Dark pools have been a subject of concern to Congress, the SEC and the public for years. Despite those concerns the pools are used by institutional and other large traders to cloak their trading activity and minimize its market impact. In contrast to the typical securities market where details about the order are publically displayed, dark pools make display little or no information about customer orders.

Now the SEC has brought its first action involving a dark pool. The misrepresentations about the manner in which the pool functioned and the undisclosed conflicts at the center of its operations suggest that the pool was only dark for some traders. In the Matter of Pipeline Trading Systems LLC, Adm. Proc. File No. 3-1460 (Oct. 24, 2011).

The actions named as Respondents Pipeline Trading Systems, LLC, Fred Federspiel and Alfred Berkley. Pipeline is a registered broker dealer and registered alternative trading system or ATS. Messrs. Federspiel and Berkley are, respectively, the founder and CEO and Chairman of Pipeline. The Order alleges violations of Securities Act Section 17(a)(2) and the pertinent rules under Regulation ATS.

Pipeline began operation in 2004 as an alternative trading system. The system operated as a dark pool. It assured potential users that Pipeline’s proprietary system would reduce market impact by denying day traders, predator dealers and other speculators the information they need to front run institutional orders. Customers were told that Pipeline utilized a trading system that was designed to prevent users from uncovering customer order information for the purpose of trading in front of those orders. Pipeline customers were also assured that all were treated equally.

Pipeline represented that it used a “natural” liquidity to fill orders. Such a system excludes trading opportunities generated by a dealer or by the trading venue itself specifically for the purpose of filling a particular customer order. Press releases suggested that rising trading volume on the venue accounted for the increasing number of “natural” trades.

In fact the representations were false and concealed a conflict of interest, according to the Order. The vast majority of the trades executed in the ATS were with Milstream Strategy Group LLC, a wholly owed affiliate of the pool. Milsream operated by trying to anticipate or predict the trading intentions of Pipeline customers. The affiliate would then trade elsewhere in the same direction as customers prior to filling their orders in the pool. Pipeline favored Milstream, and facilitated this trading, by at times making certain proprietary information available to its affiliate. The traders at this affiliate were compensated for giving Pipeline customers favored treatment.

The Respondents resolved the action by consenting to the entry of a cease and desist order based on the sections and rules cited in the Order. In addition, Pipeline agreed to pay a civil penalty of $1 million while Respondents Federspiel and Berkeley each agreed to pay a penalty of $100,000.

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