Could SEC's Plan to Track Trades Also Combat Financial Fraud?

The United States Securities and Exchange Commission ("SEC") recently voted to establish a centralized database to track and monitor all trading activity across U.S. equity and options markets, prompted in large part by the difficulties encountered in pinpointing the cause of the "flash crash" on May 6, 2010 that temporarily wiped out nearly $1 trillion in shareholder value.  Because various exchanges and centralized clearing firms stored market data in different formats, it took the SEC nearly five months to gather and analyze market data from just a few hours of trading activity.  According to SEC Chairman Mary L. Shapiro, the establishment of a single, market-wide 'consolidated audit trail' "will provide us with an unprecedented ability to effectively oversee the markets we regulate."  While the move will help regulators respond quicker to future market anomalies, it may also present a valuable new weapon against financial fraud such as insider trading and Ponzi schemes.

Currently, the SEC uses several independent tools to monitor and analyze market data.  One is the Electronic Blue Sheets ("EBS") system, which provides the sole existing method to identify customers of broker-dealers who have executed trades.  While records include detailed execution information on specific securities at specified times, the information is limited to executed trades, does not track orders or quotes, and contains only the date, rather than the specific time, of each execution.  Additionally, the identification of customers using EBS data is difficult, and follow-up record requests can often take days or weeks depending on the nature of the request.

Regulators also use reports that track the daily volume of equity and options trading, known as the Equity Cleared Report ("ECR") and Options Cleared Report ("OCR"), respectively.  While the reports are generated daily, they are currently only provided to regulators upon request.  Additionally, various financial exchanges and broker-dealers maintain separate audit trails comprised of member-reported data.  This data is viewed as largely incomplete in that it does not identify customers, is not stored in a centralized database available to other exchanges, and is not readily accessible by regulators.

Under the newly-adopted proposal, officially known as Rule 613 of the Securities and Exchange Act of 1934 (the "Rule"), the financial exchanges and members of the Financial industry Regulatory Authority must work together to develop a centralized database that would store information on every single trade order, execution, and cancellation across across numerous equity and options trading markets.  Exchanges and member firms will be required to submit gathered data to a central repository by 8:00 a.m. on the next trading day.  The consolidated audit trail, or "CAT", will contain a time-sequenced record measured in milliseconds.  To better facilitate analysis of the data, each reporting broker-dealer, customer, and order will be assigned a unique order identification number.

Besides its primary stated purpose of better equipping regulators to reconstruct data from market events, the establishment of a centralized trading database could be a "game changer" for combating financial fraud.  For example, an insider-trading investigation is often a complex and time-consuming process spurred by a market event, usually the announcement of a corporate takeover or, in the case of convicted fund manager Raj Rajaratnam, the disclosure of quarterly earnings.  An investigation would first involve a request by the SEC to gather daily equity and options trading records (the ECR's and OCR's) maintained by the National Securities Clearing Corporation and the Options Clearing Corporation, respectively.

After obtaining and reviewing the data, which is limited to the date, clearing firm, and number of transactions cleared by each clearing firm, the SEC would then contact individual clearing firms to obtain the identity of customers making questionable transactions and further information.  Because of the various players involved, this is often not a routine or simple process.  With a centralized database at its fingertips containing the entirety of trading records from the previous trading day, the SEC would be able to eliminate having to obtain trading records and customer from outside parties.

Boston attorney Michael Gass, Chair of the Securities Litigation Group at Choate, Hall & Stewart LLP, believes the consolidated audit trail could "significantly enhance fraud enforcement."  For example, regulators would have the ability to independently scrutinize trading activity of a suspected Ponzi scheme.  Pointing to the $65 billion Ponzi scheme perpetrated by Bernard Madoff, Gass remarked on the "extraordinary fact that..he was making virtually no trades."  Had regulators had the ability to review Madoff's trades simply by querying his customer identification number on the CAT, the disparities between his reported and actual trading would have likely raised glaring red flags.  Indeed, it was discovered after Madoff's fraud was revealed that there were multiple instances where reported daily trading volume in stocks by Madoff's brokerage exceeded the entire daily volume for those shares.

For instance, on one day in October 2002, Madoff reported that he had acquired 17.8 million shares of energy company Exxon Mobil - certainly a large block of shares, but not altogether unusual for a fund managing billions of dollars.  However, 17.8 million shares did not trade hands that particular day.  Instead, the total volume of shares traded that day was much lower - 13,574,500 shares, to be exact.  Had regulators been able to scrutinize Madoff's actual trading, they would have learned that Madoff owned less than 6,000 shares of Exxon Mobil in October 2002 - not 17.8 million.

Additionally, customer identification numbers could also allow regulators to track cancelled or modified orders.  Thus, a Ponzi schemer who provided customers with screenshots of trade confirmation - only to then cancel those orders, unbeknownst to customers - might raise red flags with regulators privy to the full "lifespan" of each order.

However, not all are sold on the Rule's benefits, including Yaron Reuven, the President and Chief Investment Officer of Reuven Capital Investments LP.  While acknowledging that the Rule may assist in the detection of certain types of market manipulation, Reuven believes that the standardization of compliance procedures across reporting firms - regardless of size - unnecessarily burdens smaller firms that are less capable of shouldering the increased costs.  "In so many words," says Reuven, "FINRA expects a 2-man firm to have the same compliance system as Merrill Lynch's."  Reuven also questions whether the SEC has adequate manpower and resources to handle the expected influx of data.

While the benefits of the Rule potentially represent a huge step forward for regulators, their effect will not be seen for several years as regulators devise and implement the consolidated audit trail.  Small broker-dealers, facing the highest costs of compliance, have three years from the system's enactment to comply.  In the meantime, argues Gass, the mere possibility of the dramatically increased transparency offered by an efficient consolidated audit trail could have a significant deterrent effect.

A copy of the Rule is available here.

Jordan Maglich is an attorney at Wiand Guerra King P.L. in Tampa, Florida whose practice includes white-collar crime and securities and financial litigation.  He also covers Ponzi schemes on his blog, PonziTracker.  Follow him at @PonziTracker.