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.