The suit New York Attorney General Eric Schneiderman has brought against Barclays, accusing the bank of running its dark pool for the benefit of high-frequency traders, has all Wall Street wondering: What will Barclays do?
Barclays has 30 days to respond. It has several options, but there is only one likely outcome.
- Dispute the facts.
- Make a motion to dismiss, arguing, for example, the complaint does not make out a cause of action. One it would argue even if everything Schneiderman says is true, it doesn't violate New York law.
- Settle the case. Which is the most likely scenario.
Why? Because Schneiderman has a very blunt, powerful weapon called the Martin Act.
The Martin Act gives the New York State Attorney General broad powers to bring civil and criminal action against almost anyone that has business that affects New York State.
The Martin Act was originally passed in 1921. Hard to believe, but at the time there were no federal laws to protect investors against fraudulent claims by brokers nor investment advisors. Federal laws were not passed until the SEC Act of 1933.
Instead, there was a crazy-quilt patch of state laws known as "blue-sky laws," so called because they were designed to protect against schemes that were backed by nothing but blue sky.
And none were more powerful than the Martin Act. It gives the Attorney General the power to regulate and investigate securities fraud.
Sounds pretty straight forward, right? Yes, but the devil is in the details, and here the details are a doozy.
Under federal law, to be convicted of securities fraud you essentially need to prove: 1) There was a misrepresentation of a material fact, 2) the facts represented were false, 3) there was an intent to defraud and 4) there were damaged caused by the fraud.
But under an early series of court cases, the "fraud" that is forbidden under the Martin Act is defined in a much broader sense than under federal law.
Under the Martin Act, you don't need to prove there was a fraud to be convicted. You don't need to demonstrate intent to defraud, or what is known as "scienter."
Under the Martin Act, you only need demonstrate there has been a misrepresentation or an omission of a material fact when selling or promoting securities.
And that's Barclays' problem: All Schneiderman needs to do is demonstrate a misrepresentation or an omission of a material fact.
That's why the entire complaint was riddled with phrases like "falsified information," "gave clients a false understanding" and "falsified marketing materials."
This is all about misrepresentation. Exactly what the law covers.
Bottom line: With such a low barrier, Barclays will have a tough time fighting the charges.
That's why so many cases brought under the Martin Act settle. There is actually a very small body of case law because the law is framed so broadly.
What's the likely fallout from this?
First: Some dark pools may lose orders. Already The Wall Street Journal has reported some clients of Barclays' dark pook Barclays LX are no longer sending orders to them.
Second: This will increase momentum to return order flow to exchanges and away from "unlit" markets, like dark pools. Right now off-exchange" trading volume (dark pools and internalizers) account for nearly 40 percent of trading.
The SEC has been very nervous about all this trading off exchanges. The NYSE (ICE) has already said the trading environment is too complex...too many exchanges, too many dark pools and too many order types.
Letting the market decide...by having clients simply leave dark pools...may alleviate some of the SEC's concerns.
But it doesn't address why traders use dark pools. Some use them to execute larger orders, but that is a minority. They use them because they don't want to pay the fees stock exchanges charge to "take" liquidity.
It's likely this will accelerate a discussion of the whole "payment for order flow" issue, as well as the fees that the exchanges charge and collect to trade on their platforms.
Third: More disclosure on how brokers route institutional orders. SEC Chair Mary Jo White, in a June 5 speech, specifically asked her staff for recommendations on how to provide more information on dark pool trading. You can be sure there are lots of discussions going on right now between clients, brokers and dark pools.
Are there investigations into other dark pools? Almost certainly, but Schneiderman had a big advantage with Barclays, with several former (disgruntled) employees coming forward who were key to the investigation.
He is likely hoping that others might come forward from other organizations.