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by Bill Singer

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Is Another Regulatory Scandal Brewing: Who is regulating the Exchanges?

Written: March 5, 2009

By Bill Singer

http://RRBDLaw.com

http://BrokeAndBroker.com

Yesterday I posted an article (14 Specialists Caught by SEC -- better never than late?) about the SEC’s actions against 14 Specialist firms for violations that first occurred in 1999 and largely ended in 2002 (or by 2004 at the latest).  I got some interesting comments and am posting this follow-up in reply.  

Why did it take the SEC so long to bring these cases?  

That was about the most common question – and, frankly, I don’t have a simple answer.  First off, if you are fairly reading yesterday’s blog, you should note that the misconduct occurred on the floors of the American Stock Exchange, the Philadelphia Stock Exchange, the Chicago Stock Exchange, and the Chicago Board Options Exchange.  To be fair, last I looked, the SEC didn’t exactly have a trading floor.  As such, some of the SEC's tardiness may not be solely its fault. The federal regulator may have been relying upon the exchanges to do their jobs.  That may well have been a misplaced reliance.  Nonetheless, it just seems to have become acceptable for us to read about final regulatory actions taken a decade or so after the underlying misconduct--or several years after the regulator became aware of the problem.  It's as if Wall Street's cops are out for a leisurely stroll and unaware of the cries for help.

Why didn’t the Exchanges catch the violations?  

The way our regulatory system was and is structured, the so-called first line of defense for most specialist matters is supposed to be with the in-house regulatory staff at the Exchanges --- that’s the self-regulatory arena.  After all, one of the supposed “truths” of our three-tiered system of securities regulation (federal, state, and self-regulatory organization (SRO)) is that the SROs are imbued with more industry savvy and are best suited to discern nascent problems among their members and on their turf.  As with many supposed truths, the SRO’s role within the tripartite scheme doesn’t seem to withstand scrutiny.  Ask most industry veterans about the specialist system and they will likely identify the two most common abuses as “trading ahead” and “interpositioning.”  It’s that irresistible urge to take a few pennies here and there out of the pockets of an unsuspecting public.  Sometimes there’s this just oh so juicy trade that, well, let me just step in here and make a few bucks on the sly.  Other times, business has been slow or the market lousy and, geez, we could use the extra dollars this month so, what the hell, no one will be any the wiser.  

Part of the problem with trading ahead or interpositioning is that the misconduct is easily rationalized.  It’s not exactly face-to-face fraud with a widow or orphan.  It’s more like dropping bombs from a high altitude rather than hand to hand combat. It’s a somewhat sterile fraud and one that has become so accepted by the specialist community that it’s often seen as more of a perk than a wrong.  Similarly, these occasional lapses have been winked at by the in-house cops at most exchanges for so long that members sincerely believe that the hands-off policy is tantamount to an official sanction.

But don't you need to give the SEC some time to become aware of such violations?

Of course you do.  But at some point it is no longer an issue of fair notice and it becomes a matter of incompetence, if not reckless disregard or gross negligence.  Sometimes an engine fails to work because the battery is dead.  Fine, you replace the battery and get on your way.  However, sometimes it's not merely the battery but the engine is dead and beyond repair.  At that point, you junk the car. You don't sit in the driver's seat forever turning the key. If the SEC can do no better than recent events indicate, the engine is stone-cold dead and we might as well junk the vehicle for salvage value.  If the SEC can do better, then it sure as hell needs to get it's act in gear.

Please read this April 12, 2005 SEC Press Release (http://www.sec.gov/news/press/2005-53.htm): 

SEC CHARGES THE NEW YORK STOCK EXCHANGE WITH FAILING TO POLICE SPECIALISTS. 
NYSE Agrees to Settlement With SEC, Including Censure, Cease and Desist Order, $20 Million Fund for Regulatory Auditor, and Audio-Video Surveillance

[S]pecifically, the Commission's Order finds that from 1999 through 2003, various NYSE specialists repeatedly engaged in unlawful proprietary trading, resulting in more than $158 million of customer harm. . .

[S]pecifically, the NYSE failed in 3 primary areas.

The NYSE Failed to Adequately Surveil for Trading Ahead and Interpositioning Violations: The NYSE established and relied on an overbroad surveillance system for trading ahead, which captured only a small fraction of violations. Despite advice by the NYSE's internal audit group and other indications that the surveillance was inadequate to detect the full extent of trading ahead, the NYSE failed to make necessary adjustments to the surveillance parameters. The NYSE Failed to Adequately Investigate Trading Ahead and Interpositioning Violations: Although the NYSE's existing surveillance parameters were designed to capture only the most egregious instances of trading ahead and interpositioning, the surveillance unit responsible for reviewing the alerts routinely ignored scores of likely violations. When the surveillance unit made referrals to the NYSE's investigative unit, investigators failed to investigate the full extent of the misconduct. The NYSE Failed to Appropriately Discipline Trading Ahead and Interpositioning Violations: Despite compelling evidence of misconduct, the NYSE routinely failed to take disciplinary action or imposed only the most minor of sanctions.

. . .

This failure by the NYSE to police trading ahead and interpositioning by specialists follows on the heels of a regulatory failure by the NYSE in the late 1990s involving independent floor brokers, which was addressed by the Commission in an order against the NYSE in June 1999. See In the Matter of New York Stock Exchange, Inc., Release No. 34-41574 (June 29, 1999).

The Commission has previously brought settled enforcement actions against all seven specialist firms responsible for the unlawful proprietary trading at issue in this case. See In the Matter of Bear Wagner Specialists LLC, Rel. No. 34-49498 (March 30, 2004); In the Matter of Fleet Specialist, Inc., Rel. No. 34-49499 (March 30, 2004); In the Matter of LaBranche & Co. LLC, Rel. No. 34-49500 (March 30, 2004); In the Matter of Spear, Leeds & Kellogg Specialists LLC, Rel. No. 34-49501 (March 30, 2004); In the Matter of Van der Moolen Specialists USA, LLC, Rel. No. 34-49502 (March 30, 2004); In the Matter of SIG Specialists, Inc., Rel. No. 34-50076 (July 26, 2004); In the Matter of Performance Specialist Group LLC, Rel. No. 34-50075 (July 26, 2004).

. . .

Sound familiar?  Sound very similar to yesterday's SEC release about 14 other specialists on four other exchanges?  Yeah, I thought so too.  All of which closes a somewhat alarming circle and returns me to the point of yesterday's blog and today's follow-up. 

Ten years ago, in 1999, the SEC slammed the NYSE as part of what was known as the Oakford scandal. In the Matter of the New York Stock Exchange, Inc. (Rel. No 34-41574/June 29, 1999), the SEC stated in its Order:

etween approximately 1993 and early 1998, groups of independent floor brokers violated Section 11(a), Rule 11a-1, and NYSE Rules 90, 95, and 111, by engaging in illegal schemes of trading on the NYSE floor while sharing in the profits or losses generated from those trades. The NYSE failed for several years to uncover and halt these illegal schemes. In February 1998, the Commission and Office of the United States Attorney for the Southern District of New York ("USAO") charged eight independent floor brokers with perpetrating one such trading scheme with The Oakford Corporation, a former broker-dealer member of the National Association of Securities Dealers and the American Stock Exchange ("Oakford" cases) and the NYSE, having learned of the scheme from the USAO in late 1997, suspended those independent floor brokers.

That tells us that as early as 1993, the venerable NYSE had failed to uncover illegal schemes on its Floor --- and had failed to do so for the five-year period outlined in the SEC's Order. What we are then asked to swallow, is that first the NYSE permitted five-years of undetected floor violations; second, the SEC then sanctions the NYSE in 1999; third, from 1993 through 2003, seven specialist firms engaged in unlawful proprietary trading involving trading ahead and interpositioning; fourth, the SEC sanctioned those firms in 2004; and fifth, in 2005, years after virtually all of the aforementioned, the SEC once again sanctions the NYSE for failing to police its specialists.  Please note that this means the SEC sanctioned the NYSE as a failed regulator in both 1999 and again in 2005.  I guess you get at least a second chance as an SRO when it comes to failing to do your job.

But the NYSE was not among the exchanges involved in the SEC's recent action against 14 specialists at four other exchanges--so what's your point?

My point is a fairly simple one.  Interpositioning and Trading Ahead are often the bread and butter cases for a Floor-based regulator.  Since a specialist is charged with maintaining an orderly market, and that largely entails daily decisions as to whether a given order goes to the crowd or to the specialist's proprietary book, this is a recurring issue.  As such, one would expect some vigilance from exchange regulatory staff and their SROs.  At the worst (and most unfavorable to the U.S. regulatory community), we know that in 1993 independent floor brokers at the NYSE were engaged in illegal schemes through at least 1999 that the NYSE "failed for several years to uncover and halt." 

In 1999 the SEC took dramatic action against the NYSE itself for failing to detect and regulate the floor conduct of its indie brokers.  As such, when the first round of SEC actions came down in 1999, what the hell did the SEC do in order to fully discharge its mandate to ensure a fair market?  Commonsense would dictate that the SEC send teams of investigators to all the exchanges to see if similar problems were ongoing.  Similarly, commonsense would dictate that the various exchanges and their SROs pull out all the stops to see if there were similar lapse at their floors. Moreover, one would have expected the SEC to read the Riot Act to the exchange community and warn them to clamp down with a vengeance.  Doesn't seem like much happened, and if the SEC and the exchanges did do something, it sure as hell would be filed under "too little, too late."

Why do I deduce that whatever message the regulators sought to send was not delivered?  First there was indie trader misconduct resulting in criminal charges and the NYSE itself being sanctioned -- and no sooner had the dust settled then the NYSE specialists took that as a green light to start trading ahead and interpositioning.  Why did it take the SEC until 2004 to charge the specialists and until 2005 to charge the NYSE?  While you're mulling over those questions, do some research and give me the names of individual regulators at the NYSE who were suspended or fired for their role in failing to regulate.

Now, let's bring this to a conclusion.  In 1999 and 2005 the SEC knew that the NYSE wasn't exactly the diligent cop on the exchange beat. Twice in six years the SEC sanctioned the NYSE for floor based supervisory failures. And both of those sanctions pertained to violations on the NYSE's floor involving the improper sharing of profits/losses from floor trading or the interpositioning/trading ahead violations involving profits/losses derived from floor trading. 

Was there not a single genius at the SEC who thought...hmmm...if it's going on here at the NYSE, maybe it's also going on at other exchanges?  Was there not a single enlightened soul at the four exchanges referenced in the recent SEC interpositioning/trading ahead cases who thought . . .hmmm. . . if it's going on at the NYSE maybe it's also going on at our floor? Why is it now four years after the 2005 NYSE action and the SEC is first getting around to sanction the exact same misconduct cited in that 2005 case but which occurred at four other exchanges?  Why did the NYSE violations get resolved in 2005 but virtually identical violations at four other exchanges on similar dates remain unresolved for four additional years?

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