Peter J. Henning follows issues involving securities law and white-collar crime for DealBook's White Collar Watch.
The Securities and Exchange Commission and the Commodity Futures Trading Commission are still trying to figure out what caused the flash crash on May 6. As part of that process, the S.E.C. will look into whether any market participants engaged in securities fraud.
The S.E.C.’s chairwoman, Mary L. Schapiro, told a Senate hearing that the commission's enforcement division was taking part in the review process to determine whether broker-dealer firms might have shirked their obligations to customers that fed into the rapid decline that day.
About White Collar WatchPeter J. Henning, writing for DealBook's White Collar Watch, is a commentator on white-collar crime and litigation. A former lawyer at the Securities and Exchange Commission's enforcement division and then a prosecutor at the Justice Department, he is a professor at the Wayne State University Law School. He is currently working on a book, "The Prosecution and Defense of Public Corruption: The Law & Legal Strategies," to be published by Oxford University Press.
The enforcement division will focus on registered broker-dealer firms that acted as market makers, a term we heard used quite often in the recent Goldman Sachs hearing in April. While a market maker does not owe a fiduciary duty to clients, as Goldman repeatedly stressed, it is obligated to fulfill the "best execution" duty, which means it must seek the most favorable terms reasonably available under the circumstances in fulfilling an order for a client. According to Ms. Schapiro, some market makers may have disappeared during the worst moments of the flash crash, thereby pulling a key prop out from under the market that could have exacerbated the precipitous fall in stock prices.
S.E.C. Rule 15c1-2 prohibits "any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person." Under the commission's view, the best execution duty derives from common law agency principles that require an agent to put the principal's interests ahead of its own, so a violation of that obligation operates as a fraud.
Ms. Shapiro testified that "it appears that some professional liquidity providers temporarily did not participate in the market on the buy side in many stocks that suffered particularly egregious price declines, whether because of an intentional decision to withdraw or because of specific market practices."
The term "professional liquidity providers" may be a new one for most investors. The term includes firms that engage in proprietary trading who submit limit orders to the market to buy and sell securities at predetermined prices in large volumes to provide — you guessed it — liquidity. Broker-dealers acting as market makers are also professional liquidity providers who agree to match orders and, when necessary, step in and complete trades so that the securities markets can operate efficiently.
Unlike a broker-dealer firm, which is registered with the S.E.C. and must abide by certain rules that require it to maintain trading in securities, the proprietary firms can simply leave the market whenever they wish. Thus, there is a mix of regulated and unregulated entities that undergird the liquidity in the market, which may have contributed to the market volatility when they did not continue to supply liquidity to the market.
As Ms. Schapiro pointed out in her testimony, "Many of the most active and sophisticated traders in today’s market structure are not subject to any obligations with respect to the nature of their trading." Any investigation by the enforcement division will not include the unregulated firms because they are not subject to the fraud prohibition in Rule 15c1-2, because they do not owe a duty to any participants. Any effort to bring these firms under the securities law would require new regulations, which would likely take months to draft and refine and may end up causing these firms to cut back on their trading activities if they were exposed to additional risks.
Determining whether a registered broker-dealer engaged in fraudulent activity by failing to fulfill the best execution obligation may also be difficult. Like the other antifraud provisions of the federal securities laws, proving a violation of Rule 15c1-2 requires the S.E.C. to show the firm, or any individual associated with it, acted with scienter — i.e., intent to defraud.
Intent is usually the most difficult element in a case, and proving it would be particularly hard in the flash crash because of the very narrow time frame involved. The usual evidence the S.E.C. relies on to prove intent, such as e-mail messages and documents, may not exist because much of the market drop took place in less than half an hour. Without circumstantial evidence of intent, a fraud case could not be established.
Moreover, even showing that a broker-dealer walked away from the market during the steep decline will be difficult because it requires the S.E.C. to prove that the absence of trading activity was done purposefully and not due to other reasons. The flash crash was a bit like driving by a small town on the highway — blink and you missed it. The tumult occurring on the floor of the New York Stock Exchange and the tremendous leap in trading volume through the electronic exchanges may well explain why a firm did not act as a market maker during the decline, so showing what anyone did — and did not — do might well be impossible.
The flash crash highlights how the market can take on a life of its own. Proving that a broker-dealer firm violated its obligation to fulfill the best execution duty will be no easy task when there were so many different aspects to the market drop that can be viewed as contributing to the decline on May 6.
– Peter J. Henning
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