iAt the outset of this blog it is important to have some understanding of the economic consequences of particular transactions. At least since the seminal work of the great Scottish Professor of Moral Philosophy Adam Smith in his 1776 opus “The Wealth of Nations,” we have understood that the price of any particular good is dependent on both of the following:
- the availability of the good, i.e., the volume of the good that can be sold to willing buyers; and
- the aggregate level of desire (whether due to need, status rewards for acquiring the good, or simple interest in doing what “everyone else” is doing) for that good.
In a market economy such as that of the U.S., “the market forces of supply and demand will determine the logical price point” (see “What is Theory of Price?” by Caroline Blanton). Price Theory points out that as the supply of goods (or services, for that matter) increases while the demand remains relatively the same, the price per unit of goods will decline. Although this may seem self-evident to some, leading economists over the last 250 years have written tomes analyzing aspects of this microeconomic principle.
The capital markets comprise one area of economic activity that provides daily illustrations of the working of Price Theory. Indeed, in the world of securities trading, concerns about the efficiency of the pricing mechanism for stocks and bonds led initially to the invention of specialists, i.e., market makers on stock exchanges. These “middlemen,” quite literally, would be expected to maintain holdings of assigned securities to provide “depth in the market” and dampen the effects of sudden bursts of buying or selling, so that price changes were moderated. In other words, Specialists maintained a level of liquidity that inhibited price gyrations. On the New York Stock Exchange, each Specialist firm was assigned specific securities, and any buyer or seller of those securities had to (through his or her broker) buy or sell from the Specialist’s “store.” I represented a Specialist firm in the 1980s. However, enormous advances in electronic trading have reduced the need for liquidity provided by Specialists.
A particular corner of the securities markets that involves major effects on pricing arises when a buyer or seller wants to complete a transaction covering the purchase or sale of a large volume of a single security. The old image of a python attempting to swallow an oversized hog may come to mind. If the purchase or sale is conducted on either the New York Stock Exchange or the NASDAQ trading system, the price per unit of the security will be driven higher in the case of a purchase; and lower in the case of a sale. To avoid price disruptions caused by big trades, the market has developed “Block Trading.” As laid out in James Chen’s 2022 article “Block Trades: Definition, How it Works, and Example”:
A block trade is a large, privately-negotiated securities transaction. Block trades are arranged away from the public markets to lessen their effect on the security’s price. They are usually carried out by hedge funds and institutional investors via investment banks and other intermediaries, although high-net-worth accredited investors may also be eligible to participate… Block trades are generally broken up into smaller orders and executed through different brokers to mask the true size. Block trades can be made outside the open market through a private purchase agreement… A bulk-sized sell order placed on a stock exchange may have an outsized effect on the share price… a block trade negotiated privately will often provide a discount to the market price for the buyer; it will not inform other market participants about … the transaction…
Block trades not yet publicly disclosed are considered material non-public information, and the financial industry’s self-regulatory organization, FINRA, prohibits the disclosure of such information as front running.
Now let us consider who or what Morgan Stanley is. It is an international investment bank with operations in 41 countries and over 75,000 employees. According to a 2023 piece in Fortune magazine, Morgan Stanley is the 61st largest company in the U.S. It was formed by Henry Sturgis Morgan (the grandson of J.P. Morgan) and Harold Stanley, both former partners of J.P. Morgan & Co., on Sept. 16, 1935, in response to the Glass-Steagall Act, which split off commercial banks from investment banks. Subsequently in 1997, Morgan Stanley merged with Dean Witter Discover & Co., The Financial Stability Board, created by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 in response to the “Great Recession” of 2007-2009, had determined that Morgan Stanley is “systemically important,” and hence, subject to more extensive regulatory oversight. Morgan Stanley & Co., LLC, is a Delaware Limited Liability Company (“LLC”) and the wholly-owned subsidiary of Morgan Stanley, a Delaware corporation. Both the LLC and its parent company are headquartered at 1585 Broadway, New York, N.Y. The LLC is registered with The U.S. Securities and Exchange Commission (“SEC”) as a broker-dealer.
Pawan Kumar Passi, now age 40, was a Managing Director and head of the LLC’s Equity Syndicate Desk from June 2018 through the termination of his employment by the LLC in August 2021. During that period, according to the Jan. 12 2024 SEC Order Instituting Administrative and Cease-And-Desist Proceedings (the “Passi Order”), “Passi disclosed to certain buy-side investors non-public, potentially market-moving information concerning impending ‘block trades’ that the firm [i.e., the LLC] had been invited to bid on or was in the process of negotiating with the selling shareholders. Those buy-side investors used such information to ‘pre-position’ – or take a short position in – the stock that was the subject of the upcoming block trade.”
The Passi Order specifically notes that:
Such disclosures by Passi violated the selling shareholders’ expectations of – and in certain instances, express requests for – confidentiality conveyed to the Syndicate Desk, representations of confidentiality made by the Syndicate Desk, and/or… [the LLC’s] policies regarding the treatment of confidential information.
The Passi Order contains a 2-page discussion of block trading and 8 pages of examples of Passi’s violative activities in the case of several block trades, including the following points about block trading:
A block trade can be executed in a variety of ways, but generally involves an investment banking firm, such as [the LLC], committing its own capital to purchase the stock directly from the selling shareholder and then offering the stock to buy-side investors (e.g., large institutional investors, including hedge funds and mutual funds) at a markup to the firm’s purchase price.
The investment banking firm’s profit on a block trade is the spread between the discounted price at which it purchases the stock and the price at which it resells the stock. If the firm cannot find sufficient demand for all the shares purchased in the block transaction, the firm is left holding a residual position, which exposes it to the risk of stock price movements until it can fully sell the position.
As a result of the SEC investigation, Passi was found to have violated Section 10(b) of the Securities Exchange Act of 1934, as amended (the “1934 Act”), and Rule 10b-5 thereunder. He was ordered to cease and desist from future violations of those provisions and suspended from association with any broker or other securities industry professional or any involvement with any penny stock offering, with the right to reapply after one year. Further, he was barred from holding any supervisory position with a broker/dealer, municipal securities dealer, transfer agent, or rating agency for a period of two years, with a right to reapply. Passi was ordered to pay a civil penalty of $250,000 to the SEC. He was also required to forfeit any right to an offset to any claims by third parties against Passi.
On the same day, Jan. 12, 2024, the SEC issued a Press Release (the “Press Release”) covering both the Passi Order and the Order Instituting Administrative and Cease-And-Desist Proceedings against LLC (the “LLC Order”). In addition to holding LLC responsible for the unlawful disclosure of material non-public information (as in the Passi Order). LLC was also charged with failing:
…to enforce written policies and procedures reasonably designed, taking into consideration the nature of its business, to prevent the misuse of material non-public information. Specifically, …[the LLC] failed to enforce information barriers to prevent material non-public information involving certain block trades from being discussed by the Syndicate Desk, which sits on the private side of …[the LLC], with the Institutional Equity Division, which was on the public side of the firm.
The LLC Order notes the LLC had entered into “a written non-prosecution agreement with the U.S. Attorney’s Office for the Southern District of New York…that acknowledges responsibility for conduct relating to the finding in the [LLC] Order. Specifically, Respondent acknowledged facts sufficient to constitute violations of Section 10(b) of the…[1934 Act] and Rule 10b-5(b) thereunder.”
The LLC Order notes that the Commission “considered remedial acts undertaken by Respondent, including the termination of…[Passi and another executive], and cooperation afforded the Commission staff. …[the LLC] has engaged in a review of its internal controls and procedures relating to the firm’s handling of block trades.”
The SEC then ordered the LLC to cease and desist from further violations of Section 10(b) of the 1934 Act and of Rule 10b-5(b) thereunder, and Section 15(g) of the 1934 Act. LLC was censured. LLC was further ordered to disgorge $138,297,046 in ill-gotten gains plus interest of $28,057,775. The LLC Order notes that the amount “shall be offset in an amount equal to any assets and funds actually paid pursuant to a forfeiture or restitution order, for the benefit of victims, in the parallel non-prosecution agreement” with the U.S. Attorney for the Southern District of New York. In addition, the LLC is ordered to pay a civil money penalty of $83 million to the SEC. The Press Release notes that the investigation was led by the Market Abuse Unit of the SEC’s Enforcement Division. Chair Gensler is quoted in the Press Release:
Sellers entrusted Morgan Stanley and Passi with material non-public information concerning upcoming block trades with the full expectation and understanding that they would keep it confidential… Instead, Morgan Stanley and Passi abused that trust by leaking that same information and using it to position themselves ahead of those trades.
And the SEC’s Director of Enforcement added:
…Morgan Stanley and Pawan Passi instead leaked that material non-public information to mitigate their own risk, win more block trade business, and generate over a hundred million dollars in illicit profits…
In a peculiar way it is the breach of trust even more than the grasping for trading profits that is most disturbing, especially when perpetrated by a “systemically important” major American financial institution.
