The US District Court in New York hearing the enforcement action by the Securities and Exchange Commission against Lek Securities and Samuel Lek, its 70 percent owner and chief executive officer (collectively, the “LEK Defendants”), denied the defendants’ motion to dismiss, ruling that layering and cross-market manipulation as alleged by the SEC in its complaint can constitute market manipulation in violation of federal securities laws.

The SEC sued the LEK Defendants on March 10, 2017, for facilitating manipulative trading by Avalon FA Ltd., a non-US entity, and its two control persons, Nathan Fayyer and Serge Pustelnik

In its complaint against the LEK Defendants, the SEC alleged that on “hundreds of thousands of instances” from December 2010 through at least September 2016, Avalon placed false orders in various stocks on one side of a marketplace to drive a stock’s price up or down. It did this, said the SEC, “to trick and induce other market participants to execute against Avalon’s bona fide orders (i.e., orders Avalon intended to execute) for the same stock on the opposite side of the market.” After executing its legitimate orders at more favorable prices, Avalon cancelled its other-side-of-the-market layering or spoofing orders, the SEC claimed. In addition, charged the SEC, from April 2012 through December 2015, Avalon bought and sold stocks at losses in order to influence the market for corresponding options on the stocks. Avalon then made a profit by trading these options at “artificial prices.” The SEC charged that the LEK Defendants facilitated Avalon’s allegedly improper conduct.

In their motion to dismiss, the LEK Defendants argued that all of Avalon’s layering activity involved “live, real and actionable” orders that were subject to market risk, and thus could not create a false impression of supply and demand. They also claimed that Avalon’s cross-market activity also involved “real buyers” and that its activity was to hedge stock trades – a legitimate activity. The court rejected these arguments noting that, in a motion to dismiss, factual assertions are inappropriate. In addition, the court said that providing brokerage services to a market manipulator if done with requisite knowledge could be deemed to assist the manipulator in violation of federal securities laws. (Click here to access 15 U.S.C. §77o(b) and here to access 15 U.S.C. §78i(a)(2).)

(Click here for background on the SEC’s enforcement action against the LEK Defendants in the article “US Broker-Dealer, Its CEO and a Non-US Client Sued by SEC for Layering and Other Manipulative Schemes” in the March 12, 2017 edition of Bridging the Week.)

Legal Weeds: As the SEC’s action against the LEK Defendants and the Commodity Futures Trading Commission’s September 2016 enforcement action against Advantage Futures LLC and two of its principals demonstrates, neither the SEC nor the CFTC appear reluctant to bring an enforcement action against a broker if the broker fails to take what the regulators consider to be responsible appropriate action in the face of well-supported allegations of wrongdoing by a customer.

In response to the CFTC’s enforcement action, Advantage, Joseph Guinan, its majority owner and chief executive officer, and William Steele, who until May 2016 was Advantage’s chief risk officer, settled charges related to the firm’s handling of the trading account of one customer in response to three exchanges’ warnings regarding the customer’s possibly illicit trading conduct.

According to the CFTC, between June 2012 and April 2013, three exchanges alerted Advantage to concerns they had regarding the trading of one unspecified customer’s account, which they thought might constitute disorderly trading, spoofing and manipulative behavior, in violation of the exchanges’ relevant rules.

The CFTC claimed that Advantage initially failed “to adequately respond to the Exchange inquiries and did not conduct a meaningful inquiry into the suspicious trading.” Only after the three exchanges threatened to hold Advantage responsible for its customer’s conduct, did Advantage cut off the trader’s access to three exchanges. (Click here for details of this enforcement action in the article “FCM, CEO and CRO Sued by CFTC for Failure to Supervise and Risk-Related Offenses” in the September 25, 2016 edition of Bridging the Week.)

Registrants should consider developing databases that permit them to log all regulatory inquiries and other extraordinary matters regarding their customers so they can more systematically evaluate potential red flags regarding customers’ conduct.