Monday, March 04, 2013 / By Olumide Olusegun-Obayemi**
That the Nigeria Stock Exchange (NSE) and the capital market regulations and laws are not as dynamic as those existing in the more sophisticated western world is not in dispute: what remains in contention is whether our laws and regulations are effective enough to cope with the jet age and computerized stock trading antics by Nigerian whiz-kids who have been trained in the United States, Great Britain, and other western world.
Do we have far-reaching laws such as United States’ SEC Rule 10b-5, codified at 17 C.F.R. 240.10b-5? Are such effectively applied against erring stock traders? Your answers are as good as mine.
In a case for insider trading, anyone who uses insider information can be held liable. A tippee can be liable if the tipper breached a fiduciary duty and the tippee knew or had reason to know that the tipper was breaching the duty. Thus, according to David Meister, the Director of the Division of Enforcement of the U.S. Commodity Futures Trading Commission (CFTC)
“The CFTC will not tolerate traders who try to gain an unlawful advantage by using sophisticated means to drive oil and gas futures prices in their favor,...Manipulative schemes like ‘banging the close’ harm market integrity, and false and misleading statements to exchange officials to cover tracks obstruct the investigative process. As reflected by the court’s order, we will seek significant financial penalties from violators and limitations on their privileges to trade on markets in the United States.”
According to John Katovich, the chief regulator with NASDAQ’S Boston Options Exchange Regulation, high-frequency trading, trading equity at tens of thousands of times per second, now represents over two-thirds of all stock trading in the U.S.
This author’s very first contact with High-Frequency Stock Trading was accidental. I had resumed my studies as a doctoral student in the Fall of 2000 in San Francisco California, and later on, became a Law Clerk with Wiggins, Robin and Richard at al located at the Old Stock Exchange Building on Sansome Street. It was inevitable that I would run into smartly dressed young men and women working at E-TRADE at the rotunda building at the corner of Sansome and Market Streets. They were always at their desks no matter how early I arrived at the office. I later learned that since California was three (3) hours behind New York—they were to arrive at 5.00am, which would be 8.00 am in New York in order to catch up. Strikingly, they were always with their latest gadgets, even during breakfast and lunch—calculating and monitoring NSE on the east coast. In the United States, there have been new laws and regulating and monitoring high-frequency stock trading (“HFST”), via the use of computerized mathematical algebraic and algorithm software. Is Nigeria ready for such jet age stock trading practices? We submit that the Nigerian stock regulators take cue from the present state of the laws and regulations in the United States.
First, we shall define what constitutes high-frequency stock trading (“HFST”). Second, we shall discuss, the origin, impact and elements of Rule 10-b(5) of the American Stock Exchange Act and the amendments under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act.. Third, we shall examine the investigations and sanctioning of Optiver and Trulium by the U.S. Commodity Futures Trading Commission (CFTC) and SEC. We round up with how the regulators, private litigants and defense lawyers view the laws and regulations on HFST as of present. Finally, we make recommendations for the Nigerian capital market practitioners.
High-Frequency Trading Defined
According to Eliot Lauer, Jason Gottlieb and Alyssa Astiz, high-frequency trading (also called high-speed trading) employs computerized systems capable of rapid calculation and data transmission time to run algorithms that identify and execute trading opportunities in milliseconds—and increasingly in microseconds. The principal objective "involves minimizing risk and posting small deal sizes that enable [high-frequency traders] to move in and out of trades extremely quickly, arbitraging between spreads available on different exchanges and platforms, and even between the speed of trading available on them." High-frequency traders often hold positions for very short periods, collecting fractions of a penny on each share of a large-quantity trade.
Take this scenario—John WAZOBIA was born in Lagos and attended Corona Private School, then to Kings’ College, and then to University of Lagos his Undergrad in computer science. He later attended Princeton for another Pre-Law degree and finally to Harvard for law school. He becomes a computer geek who knows his ways around to bid and unbid for stocks on the internet within a matter of minutes.
Wazobia has an Uncle who wants to make millions from Unilever stock—Lever Brothers Nigeria PLC. Wazobia uses his friends at Guardian, Tribune, daily Times, and Thisday to publish unpalatable deals engaged in by Lever Brothers’ Board. The public is shocked. They shares of Lever Brothers fell. Wazobia’s Uncle buys enmasse. 2 weeks later, Wazobia retracts his criticisms through another pseudonym. Lever Brothers’ Stock’s values rise again within the next 2 months. Wazobia’s Uncle makes NGN 200 million Naira. This is unethical stock trading with gains made through the dissemination of false and misleading information calculated to gain financial gains.
Assume, again, that Wazobia, using his Dell Inspiron 50, with million megabytes aiming to allow his father make enormous gain, decides to buy huge and repeated stocks of Lever Brothers within 8am and 12 noon on March 3rd, 2013 driving the process very high, and then unloads the same shares between 4.30pm and 5 pm on the same day. Unbeknownst to most people, Wazobia purchased the 10 million stock with his father’s corporations, family members and friends. Greedy investors seeing the rise in demand for Lever Brothers’ stock join the frenzy between 12.30pm and 3.00 pm purchasing 10 million stock from Wazobia’s stooges at higher prices. By 5 pm, Wazobia’s father has made NGN20 million Naira simply because Wazobia created an artificial high demand for lever Brothers’ shares. This is also punishable and sanctionable.
But, do we have means and mechanisms for detecting these fraudulent schemes in Nigeria? Can we punish the “powerful” and “highly connected” friends of Major-General, Senator, Alhaji, and Pastor XYZs?
To instill integrity in the stock market, we must eschew manipulative schemes like ‘banging the close’ harm market integrity, and the making of false and misleading statements
SEC Rule 10b-5
SEC Rule 10b-5, codified at 17 C.F.R. 240.10b-5, is one of the most important rules promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of the Securities Exchange Act of 1934. The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. For instance, in 1942, SEC lawyers in the Boston Regional Office learned that a company president was issuing pessimistic statements about company earnings while simultaneously purchasing the company's stock. Although the Securities Act of 1933 prohibited fraudulent sales of securities, no regulation precluded fraudulent purchases. Rule 10b-5, issued by the SEC under section 10b of the Exchange Act, was implemented to fill this regulatory void.
"Rule 10b-5: Employment of Manipulative and Deceptive Practices":
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security."
In TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), 449, the word "material" was defined by the U.S. Supreme Court - "an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote." Clearly, some strategies of high-frequency stock trading (“HFST”) are simply high-speed variants of old market manipulations.
Yet, the high-speed, algorithmic nature of high-frequency stock trading (“HFST”) now complicates the nature of the violation by present day computer savvy criminals.
Of particular importance in litigations involving capital markets are the elements of the offense, under Rule 10b-5: Employment of Manipulative and Deceptive Practices. In order to establish a claim under Rule 10b-5, plaintiffs (including the SEC) must show (i) Manipulation or Deception; (ii) Materiality; (iii) "In Connection With" the purchase or sale of securities; and (iv) Scienter. Private plaintiffs have the additional burden of establishing (v) Standing - Purchaser/Seller Requirement; (vi) Reliance; (vii) Loss Causation; and (viii) Damages.
Types an d Varieties of High-Frequency Trading Manipulations
There are various types of high-frequency trading strategies, referred to as "market manipulation," "nefarious, predatory behavior," and "inherently wrong." Traditional practices targeted by regulators that have new, high-speed variants include:
"Layering": "[T]he placement of multiple, non-bona fide limit orders on one side of the market at various price levels at or away from the [National Best Bid or Offer (NBBO)] to create the appearance of a change in the levels of supply and demand, thereby artificially moving the price of the security." Upon execution at the artificial price, the non-bona fide orders are immediately cancelled.
"Spoofing": "[P]lacing certain non-bona fide order(s), usually inside the [NBBO], with the intention of triggering another market participant(s) to join or improve the NBBO, followed by cancelling the non-bona fide order, and entering an order on the opposite side of the market."
"Quote stuffing": Placing a large number of buy or sell orders that are then cancelled almost immediately, thereby generating order congestion that slows down traders with inferior technology and creating a false sense of actual supply and demand.
"Pinging": Submitting and rapidly withdrawing an order to gauge market interest, thereby providing traders with response information that can enable them to force buyers into accepting a higher price simply by virtue of access to faster technology systems.
"Marking the close": Acquiring a substantial position in a security prior to the close of trading, followed by offsetting the position at or immediately before the close in order to manipulate prices.
An Appraisal of High-Frequency Trading Activities
High-Frequency Stock Trading is fraught with disadvantages and lopsided favors. Pray, how can a village boy (without a computer) from Otapiapia Primary School and Erinjagunmolu Community High School compete with Wazobia from Princeton/Harvard? As they say in Nigeria—Ground no level and/or E get as e be.
There are arguments in favor of High-Frequency Stock Trading. For instance, proponents of High-Frequency Stock Trading state that it results in financial liquidity and that the resulting liquidity affords other investors trading opportunities
High-Frequency Stock Trading proponents also state that the resulting financial liquidity has led to historically low transaction costs and increased market efficiency.
On the other hand, critics of High-Frequency Stock Trading argue hat high-frequency trading has disadvantaged investors without access to cutting-edge technologies, contributed to market volatility, eroded investor confidence, and has led to a two-tiered marketplace: high-frequency traders, and "everyone else."
In September 2010, Trillium Brokerage Services was fined $1M, because it had created 'Beneficial Prices' for Stocks 46,000 times in Two Years. In addition, Trillium Brokerage Services agreed to pay the fine but did not admit or deny the charges, the Financial Industry Regulatory Authority said Monday. Nine traders and two officers at the firm were suspended from the securities industry for periods of six months to two years. They were also fined a total $802,500. Further, in addition to the $1 million fine, Trillium agreed to give back about $173,000 in profits. The firm reaped a total of around $575,000 in profits from the 46,000 instances of using the trading strategy on the Nasdaq Stock Market.
The background to this was that Trillium placed huge numbers of artificial orders to buy or sell, and then canceled them almost immediately. It was done to obtain beneficial prices on stocks 46,000 times in 2006 and 2007. Federal regulators started probing such trading strategies, often referred to as "quote stuffing." The practice has become more prevalent as more firms rely on powerful computers to make frequent trades. Regulators are reviewing it to see if it creates the illusion of a greater trading volume, which could allow sellers to profit from the perception of rising demand. By using the strategy, Trillium's traders got "advantageous prices that otherwise would not have been available to them,…Other market participants were unaware that they were acting on the ... illegitimate orders entered by Trillium traders."
April 19, 2012 Federal Court Order Mandating $14 Million in Fines and Disgorgement Stemming from CFTC Charges against Optiver and Others for Manipulation of NYMEX Crude Oil, Heating Oil, and Gasoline Futures Contracts and Making False Statements.
On April 19, 2012, per Chief Judge Loretta A. Preska of the U.S. District Court for the Southern District of New York, the U.S. Commodity Futures Trading Commission (CFTC) obtained $14 million in civil monetary penalties and disgorgement pursuant to a federal court consent order against defendants Optiver Holding BV, a global proprietary trading company headquartered in the Netherlands, and two subsidiaries – Optiver US, LLC (Optiver), a Chicago-based corporation, and Optiver VOF, a Dutch company, as well as against then company officers who were responsible for the unlawful trading: Randal Meijer, Bastiaan van Kempen, and Christopher Dowson, the only individual defendant who remains employed by Optiver. Specifically, the consent order requires the defendants to pay a $13 million civil monetary penalty and $1 million in disgorgement. The order provides for trading limitations on Optiver and prohibits Dowson, Meijer, and van Kempen from trading commodities for 8 years, 4 years, and 2 years, respectively.
Earlier, the CFTC’s complaint charged defendants with engaging in manipulation and attempted manipulation of New York Mercantile Exchange (NYMEX) Light Sweet Crude Oil, New York Harbor Heating Oil, and New York Harbor Gasoline futures contracts in March 2007 (see CFTC Press Release 5521-08, July 24, 2008). Optiver and van Kempen were charged with concealing the manipulation by making false statements in response to an inquiry from NYMEX. In at least 19 instances in March 2007, the defendants attempted to manipulate prices, and in at least 5 instances, were successful in causing artificial prices. In each instance, defendants intentionally accumulated a large position in Trading at Settlement (TAS) contracts in Light Sweet Crude Oil, Heating Oil, or New York Harbor Gasoline contracts. TAS contracts are priced based on the NYMEX closing price each day. As alleged, the defendants offset their large TAS position by trading futures contracts shortly before and during the closing period, in a manipulative manner. This manipulative tactic, commonly known as “banging the close” or “marking the close,” involves acquiring a substantial position leading up to the closing period, followed by taking offsetting positions in a manner intended to push prices in the manipulator’s favor. When the NYMEX began an inquiry into the trading, Optiver and van Kempen made false statements to the NYMEX compliance officials to conceal the manipulative scheme. NYMEX’s proactive surveillance program detected the subject trading by Optiver in the Crude Oil, New York Harbor Gasoline, and Heating Oil contracts and contributed to the cessation of the activity alleged in the complaint.
We recommend up-to-date laws to cope with stock manipulations that are not very obvious—i.e., high-frequency stock trading (“HFST”), via the use of computerized mathematical algebraic and algorithm software.
We recommend the hiring of highly qualified Computer Science and Computer engineers to work in a Monitoring Sections of the Nigerian NSE and SEC. the use of Business Administration graduates as the main crop of administrators serves no good purpose in these days and age.
We also recommend the creation of an elite group to undertake trainings in the US and/or UK to learn how the western world tackle such problems. A good example is Dr. Nnenna Orji. With backgrounds in law, business and economics, Dr. Orji is well prepared for the job she is doing at the Investment and Securities Tribunal--IST.
"My background in economics and business has paid-off,…I read Economics at Howard University USA, I did my Doctorate degree in Jurisprudence at the same university. My LLM was done at the New York University. The benefits of having knowledge in economics has helped me a lot because corporate law and security law deal mainly with economics, business, finance and the corporate world. At least you understand the transaction not just the law. It makes your work easier. It is an advantage if one has experience in other fields of study before dabbling into law. You come out with more analytical minds.
We recommend the creation the enhancement of the Abuja-based Investment and Securities Tribunal (IST) to cover such cases. According to Dr. Orji:
The Investment and Securities Tribunal is a specialized court that handles complex civil cases. If an investor has an allegation or complaints of misconduct by any professional market operator he should come to the investment and securities tribunal. If an investor or a market operator is aggrieved by the decisions of the Securities and Exchange Commission or Stock Exchange Commission, he should come to us for remedy. If we find out that those regulatory agencies were wrong in their decision or interpretation of the law, we can review or overrule it, thereby clearing the market operator and putting him back into good standing. If a shareholder does not get his share certificates as and when due, such a person can come to us for remedy.
There are other misconduct and grievances that can be brought to us if the objective is to get back your money, your investment, your certificate and to make sure that the rights that you were deprived of are restored to you. We have professional judges in capital markets, finance, investment banking laws to quickly dispense justice in a maximum of 90 days. I think that should interest any investor or any person in the capital market."
Nigeria must be ready for such jet age stock trading practices? We submit that the Nigerian stock regulators take cue from the present state of the laws and regulations in the United States.
We must fight the so-called “Nigerian factor” There must be no sacred dogs.
**Dr. Olumide K. Olusegun-Obayemi is an attorney licensed in both California and Nigeria and can be reached a firstname.lastname@example.org