by T. GormanPosted on Posted in SECActions

Market integrity and the fairness of the markets is a much discussed topic. The Commission began the week with a day long round table discussion of computerized trading and its impact on the markets. Last month the agency filed a settled administrative proceeding which named the New York Stock Exchange as a Respondent. The proceeding centered on a charge that the exchange provided its proprietary customers and informational edge by giving them access to its market data before making it available to the public. Now the SEC has filed another settled administrative proceeding which centers on a charge that again a market operator gave an unfair informational edge to another. In the Matter of eBX, LLC, Admin. Proc. File No. 3-15058 (Oct. 3, 2012).

eBX is a registered broker dealer. It operates LeveL ATS, an alternative trading system. LeveL is marketed as a dark pool trading system. Subscribers are told that the system maximizes liquidity and provides best execution, all while minimizing information leakage and market impact. Its subscribers are all broker dealers.

LeveL outsourced its operation to a third party technology company identified in the Order only as Service Provider. That firm executed an agreement with LeveL for the services. The Service Provider also had a separate order routing business unit through which it sold order routing services to its own customers. It is identified only as Order Routing Business.

Beginning in 2008, and continuing through early 2011, Order Routing Business was permitted to remember LeveL information in its router regarding the unexecuted orders of LeveL subscribers. That information was then used to make routing decisions for its benefit. This permitted the firm to route an order in a manner which significantly increased its change of obtaining an execution. Because of this informational advantage the Order Routing Business was able to obtain a much higher fill rate for its orders than any other LeveL subscriber and avoid situations where a fill was less likely. This informational advantage was touted in marketing materials, which stated that the firm “provided a private market data source, which was known only to the Router . . .”

The percentage of fills obtained by the Order Routing Business significantly eclipsed that of other LeveL customers. From May 2008 through June 2009, according to the Order, the Order Routing Business’ LeveL IOC orders had fill rates ranging from about 30% to 70%. Other LeveL subscribers had fill orders of about 1 – 2% for their IOC orders. According to the Order, during this period “the Order Routing Business accounted for approximately 1 to 2% of all IOC shares directed to LeveL, while its executed IOC shares were between 16 and 39% of all IOC shares executed at LeveL, which accounted for between 4 and 11% of all shares executed in LeveL.”

Regulation ATS or Alternative Trading System was violated by permitting the Order Routing Business to remember the confidential information from LeveL, according to the Order. Rule 301(b)(10) of Regulation ATS requires an alternative trading system to establish adequate safeguards and procedures to protect subscribers’ confidential trading information. The Rule also requires that there be adequate procedures and safeguards to ensure the procedures are followed. Here LeveL failed to comply with this Rule. Despite outsourcing its operation, LeveL remained responsible for compliance. The firm also failed to inform or notify its subscribers regarding the use of their information. In addition, LeveL failed to amend its Form ATS to disclose its information sharing arrangement until 2011 and to correct other inaccuracies.

To resolve the proceeding eBX consented to the entry of a cease and desist order based on Rule 301(b)(2) and 301(b)(10) of Regulation ATS and to a censure. The firm also agreed to pay a penalty in the amount of $800,000.

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by T. GormanPosted on Posted in SECActions

The President’s Residential Mortgage-Backed Securities Working Group, announced earlier this year in the State of the Union speech, brought its first case. The action is against Bear, Stearns & Co., Inc., which has been acquired by JPMorgan Chase. It was brought by the New York Attorney General who serves as the co-chair of the joint federal – state working group. People of the State of NY v. J.P.Morgan Securities LLC. (S.Ct. N.Y. Filed Oct. 1, 2012).

The complaint focuses on the sale of mortgage backed securities or RMBS by Bear Stearns as the market crisis unfolded. The securities were pools of mortgages deposited into trusts. Shares were sold to investors who were to receive a stream of income from the packaged mortgages. Bear Stearns sold billions of dollars of RMBS.

Critical to the entire securitization process was the quality of the mortgages put in the pool. Sales representations thus focused on the careful selection process for the loans included. Bear Stearns told investors about its due diligence process and quality control guidelines. They were assured that there were procedures in place to ensure that the loans which had been pooled had only been extended to those who had a demonstrated willingness and ability to repay.

Investors were also told that Bear Stearns operated a quality control department. That department was supposed to detect red flags and resolve difficulties. When necessary there were procedures to resolve a difficulty.

Contrary to these representations, the complaint alleges that Bear Stearns ignored its own procedures and was overwhelmed by the number of securitizations. The firm systematically failed to properly conduct due diligence during the securitization process and often overlooked defects. The quality control department could not handle the large number of issues. Even when Bear Stearns’ executives became aware of difficulties they were not resolved. The firm had an incentive not to raise issues, according to the complaint, since it needed to maintain business relationships with those from whom it acquired the mortgages. Thus even when the firm entered into settlements they tended to favor the originator at the expense of investors.

Investors were never informed about the firm’s failures. They were not told about Bear Stearns’ routine failure to properly conduct due diligence. They were not told about its failure to follow up on red flags or that the quality control department was overwhelmed. Nor were they told that quality control procedures were used to secure monetary recoveries for Bear Stearns which were not passed on to investors.

As of August 2012 Bear Stearns had MSRB outstanding with a principle balance of $87 billion. At that point about 26% of the 103 subprime and Alt.A securitizations that Bear Stearns sponsored and underwritten in 2006 and 2007 were suffering losses. Those losses total $22.5 billion.

Another $30 billion in implied principal on the mortgages remain in the trusts today. About 43% of those loans are 90 days delinquent, in foreclosure, in bankruptcy or are considered to be bank owned real estate. Accordingly, investors are likely to suffer further losses.

The complaint alleges violations of General Business law Article 23-A, securities fraud and Executive Law Section 63(12), persistent fraud or illegality. It seeks an injunction, an accounting of all fees and revenues received, disgorgement, damages caused, restitution, and costs and attorneys’ fees.

The Residential Mortgage Backed Securities Working Group is one of eight working groups within the President’s Financial Fraud Enforcement Task Force. The group includes the NY AG, the Justice Department, the Securities and Exchange Commission, Housing and Urban Development and the Federal housing Finance Agency Inspector. At the press conference announcing this case, it was indicated that more suits will be brought.

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