Helping yourself while serving two masters: do specialists violate rule 10B-5 when they interposition?

• Author: Asudulayev, Roman

ABSTRACT

The decision of the Second Circuit in United States v. Finnerty (Finnerty III) was the culmination of a number of District Court decisions that found that specialists on the New York Stock Exchange (NYSE) could not be held liable for fraud under Rule 10b-5 for interpositioning, whereby they put themselves between buy and sell limit orders, in violation of NYSE rules, and profited on the spread. Finnerty III and its District Court sibling decisions were wrongly decided. Specialists presented a uniquely thorny issue of agency law to the Federal Courts in New York. This issue was under-analyzed by the Federal Prosecutors and left the courts without a coherent theory of fiduciary duty for specialists. This Note will demonstrate that there is a fiduciary relationship between specialists and their public customers and will untangle that relationship to show that it prohibits interpositioning and that interpositioning was fraud under Rule 10b-5.

Introduction I. The Legal Background of Interpositioning and Some Economics A. Specialists B. Interpositioning C. Rule 10b-5 and Fraud D. Some Possible Analogies to Interpositioning 1. Trading Ahead 2. Insider Trading E. The Fiduciary Duties of Specialists 1. Establishing Fiduciary Duty 2. Fiduciary Duties F. Economic Terminology and a Dose of Legal Realism: Arbitrage and Rent II. The Conflict: The Courts' and the Government's Analyses of Interpositioning and Fraud A. The Logic of the Courts B. The Counter-Argument III. Who's Right? A. Economic Analysis for Legal Realism B. Mistakes in the Law and a Fact: Fiduciary Duty, Fraud, and Rule 10b-5 C. And All of the Analogies: Insider Trading and Trading Ahead D. Of Missing Steps and Synthesis Conclusion INTRODUCTION

With increasing public furor over the actions of various financial institutions, (1) it is easy to forget that apparent fraud in finance can create tricky legal issues. In 2005, federal prosecutors charged fifteen broker-dealers on the New York Stock Exchange, called "specialists," (2) with fraudulent trading. (3) The gist of the charge was that the specialists took advantage of trade requests that clients had sent to them. (4) Although specialists are allowed to trade on their own accounts, "when a buy order comes in at a higher price than a sell order, the specialist's duty is to match the customers rather than profit from the spread." (5) The practice of profiting from the spread is called "interpositioning." (6) Between 2005 and 2008, the Federal Prosecutor for the Southern District of New York began fifteen prosecutions. (7) All fifteen failed ignominiously (8): seven were dropped voluntarily; two ended in acquittal; (9) two guilty pleas were set aside; the government dropped a case against a fugitive; (10) two had their convictions overturned by the Second Circuit Court of Appeals; (11) and one individual, David Finnerty, had his conviction set aside by the District Court, and the Second Circuit upheld the decision. (12) Apparently, the government is quite unaccustomed to losing cases, (13) fifteen especially. How did this fiasco occur?

This Note will shed light on the operation of the NYSE, discuss the prosecutions, and explore the difficult legal questions they presented--questions that arguably have been left unanswered. Part I of this Note introduces the reader to the NYSE and its specialists, explains interpositioning, discusses the background law that relates to specialists--SEC Rule 10b-5, (14) fraud, and fiduciary duty--and explains some economic terminology that will later help put the role of specialists and interpositioning into perspective, and to consider this area of law from a more Legal Realist perspective.

Part II of this Note will discuss the logic used by the courts in their ultimate rejection of the allegation of fraud against specialists for interpositioning: the courts did not receive a strong argument that specialists were fiduciaries of their clients, meaning that mere theft by the specialists without any express promises to the contrary could not be considered fraud. Part II will also discuss the arguments that federal prosecutors put forth to show that the specialists were fiduciaries of their clients and that therefore their actions amounted to fraud.

Part III of this Note explains that specialists play a negative role in the economy when they interpose themselves as traders between their customers, and therefore are an appropriate target for Rule 10b-5 fraud prosecution. Part III demonstrates how the arguments of the prosecution were correct in their conclusion but not in their reasoning, meaning that the courts were right to reject those arguments. Part III concludes that specialists were agents of their clients because they were their brokers, who are agents of their clients to the extent of executing their clients' trades. As agents, these brokers had a fiduciary duty not to trade for their own benefit without their clients' knowledge, as both a formal matter and by analogy to other legal doctrines.

1. THE LEGAL BACKGROUND OF INTERPOSITIONING AND SOME ECONOMICS

   This Part discusses the background concepts and law behind the interpositioning prosecutions. It defines the term "specialist" (15) and the act of interpositioning. (16) This Part also explains the relation of fraud under Rule 10b-5 to breaches of fiduciary duty generally. (17) It then discusses two practices that are analogous to interpositioning: trading ahead (18) and insider trading. (19) This Part also offers a discussion of fiduciary duty, both in its inception (20) and its operation. (21) And, finally, it explains some economic terminology that shall be useful to understand the role that interpositioning plays in the financial system. (22)

   1. Specialists

      Specialists have a long history whose beginnings are obscured by legend. (23) "In simplest terms," George T. Simon and Kathryn M. Trkla describe the specialist as "a member of an exchange that specializes in trading a particular security or group of securities as broker or as dealer." (24) Thus, when a member of the public wants to buy a particular security at the NYSE, she must go through a specialist (25) unless she trades electronically. In other words, "[s]pecialists act as auctioneers in the specific stocks they are designated to trade." (26) Thus, part of the specialist's role is to match up bids and offers, (27) acting as a sort of "brokers' broker," taking orders from public customers' brokers to buy or sell securities. (28) Generally, there are two kinds of orders that specialists take: market orders, which are orders to buy or sell a security at the market price, and limit orders, which are orders to buy or sell only if a certain price is available. (29) Generally, a bid limit order will ask that a security be bought only when it is at or below a certain price, while an offer limit order will ask that a security be sold only when it is at or above a certain price. (30)

      Yet, specialists also have a second function: they can buy and sell securities on their own accounts. (31) Specifically, specialists may buy or sell securities when there are no matching orders. (32) In other words, when there is a bid limit order that is too low for any existing offers, the specialist may take the opposite side of the bid, and sell at the bid price to prevent erratic market shifts. (33) Another way to describe this function is to say that specialists provide liquidity to the market, by providing buyers or sellers for securities, when there would otherwise be an imbalance. (34) In this capacity, specialists act as "market makers." (35) New York Stock Exchange Rule 104 prohibits specialists from trading on their own account as market makers unless there are no matchable customer orders. (36) As a corollary, specialists are supposed to match orders at either the bid or offer price. (37)

      Finally, specialists receive commissions for trades that they help broker. (38) Interestingly, this fact was subject to some controversy: some of the courts specifically stated that specialists were not compensated by their clients through commission. (39) This may be because the government appears to have conceded that specialists are not compensated for these kinds of trades. (40) Specialists are no longer compensated through commissions for the trades that they broker; rather, they are compensated through a profit-sharing system, whereby the NYSE will pay them directly. (41) What one must keep in mind is that at the time of specialist prosecutions, specialists were compensated for the orders that they brokered between their public customers. (42)

   2. Interpositioning

      Interpositioning is occasioned by a pair of matchable limit orders for some security, say a bid limit order at $100 and an offer limit order at $99.90. (43) The specialist "interposes" when she buys the security from the offeror, at $100, and then sells to the bidder at $99.90, pocketing ten cents on the trade. (44) In this way, specialists can take advantage of their function of receiving limit orders (45) and their ability to buy and sell on their own accounts (46) by interposing themselves between a lower offer price and higher bid offer and trading on their own accounts, to buy from the offeror and then resell to the bidder. (47) These trades added up to a rather large amount: $158 million of lost client money, with one firm taking $38 million. (48)

      Thus, in 2005, the U.S. Attorney for the Southern District of New York indicted fifteen individuals working for specialist firms for fraud under Section 10(b) of the Securities Exchange Act of 193449 and Rule 10b-5 (50) for interpositioning. (51) These indictments followed on the heels of a settlement between the Securities and Exchange Commission (SEC) and the specialist firms, as well as another settlement with the NYSE. (52)

      The courts generally found that interpositioning did not violate Rule 10b-5 because the government could not prove deception (53) or...