Marking the Close: SEC Mostly Wins in Market Manipulation Appeal
Market manipulation is a big deal to the SEC. You can expect the Commission to hang tough when its orders in cases alleging such activities are challenged – and a recent U.S. Court of Appeals ruling would seem to back that strategy.
A three-judge panel of the U.S. Court of Appeals for the District of Columbia, in a 20-page ruling issued July 14, mostly upheld a May 2014 SEC order that advisory firm Koch Asset Management and its owner, Donald Koch, between September and December 2009 manipulated the closing price of certain stocks held in client portfolios on the last trading date of the month, a practice known as "marking the close." The SEC order upheld by the appellate panel was itself the result of an appeal from a May 2012 administrative law judge ruling. The original SEC allegations against the adviser and its owner were filed in an April 2011 administrative order.
The appellate court panel, which began its ruling by quoting financier Bernard Baruch as saying that "the main purpose of the stock market is to make fools of as many men as possible," upheld the SEC’s finding that KAM manipulated the market, and that it failed to implement policies and procedures to prevent violations of the Advisers Act.
In the same ruling, however, the panel said that the Commission was wrong to bar the adviser from associating with municipal advisers and ratings organizations, as the alleged manipulation violations occurred before such bars were allowed under the Dodd-Frank Act. "Although we agree with the Commission’s order in large part, one of the SEC’s sanctions is impermissibly retroactive and requires us to grant the petition in part and vacate the order in part."
KAM did not challenge a bar preventing it from associating with other advisers, broker-dealers or transfer agents. An attorney representing the adviser did not respond to requests seeking comment.
"It’s very hard to get an SEC order reversed on appeal to a court," said Stern Tannenbaum partner Aegis Frumento. "The SEC’s factual findings will be accepted if the evidence supports them, even if the evidence could also support a contrary finding. The remedies will be accepted unless they are ‘arbitrary or capricious.’ The only avenue of appeal is if the SEC clearly misapplied the law. Here, you have an example – remedies imposed by Dodd-Frank in 2010 can’t be applied retroactively to conduct that occurred in 2009. That’s a pure issue of law that the SEC got wrong."
DLA Piper senior counsel Patrick Hunnius saw a link between the decision and the agency’s efforts to try more cases in administrative hearings rather than in court (ACA Insight, 5/18/15). "Everyone knows the SEC has an incredible track record trying administrative proceedings and that the first appeal of an ALJ’s decision is heard by the Commission, which is the same body that voted to bring the case in the first place," he said. "This decision highlights the third hoop an administrative procedure defendant may have to jump through: appealing the SEC ruling in court. It is the rare case where you can win the appeal at the Court of Appeals, as it will be highly deferential to the Commission on issues of fact and accord great deference to the Commission on issues of remedy."
Friends, clients and results
Koch’s investment strategy when he started KAM in 1992, according to both the appellate panel ruling and the SEC, was to buy the stock of small community banks as long-term investments. He believed that "the shares of many small banks were undervalued … and sought to purchase stock of promising banks at or below the tangible book value per share," the SEC said. "It was Koch’s experience that if a small bank was acquired by a larger bank, the larger bank would pay two or more times tangible book value."
"Koch was particularly concerned about investment performance because many of KAM’s clients were his friends or people he would interact with regularly," the SEC order upholding the administrative judge’s initial ruling said. It quoted Koch as testifying that when you know your clients well, "’the last thing you need is to take money from someone and not perform.’"
To that end, KAM waived more than $234,000 in quarterly client fees between 1995 and 2010, the agency said. He charged his clients a quarterly fee of 0.25 percent of the account’s value, but not if the value declined. He also charged an annual fee of 20 percent of realized net gains that exceeded 5 percent a year. For himself, members of his family and for his assistant, he did not charge account fees at all, the SEC said.
Then the 2008 financial crisis hit. Koch’s clients "became increasingly worried that their investments would decline in value," the appellate panel wrote. At about the same time, the brokerage firm his clients used began allowing clients to access their account information online. Koch, according to the panel, "worried that his clients would be concerned if their online account information suggested that their accounts were under performing. It was in order to ensure that his clients’ accounts appeared to retain their value, the appellate panel wrote, that Koch allegedly marked the close for three small banks.
Investigations and rulings
"Koch’s conduct aroused suspicions," according to the appellate panel. What followed, the ruling said, was a letter from a New York Stock Exchange investigator to the brokerage firm calling attention to the trading, which led to the broker firing the representative who had been working with Koch and terminating the brokerage firm’s relationship with KAM.
"Note the role of the broker-dealer custodian in bring the conduct to the fore," said Frumento. "The broker-dealer acting on behalf of the RIA ends up being a natural gatekeeper in these situations, and its role in policing investment adviser conduct can’t be overstated."
The SEC then launched its investigation, resulting in charges against Koch and KAM in April 2011, followed by the May 2012 ALJ ruling. The ALJ found that Koch "illegally marked the close" for one bank’s stock on September 30 and December 31 of 2009, and for two other bank stocks on December 31, and that the adviser failed to follow its own policies and procedures to prevent Advisers Act violations. KAM appealed the ALJ decision to the Commission.
The Commission, perhaps not surprisingly, backed the ALJ, reviewing transcripts of telephone conversations, emails and other information. "It found ‘compelling’ evidence that Koch intended to manipulate the trading price for all three bank stocks by marking the close on September 30 and December 31," the appellate panel said. KAM and Koch then took their case to the U.S. Appeals Court.
The appellate ruling
The appellate court panel listed three arguments made by Koch, rejected two of them, and agreed with the third. Specifically, the arguments advanced by Koch’s attorneys were:
Not enough substantial evidence and a misreading of the governing statutes. Koch’s primary argument on appeal was that the Commission’s decision applied the wrong legal standard and was not supported by substantial evidence, according to the appellate decision. "We think the contrary is true: The Commission applied the correct standard and properly concluded that there is ample evidence Koch manipulated the market by marking the close," the appellate panel wrote. It noted the trades conducted by Koch’s broker on September 30 and December 31, instructions Koch gave to his broker, and the contents of the recorded telephone calls between Koch and his broker. The panel also noted that market manipulation does not have to be successful to be a violation, as some of the broker’s attempts to set the closing price sometimes did not work, as long as the intent to manipulate the market is there – and the panel concluded, despite Koch’s argument to the contrary – that such intent was there. "Many securities law violations are determined by their intent, not by whether they are successful," said Frumento. "Attempted but failed financial frauds are as bad as successful ones from a regulator’s perspective."
Koch should not have been charged as a primary violator. This argument was pressed on the grounds that, based on the attorneys’ interpretation of a previous case as well as their reading of the Advisers Act, Koch could not be charged as a primary violator under either the Exchange Act or the Advisers Act. But, the appellate panel said, Koch "misreads both" of these documents. The previous case Koch relied on, according to the appellate panel, applied only to statements, not the act of market manipulation, which is what he was charged with. As for his reading of the Advisers Act, Koch argued that only advisers registered with the SEC could be charged as primary violators under the Act, and that since he was not registered, he could not be so charged. "The Advisers Act, however, draws no such distinction," the appellate panel wrote.
The bar against associating with municipal advisers or rating organizations was "impermissibly retroactive." Here’s where the appellate panel agreed with Koch, who argued that since his alleged attempts to mark the close occurred before the remedial provisions of the Dodd-Frank Act took effect in 2010, barring him from associating with municipal advisers or rating organizations – which was not within the scope of SEC powers prior to enactment of Dodd-Frank – was incorrect. The appellate panel agreed, but added that the SEC’s barring of Koch from association with other securities industries still applied.