Are Big Banks’ Dark Pools Behind the Run-Up in Bank Stock Prices?

Source: FINRA

Source: FINRA

By Pam Martens and Russ Martens: February 24, 2017 

The biggest banks on Wall Street, both foreign and domestic, have been repeatedly charged with rigging and colluding in markets from New York to London to Japan. Thus, it is natural to ask, have the big banks formed a cartel to rig the prices of their own stocks?

This time last year, Wall Street banks were in a slow, endless bleed. The Federal Reserve had raised interest rates for the first time since the 2008 financial crisis on December 16, 2015 with strong hints that more rate hikes would be coming in 2016. Bank stocks never do well in a rising interest rate environment because their dividend yield has to compete with rising yields on bonds. Money gravitates out of dividend paying stocks into bonds and/or into hard assets like real estate based on the view that it will appreciate from inflationary forces. This is classic market thinking 101.

Bizarrely, to explain the current run up in bank stock prices, market pundits are shoving their way onto business news shows to explain to the gullible public that bank stocks like rising interest rates because the banks will be able to charge more on loans. That rationale pales in comparison to the negative impact of outflows from stocks into bonds (if and when interest rates actually do materially rise) and the negative impact of banks taking higher reserves for loan losses because their already shaky loan clients can’t pay loans on time because of rising rates. That is also classic market thinking 101.

Big bank stocks also like calm and certainty – as does the stock market in general. At the risk of understatement, since Donald Trump took the Oath of Office on January 20, those qualities don’t readily come to mind in describing the state of the union.

Prior to the cravenly corrupt market rigging that led to the epic financial crash in 2008 (we’re talking about the rating agencies being paid by Wall Street to deliver triple-A ratings to junk mortgage securitizations and banks knowingly issuing mortgage pools in which they had inside knowledge that they would fail) the previous episode of that level of corruption occurred in the late 1920s and also led to an epic financial crash in 1929. The U.S. only avoided a Great Depression following 2008 because the Federal Reserve, on its own, secretly funneled $16 trillion in almost zero interest rate loans to Wall Street banks and their foreign cousins. (Because the Fed did this without the knowledge of Congress or the public, this was effectively another form of market rigging. Had the rest of us known this was happening, we also could have made easy bets on the direction of the stock market.)

As we contemplated a more rational basis for the heady uplift in Wall Street bank stock prices this year, we were forced to consider the fact that the Wall Street banks run their own Dark Pools — which are effectively unregulated stock exchanges. That’s right. In addition to owning FDIC-insured banks holding Mom and Pop deposits; in addition to parking trillions of dollars of squirrely derivatives on the books of the FDIC banks; in addition to using those demand deposits to make wild, speculative gambles in the markets; in addition to being charged by regulators around the globe, including the U.S. Justice Department, with an insidious disregard for rigging and colluding in markets, the very same banks are allowed to operate quasi stock exchanges in the dark bowels of their own trading houses.

The chart above from Wall Street’s self-regulator, FINRA, shows that in the week of January 9, 2017 the Dark Pools of Wall Street’s banks made 49,487 trades in the stock of JPMorgan Chase. The biggest traders were UBS, which traded 1.7 million shares; Credit Suisse’s CrossFinder, which traded 1.2 million shares; and, shockingly, JPMorgan’s own Dark Pool, JPM-X, which traded 1.1 million in its own shares. In a rational world, we would be seeing handcuffs and perp walks for this kind of backroom dealing.

Adding to the curiosity, in the same week that JPMorgan and its “competitors” were trading in its stock, JPMorgan’s Best Friends Forever were putting out buy recommendations on its stock. (That’s right. In addition to one-stop shopping for everything from credit cards to junk bonds to dicey derivatives, these same Wall Street banks are allowed to make buy, hold and sell recommendations to the public on publicly traded stocks, including those banks that are counterparties to their derivative holdings. They are allowed to issue this “research” despite being charged with craven research practices by the Securities and Exchange Commission in 2003.)

On Wednesday of the week depicted on the Dark Pool chart above, Morgan Stanley reaffirmed its buy rating on JPMorgan’s stock. Its Dark Pool, indicated above as MSPL, traded over 400,000 shares of JPMorgan stock that week. Bank of America reaffirmed its buy rating also. Its Dark Pool, the Merrill Lynch Instinct-X, traded over 293,000 shares of JPMorgan stock that week. Deutsche Bank also reiterated its buy rating on JPMorgan stock and traded more than 584,000 shares of JPMorgan stock in its Dark Pool known as SuperX.

We don’t mean to suggest that JPMorgan’s stock is the only one being traded in the Dark Pools of Wall Street banks. In fact, every mega Wall Street bank is being similarly traded.

In the leadup to the crash of 1929, Wall Street was also operating Dark Pools. Back then, they were simply called “Pools.” From 1932 to 1934, the Senate Banking Committee conducted an exhaustive investigation into the systemic market rigging tactics used by the trading houses on Wall Street. A major part of the investigation looked at the activities within the “Pools.”

On June 6, 1934, the Senate released a final report on its findings. One finding addressed the serious amounts of money flowing into the pools:

“Banks also made substantial loans for the financing of syndicate or pool operations in stocks. In 1929 the 33 reporting banks made 34 loans to finance syndicate or pool operations, totaling $76,459,550…During 1929 some or all of these 33 banks participated in 434 stock syndicate or pool accounts.”

Just as today, Wall Street ran a massive campaign during the Senate hearings of 1932 to 1934 to ridicule any suggestion that it was running a market-rigging cartel. The report notes:

“The tendency has been to belittle reports of manipulative activities as unfounded rumors, unworthy of serious attention. The evidence adduced before the subcommittee has thoroughly discredited this attitude.”

The report provided the public with a clear understanding of the motivations behind creating a Pool:

“A pool, according to stock exchange officials, is an agreement between several people, usually more than three, to actively trade in a single security. The investigation has shown that the purpose of a pool generally is to raise the price of a security by concerted activity on the part of the pool members, and thereby to enable them to unload their holdings at a profit upon the public attracted by the activity or by information disseminated about the stock. Pool operations for such a purpose are incompatible with the maintenance of a free and uncontrolled market.”

That finding is worth repeating: “Pool operations for such a purpose are incompatible with the maintenance of a free and uncontrolled market.”

The report noted further:

“The testimony before the Senate subcommittee again and again demonstrated that the activity fomented by a pool creates a false and deceptive appearance of genuine demand for the security on the part of the purchasing public and attracts persons relying upon this misleading appearance to make purchases. By this means the pool is enabled to unload its holdings upon an unsuspecting public.”

Wall Street On Parade, to the chagrin of Wall Street, has recently asked the question, in regard to banks trading their own stocks in their own Dark Pools, “How Is This Legal.” We received several dismissive emails. But the Senate Banking Committee of 1934 and its myriad lawyers saw a big legal problem, writing:

“The conclusion is inescapable that members of the organized exchanges who had a participation in or managed pools, while simultaneously acting as brokers for the general public, were representing irreconcilable interests and attempting to discharge conflicting functions. Yet the stock exchange authorities could perceive nothing unethical in this situation.”

The Senate report found that “The propitious time to commence operations [in a Pool] is when public attention has been attracted either by the condition of the corporation issuing the stock or the industry of which it is a part, or by external factual conditions, such as the possibility of legislation affecting the industry.”

In other words, levitating the stock price works so much better if there is a news angle that can be bandied about in the press. For example, today we are hearing a lot about how Wall Street will reap big profits from Trump’s plan to repeal the Dodd-Frank financial reform legislation. In reality, that was fairly toothless legislation but repealing it without restoring the much stronger Glass-Steagall Act would doom Wall Street to another crash.

The Senate report explains how these publicized legislative windfalls can be constructed out of fairy dust. For example, in 1933 a Pool was created to levitate the shares of Libbey-Owens-Ford Glass Co. on the premise that it made liquor bottles and its share price would soar on the proposed repeal of prohibition. In fact, says the report, “it made no bottles and its business was in no way enhanced by the repeal of prohibition.”

Like the flattering buy recommendations we see emanating today from the deeply conflicted big banks, Wall Street had a similar hawking machinery in the late 20s and early 30s. The Senate report found:

“…The dissemination of information flattering to the stock in which the pool is operating is the fourth factor in bringing the operation to a successful conclusion. Although the nature and extent of the pool’s own operations are shrouded in utmost secrecy, the participants make use of various channels to disseminate information subtly designed to excite public attention toward the security. A method commonly followed is to cause market letters to be sent by brokerage firms to their branch offices, which letters are made accessible to the investing and speculating public…

“David M. Lion, who characterized his business as ‘financial publicity,’ testified before the subcommittee that he was the publisher of a paper known as ‘The Stock and Bond Reporter.’ This sheet publicized particular stocks which formed the basis of pool operations. As compensation for such publicity, Lion received calls on substantial blocks of stock from the pool operators…Lion also testified that he employed newspaper writers to publish articles concerning the securities, and that he paid for their services either by options on stock or by cash. The extent of his activities is manifested by the fact that he engaged in as many as 30 operations at one time on behalf of various pool operators.”

During the Senate hearings, Congressman Fiorella LaGuardia of New York produced a trunk of documents showing that financial journalists at some of the then august newspapers of New York were on the take to help the Pools accomplish their goals. One document showed that a man named Plummer, a publicity man, had “expended on behalf of his pool-operating employers the sum of $286,279 for the publication of articles in the press favorable to their stocks,” according to the Senate report.

Despite this rich and detailed history of Pool operations, the U.S. Congress has shown little interest in pulling back the dark curtain on today’s Dark Pools. We urge our readers to call their Senators and demand a serious investigation before the next financial crisis in unleashed on an unsuspecting public.

Related Articles:

Another Wall Street Inside Job?: Stock Buybacks Carried Out in Dark Pools

Citadel’s Dark Pool: SEC Draws a Dark Curtain Around Its Operations

Wall Street Journal Reporter: “The Entire United States Market Has Become One Vast Dark Pool”

Goldman Sachs’ Very Fishy Dark Pool Settlement With FINRA

After Charges of Running a Price Fixing Cartel on Nasdaq in the 90s, Wall Street Banks Are Now Trading Their Own Stocks in Darkness

What JPMorgan and Citigroup Have in Common When It Comes to Crime

By Pam Martens and Russ Martens: February 23, 2017

Jamie Dimon, Chairman and CEO of JPMorgan Chase, Testifying Before Congress on the London Whale Trading Losses at His Bank

Jamie Dimon, Chairman and CEO of JPMorgan Chase, Testifying Before Congress on the London Whale Trading Losses at His Bank

On September 8, 2016, the Consumer Financial Protection Bureau (CFPB) fined Wells Fargo $185 million following an investigation that found that its employees had engaged in a widespread practice of “secretly opening unauthorized deposit and credit card accounts” in order to meet sales quotas or qualify for bonuses. An estimated 2 million accounts were involved. One month later, the Chairman and CEO of Wells Fargo, John Stumpf, was gone.

Consider that swift action to acknowledge and punish egregious abuse of clients with how the Boards of Directors of JPMorgan Chase and Citigroup have responded to criminal felony charges and seemingly endless regulatory fines for abusing clients’ trust. The Boards have kept their CEOs in place, paid the monster fines and moved on to the next settlement.

Jamie Dimon became the CEO of JPMorgan Chase on January 1, 2006. At that point, the bank was more than a century old and had never been charged with a criminal felony. In 2014, the Justice Department charged JPMorgan Chase with two felony counts in connection with their role in facilitating the Madoff Ponzi scheme. The bank was given a two-year deferred prosecution agreement.

The very next year, in May 2015, JPMorgan Chase was hit with a new felony count for its role in rigging foreign currency markets as part of a banking cartel. That’s three felony counts in two years and yet Jamie Dimon kept his job. Before the felony counts there was a $13 billion settlement with the Justice Department and Federal and State regulators in 2013 for JPMorgan Chase’s role in selling toxic mortgage investments to investors as worthwhile products when the bank had good reason to believe they would blow up.

In 2012, Dimon himself was hauled before Congress to explain why his bank was making speculative bets with depositors’ money in high risk derivatives in London. The bank eventually owned up to losing $6.2 billion in the wild trades. The scandal  became infamously known as the London Whale. In 2013, the Senate Permanent Subcommittee on Investigations released a damning 307-page report on the London Whale matter. The same year, the regulator of national banks, the Office of the Comptroller of the Currency (OCC), released the following statement regarding the London Whale trades:

“The credit derivatives trading activity constituted recklessly unsafe and unsound practices, was part of a pattern of misconduct and resulted in more than minimal loss, all within the meaning of 12 U.S.C. § 1818(i)(2)(B)”;  and “The Bank failed to ensure that significant information related to the credit derivatives trading strategy and deficiencies identified in risk management systems and controls was provided in a timely and appropriate manner to OCC examiners.”

Senator Carl Levin, Chair of the Senate Permanent Subcommittee on Investigations at the time, said that the bank “piled on risk, hid losses, disregarded risk limits, manipulated risk models, dodged oversight, and misinformed the public.”  And, unbelievably, Jamie Dimon continued his tenure as Chairman and CEO of JPMorgan Chase.

The crime spree at JPMorgan Chase became so surreal that two trial lawyers, Helen Davis Chaitman and Lance Gotthoffer, published a breathtaking book on the subject, comparing the bank to the Gambino crime family. In addition to the settlements noted above, the authors add more details as to what has occurred on Dimon’s watch, such as:

“In April 2011, JPMC agreed to pay $35 million to settle claims that it overcharged members of the military service on their mortgages in violation of the Service Members Civil Relief Act and the Housing and Economic Recovery Act of 2008.

“In March 2012, JPMC paid the government $659 million to settle charges that it charged veterans hidden fees in mortgage refinancing transactions.

“In October 2012, JPMC paid $1.2 billion to settle claims that it, along with other banks, conspired to set the price of credit and debit card interchange fees.

“On January 7, 2013, JPMC announced that it had agreed to a settlement with the Office of the Controller of the Currency (‘OCC’) and the Federal Reserve Bank of charges that it had engaged in improper foreclosure practices.

“In September 2013, JPMC agreed to pay $80 million in fines and $309 million in refunds to customers whom the bank billed for credit monitoring services that the bank never provided.

“On December 13, 2013, JPMC agreed to pay 79.9 million Euros to settle claims of the European Commission relating to illegal rigging of benchmark interest rates.

“In February 2012, JPMC agreed to pay $110 million to settle claims that it overcharged customers for overdraft fees.

“In November 2012, JPMC paid $296,900,000 to the SEC to settle claims that it misstated information about the delinquency status of its mortgage portfolio.

“In July 2013, JPMC paid $410 million to the Federal Energy Regulatory Commission to settle claims of bidding manipulation of California and Midwest electricity markets.

“In December 2013, JPMC paid $22.1 million to settle claims that the bank imposed expensive and unnecessary flood insurance on homeowners whose mortgages the bank serviced.”

Michael Corbat has been CEO of Citigroup since October 2012. Below is just a sampling of the regulatory charges against the bank under Corbat’s reign, including a guilty plea to a felony count in May 2015 which covered conduct that continued after Corbat took the helm.

July 1, 2013: Citigroup agrees to pay Fannie Mae $968 million for selling it toxic mortgage loans.

September 25, 2013: Citigroup agrees to pay Freddie Mac $395 million to settle claims it sold it toxic mortgages.

December 4, 2013: Citigroup admits to participating in the Yen Libor financial derivatives cartel to the European Commission and accepts a fine of $95 million.

July 14, 2014: The U.S. Department of Justice announces a $7 billion settlement with Citigroup for selling toxic mortgages to investors. Attorney General Eric Holder called the bank’s conduct “egregious,” adding, “As a result of their assurances that toxic financial products were sound, Citigroup was able to expand its market share and increase profits.”

November 2014: Citigroup pays more than $1 billion to settle civil allegations with regulators that it manipulated foreign currency markets. Other global banks settled at the same time.

May 20, 2015: Citicorp, a unit of Citigroup becomes an admitted felon by pleading guilty to a felony charge in the matter of rigging foreign currency trading, paying a fine of $925 million to the Justice Department and $342 million to the Federal Reserve for a total of $1.267 billion.

May 25, 2016: Citigroup agrees to pay $425 million to resolve claims brought by the Commodity Futures Trading Commission that it had rigged interest-rate benchmarks, including ISDAfix, from 2007 to 2012.

July 12, 2016: The Securities and Exchange Commission fined Citigroup Global Markets Inc. $7 million for failure to provide accurate trading records over a period of 15 years.

President Donald Trump’s naïve (or willfully blind) notion that Wall Street will work better at raising capital if it is unleashed from strident Federal regulation is unhinged from the facts on the ground. Those facts, as illustrated above, are that the Boards of two of the largest banks in the U.S. are utterly spineless when it comes to holding their CEOs and employees accountable in the face of a tsunami of crimes.

SEC Nominee Has Represented 8 of the 10 Largest Wall Street Banks in Past Three Years

By Pam Martens and Russ Martens: February 22, 2017

Jay Clayton, Law Partner at Sullivan & Cromwell, Has Been Nominated to Chair the SEC by Trump

Jay Clayton, Law Partner at Sullivan & Cromwell, Has Been Nominated to Chair the SEC by Trump

President Trump’s nominee to head the Securities and Exchange Commission, Walter J. (Jay) Clayton, a law partner at Sullivan & Cromwell, has represented 8 of the 10 largest Wall Street banks as recently as within the last three years.

Clayton’s current resume at his law firm is somewhat misleading. It lists under “Representative Engagements” in “Capital Markets/Leveraged Finance” the following:

Initial public offering of $25 billion by Alibaba Group Holding Limited;

Initial public offering of $190 million by Moelis & Company;

Initial public offering of $2.375 billion by Ally Financial.

All three of the above IPOs occurred in 2014 – less than three years ago. A quick check of the prospectuses for the IPOs that were filed with the Securities and Exchange Commission shows that Clayton, as a law partner at Sullivan & Cromwell, was representing the underwriters in the offering, which include the largest Wall Street banks. Put the three deals together and you have 8 of the 10 largest banks on Wall Street being represented by the SEC nominee within the past three years. These are the same banks that are serially charged by the SEC for increasingly creative means of fleecing the public.

If that’s not enough to conflict Clayton out of consideration to Chair the SEC post, then conflicts of interest have lost all meaning within the legal lexicon of the United States.

According to the IPO for Alibaba, the underwriters were Credit Suisse, Deutsche Bank, Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley and Citigroup. The prospectus from Alibaba reads as follows:

“We are being represented by Simpson Thacher & Bartlett LLP with respect to certain legal matters of United States federal securities and New York State law. The underwriters are being represented as to United States federal securities and New York State law matters by Sullivan & Cromwell LLP.”

Lead underwriters in the Moelis IPO were Goldman Sachs and Morgan Stanley. The prospectus reads: “Sullivan & Cromwell LLP, New York, New York, is representing the underwriters in this offering.”

Lead underwriters on the Ally Financial deal were Citigroup, Goldman Sachs, Morgan Stanley and Barclays. Joint book-running managers were: Bank of America Merrill Lynch, Deutsche Bank Securities, JPMorgan. Co-Managers included Sandler O’Neill + Partners, Keefe, Bruyette & Woods, Credit Suisse, Evercore, RBC Capital Markets, Scotiabank, Credit Agricole, Raymond James, and Societe Generale.

The prospectus reads:

“The validity of the issuance of the shares of common stock offered hereby will be passed upon for us by Jeffrey Belisle, Esq., Ally Legal Staff, and certain other legal matters related to the common stock will be passed upon for us by Davis Polk & Wardwell LLP, New York, New York and by Cahill Gordon & Reindel LLP, New York, New York, for the underwriters. Sullivan & Cromwell LLP also has advised the underwriters with respect to certain matters. Sullivan & Cromwell LLP represents and has in the past represented the Company in certain matters.”

The only two mega banks missing from the past three-year lineup of representation by Clayton are UBS and Wells Fargo. However, Clayton lists under his “Representative Engagements” the IPO of Higher One. That deal came in 2010 and included UBS as an underwriter. The IPO prospectus notes: “The validity of the issuance of the common stock offered hereby will be passed upon for us by Cleary Gottlieb Steen & Hamilton LLP, New York, New York, and for the underwriters by Sullivan & Cromwell LLP, New York, New York.”

In 2009, Clayton represented the underwriters in an IPO for Artio Global Investors. Wachovia Securities, now part of Wells Fargo, was one of the underwriters.

If all of these conflicts weren’t enough, Clayton has been outside counsel to Goldman Sachs for years and is married to a Vice President at Goldman Sachs, Gretchen Clayton, who has worked there for 17 years. Under 18 U.S.C. § 208, the basic criminal conflict of interest statute, an executive branch employee is prohibited from participating personally and substantially in a government matter that will affect his own financial interests, as well as the financial interests of his spouse. This effectively means that the SEC Chair will have to recuse himself permanently from any matter involving Goldman Sachs.

The banks with whom Clayton has conflicts are not Eagle Scouts that require no ongoing oversight. They are, for the most part, serial recidivists who are charged time and again by their regulators for breaking the law. Four of the banks named above pled guilty to criminal felony charges brought by the U.S. Justice Department in 2015. Citicorp, a unit of Citigroup, JPMorgan Chase & Co., and Barclays were charged with the rigging of foreign currency trading. UBS pled guilty to a felony charge related to rigging the interest rate benchmark known as Libor.

The majority of the above banks have also been fined billions of dollars by the Justice Department for issuing illegal mortgage securities that helped to bring on the U.S. financial crisis in 2008. Just last month Deutsche Bank settled its claims for $7.2 billion. In its announcement, the Justice Department noted:

“ ‘This resolution holds Deutsche Bank accountable for its illegal conduct and irresponsible lending practices, which caused serious and lasting damage to investors and the American public,’ said Attorney General Loretta E. Lynch.  ‘Deutsche Bank did not merely mislead investors: it contributed directly to an international financial crisis…

“ ‘This $7.2 billion resolution – the largest of its kind – recognizes the immense breadth of Deutsche Bank’s unlawful scheme by demanding a painful penalty from the bank, along with billions of dollars of relief to the communities and homeowners that continue to struggle because of Wall Street’s greed,’ said Principal Deputy Associate Attorney General Bill Baer. ‘The Department will remain relentless in holding financial institutions accountable for the harm their misconduct inflicted on investors, our economy and American consumers.’ ”

The SEC has no criminal powers. It brings only civil actions against Wall Street lawbreakers. We have to rely on the SEC to refer potential criminal matters to the Justice Department in a forthright manner. Can we really expect Jay Clayton, who will more than likely follow in the footsteps of his predecessor Mary Jo White and return to his law firm when his government stint is over, to aggressively pursue his former clients or the current clients of Sullivan & Cromwell?

Who Would Sell This Money Guzzling Product to Retail Clients? The Biggest Names on Wall Street.

By Pam Martens and Russ Martens: February 21, 2017

Wall Street Street SignThere’s a very old joke on Wall Street that goes like this: “How do you make a small fortune on Wall Street? Answer: Start with a large one.” Unfortunately, millions of Americans have discovered since 2008 that this is no laughing matter.

There are now more than 1,000 articles on this website that address the failure of our Congress and regulators to rein in the serial and frequently, conspiratorial, abuses of Wall Street against the investing public. There are brilliantly written books on the fleecing and insatiable greed of Wall Street; there are movies and documentaries on how Wall Street’s reign of financial terror brought the U.S. to the brink of financial collapse in 2008. And yet, the public continues to play the role of sucker at the big trading houses on Wall Street.

Just last week the Securities and Exchange Commission (SEC) provided a glimpse into more nefarious shenanigans on Wall Street that it has allowed to shrivel the life savings of retail clients for years. The SEC fined Morgan Stanley a meaningless $8 million for selling high risk, non-traditional Exchange Traded Funds (ETFs) to retail clients without adequate disclosures and safeguards, thus violating antifraud provisions of the Investment Advisors Act.

The SEC Order focused on a product called a “single inverse ETF,” which, it turns out, was not the worst kind of non-traditional ETF that Morgan Stanley had sold to its clients. A single inverse ETF is a product that seeks to deliver the opposite performance of a benchmark index like the S&P 500 on a “single” basis meaning a 1-to-1 basis. The single nomenclature is necessary because there are also leveraged ETFs that seek to provide to 2-to-1 or even 3-to-1 performance of the index (inverse or regular). Based on a review of arbitration claims filed against Morgan Stanley and other big banks on Wall Street, leveraged and inverse ETFs have been savaging the life savings of retail investors for years, while the industry’s self regulator, FINRA, has allowed the parties in the arbitration claims to settle quietly. It has also agreed to expunge the charges from the broker’s official record in many of the cases.

The history of these abuses are long and sordid. On May 1, 2012, FINRA fined and sanctioned the following firms for abuses in selling leveraged and inverse ETFs:

  • Wells Fargo – $2.1 million fine and $641,489 in restitution;
  • Citigroup – $2 million fine and $146,431 in restitution;
  • Morgan Stanley – $1.75 million fine and $604,584 in restitution;
  • UBS – $1.5 million fine and $431,488 in restitution.

At the time, FINRA noted the following: “…the firms did not have adequate supervisory systems in place to monitor the sale of leveraged and inverse ETFs, and failed to conduct adequate due diligence regarding the risks and features of the ETFs. As a result, the firms did not have a reasonable basis to recommend the ETFs to their retail customers. The firms’ registered representatives also made unsuitable recommendations of leveraged and inverse ETFs to some customers with conservative investment objectives and/or risk profiles. Each of the four firms sold billions of dollars of these ETFs to customers, some of whom held them for extended periods when the markets were volatile.”

The operative words here are “billions of dollars.” This wasn’t one or two brokers screwing up. “Billions of dollars” of inappropriate investments were being sold to the gullible investing public.

Wall Street is required by law to sell investments that are suitable to its customers. According to FINRA arbitration records, on October 22, 2012 an investor brought an arbitration claim against Morgan Stanley for selling him, among other things, “a Direxion triple leveraged inverse ETF.” The client sought $383,334.64 in compensatory damages, meaning the losses were significant. (The case was settled in secrecy with no settlement amount disclosed to the public.)

Direxion has this to say about its leveraged and inverse ETFs:

“Leveraged and inverse ETFs pursue daily leveraged investment objectives which means they are riskier than alternatives which do not use leverage. They seek daily goals and should not be expected to track the underlying index over periods longer than one day. They are not suitable for all investors and should be utilized only by investors who understand leverage risk and who actively manage their investments.”

When a product “should not be expected to track the underlying index over periods longer than one day” it is effectively created for a day trader and not a retail client of a big Wall Street bank.

Here’s another big problem for Morgan Stanley. According to the SEC complaint filed last week, in March 2010 Morgan Stanley put compliance policies and procedures in place to deal with non-traditional ETFs. One of those procedures required “that the positions be monitored on an ongoing basis, that the purchase of single-inverse ETFs be a hedge, and that financial advisors complete single-inverse ETF training.”

As with all of the big Wall Street firms that have a retail broker sales force, the brokers are required to take and pass a Series 7 licensing exam before they handle client money. It typically takes months of study to pass this exam and it is frequently compared in difficulty to the CPA exam. If that comprehensive understanding of securities is inadequate to sell these non-traditional ETFs, and Morgan Stanley has mandated that the broker must take extra training to sell these non-traditional ETFs, then how can it blame a retail client who has no Series 7 license or special ETF training for his losses? And yet that is exactly what Morgan Stanley did time and again in the arbitration hearings.

We are not alone in thinking that this is one of the worst products for a retail investor. In 2011, Howard Gold wrote a brilliant analysis on leveraged ETFs for Dow Jones’ MarketWatch. Stating that the products had “blossomed like poison mushrooms,” Gold wrote further:

“Leveraged ETFs purport to give investors two or three times the return of the underlying indexes on which they’re based. Inverse leveraged ETFs let you do the same thing on the short side.

“The problem is, these instruments are designed to be used as daily hedging and trading vehicles, but investors are holding them much longer than a day, which is particularly dicey in today’s volatile markets.

“That’s why I think these are the single worst product for individual investors I’ve seen in two decades of covering markets.

“There are plenty of other ways investors can hedge their portfolios with less risk, like using certain simple options strategies. Successful investing in leveraged funds requires the discipline of a computer-driven hedge fund or a steely eyed professional trader. Using them improperly is all too easy.”

In 2015, the Attorney General of Massachusetts, Maura Healey, also agreed that leveraged ETFs are “unsuitable for retail investors in most cases.” Healey fined LPL Financial $1.8 million over its sale of leveraged ETFs to retail clients. Healey stated at the time:

“The leveraged ETFs at issue are complex investment funds that try to perform at a multiple of the daily returns of an index like the Standard & Poor’s (S&P) 500. For reasons normally not known to casual investors, holding investments in these funds for long periods of time can produce unexpected outcomes. Even an investor who bets correctly on the direction of the index can lose money when holding a leveraged ETF…LPL also failed to supervise its financial advisors who caused clients to hold these investments for extended periods of time, and did not consistently adhere to its policy of imposing fines on financial advisors who exceeded concentration limits.”

Given this background, one can see why Wall Street is fighting so hard to keep the “suitability standard” that it can game so easily in its industry-run private justice system of mandatory arbitration and gut the Labor Department’s new Fiduciary Rule that was set to take effect in April. The Fiduciary Rule, hated by the big banks on Wall Street, would force brokers to put the interests of clients above the interests of the firm. Even that rule doesn’t go nearly far enough. It covers just retirement accounts – not all customer accounts.

Why Did SEC Acting Chair Take an Ax to Enforcement Unit’s Subpoena Power?

By James A. Kidney: February 20, 2017

The Trump administration assault on investor protections put in place following the 2007-08 financial crisis continues apace.  The war on investors takes place in arenas both large and small.

The large issues get the attention, of course.  These include repeal of much of the Dodd-Frank law and regulations of the biggest Wall Street banks, limiting or eliminating the Consumer Financial Protection Bureau, which actually helps individual customers abused by giant financial institutions, and preventing adoption of fiduciary standards for financial professionals recommending securities that line their pockets but are risky to customers.

But Washington is not merely a swamp of self-interest with large, highly visible alligators munching on small fish to satisfy their insatiable greed.  Another apt metaphor is a field of giant weeds — weeds of rules, processes and procedures that can be manipulated for the interests of the Fat Cats.

These weeds are everywhere in Washington. Whether your particular self-interest lies in financial dealings regulated by the Federal Reserve and the Securities and Exchange Commission, looser regulations at the Environmental Protection Agency, exercising greater control of your employees by removing Labor Department regulations, or a host of other rules, processes and procedures, powerful interests with highly paid lawyers can push back easily against the much-maligned bureaucracy every day.

This is especially the case when there is one-party government and the president appoints those at the center of the oligarchy to head government agencies, as is true today.

What goes on hidden by these weeds is not usually paid attention to by either the press or the public.

Case in point:  Although the SEC currently has three vacancies on its five-person commission, the designated temporary chairman, Republican Michael S. Piwowar, has quietly restricted the authority of the SEC’s civil servants in the Enforcement Division to issue subpoenas for witnesses and documents when investigating whether securities laws have been violated.  A small number of news articles suggest this unwarranted reversal of an eight-year-old policy delegating authority to the supervisors in the Enforcement Division may remove Division discretion in its use of civil investigative powers completely.

There is zero evidence that this power has been abused.  Rather, reinstating a requirement that all investigations be approved in advance by the commissioners before a subpoena can be issued is simply an opportunity to allow the Wall Street lawyers (some of whom generally end up as chairman of the SEC and head of the Division of Enforcement, then return to the fold) to intervene to slow or kill an investigation deemed worthy by those who actually conduct the investigations and have long experience at the SEC.

A little background is in order.

Until 2009, SEC rules required that the Commissioners themselves vote to approve issuance of a “Formal Order.” Approval permitted the Commission staff to employ the power of a subpoena to obtain witness testimony and documents.  Absent a formal order, the Division of Enforcement staff only could open an “informal investigation” to seek voluntary compliance with requests for witnesses to appear and documents to be produced.  Obtaining a formal order to issue subpoenas required circulating a memo to all commissioners, meeting with some or all of them, and, sometimes, appearing in a closed commission meeting to defend the request.  Doing so was time consuming and clearly an opportunity for lobbying by the investigation target.

As in any bureaucracy with built-in routines, many formal orders were obtained without controversy and in relatively short order.  For that very reason, authority was finally delegated.

Voluntary production was usually not a problem when the SEC went after minor league fraudsters.  They are often scared to death of the cost of hiring a lawyer to run interference for them in a run-of-the-mill case of insider trading.  The cost of defending an investigation for the average guy or gal can quickly exceed the likely penalty imposed if insider trading profits were small.  (As an aside, the Division of Enforcement spends a lot of time on such small stuff.) In my experience, many small insider traders came clean without a formal order or subpoena because they wanted to put the personal disruption behind them quickly.

But the bigger cases, especially those involving a large institution such as a broker-dealer firm or a public company, could be delayed for months by “voluntary production.”  Pricey lawyers can stretch out matters without actually telling the SEC staff that no material documents or witnesses will be forthcoming.   Lawyers know how to “voluntarily” bury the staff in irrelevant documents and produce witnesses low on the totem pole who can honestly testify they know nothing about improprieties arranged by those higher up in the organization.

The power of a subpoena, enforceable by going to court and publicly exposing that an investigation is in process, is a substantial lever for the Division of Enforcement.  Subpoenas enable investigators to more quickly get to the heart of a matter and assess whether a rule or law has been violated.  That is why, beginning in 2009, the SEC delegated authority to issue investigative subpoenas to supervisory staff in the Enforcement Division.

In announcing a new SEC rule delegating subpoena power to the Division of Enforcement, then Division Director Robert Khuzami said, “This means that if defense counsel resist the voluntary production of documents or witnesses, or fail to be complete and timely in responses or engage in dilatory tactics, there will very likely be a subpoena on your desk the next morning.”

The SEC release announcing the change of rules (originally for one year, but later made permanent) stated that “this delegation will expedite the investigative process by reducing the time and paperwork previously associated with obtaining Commission authorization prior to issuing subpoenas.”

At least two sources (here and here) report that Piwowar, who is an economist, not a lawyer, and worked for very conservative Republicans on the Senate Banking Committee before arriving at the Commission, reportedly already has restricted authority to issue a subpoena to the Division director alone and is considering eliminating the authority altogether.

The question, which Piwowar and the SEC have thus far declined to answer, is why retract the delegation?

There is no evidence that the Division of Enforcement has gone mad with its authority.  In fact, the Division of Enforcement under Khuzami is mostly known for having applied its investigative powers very sparingly to the big Wall Street banks, as evidenced by the few cases brought, low sums in settlements relative to much larger settlements by the Department of Justice, and the near total absence of individuals named in civil SEC complaints arising from the financial collapse.

Nor did the Commission under Chairman Mary Jo White and Khuzami’s successor, Andrew Ceresney, run amuck with investigations.  To the contrary, White preached the notion of “broken windows” during her run.  She claimed that if the SEC went after small violators, the big financial institutions would be fearful of the “cop on the street.”  There is no evidence that Fat Cats looking on the Street from the 60th floor were especially concerned about those souls on the sidewalk grabbing the attention and resources of their regulator.

If there is evidence of large, unwarranted investigations in which the Division of Enforcement has used its delegated powers irresponsibly, Piwowar and the SEC should let the public know about them if they want to change the rules.

If there is no such evidence, the only reason for reversing the rule is the old one:  Let’s give the lawyers for the biggest potential defendants a way to continue exhausting Commission time and effort on meaningless “voluntary” production of evidence.  If, despite the delays, an exhausted staff pushes for Commission approval to use tougher enforcement tools, the lawyers and their clients can get an audience with the commissioners themselves to push their defense. The commissioners might then tell the SEC staff to back off or to restrict their investigation.

This would allow unscrupulous financiers to pursue their real work — fleecing the public.

The weeds are tall in Washington. Just know that the harmful insects are alive and working hard.


James A. Kidney, Former SEC Trial AttorneyJames Kidney retired as trial counsel in the Division of Enforcement of the Securities and Exchange Commission in 2014 after a 25 year career.  You can read more of his work at