Unlawful Proprietary Trading Charges Net $42M for the SEC

Holding:

Defendants Automated Trading Desk Specialists, LLC (“ATD”); E*Trade Capital Markets LLC (“E*Trade”); Melvin Securities, L.L.C. (“Melvin”); Melvin & Company LLC (“Melvin Co”); Sydan, LP (“Sydan”); and TradeLink, LLC (“TradeLink”) have settled unlawful proprietary trading charges filed by the Securities and Exchange Commission (“SEC”) in the U.S. District Court for the Southern District of New York. Without admitting or denying the allegations set forth in the six separate complaints, defendants have consented to entry of orders permanently enjoining them from engaging in the violations set forth in the complaints, particularly trading violations stated in Chicago Stock Exchange (CHX”) Article 9, Rule 17, and Section 17(a) of the Securities Exchange Act of 1934 and Rule 17a-3(a)(1), and have agreed to disgorge ill-gotten gains totaling in the aggregate over $35.7 million and pay civil penalties totaling more than $6.7 million.

Detailed Summary:

In its complaints, the SEC alleged that the defendants failed to meet their basic obligation as specialists to serve public customer orders over their own proprietary interests while executing trades on the CHX.

According to the SEC, as specialists operating on the CHX, each of the defendants had a general duty to match executable public customer or “agency” buy and sell orders and not to fill customer orders through trades from the specialist firm’s own accounts when those customer orders could be matched with other customer orders. However, from 1999 through 2005, each defendant violated this obligation by filling orders through proprietary trades rather than through other customer orders, thereby causing upwards of $35 million in customer harm.

The SEC’s complaints alleged that the violative conduct engaged in by the Defendants took three basic forms:

—Trading Ahead. In certain instances, specialists filled one agency order through a proprietary trade for their firm’s account while a matchable agency order was present on the opposite side of the market, thereby improperly “trading ahead” of such opposite-side executable agency order. The customer order that was traded ahead of was then disadvantaged when it was subsequently executed at a price that was inferior to the price received by the firm’s proprietary account. For example, if a specialist has present on his book, at the same time, a marketable customer order to buy 1,000 shares of a security and a marketable customer order to sell 1,000 shares of the same security, the specialist would be obligated to pair off those matchable orders. Trading ahead would occur if the specialist filled the sell order from the firm’s proprietary account at $25.00 per share, and then subsequently executed the buy order at the inferior price of $25.05 per share. In this example, the buy order received a price inferior to that which it was entitled ($25.00) and the customer was disadvantaged by $50.00 (1,000 shares x $0.05 per share).

—Interpositioning. In certain instances, after trading ahead, specialists also traded proprietarily with the matchable opposite-side agency order that had been traded ahead of, thereby “interpositioning” themselves between the two agency orders that should have been paired off in the first instance. By participating on both sides of trades, the specialist captured the spread between the purchase and sale prices, thereby disadvantaging the other parties to the transactions. Alternatively, specialists sometimes sold shares of a security into a customer buy order, and then filled the customer sell order by buying for the firm’s proprietary account at a lower price. In either case, the specialists participated on both sides of trades, capturing the spread between the purchase and sale prices, and disadvantaging the other parties to the transaction.

—Trading Ahead of Unexecuted Open or Cancelled Orders. In certain instances, specialists traded ahead of opposite-side executable agency orders, as described above, but in these instances, the unexecuted orders were left open until the end of the trading day, or were cancelled by the customer prior to the close of the trading day before receiving an execution.

The complaints further alleged that, during the relevant period, each of the defendants failed to make or keep current a blotter containing an itemized daily record of all purchases and sales of securities effected by it for its proprietary accounts. Specifically, the complaints allege that the Defendants sometimes received orders to buy or sell securities that are dually listed on the CHX and on a different exchange, such as the New York Stock Exchange (NYSE). In order to fill these orders, the specialist would sometimes place a corresponding order (lay-off trade) on the NYSE for the firm’s proprietary account. With respect to lay-off trades, the Defendants failed to make or keep current records showing the account for which each such transaction was effected, the name and amount of the securities, the unit and aggregate purchase or sale price, and the trade date.

The SEC’s complaints alleged that by engaging in the conduct described above, the Defendants violated CHX Article 9, Rule 17, and Section 17(a) of the Securities Exchange Act of 1934 and Rule 17a-3(a)(1) thereunder.

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