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December 09, 2015 Articles

D.C. Circuit Clarifies that SEC Need Not Show Market Impact in Manipulation Cases

A road map to how the commission will evaluate trading activity to prove intent in manipulation cases in future administrative actions

By Dayrel S. Sewell and Amulya Appalaraju

Recent appellate review of the Securities and Exchange Commission’s prosecution of market manipulation cases provides a road map to how the commission will evaluate trading activity to prove intent in manipulation cases in future administrative actions.

In Securities & Exchange Commission v. Donald L. Koch & Koch Asset Management, LLC, No. 14-1134 (D.C. Cir. 2015), the D.C. Circuit reviewed the SEC’s decision in an administrative action against an investment advisor who was found to have “marked the close”—i.e., entered uneconomic trades at the end of the trading day to attempt to bias or influence the “mark”—in three small bank stocks. It clarified its interpretation of Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1997), stating that the Court in that case described manipulation as practices “intended to mislead investors by artificially affecting market activity” but “did not, by this language, require the SEC to prove actual market impact, as opposed to intent to affect the market, before finding liability for manipulative trading practices.” Koch, slip op. at 13 (citing Santa Fe Indus., Inc. v. Green, 430 U.S. at 476).

Marking the close can be used to bias a price or other market outcome to benefit the trader’s fortunes tied to that outcome. In this case, that outcome was Koch’s reputation as an asset manager for his clients, which would benefit from higher stock prices for the assets in which he had directed them to invest. Normal trading behavior is conducted to minimize market impact that may make purchases more expensive or sales less lucrative. In contrast, marking the close involves trading explicitly for the purpose of creating a market impact, which would be relatively more costly (or “uneconomic”) on a stand-alone basis.

Consequently, without any benefit derived from a tied position or interest, such behavior would be expected to incur a loss relative to trades designed to minimize their impact on the market. This is why marking the close, like many other types of manipulation involving strategically concentrated bursts of trading activity, is a form of intentional uneconomic behavior that is actionable under the SEC’s Rule 10b-5 and the related fraud-based market manipulation rules of the Federal Energy Regulatory Commission (FERC) and the Commodity Futures Trading Commission (CFTC). See, e.g., BP Am. Inc. et al., 152 FERC ¶ 63016 (Aug. 13, 2015) (initial decision); CFTC v. Optiver US, LLC, et al., No. 08 Civ. 6560 (S.D.N.Y. 2008) (Final Consent Order of Permanent Injunction, Civil Monetary Penalty and Other Relief).

In Koch, the SEC noted that Jeffrey Christanell, who executed trades for Koch, testified to an apparent deviation from “best execution”—i.e., getting the best price possible for a trade in the shortest possible time—saying “trades were different from typical trading because they did not involve trying to purchase [stocks] at the best price we can.” Koch, slip op. at 12. The court considered this the key indicator of uneconomic activity in support of its finding of manipulation. However, the decision also clarifies that under fraud-based, anti-manipulation protections provided by Rule 10b-5, it is not necessary to show trading actually fell short of “best execution” available from the market at the time the trades were placed. Rather, it is merely necessary to show that trades were placed with “an intent that is inconsistent with a desire to seek best execution.” Id. at 13.

This standard of proof of manipulation under Rule 10b-5 stands in contrast to the requirement to prove market impact under the CFTC’s long-standing artificial price rule. See Shaun D. Ledgerwood & Paul R. Carpenter, “A Framework for the Analysis of Market Manipulation,” 8 Rev. L. & Econ. 253 (Sept. 2012). The CFTC has had only one successful prosecution of market manipulation under its artificial price rule since its enactment in 1976, due in part to the difficulty of proving an artificial price. See In re Anthony J. DiPlacido, CFTC No. 01-23 (Nov. 5, 2008). The Dodd-Frank Act addressed this difficulty by amending the Commodity Exchange Act (CEA) to add a fraud-based rule—17 C.F.R. part 180—to implement and amend CEA section 6(c)(1), fashioned on Rule 10b-5, allowing for comparable enforcement of manipulation in commodities and futures markets.

As a general matter, using loss-making trades as proof of manipulative intent can be problematic because an unprofitable outcome is an inevitable occurrence of risk taking, including in markets free from abusive practices. Consequently, proof of scienter usually involves some combination of economic evidence of uneconomic trading and documentary evidence confirming intent.

In Koch, the SEC developed a record that included trading data, emails, and recorded phone conversations, which it used to prove intent to raise the price of securities before the market closed. Although the existence of smoking-gun communications meant that the burden of proving scienter did not fall heavily on the economic evidence, the SEC argued that both the pattern of trading and deviation from best execution pointed strongly to manipulative intent.

The SEC found that the trading conducted by the defendant just before the close was, in one case, the only time that the stock traded that day and, in another, all concentrated in the last four minutes of trading. The SEC also pointed to the fact that the price at which trading occurred in one of the stocks was at a level that was not exceeded over the following three months. The evidence of a deviation from best execution was provided by the record of trading activity as well as testimony that trading was conducted that did not involve trying to purchase stocks at the best obtainable price. The implication was that Koch’s direction to Christanell to buy shares at a higher price than necessary only made economic sense because the preservation of Koch’s reputation with his clients was worth more to him than the loss he expected to incur on the offending trades.

Detailed economic analysis of trading activity is often needed to test whether trades are uneconomic. Traders sometimes ease the regulator’s burden of proving scienter by creating documentary evidence that confirms ulterior motivations for their trades. In Koch, the email instruction to trade “without appearing manipulative” provided the SEC with just such a smoking gun confirming Koch’s manipulative intent.

Whether the clarity provided by the D.C. Circuit as to the standard of proof needed in manipulation cases under the Securities Exchange Act will lead to an increase in enforcement, only time will tell. However, while the SEC may impose sanctions for manipulation without proving market impact, any damages claim in private litigation will inevitably require a showing of how an alleged manipulation affected securities prices.

Keywords: litigation, securities, market manipulation, proof of intent, market impact, marking the close