By Anne Sherry, J.D.
An appeals court heard oral argument on whether an adviser’s transactions in thinly-traded stocks were illegal market manipulation or a legitimate strategy to induce holders to come forward and sell. The SEC found that the adviser’s late-afternoon trades were intended to mark the close in order to reflect higher portfolio balances in clients’ monthly account statements (Koch v. SEC, April 20, 2015).
Background. Donald L. Koch and Koch Asset Management LLC (KAM) were found to have engaged in market manipulation through marking the close of three thinly-traded securities. According to the SEC’s order instituting proceedings, the transactions, which occurred near or at the end of the month, were meant to boost the portfolio performance reflected in monthly statements sent to KAM’s advisory clients. After a six-day hearing, the administrative law judge held that the respondents violated the antifraud provisions of the Exchange Act and Advisers Act and imposed a $75,000 penalty and $4,000 in disgorgement. These sanctions were stayed pending appeal to the D.C. Circuit.
Focusing on price. The pointed questions from Judges Henderson, Millett, and Ginsburg at the oral argument focused heavily on the facts and characteristics of the trading at issue. Thomas O. Gorman of Dorsey & Whitney LLP, arguing for Koch and KAM, characterized the case as one where an investment adviser with a long-term track record placed trades with a valid business purpose but then was sidelined by an SEC enforcement action creating a retroactive rule of decision. But Judge Millett questioned Gorman’s focus on the inference of manipulative intent from the mere fact of seeking a higher price for your trade. Wasn’t the SEC’s argument, she asked, that the petitioners sought a higher closing price for the sake of a higher closing price? Gorman responded that the traders were trying to obtain a particular price within the confines of their trading strategy and consistent with the limit order that they set, something that happens every day in the market.
Judge Millett also asked about an audio recording of a telephone conversation in which Koch told his broker, “My parameters are, if you need 5,000 shares, do whatever you have to do. I need to get it above 20 … 20 to 25, I’m happy.” “Isn’t that all about the price?” she asked. Gorman emphasized that the stock in question was so illiquid that it acted almost as a private negotiation to buy. By laddering up the price, Koch was enticing holders to enter the market. But the judge expressed doubts about this explanation, noting that the order was so close to the close of the market that there would be no time left for someone to come in and trade that stock before the market closed.
Evidence of intent to manipulate. Dominick Freda, representing the SEC at the argument, pointed to substantial evidence supporting the finding that the respondents engaged in marking the close. All the arguments that Gorman raised were raised at the hearing below, and the Commission considered and rejected those arguments based on the evidence, including emails and audio recordings of phone calls demonstrating the intent of Koch and KAM to raise the price of the stocks and, in turn, raise their clients’ account balances.
The judges’ questions of Freda focused on the line between a legitimate and legal trading strategy, on the one hand, and unlawful manipulation, on the other. Judge Millett asked whether, if Koch intended to raise the price but did so at noon instead of close, that would have been manipulation. Freda conceded that if he did so with a genuine intent to induce others to enter the market, that would be legitimate, but stressed that the evidence did not support this interpretation. Judge Ginsburg also asked whether an email from Koch instructing his broker to make a trade “as near to $25 as possible without appearing manipulative,” which the initial decision construed as evidence of manipulation, could be interpreted as a sensible and lawful message; in other words, make the trade in such a way that complies with the rules. That could be a viable interpretation, Freda responded, if that were all the SEC had. The Commission acknowledged that what Koch argued he was doing could be a legitimate business strategy, but his intent, based on the email and phone communications, clearly was to artificially raise the price at the end of the day to mark the close.
Mixed motive. Judge Millett brought up the possibility that Koch had a mixed motive: He wanted to induce people into the market as he argued, but his trading strategy would also have the benefit of placating his clients by increasing their account balances. The effect on the market is exactly the same, she noted. To Freda’s response that the respondents never proved that they had a legitimate trading strategy, Judge Millett retorted, “Didn’t you have the burden of proof?”
Freda said that if this were a legitimate trading strategy, you’d see evidence of Koch’s using it in other circumstances. Outside of these illiquid stocks, he said, Koch rarely traded at the end of the day and often traded in the middle of the month. Judge Millett countered that maybe “the fishing was best at the end of the quarter.” The record showed that Koch had tried, and failed, to buy these particular stocks at other times. She asked whether it was legal error not to treat this as a mixed-motive case. Freda responded that all the evidence pointed to the fact that Koch was trading at the end of the day to mark the close and that he did not raise any credible evidence to support his claim of a legitimate motive.
SEC’s market rules. On rebuttal, Gorman reiterated that a trader may wish to bid up over the market ask price in order to get a large block of stock. That is what the SEC National Market System rules accomplish, but he argued that if the result of this enforcement action stands, large mutual fund companies like Fidelity and Vanguard will be unable to bid up in order to obtain large blocks of shares, and instead will have to buy in lots of 100 or 200 shares. Judge Ginsburg asked whether, as a result, the firms will not trade in these shares. Gorman responded that either they won’t trade at all, or they will pass the costs along to their clients. This is why, he said, Rule 610 of Regulation NMS has brokers avoid displaying orders that cross the market (i.e., go over the market ask). The rule does not illegitimatize these orders, only prevents them from influencing the price.
The case is No. 14-1134.