By Martina Rejsjo, Director of Regulatory Affairs, Eventus
The Securities and Exchange Commission (SEC) recently filed a civil enforcement lawsuit against an individual for an alleged fraudulent scheme to inflate the value of a private hedge fund by manipulating the price of the fund’s single largest holding, a thinly-traded equity.
The individual was the fund manager of a private hedge fund (the “Fund”). Over at least six months, the manager allegedly funneled money to a friend’s account with instructions to place multiple orders in the security at or near the close on random trading days, including the last trading day of the month. The instructions were to place limit orders at prices above the quoted price for the stock. The friend purchased the stock more than 100 times, typically in small quantities, in an otherwise illiquid security.
The friend’s orders often set the high price for the day because they were above the day’s opening price and other orders that day. Toward the end of the month, when the fund manager was to report account balances to fund investors, the friend’s orders increased in frequency and size. As a result of these orders, the stock price jumped significantly on the last trading day of the month for several months. The stock’s price was artificially inflated between 13-99% on the last day of the month for three consecutive months.
Based on the SEC complaint, the artificial high price on the largest holding in the Fund had a threefold effect:
- inflating the net asset value of the Fund and the value of each investor’s share of the Fund in order to report an inflated performance of the Fund to current investors;
- the inflated performance was also used to promote the Fund to prospective investors to attract more capital; and
- compensation was based on the Fund’s performance and therefore the fund manager received greater compensation when the Fund reported a higher return.
ViP: This trading behavior, called “marking the close” is a trading pattern that attempts to influence a closing price by executing buy or sell orders near the close of market in a manner that seeks to secure a certain price level. This specific manipulative behavior in the US equity markets is regulated by the SEC through:
- Securities Exchange Act, Sections 10(b) and 9(a)(2) that prohibit manipulation of securities prices and make it unlawful to effect, alone or with one or more other persons, a series of transactions in any security creating actual or apparent active trading in such security, or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.
- SEC Rule 10b-5 that prohibits fraud, misrepresentation, and deceit in connection with the purchase or sale of any security and makes it unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails or of any facility of any national securities exchange, to use any device, scheme, or artifice to defraud.
The Validus “Marking the Close” procedure alerts users when the price of a security moves in one direction during a short period of time leading up to the market close, relative to the Volume Weighted Average Price (VWAP) established during a preceding period. The procedure also includes parameters around trading activity thresholds and the security’s average daily volume, making the procedure effective at identifying the behavior the SEC identified in the above case, where one account moved the price at end of the day through dominant trading activity relative to the stock’s normal turnover.
About Eventus
Eventus is a leading global provider of multi-asset class trade surveillance and market risk solutions. Its powerful, award-winning Validus platform is easy to deploy, customize and operate across equities, options, futures, foreign exchange (FX), fixed income and digital asset markets. Validus is proven in the most complex, high-volume and real-time environments of tier-1 banks, broker-dealers, futures commission merchants (FCMs), proprietary trading groups, market centers, buy-side institutions, energy and commodity trading firms, and regulators. The company’s rapidly growing client base relies on Validus and Eventus’ responsive support and product development teams to overcome its most pressing regulatory challenges. For more, visit www.eventus.com.