The SEC approved new rules proposed by the exchanges and FINRA to ensure that market makers make real, meaningful quotes. In September the SEC proposed rules governing short term borrowings to address what many call “window dressing.” The proposals are unrelated. Yet each raises the same question: Are more rules necessary?
The new market maker rules are designed to prohibit what are called “stub quotes.” This is a price quote which is “an offer to buy or sell stock at a price so far away from the prevailing market that it is not intended to be executed, such as an order to buy at a penny or an offer to sell at $100,000.” This type of offer was involved in the “flash crash.”
Under the new rules, market makers will effectively be barred from making stub quotes. Now, depending on the security, a market maker will have to make a bid which fits within certain parameters. For example, for securities subject to the circuit breaker pilot program, the market maker will be required to enter a quote that is not more than 8% away from the best bid and offer. For exchange listed equities that are not included in the circuit breaker pilot program, a market maker will be required to enter quotes that are no more than 30% away from best bid and offer.
The short term borrowing rules proposed in September focus on a similar practice. According to the release, many financial institutions and others engage in short term borrowing to fund operations. These types of borrowings can fluctuate significantly during a reporting period. Those changes may not be shown on financial statements prepared as of the end of a period. The borrowings can also be used to improve the balance sheet at the end of the period reporting requirements. This practice, called “window dressing,” was supposedly involved in the collapse of Lehman Brothers. The proposed rules will provide additional disclosures to try to ensure that investors are informed about the short term borrowings.
Before writing any new rules it is good to return to basics. The Exchange Act defines “market maker” in Section 3(38) as any “specialist permitted to act as a dealer . . . who, with respect to a security, hold himself out . . . as being willing to buy and sell such security for his own account a regular or continuous basis.” This type of activity is critical to the proper functioning of the markets. It relies on the market maker to put real quotes in the market place which can be executed.
In contrast, a market maker who uses a stub quote, according to the SEC’s release, is only doing so “to nominally comply with its obligation to maintain a two-sided quotation at those times when it does not wish to actively provide liquidity.” Stated differently, the stub quote is not really an offer to buy and sell. Rather, it is a kind of place holder which permits the market maker to give the appearance of fulfilling his or her obligations. In reality, the stub bid is an illusion, lacking substance. No doubt there are rules to prevent this type of conduct.
Financial statements are supposed to provide the shareholder and investor with a snap shot of the enterprise’s financial condition at a point in time. Accounting principles are applied consistently from period to period to ensure the statements can be compared from period to period. MD&A is supposed to put the investor in the seat of management, showing the cash flows of the company. It goes along with the pictures in the financial statements.
Transactions undertaken as “balance sheet window dressing” are the same as a stub quote – they lack economic substance. Round trip transactions or those done and undone just to temporarily improve the balance sheet undercut the purpose of furnishing investors with financial statements. Investors and shareholder are entitled to see how their money is being used by those to whom they trusted it. As with the stub quote, there are rules which preclude giving investors what amounts to a photo shopped picture.
In the end, the federal securities laws are a code of ethics for the market place, not a rule book to plan around. This means market makers have an obligation to offer real quotes to the market, not place holders lacking substance. It means companies have an obligation to give investors an accurate picture of their company’s financial health, not which hides it. The new rules are no doubt well intended and may add to the market and the total mix of disclosed information. At the same time, if the current provisions are being ignored, there seems little reason to believe that more rules will change anything.