What Turns Legal Conduct into Market Manipulation? A District Court Answers That Bad Intent Is Enough, But Only Where It Is the Sole Intent
PDF version A decision by the Southern District of New York in SEC v. Masri, 04 Civ. 1584 (S.D.N.Y. Nov. 21, 2007) (RJH), granting summary judgment and dismissing claims against a broker, seeks to clarify the intent necessary to prove a violation of Section 10(b) of the Securities Exchange Act for market manipulation when the alleged manipulative conduct is otherwise legal. An investor and a broker, who allegedly sought to raise prices in a thinly traded stock by placing a large buy order near market close (“marking the close”), argued that a market transaction unaccompanied by other deceptive or fraudulent conduct cannot, as a matter of law, support a finding of market manipulation. Although the court disagreed, holding that the SEC need not prove other deceptive or fraudulent conduct, it required the SEC to prove that but for the manipulative intent, a defendant would not have conducted the transaction. At the same time, the court held that there was no set of circumstances in which a jury could conclude that the broker had manipulative intent or knowledge of the investor’s manipulative intent. Thus, it granted the broker’s motion for summary judgment. In so doing, the court sought to strike a balance where brokers would not be “at risk of liability for market manipulation every time they executed a sizeable order in thinly traded stock at the end of the day.”
Background: Uncertainty in the Circuit Courts
Section 10(b) of the Securities Exchange Act prohibits “in connection with the purchase or sale of any security” the use of “any manipulative or deceptive device.” The Supreme Court has found that in this context, “manipulative” is “virtually a term of art when used in connection with securities markets. It connotes intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, 198 (1976).
Although most commonly associated with wash sales, matched orders, and rigged prices, the SEC has maintained that manipulation can also be accomplished through otherwise legal means, including short sales and large or carefully timed securities transactions. What, then, causes conduct to cross the line? Is manipulative intent enough? And what if a trader has manipulative and legitimate intent?
As outlined by the district court in Masri, only three circuit courts have addressed the issue. The Third Circuit in GFL Advantage Fund, Ltd. v. Colkitt, 272 F.2d 189 (3d Cir. 2001), held that manipulative intent alone is not enough to sustain a claim. The conduct involved large-scale short selling allegedly effected to depress stock prices and allow conversion of credit into a larger number of shares. To find a violation of the securities laws under these circumstances, the Third Circuit required evidence “that the alleged manipulator injected inaccurate information into the market or created a false impression of market activity.” Id. at 205.
The District of Columbia Circuit reached the opposite conclusion in Markowski v. SEC, 274 F.3d 525, 527-28 (D.C. Cir. 2001). Defendants argued that the SEC should not have affirmed a NASD hearing panel’s finding of market manipulation because their bids and trades were “real.” The D.C. Circuit rejected the argument “in light of what appears to be Congress’s determination that ‘manipulation’ can be illegal solely because of the actor’s purpose.” Id. at 529. As an example, the D.C. Circuit cited Section 9(a)(2) of the Securities Exchange Act, which makes it unlawful “[t]o effect . . . a series of transactions in any security . . . creating actual or apparent active trading in such security or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.”
The Second Circuit explicitly declined to answer the question of whether manipulative intent is enough to prove liability in United States v. Mulheren, 938 F.2d 364, 366-68 (2d Cir. 1991). Instead, it dismissed the case on the grounds that the government had failed to prove beyond a reasonable doubt that the defendant’s sole intent was to artificially increase the stock price.
Proof of Intent in Masri: “Marking the Close” or Not?
Moises Saba Masri (Saba), an active investor, directed trades in an account of Tentafin Limited. Albert Meyer Sutton, a broker, handled the trades. In late December 1998, Saba deposited more than 1,300,000 shares of TZA in Tentafin’s account, and in the next months sold and bought back TZA put and call options and TZA shares. On the afternoon of August 20, 1999, Saba phoned Sutton, who then executed an order to purchase 200,000 TZA shares by effecting seven discrete orders through a floor broker during the final 10 minutes of the trading day. This was around 94% of all TZA buy-side activity in the last hour of trading.
The SEC brought charges against Saba and Sutton, alleging that the purchase of 200,000 TZA shares was “marking the close.” According to the complaint, the goal was to push the price of TZA over $5.00, causing certain put options to expire worthless and allow Saba to avoid the required purchase of 860,000 shares at $5.00 a share. After discovery, Saba and Sutton moved for summary judgment, arguing that, regardless of intent, an open market transaction unaccompanied by other deceptive or fraudulent conduct cannot, as a matter of law, support a finding of market manipulation.
The district court noted that “marking the close” has been defined as “the practice of attempting to influence the closing price of a stock by executing purchase or sale orders at or near the close of the market.” In re Kocherhans, 52 S.E.C. 528 (Dec. 6, 1995). The court emphasized, however, that “[i]t should be stated clearly that stock transactions made at the close of the day are not prohibited.” Thus, “the SEC goes too far in arguing that end-of-day transactions, by themselves, have long been actionable.” In this regard, the court noted that the case most on point (THC, Inc. v. Fortune Petroleum Corp., 96 Civ. 2690, 1999 U.S. Dist. LEXIS 4039, at *11-12 (S.D.N.Y. Mar. 31, 1999)) involved conduct over a two-month period and did not discuss “the obviously unsettled state of the law in the Second Circuit with regards to market manipulation through open-market purchases.” In addition, while the court’s survey of SEC settlement orders indicated the SEC’s understanding that “‘marking the close’ . . . can by itself constitute market manipulation given the requisite manipulative intent,” the orders all involved repeated conduct over a period of time and none of them had been subject to judicial review.
Given the lack of guiding precedent, the district court approached the question instead by “keeping in mind the purpose of securities law to ‘prevent practices that impair the function of stock markets in enabling people to buy and sell securities at prices that reflect undistorted (though not necessarily accurate) estimates of the underlying economic value of the securities traded’” (citations omitted). This led the district court to reject the defendants’ proposed per se rule that open market activity cannot be considered manipulative based solely on manipulative intent. Instead, the court concluded that “if an investor conducts an open-market transaction with the intent of artificially affecting the price of a security, and not for any legitimate reason, it can constitute market manipulation.” This approach “focuses entirely on the mind of the trader.” Under this approach, the court found that the SEC had stated a claim against Saba and Sutton.
Before it could turn to the evidence, however, the court had to consider whether the SEC’s complaint could be sustained if there were evidence both of manipulative and nonmanipulative intent. Here, the balance swung more favorably to the defendants, with the court holding that “the SEC must prove that but for the manipulative intent, the defendant would not have conducted the transaction.” With respect to this standard, the district court noted that the Second Circuit had accepted, with “misgivings,” see Mulheren, 938 F.2d at 368, the government’s theory that an open market transaction done with the “sole intent” to affect the price of securities could violate Section 10(b). If this was the Second Circuit’s view, “then a fortiori, it would find problematic a theory under which an investor could be found liable for market manipulation when only one of the investor’s purposes was to alter the price.”
Applying the standard, the court noted that while Saba’s proffered evidence about his strategy and financial means suggested a credible and innocent explanation for his conduct, the SEC’s evidence was “not so unconvincing as to allow the Court to encroach on the province of the fact-finder at this stage of the proceeding.” By contrast, the court rejected the evidence against the broker. Sutton followed his client’s directions. There was no evidence that Saba had told him to drive up the price, and the trading itself did not indicate Sutton had sought to drive up the price; rather, it weighed in Sutton’s favor that the price increased less than $0.15 per share. Therefore, the court found that the trading could not establish Sutton’s manipulative intent or knowledge of such intent of Saba, stating: “Indeed, to hold otherwise would be to put brokers at risk of liability for market manipulation every time they executed a sizeable order in thinly traded stock at the end of the day.” Finally, Saba’s and Sutton’s longstanding relationship did not raise a question of fact, as neither had ever been accused or convicted of a securities violation.
Significance
Until the Second Circuit addresses the issue of whether charges of market manipulation can be sustained unaccompanied by other deceptive or manipulative conduct, Masri offers a sensible and balanced approach to such cases when there are few or no indications of manipulative intent (e.g., the activity in question is isolated or sporadic; there are equally plausible and innocent explanations for the activity; or there are no dubious statements in emails). In particular, while a regulator may treat the broker and investor as one and the same, Masri requires an independent evaluation of the broker’s conduct.
For broker-dealers conducting an internal review or facing a regulatory inquiry, Masri can help formulate the questions to ask about intent: What did the trader intend? What was known about the investor’s intent? And, if there were indications of manipulative intent, would the trader, but for that manipulative intent, have effected the transaction? Assuming the trader has acted at arm’s-length from the investor, whose intent may never be known, the broker-dealer can distinguish its conduct and demonstrate its legality.
To view a copy of the court’s opinion, please visit http://morganlewis.com/documents/SECvMasri.pdf.
If you have any questions regarding the issues raised in this Morgan Lewis LawFlash, please contact either of the following Morgan Lewis attorneys:
New York
Anne C. Flannery
212.309.6370
aflannery@morganlewis.com
Adrienne M. Ward
212.309.6794
award@morganlewis.com