If I want to buy a million shares of Facebook, I could call my broker and tell him "go buy me a million shares of Facebook." What I would like him to then do is:
- tell everyone who is looking to sell Facebook that he's got a buyer, to try to find the best price possible, and
- tell no one else, so that no one steps in front of me to buy some of those shares and push up the price I have to pay.
And it would be great if he did that. But we live in a fallen world where brokers sometimes fail to find every last seller for big orders and thus miss out on getting potentially better prices for their clients, and sometimes disclose big orders to others on the same side who end up front-running them, and mostly manage to do both. This problem is unavoidable - unless he knows everything about the portfolios and desires and honesty of everyone else in the world, even the most honest broker can't get the order exposure decision perfectly right - though its impact can be reduced by using brokers who are smart and honest rather than the reverse.
In this fallen world, though, it's hard to know whether your broker is honest, because you can't always tell what he's up to when he discloses an order. If I tell him I want a million shares of Facebook and he calls up Fidelity and says "I need a million shares of Facebook, you selling?" and Fidelity then buys Facebook in front of my order, I'll usually never know if he called Fidelity because he genuinely though wrongly thought Fidelity would sell me some shares, or because he's friends with Fidelity and wanted to help them front-run me.
But sometimes you can tell! When a bunch of brokers "placed phone receivers up to their respective squawk boxes and transmitted squawks [about pending client orders for specific blocks of securities] over open phone lines directly to [day trading firm A.B.] Watley, where traders then placed trades in the squawked securities before the brokerage firms executed the squawked customer orders," and when "in exchange for providing access to the direct feeds of squawks, Watley placed 'wash trades' with the [brokers] in which Watley traders simultaneously bought and sold the same security at the same price through different accounts," you can be pretty pretty sure that they were up to no good.
Apparently not sure beyond a reasonable doubt though. Those quotes are from this opinion from the Second Circuit yesterday, overturning the fraud convictions of those brokers and the day traders who loved them.* The court's decision may not be totally free of anything resembling error,** but it's certainly right that the evidence was pretty bad for these brokers:
Lastly, and perhaps most tellingly, evidence showed that Watley traders never took the other side of a squawked order. A jury reasonably and permissibly could have concluded, therefore, that the Broker Defendants knew that they were not transmitting squawks for the accepted purpose of finding the other sides of squawked trades.
But! To prove the particular flavor of fraud that these guys were charged with, the government needed to show "that the brokerage firms had exclusive use of the squawked information, considered that information to be confidential, and that they treated it as such."*** Which the government did in part by getting someone from each brokerage firm to get up on the stand and say "oh, yeah, client orders are confidential and we treat them as such." But what it didn't do is turn over to the defense the SEC's previous interviews with those executives, and the court found that it should have, and therefore threw out the convictions.
Because those interviews are full of people saying "hmm, hold up a phone to the squawk box all day? I don't see a problem with that." Here is Merrill Lynch institutional equity executive Brian Hull:
Hull also discussed Merrill’s responsibility to handle client orders “with the appropriate amount of care,” and that it was important for Merrill’s traders “to use professional judgment and discretion in how they convey to their customers the order information that [they] have heard over the squawk box.” When asked what was wrong with transmitting squawked information directly, however, Hull replied that he “d[id]n’t think there’s actually anything wrong with it.”
Here is a Merill Lynch branch manager, Joseph Lauricella, and a broker named Ronald Ledwith, describing a conversation with Merrill compliance manager Howie Geiler:
During their SEC depositions, Lauricella and Ledwith both testified about a Merrill broker, Matt Shulman, who had transmitted squawks directly to Millennium. The two together phoned Merrill’s compliance manager Howie Geiler to tell him that Shulman was transmitting squawked information to Millennium word for word. Lauricella indicated that he did not “see the difference between . . . whether or not [a phone] was held up to the machine or if someone is just repeating it word for word.” In response, according to Lauricella, Geiler said that “he never knew of any rule that said you could not broadcast that information,” and that “in the old days people used to actually come into the office and listen to [the squawk box] directly in the office.” Geiler then told Lauricella that “he was going to research it. He said he had never heard of such a rule. . . . He spoke about how he is going to triple check and make sure there is no rule or anything like that.” When Geiler called Lauricella back, he “said he checked all the rules,” and “[n]o one has ever heard of a rule. . . . Between all of us [with a combined] 100 years of experience [at Merrill], . . . [Geiler] said he never heard of a rule that you can’t disseminate the information on a squawk box.” When asked if anyone from Merrill ever told Lauricella that “you had to be careful in using a squawk box because of a risk of front-running,” Lauricella responded, “No. It was actually the exact opposite the way I understood it. The people at the desk described it as it wasn’t the magic bullet to try to trace or monitor any type of portfolio. . . . It was akin to reading tea leaves.” In other words, Lauricella had testified before the SEC that he did not believe that transmitting squawks actually threatened to lead to manipulated prices in the market as a result of front-running.
Or this guy:
Michael Legieza worked at Lehman as, alternately, co-head of the firm’s New York office, administrative manager of the New York office, and the firm’s Business Control Manager for private investment management. He testified before the SEC that he “d[id]n’t know what the purpose of having a [squawk] system would be if it weren’t to facilitate the communication of information to the appropriate people within the organization and then ultimately to our customer base,” and that, although “there is always a judgment to be made and information may not be relevant to all clients,” disseminating squawked information broadly was not necessarily prohibited.
For the most part these people are saying sensible things: a core part of the broker's professional judgment is deciding how broadly to expose an order to balance the client's interest in getting the widest possible range of potential counterparties against her interest in not getting front-run, and so having hard-and-fast "never give out orders broadly" rules would be counterproductive. That is not the same thing as saying "yeah, we're cool with a broker giving out a live stream of all of our customers' orders in exchange for some bribes."****
Still, you can see why evidence of the grayness of these firms' rules could be relevant to a jury, and why the court was unimpressed by the prosecutors' desire to hide that evidence from the defense. Explaining to juries the complexities and nuances of financial markets may make it harder for the government to win cases, but covering up the evidence of those nuances doesn't seem like a great solution.
* Here is an amazing fact:
In early 2002, [Watley executive Robert] Malin hired day trader Jay Amore, first as a consultant to Watley and later as the firm’s Chief Executive Officer. Amore brought former coworkers with him ... along with access to Mahaffy’s Merrill squawk box and Ghysels’ box at Lehman. According to Amore, he had used that access to frontrun at his prior day trading firm and he planned to do the same at Watley. After Amore demonstrated his frontrunning strategy to Malin and others, Leonard hired more than a hundred day traders to implement the strategy.
Imagine being one of them! "Hey, we're going to cram 100 of you in a big windowless room so you can eavesdrop on some phone calls all day and get rich." How do you find that job? What do you tell your parents you do? The world is very strange.
** "Various witnesses testified that, in order to pass the Series 7 exam, an individual would have known of the dangers of frontrunning and an accompanying need to keep block order information confidential." As a slowly lapsing Series 7 holder, I would happily have testified the other way.
*** Note to anyone planning to recreate this scheme: I don't think that's a Platonic requirement of jailing you, it's just a requirement of the particular "honest services fraud" crime charged in this case for a series of fortuitous reasons. Complexity is being elided left and right here, but let's just say that even if the brokerage firm hadn't treated client orders as confidential, that's not a good reason for you to arrange a frontrunning scheme using them. Consult your lawyer etc.
**** Though Geiler comes close, doesn't he?