Category Archives: Securities Markets

Third Circuit Adopts “Craven Watchdog” Standard for Extraterriorial Reach of Securities Laws in U.S. v. Georgiou

In United States v. Georgiou, No. 10-4774 (Jan. 20, 2015), the Third Circuit recently applied the Supreme Court’s extraterritoriality ruling in Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010), to a criminal securities fraud conviction.  Georgiou was convicted of securities fraud, wire fraud, and conspiracy for a stock manipulation scheme orchestrated outside of the United States. The court affirmed the conviction, finding that even though the securities trading did not occur on a U.S. securities exchange, it was actionable under the U.S. securities laws because an aspect of the securities transactions was completed within the United States.  A copy of the opinion can be found here: US v Georgiou.

The case involved an alleged classic manipulative scheme to buy thinly-traded stocks, inflate their prices with matched trades, wash sales, and the like, and dump the stocks at the artificially high prices.  Georgiou used brokerage accounts in Canada, the Bahamas, and Turks and Caicos for the manipulative trading.  The stocks were traded over-the-counter on the OTC Bulletin Board (“OTCBB”) or the Pink OTC Markets (“Pink Sheets”).

In Morrison, the Supreme Court limited the application of section 10(b) to the use of “manipulative or deceptive device[s]” in securities transactions involving either (i) “the purchase or sale of a security listed on an American stock exchange,” or (ii) “the purchase or sale of any other security in the United States.”  Morrison , 561 U.S. at 273.  The Third Circuit sought to apply that standard to the Georgiou trades.

The court first considered whether securities listed on the OTCBB and the Pink Sheets are “listed on an American stock exchange.”  It noted that the SEC identifies 18 nationally registered securities exchanges, but does not include the OTCBB and the Pink Sheets.  It also noted that both the OTCBB and the Pink Sheets are self-described as trading mechanisms for securities not listed on any exchange.  Finally, it noted that the securities statutes themselves distinguish between “securities exchanges” and “over-the-counter markets.”  For those reasons, it found the transactions here were not the purchase or sale of a security on “an American stock exchange,” and therefore were not subject to U.S. securities laws on that basis. See slip op. at 13-15.

The analysis then moved to the second Morrison prong: whether these transactions were the purchase or sale of securities “in the United States.”  The court took note of the fact that Morrision involved a so-called “foreign-cubed” transaction – foreign plaintiffs suing a foreign issuer based on securities transactions in foreign countries.  In contrast, the securities in the Georgiou case were those of U.S. issuers, and the transactions involved the participation of “market makers” operating in the United States.

Morrison instructed that transactions are “domestic transactions” based not on “the place where the deception originated,” but the place where the purchases and sales occurred.  Morrison, 561 U.S. at 266-67.  It is the “location of the transaction” that determines the applicability of the U.S. securities laws.  See id. at 268.  The Georgiou court noted that the 2d, 9th, and 11th Circuits had previously found that a “domestic transaction” was one (i) where the parties became obligated to proceed in the U.S., or (ii) where the actual transfer of title occurred in the U.S.  Georgiou, slip op. at 16-17 (referring to Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60, 69 (2d Cir. 2012); Quail Cruise Ship Mgmt Ltd. v. Agencia de Viagens, 645 F.3d 1307, 1310-11(11th Cir. 2011); SEC v. Levine, 462 Fed. App’x717, 719 (9th Cir. 2011)).  The court then “agreed” that “commitment” is “a simple and direct way of designating the point at which . . . the parties obligated themselves to perform . . . even if the formal performance of their agreement is to be after a lapse of time.”  Slip op. at 17 (quoting Absolute Activist, 677 F.3d at 68).  Accordingly, “the point of irrevocable liability” can be used to determine where a securities purchase or sale occurred; “territoriality under Morrison turns on ‘where, physically, the purchaser or seller committed him or herself’ to pay for or deliver a security.”  Slip op. at 17 (citations omitted).

This is all largely consistent with previous decisions.  But here the Third Circuit took a detour. The court found the involvement of U.S.-based market makers in “facilitating” at least some of the otherwise foreign transactions made them “domestic transactions” under Morrison: “Here, at least one of the fraudulent transactions in each of the Target Stocks was bought and sold through U.S.-based market makers. . . .    [A]ll of the manipulative trades were ‘facilitate[d]’ by U.S.-based market makers, i.e., an American market maker bought the stock from the seller and sold it to the buyer. . . .  Therefore, some of the relevant transactions required the involvement of a purchaser or seller working with a market maker and committing to a transaction in the United States, incurring irrevocable liability in the United States, or passing title in the United States.”  Id. at 18.  The court concluded: “We now hold that irrevocable liability establishes the location of a securities transaction. Here, the evidence is sufficient to demonstrate that Georgiou engaged in ‘domestic transactions’ under the second prong of Morrison, i.e., transactions involving ‘the purchase or sale of any [] security in the United States.’  See Morrison, 561 U.S. at 273.  Thus, the District Court’s application of Section 10(b) to Georgiou’s transactions was proper.” Slip op. at 19.

The rationale adopted by the court is, at best, designed to satisfy Morrison’s letter rather than its spirit.  Although the opinion is somewhat opaque, it seems apparent that the court concluded that the mere involvement of a U.S. person as a market intermediary in a transaction that in all other respects was between foreign persons is sufficient to make the transaction one properly governed by the U.S. securities laws.  But to allow the apparently unknown involvement of U.S. market makers “as intermediaries for foreign entities” to serve as the basis for subjecting a transaction to U.S. law seems to violate both the language and spirit of the Morrison opinion.  It totally ignores the point made by the Morrison Court that the standard for applicability of U.S. law to a transaction could not be whether some aspect of the transaction touched upon the United States: “For it is a rare case of prohibited extraterritorial application that lacks all contact with the territory of the United States. But the presumption against extraterritorial application would be a craven watchdog indeed if it retreated to its kennel whenever some domestic activity is involved in the case.”  Morrison, 561 U.S. at 266.

The Morrison Court noted that the subject “purchase-and-sale transactions are the objects of the statute’s solicitude.” Id. at 267.  It did not look to see if the interstices of those transactions involved some other agreement (i.e., between the seller’s foreign broker and a U.S. market maker) that occurred in the United States, because any such “facilitating” transaction was not “the object of the statute’s solicitude.”  Instead, “it is parties or prospective parties” to the purported unlawful transaction that “the statute seeks to ‘protec [t].’”  Id.  In the Georgiou case, the U.S. market maker is not one of those parties.

If the acknowledged test for the locus of a transaction is, as the Third Circuit says, where the parties “irrevocably” “obligated” themselves to the transaction, then, by all appearances, in this case that was outside of the United States, where the buyer and seller made their purchase and sale commitments.  It is not faithful to Morrison to rule that because the market mechanism by which those commitments were implemented included a transaction by other unaffiliated persons within the U.S., the transaction at issue morphed into a “domestic transaction.”  In a globalized electronic marketplace, almost any securities transaction that parties commit to on foreign soil can involve an “intermediary” in the United States that “facilitates” its completion.  To allow that to trigger the extraterritorial reach of the U.S. securities lawyers would, in fact, make “the presumption against extraterritorial application . . . a craven watchdog . . . retreated to its kennel.” Morrison, 561 U.S. at 266.

Straight Arrow

January 23, 2015

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Michael Lewis Saved from Paying the Piper for False Portrayal in “The Big Short”

By virtue of a poorly reasoned opinion from Second Circuit Judge Richard Wesley, author Michael Lewis narrowly escaped answering to a jury for blatantly inaccurate and unfair descriptions of CDO manager Wing Chau in Lewis’s apocryphal book, The Big Short.  On November 14, 2014, a majority of the three-judge panel in Chau v. Lewis, No. 13-1217, affirmed a district court grant of summary judgment to Lewis on Chau’s claims that descriptions of him in The Big Short were libelous.  Although the majority’s ruling for Lewis was hardly a vindication – it acknowledged the falsity of Lewis’s statements but merely inoculated them against liability in a libel action – it also reflected a myopic elevation of legal nicety over the real world.  A copy of the majority opinion can be found here: Chau v. Lewis 2d Circuit Opinion (Opinion”) .

Courtesy Lucas Jackson/Reuters

Michael Lewis (Courtesy Lucas Jackson/Reuters)

Senior Judge Ralph Winter, a dean of the 2d Circuit bench and author of many securities law opinions over the years, tried to restrain himself, but could not avoid a satiric tinge in a dissenting opinion lambasting the majority for using trees to obscure the forest, even while claiming they were deciding the case based on “the context of the publication as a whole, not just the paragraph or chapter containing them.” Opinion, slip op. at 14.  A copy of Judge Winter’s dissent can be found here: Chau v. Lewis 2d Circuit Dissent (“Dissent”).  Perhaps the great disappointment was that Senior Judge Amalya Kearse, who is highly respected, joined in Judge Wesley’s weak effort.

For those who may be interested in looking at what the lawyers of Chau and Lewis had to say on appeal, copies of their briefs filed in redacted form (to omit the most juicy stuff) can be found here (Appellant Brief in Chau v Lewis) and here (Appellee Brief in Chau v Lewis).

The case originated in Lewis’s blockbuster work of purported non-fiction about the underpinnings of the 2007-2008 financial crisis in the massive market of mortgage-backed securities offerings, and in particular collateralized debt obligations built on subprime mortgages.  Lewis’s book was on the New York Times bestseller list for 28 weeks, but over time has been shown to be far from accurate in key respects.  Nevertheless, as is the way of the world nowadays, the book created impressions that last and are taken as fact, regardless of its degree of accuracy or inaccuracy.  The district court record in Chau v. Lewis includes an expert report from a Northwestern University Medill School of Journalism professor stating: ““Lewis’ methodology in researching, drafting, and fact-checking The Big Short fell far below the standard required by this profession.”  Lewis chose not to have an expert defend his work.  Revelations about Lewis’s factual sloppiness (to be kind) in The Big Short do not bode well for verity-checks of Lewis’s new tabloid-like charges in Flash Boys that the stock market is “rigged” for the benefit of high frequency traders. 

Wing Chau’s company Harding Advisory LLC served as collateral manager for many CDO offerings.  Lewis dwelled in particular on an attack on Wing Chau in Chapter 6 of the book, entitled Spider-Man at the Venetian.  Relying on a report from co-defendant Steven Eisman of a supposed conversation between Chau and Eisman at a dinner in Las Vegas, Lewis presented a no-holds-barred indictment of CDO managers in general, and Wing Chau in particular, for having fostered the origination of worthless mortgage loans which were packaged to create also-worthless CDOs, all to satisfy the wealth and greed of Wall Street, CDO managers, and Wing Chau himself.

Any person who read Chapter 6 came away from the book believing Wing Chau was an idiot, moron, fool, greedy bloodsucker, and fraudster.  That was Lewis’s plain intent and the obvious import of what he wrote.  It ruined Chau’s career, and is a picture he will never live down.  The problem is, Lewis based it on hyperbole, insidious mockery, Eisman’s questionable portrayals, and plainly false statements.  Presumably he relied on Eisman and did little in the way of independent analysis.  I don’t know what steps he took before deciding to commit Chau to a public pillory, but one thing we do know, at least if Judge Winter is reliable, is that Lewis “admits that he does not use a fact checker.”  Dissent, slip op. at 5.  No surprise there.

Judge Wesley decided that just because Lewis ridiculed and demeaned Chau professionally and personally with false statements is not an adequate reason to force him to explain to a jury why he did what he did.  Instead, Wesley wrote down the 26 nasty, snarky, and sometimes false things Lewis said (or Lewis said that Eisman said) and, one by one, explained why each one, standing alone, was not a valid basis for a libel claim.  His opinion is the definition of myopia.  It is as far as you can get from what Wesley portrayed as the correct approach, which requires examining “the context of the publication as a whole, not just the paragraph or chapter containing them.”  Opinion, slip op. at 14.  Somehow he decides that pages and pages of statements that disparaged Chau, portrayed him as a greedy profiteer who made tens of millions of dollars for doing nothing, and accused him of being a fraudster, was not libelous because each statement taken alone was either “opinion” or not sufficiently harmful to qualify as being defamatory.  How frightening that an appellate judge tucked away in his robes and life-tenured position could be so clueless.  By deciding in his view what “an average reader” would and would not view to be defamatory – a plain invasion of the province of the jury – Judge Wesley deprived Chau of his only chance to regain dignity and a future: a decision from a jury of his peers.

As Judge Winter pointed out in dissent, the opinion is just plain wrong.  Lewis used statements that were admittedly false, or in some instances could be proved to be false, to portray Chau as lawless, stupid, greedy, unethical, and immoral.  For example:

  • He wrote that Chau “spent most of his career working sleepy jobs at sleepy life insurance companies” before turning to CDO investing, to make the point that Chau lacked the skills to work as a CDO Manager.  This is now admitted to be false.
  • He said Chau invested in only “dog shit” subprime CDOs when in fact 40 percent of his CDOs were not in that category.  Faced with this, Judge Wesley lamely opined: that this was a “fine and shaded distinction[]” that would not matter to a reader.  Opinion, slip op. at 24.  That’s what juries are supposed to decide.
  • He said Chau “made it possible for tens of thousands of actual human beings to be handed money they could never afford to repay.”  There’s so much wrong with that statement it’s hard to know where to start.  Suffice it to say that there is an ample likelihood that it would be proved false at trial.
  • He said Chau “didn’t do much of anything” as a CDO manager, which almost certainly is inaccurate.
  • He said Chau was a “double agent” who “represented the interests of Wall Street bond trading desks” and not that of investors.  He surely had no facts to support that beyond Eisman’s meanderings, but its truth or falsity is certainly a jury issue.  Judge Wesley exonerates Lewis for this and some other statements because he cloaked them by referring to “CDO Managers” generally, but not Chau in particular.  Opinion, slip op. at 21.  But that is laughable, since the whole chapter is about Chau as a CDO Manager and Eisman’s purported discussion with Chau, as Judge Winter points out (Dissent, slip op. at 3).
  • He said Chau didn’t care about what his CDOs invested in because he “simply passed all the risk that the underlying home loans would default on to the big investors.”  The point is that he allegedly failed in his duties to investors because he passed on risk to others.  Another clear jury issue.
  • He said Chau served “as a new kind of front man for the Wall Street firms,” i.e., that Chau allegedly committed fraud on investors by favoring the Wall Street firms.  That could be true or false, but is again a jury issue.  Judge Wesley gave Lewis a pass on this because he viewed calling someone a “front man” for others is a matter of “opinion.”  Opinion, slip op. at 20.  Far from it.  It is an accusation that someone falsely portrayed himself as protecting investor interests when he was not doing so, in other words, that he committed mail, wire, and securities fraud.  Accusing someone of criminal conduct is not “opinion,” as Judge Winter recognized.  See Dissent, slip op. at 10 (“This description could easily serve as the opening statement in a civil or criminal fraud trial.”).
  • He said Chau took home $26 million in a single year for doing all this but “didn’t spend a lot of time worrying about what was in CDOs.”  That is patently false as to what he earned (by a factor of ten), and likely is false as to the rest.  It suggests, falsely, that Chau earned $26 million in return for betraying his duties to investors.

How an appellate judge could declare that pages of such statements were not actionable “because an ordinary person would not take the statement (albeit incorrect) in context to be sufficiently derogatory to make an actionable claim for defamation” is totally beyond comprehension.  Judge Wesley said that a statement is defamatory if it exposes an individual to, among, other things, “shame, obloquy, contumely, odium, contempt, ridicule, aversion, ostracism, degradation or disgrace.”  Opinion, slip. op. at 15 (emphasis added).  Let’s see.  Obloquy is “the condition of someone who lost the respect of other people.”  That seems pretty clear here.  Shame means “dishonor or disgrace.”  Ditto.  Ostracism — “exclusion by general consent from common privileges or social acceptance” — was actually reflected in evidence in the district court record.  Ridicule is patently apparent on the face of the publication.  Judge Wesley either didn’t read what he wrote or didn’t bother to take it seriously.  His only role was to decide whether a reasonable jury (not him) could look at the evidence and find any of those impacts on Chau, and it really seems beyond debate that the evidence would permit that.  

Judge Winter certainly thought so.  He wrote:

Michael Lewis’s book describes appellant as admitting to acts that a jury could easily find to have breached his obligations to investors in the fund that employed him and to have constituted civil or criminal fraud. . . .  [T]heir conclusion that certain statements are not defamatory is reached only by evaluating those statements in hermetic isolation from the context in which they were made.  They conclude that certain statements can have only a single and non-defamatory meaning even where the book clearly conveyed a different and defamatory meaning that was adopted by the book’s readership. . . .

*          *          *

 A trier of fact could easily find the following.

. . .  Appellant is portrayed as lining his own pockets and foisting doomed-to-fail portfolios upon investors.  Although he was paid to monitor the amount of risk in the fund’s portfolio, he worried only about volume because he was paid by volume.  And, knowing that the default rate of residential mortgages was sufficient to wipe out the fund’s holdings, appellant sold all his interests in the fund, passing all the risk to the fund’s investors, who believed he was monitoring that risk. The portrayal of the appellant is particularly graphic because it purports to show his state of mind and his actions out of his own mouth. . . .

 The book’s author admits that he does not use a fact checker, and much of what the book says about the appellant is known even now (before a trial) as false. . . .  These falsehoods provide the scenic background for the portrayal of the appellant as engaging in conduct that a trier of fact could find amounted to fraud in order to line appellant’s own pockets.  This portrayal can be described as non-defamatory only by declining to view it as a whole; by taking some of the statements and quotations entirely out of the context in which they were made; by finding that some statements have only a single and non-defamatory meaning when the book clearly intended a different and defamatory meaning, one adopted by readers, or so a trier could find; and by labeling some statements as opinion without regard to the facts that they imply.

Dissent, slip op. at 1, 3-4, 5-6.

Perhaps Judge Wesley’s willingness to give short shrift to the allegations of defamation here derive from an excessive willingness to see people in the financial business as acceptable targets of ridicule, hyperbole, and false accusations simply because they are involved in a big money business.  Remember, Wing Chau was not a public figure when Lewis savaged him; he was just a bit player in the huge financial markets.  Let’s do a little fictional mind experiment.  Imagine a self-absorbed author decided to try to make money writing a book sensationalizing sordid legal practices in upstate New York (I know this is far-fetched, but stick with me).  As part of this book, he decided to personalize the charges by including accusations he heard about a lawyer who practiced in a well-known firm in Rochester and then became a partner in a small firm outside of Rochester with a varied practice.  He accused all upstate lawyers of breaching fiduciary duties and used this lawyer as a poster child.  Without doing any fact-checking, he accused the lawyer of breaching fiduciary duties to his clients in order make big bucks by knowingly ignoring his clients’ needs.  The accusations were false.  The lawyer didn’t make such big bucks and didn’t ignore his clients’ needs.  The lawyer tried to save his reputation but was stymied when a judge said he hadn’t actually been defamed.  As a result he was unable to continue work as a lawyer, could not become elected an assemblyman, could not be elected to serve as a judge, and could never get appointed to the federal bench.  Instead, he got hauled before the Bar on charges that he violated the law (as Wing Chau has been hauled before an SEC administrative law court).  I have little doubt Judge Wesley would not look so skeptically at the claims that the lawyer was injured by a defamatory publication.

Judge Wesley’s error was to diminish the significance of the accusations made against Chau while showing excessive deference to allowing false publications, in an effort support “the free exchange of ideas and viewpoints.”  Opinion, slip op. at 27.  But Lewis wasn’t doing that.  He set out to make money on sensational “non-fiction” revelations.  Wing Chau became a vehicle for doing this — an exemplar villain of the financial markets who met face-to-face with Lewis’s faux anti-hero, Eisman.  Lewis skillfully went about crucifying Chau based on false accusations to promote Lewis’s own personal benefit, and should sit in the dock and face the music for doing so.  The majority opinion disingenuously diminishes the substance of what happened here.  This involves more than “simple slights” or “wound[ing] one’s pride.”  Id.  What Chau suffered is a lot more than “hurt feelings.”  Id.  He is professionally disgraced; his ability to support himself and his family is shattered.  That the court deprives him of his chance to stand up for his name and dignity is an affront to the legal process.

Michael Lewis is the villain here, and Judges Wesley and Kearse are accessories after the fact.

 Straight Arrow

November 17, 2014

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Private Equity Facing Increased SEC Scrutiny Amid Ambiguous Rules

The SEC created some mild waves in late September when it entered into a modest enforcement settlement with Lincolnshire Management Inc., one of the less prominent private equity firms.  Lincolnshire agreed to pay $2.3 million to settle SEC charges that it did not properly allocate certain expenses between two of its funds.  See here.  Private equity entities incur significant expenses in the course of managing companies they control which have to be allocated among the various investment vehicles owning those companies (typically a series of limited partnerships in which investors provide capital for the acquisitions).  The SEC charged that in the course of integrating the operations of two of its portfolio companies, Lincolnshire’s allocation of expenses was not consistent with its internal policies.  Approximately $25,000 per year paid to administer a 401(k) program for both companies allegedly was funded by only one of them (for 8 years), and some other employee expenses were not properly allocated.  For this alleged transgression, Lincolnshire, without admitting or denying any violations of law, agreed to pay the SEC so-called “disgorgement” of $1,500,000, prejudgment interest of $358,112, and a civil penalty of $450,000, totaling $2,308,112.  You can see a copy of the settlement here: In re Lincolnshire Management.

In reality, given the extensive allocations of costs private equity funds normally must make, the fact that an investigation led to only a relatively minor charge suggests Lincolnshire did a pretty good job of allocating its common expenses.  And how the allegations justify a “disgorgement” of $1.5 million is a mystery, since disgorgement is only supposed to consist of ill-gotten gains, and it’s hard to see how the charged violations resulted in anything like that type of gain (or, in fact, any gain at all).  But SEC settlements are typically a product of unfettered power on one side and expediency on the other.

The significance of this enforcement action is that the private equity sector appears to be in the crosshairs of the SEC.  In April, it was reported that, as a result of new provisions in the 2010 Dodd-Frank Act, the SEC set up a new private equity unit to look into how private equity and hedge funds value their assets, disclose their fees, and communicate with investors.  Private equity funds, a major force in the institutional investor sector, now know that SEC enforcement investigations and actions are going to proliferate.

Interestingly, it has been reported that the SEC has internal disputes over how this new regulatory focus is going to move forward.  Different SEC offices have had at least one open disagreement about how to use the enforcement mechanism where the governing rules are at best ambiguous.  Examiners in the SEC’s home DC office were keen to move forward by means of enforcement, while those in New York said that in this situation new rulemaking is needed, rather than developing the scope of requirements in what are usually settled enforcement actions.

Litigators take note that such disagreements reflecting the ambiguity of regulatory requirements are just the kind information that might yield useful results in civil discovery in contested actions.  But the major private equity funds are highly unlikely to contest SEC enforcement demands.  Even unreasonable SEC settlement demands are likely to be met and viewed as a “cost of doing business,” allowing these lucrative financial juggernauts to continue to focus on making money.

Straight Arrow

November 17, 2014

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How the SEC Helps High Frequency Traders (Redux)

The Wall Street Journal reported previously on a new study revealing that the SEC was providing a special advantage to high frequency traders (HFT) by allowing them to get information filed with the SEC more quickly than most investors.  The Journal recently updated its earlier report here, and tells us that although the SEC appears to have reduced that advantage following the publication of this information, it still retains a 2-3 second timing advantage for early recipients of its data.

For those of you interested in the study, which reveals SEC conduct similar to possible similar arrangements in the private sector that the SEC Enforcement Division is investigating as potentially fraudulent securities trading, a copy is available here: How the SEC Helps Speedy Traders, a Columbia Law School Millstein Center for Global Markets and Corporate Ownership paper written by Robert J. Jackson, Jr. and Joshua R. Mitts of the Columbia Law School.

Straight Arrow

November 10, 2014

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SEC Found To Be Assisting High Frequency Traders

As they say, you couldn’t make this stuff up!

The Wall Street Journal reported today (October 29, 2014) that a new study confirms that the Securities and Exchange Commission (SEC) is feeding information to high frequency traders (HFT) before it goes to the general investment public.  What?  Could you say that again?

Yes, it’s true.  Your SEC — the U.S. government agency tasked with assuring a fair and efficient securities marketplace — provides special information access to favored investors, including the much ballyhooed high frequency traders.  Read about it here in this article: Fast Traders Are Getting Data From SEC Seconds Early.

The Journal reports that:

Hedge funds and other rapid-fire investors can get access to market-moving documents ahead of other users of the Securities and Exchange Commission’s system for distributing company filings, giving them a potential edge on the rest of the market.  Two separate groups of academic researchers have documented a lag time between the moment paying subscribers, including trading firms, newswires and others, receive the filings via a direct feed from an SEC contractor and when the documents are publicly available on the agency’s website….

When a company submits a document, the contractor forwards it to the Edgar subscribers and to the SEC website “at the same time,” according to the SEC. But the studies suggest that the SEC website can take anywhere from 10 seconds to more than a minute to post the documents, giving an advantage to the Edgar subscribers or their customers, who are often professional investors. Mom-and-pop investors can download the documents from the SEC website, but the information may already be known to others in the market, the studies indicate….

[A] forthcoming paper will document that investors could make about several cents a share, on average, on market-moving filings by receiving it in advance of those who rely on grabbing the document from the SEC website.

Straight Arrow

October 29, 2014

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SEC HFT Enforcement Action Looks Nothing Like “Flash Boys”

On October 16, 2014, the SEC entered into an administrative settlement of an enforcement proceeding involving a high frequency algorithmic trader — Athena Capital Research, LLC.  But if you review the Administrative Order, which is available here (In re Athena Capital Research), don’t expect to see anything like the fanciful musings of Michael Lewis in “Flash Boys.”  In fact, there is no suggestion that high frequency trading might be unlawful outside of the complex, labyrinthine alleged manipulation scheme described in the SEC’s charges.

I won’t bother to try to describe the charges here because they are so complex.  But they involve an algorithm of multiple high speed buy and sell transactions at the close of the trading day designed to create a favorable price increase for Athena Capital in the after-closing auction.  The important thing is that the SEC did not assert that the problem was high frequency trading (HFT), but that HFT was a vehicle for pursuing “a familiar, manipulative scheme: marking the closing price of publicly-traded securities.”

SEC Chair Mary Jo White made it clear that it was the manipulative conduct that was key: “When high-frequency traders cross the line and engage in fraud we will pursue them as we do with anyone who manipulates the markets.”  SEC officials in the division of the SEC tasked with examining trading systems and practices previously expressed skepticism about Michael Lewis’s accusations and follow-on proceedings by New York Attorney General Eric Schneiderman.  See SEC’s Berman Says Critics Like Schneiderman Misjudge Regulator and SEC official suggests order cancellations not currently a problem.

Another interesting aspect of this proceeding is that the settlement occurred based on the respondent neither admitting nor denying the charges — meaning the SEC did not have the leverage to insist on an admission of liability — and, although there was a $1 million penalty imposed, the SEC did not seek any “disgorgement” of alleged unlawful profits — probably meaning they had a hard time proving significant profits actually occurred.

Straight Arrow

October 21, 2014

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Does High Frequency Trading (HFT) “Rig” the Market?

Michael Lewis’s “Flash Boys” purports to reveal a system of “market-rigging” by the intervention of high frequency traders into executions of market orders.  Using some of the same sources that he used to source his highly misleading book “The Big Short,” he created a “sky is falling” atmosphere by promoting his book as the revelation of rigging the market.  He portrays a supposed fraud on ordinary traders by high frequency traders because of their ability to step in front of a trade and execute it for themselves at that price and then resell to the trader with a miniscule mark-up, thereby gaining huge profits when these miniscule mark-ups are repeated millions of times.

This has been labeled “insider trading” by many uninformed people, but it almost surely is not, because the high frequency traders do not appear to possess material non-public information when they trade.  I have not yet seen evidence suggesting they were engaged in committing any form of fraud, or breaching any fiduciary or fiduciary-like duty of confidentiality through the process by which they gain access to trade order information before it gets from the exchanges to market-makers responsible for trade execution.  They certainly do not have material non-public information about the public company whose stock is being traded, which is the standard fare of insider trading violations.

Whether this is a form of “front-running” is another issue.  Front-running is a description of trading that occurs when someone learns about an impending trade order, knows that this order will “move the market price,” and steps in front of the order to make a trade before the order hits the market (and moves the price), then usually pockets the profit by selling at the new market price.  This typically would be seen only when people have access to confidential order information involving large block orders of a stock that could conceivably move the market price enough to allow for a front-running profit after costs of order execution are taken into account.  What Lewis describes as high frequency trades are not this type of front-running because they do not involve large block, market-moving, trades.  And it is not at all clear, as compared to front-runners who misuse confidential access to trading information for their own benefit, whether the high frequency traders are engaging in an impropriety at all, since, once again, there is no apparent source of a duty of confidentiality they would be breaching.

Finally, the “market rigging” aspect of HFT would seem to be a hyperbolic, publicity-grabbing description, at best.  The focus appears to be on cumulative profits allegedly gained by the high frequency traders, but the actual impact on specific trades is so small as to be immaterial to the person who entered the order.  How many of us, or even institutional traders, care very much whether our trade is executed at $1 per share or $1.001 per share?  To be sure, the SEC should be making  efforts to try to assure best execution of trade orders, but the real question to ask is what costs we are willing to incur to prevent  that $.001 mark-up from occurring?  In some instances, analysts appear to be showing that there could be an issue of phantom liquidity that may be worth pursuing, not because it is a fraud, but because it may be allowing incorrect liquidity expectations to impact market executions.  I’ve included one interesting such analysis in the “securities markets” links to right ( analysis of HFT trade cancellations), which appears to show that HFT sometimes results in unreliable reports by exchanges of trade offers because of high frequency traders cancelling offers before executions can occur.  Whether spending, and causing others to spend, hundreds of millions of dollars or more to address such an issue in investigations and “settlements” of enforcement actions addressing what appear to be lawful practices may make little sense.  Moreover, if this is an issue, it would appear to be a regulatory one, not an enforcement one, and the SEC’s experts on market practices, not the enforcement division, should lead the way.  The politically-oriented state Attorneys-General with no market expertise and no authority to regulate markets should be excluded from the process altogether.

The main problem here is a common one that people like Michael Lewis, many commentators, and, unfortunately often the SEC itself, get in a huff when financial market participants find even lawful ways to make a lot of money.  They seem to forget that the entire market process is, and must be, driven by the ability to garner lawful profits from trading, because that is what creates market efficiency, which is the driver of the market system.  The huge ruckus created by “The Big Short” was just such a mistake.  The fact that some people made a lot of money by betting on the housing market to decline, and huge institutions lost a lot of money by failing to protect themselves against a massive decline in housing values, is what markets are all about.  The short trades Lewis described typically were not unlawful (the contrary verdict in the Fab Tourre case was, in my view, a travesty, because it is plain that the counter-party was not defrauded in any meaningful respect).  They were either very good bets based on informed judgments about over-exuberance in housing markets, or, in many cases, very good luck when short positions put on as a hedge became wildly, and unexpectedly, profitable.  The SEC wasted millions of taxpayer dollars investigating these matters for more than five years, and caused billions of dollars of expenses and “settlements” for no good reason other than to punish financial institutions for allowing a marketplace driven by huge, well-informed, institutional investors to function as intended.

Whether the same is true for the now-blossoming HFT investigations will remain to be seen, but the hype and hyperbole attendant to the investigations and commentating on this issue suggests we are moving down a similar path.

Straight Arrow

July 20, 2014

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