was not paid, but for which he receives compensation anyway. When the specialist places his own order on his own account in the stock ordered by the investor, he deceives the investor in three ways, he defrauds the investor in three ways, and he breaches a very real and very legally binding fiduciary duty that he owes to the investor).

The Watley traders would purchase, sell, or short (or a combination of these) the shares of the stocks which were the subject of the institutional orders broadcast over the squawk boxes. They would do this before the brokers at the larger firms had a chance to either place the order or place the entire order. As a result, the Watley traders would purchase a stock before the price rose, sell a stock before the price fell, or could short it with the confidence that their bet would be right.

That is the crux of the problem here. Whatever position the Watley traders took, they knew the ultimate outcome of their trades. It is, to paraphrase New York Attorney General Eliot Spitzer, betting on a horse race that has already been run. The basic premise behind efficient capital markets is that all players in the market have the same information or, at least, have access to the same information. Or, barring that positive premise, no one player in market has the definitive piece of information – the knowledge beyond some reasonable certainty about how each share is going to trade, up or down and by how much, at the end of the day – or no one knows they have that piece of information.

This premise about information is at the core of securities laws. Securities laws create a “disclosure regime.” Securities laws do not dictate an equal result for all market participants; rather, they ensure that at the beginning of the day, everyone in the market has the same information, or has the same access to that information – and that any lack of access is due to constitutionally permissible reasons, i.e.: lack of economic resources.

The logical corollary of the efficient free market hypothesis is that any distortion in market information (e.g.: one party knows with certainty the direction of a certain stock and trades on it) creates an asymmetry of information and either chips away at or entirely destroys the efficiency of the market. So, not only does a party’s unequal (and secret) access to information offend notions of fairness, justice, and playing by the rules, it has a theoretical consequence of actually destroying the game everyone else is playing, the free market, and the profits that are associated with the efficiencies it should normally create.

Watley acted in direct contraposition to this hypothesis. While no one is supposed to know the outcome of any trade they make, Watley knew the outcome of every single trade they made. Theoretically, this is appealing. As efficiencies in the market disappear, inefficiencies appear in the market and manifest themselves in two ways – losses (or lesser profits) to the original investor and intended beneficiary of the trade and as profits to Watley. Practically, the game the Watley traders is very appealing. By itself, a 25-cent increase in share price is not particularly appealing; there’s probably more loose change rustling around in any of the trader’s sofa cushions. However, the Watley traders weren’t dealing in just one share. They were placing bets on orders by institutional investors. Any given order could easily implicate 500,000 shares. A 25-cent increase multiplied by half a million shares comes out to $125,000. Executed in twenty minutes, as these trades were, that figure extrapolates to about $375,000 in an hour – not exactly chump change anymore. To put that in perspective, that’s a year’s worth of billable hours for three first-year attorneys at the country’s largest and most prestigious law firms (roughly 6500 hours). This illustrative example aside, the SEC complaint alleges that between June 2002 and February 2004, the Watley traders placed over 400 trades based on information from one group of brokers as part of this scheme, making over $675,000 in gross profits. Between October 2003 and January 2004, they picked up another $25,000 in gross profits based on information from another source involved in this scheme. Further, they made millions of dollars in processing fees and trading fees.

With so much cash sloshing around, how did the Watley traders keep the lid on? They did this in the same way that they acquired access to the open phone line in the first place – money. Watley paid the brokers at the larger institutions money to give them access, and presumably to remain silent about the scheme, as well as do what they could to cover it up. The money was a commission of sorts, a share of the profits, or in the vernacular, a “bribe.”

What Was the Nature of the Prosecution?

The acts summarized above resulted in prosecutions of the defendants for violations of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, as well as aiding and abetting violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and finally, aiding and abetting A.B. Watley’s violations of Section 15(c) of the Securities Exchange Act of 1934. All told, the SEC made fifteen claims for relief. The SEC sought to disgorge all “ill-gotten gains received as a result of the violations alleged” in the complaint. Further, the SEC ordered the defendants to pay civil money penalties pursuant to Section 20(d) of the Securities Act, and Sections 21(d) and/or 21A of the Exchange Act. The SEC also sought to enjoin all defendants from future violations of the rules which they were alleged to have violated in the complaint. Finally, the SEC permanently barred three of the defendants from serving as an officer or director of any issuer that has a class of securities registered under Section 12 of the Exchange Act or that is required to file reports pursuant to Section 15(d) of the Exchange Act.

What does all this mean? Let’s start with the simplest and strongest relief sought. First, the SEC sought a civil injunction. What is the effect of an injunction? When a court enjoins a party from doing something, they issue an injunction against the party. The party is forbidden from doing that thing. If that party is forbidden by the court from doing that thing and then does that thing, the party has violated the injunction. A party who violates an injunction is held in contempt of court. Contempt of court is punishable by imprisonment.

There are sensible reasons why the SEC would seek this civil injunction. First, the burden of proof in a civil proceeding is lower than that in a criminal proceeding. In a criminal proceeding, a prosecutor must prove something beyond a reasonable doubt – in layperson terms, probably more than 90% or 95% likely that the accused party is guilty of doing the thing alleged. In a civil proceeding, the party who brings the allegations only has to prove something by a preponderance of the evidence – in layperson terms, probably about 51% or so likely that the accused party is liable for doing the thing alleged. This allows the SEC to more efficiently prove that the accused party is at fault, and still hang the threat of prison over the head of the defendant without actually having to meet the burden of proof required in a criminal proceeding – which is where the threat of imprisonment would normally lie.

Below is the text of some of the securities laws under which the defendants here were prosecuted:

Section 17(a) of the Securities Act states that: It shall be unlawful for any person in the offer or sale of any securities or any security-based swap agreement (as defined in Section 206B of the Gramm-Leach-Bliley Act) by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly – (1) to employ any device, scheme, or artifice to defraud, or (2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or (3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.

Section 10(b) of the Securities Exchange Act states that: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national security exchange – To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any security-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act), any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

17 CFR 240.10b-5 Employment of Manipulative and Deceptive Devices (Rule 10b-5)

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, (a) to employ any device, scheme or artifice to defraud, (b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Section 15(c) of the Securities Exchange Act of 1934 states that: no broker or dealer shall make use of the mails or any means or instrumentality of interstate commerce to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security [exceptions omitted] otherwise than on a national securities exchange of which it is a member, or any security-based swap agreement (as defined in Section 206B of the Gramm-Leach-Bliley Act) by means of any manipulative, deceptive, or other fraudulent device or contrivance. This section of the statute also covers dealers in municipal and government securities, as well as such municipal and government securities and swap-agreements based on such.

Section 15(c) goes on to forbid similar conduct for the same types of securities when the broker or dealer engages in any fraudulent, deceptive or manipulative act or practice, or makes any fictitious quotation. Part 3(A) of this section provides the jurisdictional hook, forbidding any broker or dealer from engaging in any type of such conduct “in contravention of such rules and regulations as the Commission [SEC] shall prescribe as necessary or appropriate in the public interest or for the protection of investors.” Part 3(B) of this section provides the Commodities Futures Trading Commission jurisdiction to act on such violations but not in duplication of the SEC’s regulations. Further, Part 4 of this section gives the SEC authority to order parties with knowledge or who should have had knowledge of a compliance failure to properly comply. Part 5 brings within the meaning of the section dealers who act in the capacity of market makers.

Section 20(d) of the Securities Act of 1933 states that: there shall be monetary penalties for civil actions, sets forth the amount, and the manner of collection.

Section 21(d) of the Securities Exchange Act of 1934 states that: the SEC shall have the authority to bring a claim in a United States district court against a party which they reasonably believe has violated the rules of a national exchange or a registered securities association of which the party is a member, or the rules of the Public Company Accounting Oversight Board (PCAOB).

Section 21A of the Securities Exchange Act of 1934 gives the SEC the authority to impose civil penalties.

Section 12 of the Securities Exchange Act of 1934 is a broad provision, but the core is summarized in 12(a): “It shall be unlawful for any member, broker, or dealer to effect any transaction in any security (other than an exempted security) on a national securities exchange unless a registration is effective as to such security for such exchange in accordance with the provisions of this title and the rules and regulations thereunder. The provisions of this subsection shall not apply in respect of a security futures product traded on a national securities exchange.” According to the part 12(g) of the statute, companies that must be registered are those which have more than $1,000,000 of total assets and a class of equity security held of record by five hundred or more persons.

Some Peripheral Problems/Conclusion

One of the more disturbing and yet most telling aspects of this episode is that one of the participants in this scheme was the compliance officer at Watley. What does a compliance officer do? A compliance officer ensures that a person, either real or juristic, who is also a market participant, complies with all applicable securities rules and regulations, whether promulgated by the SEC, the NASD, or any other body with regulatory authority and jurisdiction.

In the wake of the scandals at Enron and other corporations at the dawn of this century, Congress rammed through legislation that was, according to the hype, put an end to the days of corporate malfeasance. Rules regarding liability for participants were buttressed, and the scope of parties who would be liable was expanded. By design, the threat of increased and widened punishment for wrongdoing by the SEC and other regulatory authorities should have pressured the guardians to ensure that no one permits violators to get over the wall. Who are the guardians? The guardians are the directors, attorneys, and officers of these market participants, people who have fiduciary duties to their employers and to their clients, and yes, they include compliance officers. How can you enforce a law when the enforcers are breaking it? How do you guard the sheep when the guardians are trying to eat them?

A compliance officer is mandated by NASD regulations. Failure to have a compliance officer is an event which will be sanctioned by the law. Further, the compliance officer, if he engages in a violation of the applicable laws will be sanctioned not only for the violation itself, but also for violating his duties as a compliance officer. Therefore, each single violation really becomes multiple violations, each of which carries its own penalty, financial and otherwise. However, what is to be done in the meantime? Has the deterrent worked? Would a greater number of players violate the law if there were no such deterrent? Laws are only as strong as the integrity of those charged with enforcing them. And sadly, integrity cannot be legislated.

The above does not constitute legal advice. It is mere conjecture on the part of the person who maintains the blog.