# Securities & Exchange Commission v. Pasternak

> District Court, D. New Jersey · June 24, 2008 · 561 F. Supp. 2d 459

URL: https://www.frixlaw.com/law-library/cases/1894719

## Case

- **Full name:** SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. Kenneth D. PASTERNAK and John P. Leighton, Defendants
- **Court:** District Court, D. New Jersey
- **Decided:** June 24, 2008
- **Citations:** 561 F. Supp. 2d 459; 2008 U.S. Dist. LEXIS 48289; 2008 WL 2501355
- **Precedential status:** Published
- **Opinion:** Opinion by Pisano
- **Judges:** Pisano
- **Cited by:** 9 later opinions in the Frix Law Library

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## Opinion text

OPINION
PISANO, District Judge.
TABLE OF CONTENTS
I. BACKGROUND.466
A. Procedural History.466
B. Witnesses Presented at Trial.468
C. Credibility Determinations.475
II. STATUTORY AND REGULATORY BACKGROUND.476
A. Applicable Statutes under the Securities Act and the Exchange Act.477
B. Applicable NASD Regulations.479
III. FINDINGS OF FACT. 481
A. Background of the NASDAQ Market in 1999-2000 and Formation of Knight Securities.481
B. Knight’s Execution of Trades and Retail Order Flow. 485
1. Institutional Orders.486
2. Retail Orders.488
3. Sales Credit Data .489
C. Knight’s Supervisory and Compliance Structures.489
D. Joseph Leighton’s Trading Practices .492
E. The Leightons’Departure from Knight.495
IV. CONCLUSIONS OF LAW.498
A. SEC’s Burden of Proof and Requisite Elements.498
1. Primary Liability.498
2. Secondary Liability.500
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B. Underlying Securities Fraud by Joseph.503
1. Excessive Profits.504
2. Failure to Disclose Mark-Ups.505
3. Front-Running .507
4. Improper Use of ACT Modifiers.509
5. Joseph Did Not Violate a Securities Law.510
C. Primary Liability Against Defendants .511
1. Affirmative Misrepresentations.511
2. Failure to Disclose.512
3. Defendants Did Not Violate a Securities Law.514
D. Aiding and Abetting and Control Liability Against Defendants.514
1. Aiding and Abetting Liability.514
2. Control Liability.515
V. CONCLUSION.517
This matter comes before the Court upon an Amended Complaint brought by Plaintiff Securities and Exchange Commission (“SEC”) against Defendants Kenneth D. Pasternak (“Pasternak”) and John P. Leighton (“John”) (collectively, “Defendants”). The SEC alleges that Defendants, as supervisors and senior executives of Knight Securities, L.P. (“Knight”), a registered broker-dealer firm, violated certain provisions of the Securities Act of 1933 (“the Securities Act”) and the Securities Exchange Act of 1934 (“the Exchange Act”).
From May 13, 2008 to June 2, 2008, the Court conducted a non-jury trial. After the SEC rested its case, on May 30, 2008, Defendants moved for a judgment on partial findings pursuant to Federal Rule of Civil Procedure 52(c). The SEC opposed the motion. The Court reserved decision on the motions and heard additional arguments on the issue on June 12, 2008. After careful consideration of the extensive record before it, the Court sets forth herein its findings of facts and conclusions of law pursuant to Federal Rule of Civil Procedure 52(a), and finds in favor of Defendants.
1
I. BACKGROUND
A. Procedural History
This case inquires into Knight’s “market making” business and the actions of one of Knight’s institutional sales traders, Joseph Leighton (“Joseph”) — John’s brother. In particular, the SEC focused its claims on forty-two trades executed by Joseph in 1999 and 2000 on behalf of “buy-side” institutional firms, such as mutual funds and investment advisors. All of the complained-of trades occurred in the NASDAQ Stock Market (“NASDAQ”). During the relevant time period, John, as head of Knight’s institutional sales desk, supervised Joseph, while Pasternak held ultimate supervisory responsibilities as Knight’s CEO and Chairperson of the Board of Directors.
Based on Defendants’ status as supervisors at Knight, and John’s familial relationship with Joseph, the SEC, on August 8, 2005, filed a complaint, which they subsequently amended on March 30, 2006. The Amended Complaint asserts five counts against Defendants. In Count I, the SEC alleges that Defendants aided and abetted “Knight’s violation of Section 10(b) of the ... Exchange Act ... and Rule 10b-5 thereunder[.]” (Amended Complaint (“Am. Cmplt.”) ¶¶ 72-74 (citing
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15 U.S.C. § 78j(b); 17 C.F.R. § 240 .10b-5)). In Count II, the SEC asserts that Defendants violated Section 17(a) of the Securities Act. (Am. Cmplt. ¶¶ 75-77 (citing 15 U.S.C. § 77q(a))). In Count III, the SEC alleges that Defendants aided and abetted Knight’s violation of Section 15(c)(1)(A) of the Exchange Act. (Am. Cmplt. ¶¶ 78-81 (citing 15 U.S.C. § 780 (c)(1)(A))). In Count IV, the SEC claims that Defendants aided and abetted Knight’s violations of Section 17(a) of the Exchange Act and Rule 17a-3 thereunder. (Am. Cmplt. ¶¶ 82-85 (citing 15 U.S.C. § 78q(a); 17 C.F.R. § 240 .17a-3)). Finally, the SEC alleges in Count V that Pasternak is jointly and severally liable, pursuant to the “control person liability” set forth in Section 20(a) of the Exchange Act, for Knight’s violations of Sections 15(c)(1)(A) and 17(a) of the Exchange Act, as well as Rule 17a-3. (Am. Cmplt. ¶¶ 86-87 (citing 15 U.S.C. §§ 78o(c)(l), 78q(a), 78t(a); 17 C.F.R. § 240 .17a-3)).
Throughout the trial, the SEC offered varying theories of liability. In the Amended Complaint, the SEC alleges:
Joseph Leighton, Knight’s most prolific sales trader, engaged in a pattern of fraud by trading for Knight’s institutional customers using a method that concealed from the customer the manner in which not held orders were worked, including the use of a delayed execution scheme and the improper use of ACT [ (Automated Confirmation Transaction Service) (“ACT”) ] modifiers, which obscured the quality of the execution price, resulting in profits above the industry norm at effectively no risk to Knight.
(Am. Cmplt.¶ 18). As a result, the SEC submits that “Joseph Leighton failed to make full and appropriate disclosures and failed to provide best execution for orders placed by the institutional customers.” (Am. Cmplt.¶ 18). During the trial, the SEC expressed that this pattern of fraud amounted to improper front-running; that is, Joseph, upon receipt of an institutional order, would take a position in the ordered security and delay the execution of the order to take advantage of fluctuating market conditions, thereby generating profits that the SEC deems improper. (Trial Transcript (“Tr.”) 487:15-493:3).
The SEC further alleges that Defendants knew of, or were reckless in not knowing of, Joseph’s fraud. (Am. Cmplt. ¶ 46). The Commission claims Defendants participated in the perpetration of this fraud by misstating to Knight’s customers and the public that Knight provided “best execution” and failing to disclose “the manner in which [Joseph] priced executions to customers.” (Am. CmpltV 47). During the trial, the SEC explained that John and Pasternak owed an independent fiduciary obligation to disclose to Knight’s institutional customers Joseph’s profits, and the failure to so inform the customers breached their fiduciary duties. The SEC further argued that Pasternak made a false and misleading statement by signing Knight’s 1999 and 2000 Form 10-Ks, which stated that Knight provided its customers with best execution. Finally, the SEC alleges that institutional sales traders at Knight, including Joseph, misused ACT modifiers, causing inaccurate and untimely reporting of trades to NASDAQ, and that Defendants knew of this systematic misuse. (Am. Cmplt.lffl 66-70).
Based on those allegations, the SEC seeks injunctive relief, as well as statutory damages and disgorgement. Specifically, in the form of injunctive relief, the SEC requests that the Court permanently enjoin Defendants from future violations of the Securities Act and the Exchange Act, from aiding and abetting any future violations of the Exchange Act, and “from controlling any person that is in a position to violate Exchange Act Sections 15(c)(1)(A)
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and 17(a) and Exchange Act Rule 17a-3[.]” (Am. Cmplt.¶¶ (I)-(III)).
During a fifteen-day bench trial, the Court provided both parties with the opportunity to present evidence. The SEC proffered the following witnesses from Knight: Gregory Cavallo, Carmine Curra, Thomas Fedele, David Miller, Anthony Mi-trano, Kenneth Ackerman, Alan Levinson, John Hewitt, John Howard, and Pasternak. The Commission also proffered the following fact witnesses representative of Knight’s customers: Andrew Brooks, Robert Marcotte, William Lawlor, Stuart George, Scott Thornton, William Schubert, Francine Smith, Kurt Smith, Margaret Mace, and William Perry. The SEC offered as a summary witness, Stephen P. Glascoe, in addition to the testimony of three experts: James Cangiano, Richard Gunter, and Daniel Levy, Ph.D. However, on May 23, 2008, upon Defendants’ motion
in
limine, the Court found that Richard Gunter could not properly testify as an expert in the field of “market making and institutional trading.” As a result, the Court precluded Gunter’s testimony. In response, Defendants presented in their case-in-chief the testimony of one witness: Leonard Amoruso, Knight’s Global Chief Compliance Officer at the time Joseph allegedly engaged in the fraudulent behavior.
At the close of the SEC’s case, on May 30, 2008, Defendants moved for a judgment on partial findings pursuant to Federal Rule of Civil Procedure 52(c). Defendants argued that the SEC failed to establish a fraud committed by Defendants for which they would be primarily liable, an underlying fraud committed by Joseph, or, even assuming that Joseph committed securities fraud, that Defendants are secondarily liable for any alleged violation. Defendants underscore that the SEC did not establish any supervisory standards by which the fact-finder could gauge Defendants’ conduct. The SEC opposed the motion, contending that it proffered sufficient proofs for the Court to find in its favor. After receiving briefing on the issue and hearing extensive arguments placed on the record on June 2, 2008, the Court reserved decision on the motion. Because the Court now addresses the entirety of the action on its merits, Defendants’ motions are moot.
B. Witnesses Presented at Trial
The SEC proffered the following factual witness who worked for Knight during the relevant time period: Gregory Cavallo (“Cavallo”); Carmine Curra (“Curra”); Thomas Fedele (“Fedele”); David Miller (“Miller”); Anthony Mitrano (“Mitrano”); Kenneth Ackerman (“Ackerman”); Alan Levinson (“Levinson”); John Howard (“Howard”); John Hewitt (“Hewitt”); and Pasternak.
Cavallo, who was a sales trader at Knight during the relevant time frame, testified on May 14 and 15, 2008. (Tr. 438:6-633:20). He averred as to the function of a sales trader at Knight, (Tr. 441:19-24), the setting and manner in which the sales traders worked, (Tr. 444:2-446:6, 448:19-449:20), and the management structure of Knight’s institutional sales desk, (Tr. 446:8-448:17, 479:1-480:6, 474:18-477:6). Specifically, Cavallo testified as to his obligations as a sales trader working an institutional not-held order and how he fulfilled those obligations. (Tr. 450:20-473:3, 545:10-549:25, 568:17-583:18, 587:10-594:4). He also stated that Knight compensated sales traders based on a percentage of the profit or loss for a particular trade — an allocation negotiated between the sales trader and the market maker for that trade. (Tr. 473:4-474:13, 524:24-528:14, 556:6-568:15, 583:19-587:8). Finally, Cavallo discussed his recollection of Joseph’s trade of Costco (COST:NAS
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DAQ) (“COST”) shares that generated a large “profit and loss” number (“P
&
L”) on the computer program employed by Knight, the Brokerage Real Time Application Support System (“BRASS”). (Tr. 482:4-486:24, 528:18-535:1, 596:22-600:15, 603:12-608:9).
Curra was also a sales trader at Knight during the relevant time period of 1999 to 2000. He testified on May 19 and 20, 2008. (Tr. 1002:11-1022:14, 1050:3-1069:22). Curra testified as to the general practices of a Knight sales trader in executing trades on behalf of institutional customers. (Tr. 1008:4-1021:17, 1065:8-1067:17, 1068:2-20). Notably, Curra averred that Knight’s “substantial retail order flow” could affect an order handled by a sales trader. (Tr. 1061:5-25). Curra also discussed the supervision of sales traders and compliance procedures in effect during his tenure at Knight. (Tr. 1007:20-1008:3, 1062:1-1064:2).
Another testifying sales trader was Fe-dele, who testified on May 20, 2008. (Tr. 1181:20-1231:25). Similar to Cavallo and Curra, Fedele described the atmosphere of Knight’s institutional sales desk, (Tr. 1185:19-1187:2), and testified as to his obligations as a sales trader, (Tr. 1183:12-15), and how he would fulfill those obligations, (Tr. 1183:16-1185:18). He also testified as to how he received and handled institutional not-held orders, (Tr. 1191:17-1203:8, 1214:17-1221:17), and the complexity of working those orders as the market maker handled retail order flow, (Tr. 1205:8-1210:4). In addition, Fedele discussed the manner in which sales traders were supervised, including John’s role as manager of the sales desk. (Tr. 1187:3-1191:16, 1210:6-1214:15). Finally, he explained how Knight compensated its sales traders. (Tr. 1203:9-1204:15, 1223:18-1228:22, 1229:3-1230:17).
To describe the manner in which sales traders in general and Joseph in particular worked an order, the SEC proffered the testimony of Miller and Mitrano, who both served as assistants to Joseph and John. The SEC provided Miller’s testimony on May 16, 2008, (Tr. 818:9-25); (Exhibit 1106), and Mitrano’s testimony on May 20, 2008, (Tr. 1173:11-15); (Exhibit 1111). Miller testified as to John’s supervision of the sales desk and interactions with his brother, Joseph. (Exhibit 1106 at 16-17, 21-24, 64-65, 68-69, 73-75, 145-48, 150-53). Miller also described the contents of an order ticket and his responsibilities as an assistant in respect of handling an institutional order. (Exhibit 1106 at 45-51, 55-59, 69-70, 72-73, 75-86, 88, 99-106, 112, 114-15, 124-45, 154-60). Miller further detailed Knight’s method for calculating a sales trader’s compensation on a particular trade. (Exhibit 1106 at 112-14, 116-19).
Mitrano testified in accordance with Miller’s testimony, discussing his role as an assistant on the institutional sales desk, including how he completed order tickets, handled orders, and printed shares for Joseph. (Exhibit 1111 at 16-19, 23-33, 40-41, 44-49, 52-53, 55-57, 64, 67-68, 71-72, 75-82, 88-93). Mitrano also explained how he calculated a profit and loss calculation on a particular trade. (Exhibit 1111 at 60-63, 66-67).
The SEC provided the Court with testimony from two market makers at Knight: Ackerman and Levinson. The Court heard Ackerman’s testimony on May 16, 2008. (Tr. 837:4-8); (Exhibit 1108). Ack-erman, Knight’s trading room manager and market maker, testified as to the function of a Knight market maker, the tools he used to operate, and Pasternak’s oversight of the market making desk. (Exhibit 1108 at 13-17, 26-31, 33-38, 40-45). In addition, Ackerman detailed Knight’s system of handling retail order flow and how such orders could affect the execution of an institutional order. (Exhibit 1108 at 23-
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25, 31-33). Finally, Ackerman averred as to his interactions with Joseph and his knowledge of Joseph’s trading practices. (Exhibit 1108 at 38-39, 47-49).
Levinson, a market maker who testified on May 23, 2008, (Tr. 1650:20-1735:8), described the setting of Knight’s market making desk, (Tr. 1657:19-1658:15), including managerial supervision of the desk, (Tr. 1661:3-1664:6, 1714:4-1716:2, 1725:5-1726:12), and defined the role of a market maker, (Tr. 1658:16-1659:13). Levinson explained how a market maker would handle an institutional not-held order supplied by a sales trader, including determining the price of a stock given to the customer. (Tr. 1659:14-1661:1, 1664:19-1687:23, 1706:24-1712:5). He also described how Knight handled retail order flow and automatic executions, (Tr. 1670:1-1673:9, 1721:18-1724:9), as well as the process for calculating sales credits and determining a sales trader’s compensation, (Tr. 1716:3-1718:7). Finally, Levinson detailed his handling of a trade of E-Tek Dynamics (ETEK:NASDAQ) (“ETEK”) stock brought to him by Joseph. (Tr. 1688:23-1703:15).
On May 20, 2008, the Court heard the testimony of Howard, Knight’s controller during the relevant time period of 1999-2000. (Tr. 1071:2-1144:25); (Exhibit 36 at KN 1280). Howard testified as to his responsibilities and duties as a controller, (Tr. 1072:23-1073:10), and described various documents produced by the accounting department relating to the profits generated by Knight’s sales traders, (Tr. 1073:14-1116:10, 1125:21-1138:21, 1143:9-1144:21). He also discussed how Knight calculated sales credit data for each sales trader. (Tr. 1075:23-1082:14, 1084:10-1085:8, 1117:2-1121:4, 1123:25-1124:16, 1138:23-1140:24, 1141:5-24). Howard averred that the information the accounting department used to generate its reports and the reports themselves were available to market makers, sales traders, and members of the executive committee at Knight. (Tr. 1120:3-16).
The SEC proffered the testimony of Hewitt, Knight’s President and Director from mid-1999 until mid-2001, on May 21, 2008. (Tr. 1264:11-1462:3). Hewitt detailed his role at Knight as President. (Tr. 1275:2-1279:12). Specifically, Hewitt testified as to his lack of understanding in respect of how John and Joseph generated profits for Knight and his belief, based on his incomprehension, in addition to a phone call from a trader outside of Knight, (Tr. 1287:25-1288:13), that the brothers were engaged in a form of front-running. (Tr. 1279:13-1282:14). Hewitt averred that he informed Pasternak, the Board of Directors, and Knight’s general counsel of his concern, (Tr. 1282:15-1285:16, 1295:13-1296:19), and that, in response, Pasternak agreed to permit Hewitt to hire someone to replace John as head of the institutional sales desk, (Tr. 1285:20-1286:6). Hewitt further testified that he did in fact hire Robert Stellato (“Stellato”) for that position, (Tr. 1289:4-1290:1), and that one of Stellato’s assignments was to determine how Joseph executed his trades, (Tr. 1290:3-1291:13). Hewitt also detailed the events leading to the Leightons’ departure from Knight. (Tr. 1292:13-1294:16).
On May 27 and 28, 2008, the Court heard testimony from Pasternak. (Tr. 1773:19-2076:21). Pasternak was the Chief Executive Officer (“CEO”), President, and Chairman of the Board of Directors of Knight Trimark Group, Knight’s parent company, during 1999 to 2000. (Tr. 1775:24-1778:6). Until some time before August 7, 2000, Pasternak also served as a supervisor of the market making desk. (Tr. 1778:19-1779:6, 1781:4-17). Pasternak described Knight’s formation and general business model. (Tr. 1980:14-1986:22).
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Pasternak also testified as to his duties and responsibilities at Knight, including the amount of time he spent at the market making desk and his limited role in executing institutional orders. (Tr. 1785:15-1793:3). He discussed his knowledge of Joseph’s sales credits and profits, (Tr. 1794:1-1800:1, 1805:21-1808:24, 1813:1-1814:1, 1998:21-2000:1), in addition to his review and understanding of Joseph’s trading practice, (Tr. 1800:13-1801:20, 1814:2-13, 1867:18-1870:15). Pasternak testified as to his method for spot-checking certain trades. (Tr. 1801:21-1805:20). Significantly, Pasternak averred as to Knight’s practices for generating P
&
L numbers, (Tr. 1806:20-1812:25, 1840:24-1841:22, 1902:13-1903:14), calculating compensation, (Tr. 1875:12-1889:10), and general trading practices, (Tr. 1829:11-1831:23, 1966:4-1968:22, 2000:2-2004:3, 2033:3-2036:7, 2053:5-2057:16, 2058:5-2061:2).
In his testimony, Pasternak stated that, in 1999 and 2000, he believed that Knight’s profits caused a potential “marketing problem,” and he explained how he reacted to Hewitt’s belief that the Leightons engaged in front-running. (Tr. 1842:4-1859:24, 1861:18-1864:6, 2004:12-2008:2, 2009:23-2017:3). Pasternak recounted his efforts to determine whether Joseph’s trading practice was illegal in light of Hewitt’s concerns. (Tr. 1848:22-1867:17, 1870:16-1871:21, 1911:19-1931:3, 1963:11-1966:2, 1968:24-1977:12, 2017:5-2022:17). Finally, Pasternak described the circumstances surrounding the departure of the Leigh-tons from Knight. (Tr. 2023:5-2027:20, 2036:9-2039:1, 2047:23-2051:14).
The SEC also proffered extensive testimony from Knight’s institutional customers: Andrew Brooks (“Brooks”); William Lawlor (“Lawlor”); Stuart George (“George”); Scott Thornton (“Thornton”); William Schubert (“Schubert”); Kurt Smith (“K. Smith”); Francine Smith (“F. Smith”); Margaret Mace (“Mace”); Robert Marcotte (“Marcotte”); and William Perry (“Perry”).
Brooks, the Head of the U.S. Equity Trading Desk at T. Rowe Price Group, Inc. (“T. Rowe”), testified on May 13 and 14, 2008. (Tr. 45:1-298:19). He testified as to the nature of his employer’s business, how “buy-side” firms operated, and what his business expected from broker-dealers like Knight. (Tr. 49:10-104:22, 115:24-117:3, 134:13-25, 138:22-144:17, 149:1-152:21, 154:11-155:4, 165:4-169:7, 204:24-210:9, 212:12-221:14, 283:16-289:20, 290:19-295:4). Brooks also provided a foundational background to much of the terminology employed throughout the trial, as well as general information in respect of the NASDAQ market. (Tr. 66:14-67:9, 69:18-71:15, 88:1-90:13, 96:24-97:9, 99:6-18, 105:15-110:6, 130:12-134:12, 135:2-136:4, 155:5-165:2). In addition, Brooks discussed the relationship between T. Rowe and Knight in 1999 to 2000. (Tr. 104:23-105:10, 110:8-125:14, 136:14-138:21, 144:19-148:25, 169:9-181:14, 184:1-200:13, 201:10-208:21, 221:15-235:2, 269:17-283:11, 298:3-15).
On May 14,'2008, Lawlor, Manager and Vice-President of Equity Trading at Davis Selected Advisors (“Davis Selected”), testified. (Tr. 301:4-383:10, 389:2-4). Lawlor described his responsibilities and obligations as manager of the trading desk at the private mutual fund company. (Tr. 301:14-304:7, 324:14-325:5). He also testified as to his understanding of how not-held orders operated and his expectations in respect of the execution of those orders. (Tr. 304:9-309:21, 313:18-314:11, 319:3-324:2, 327:24-329:24, 338:13-339:18, 359:2-363:7, 365:22-369:24, 375:21-382:23). Law-lor further enunciated the manner in which traders at Davis Selected traded in general, (Tr. 309:23-310:11, 315:20-316:19), and Davis Selected’s relationship with Knight, (Tr. 310:13-313:21, 316:20-318:17, 339:19-
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343:10, 346:4-351:1, 370:1-374:22). Specifically, Lawlor discussed a trade of COST shares executed by Knight. (Tr. 314:12-315:19, 326:2-327:21, 329:25-338:4, 351:2-356:10).
George also testified on May 14, 2008. (Tr. 397:10-437:24). George, the Senior Vice-President of Equity Trading at Delaware Investments (“Delaware”) during the relevant time frame, testified similar to the other buy-side customers. He described the not-held order, how Delaware sought the execution of those orders, and his expectations in respect of the execution. (Tr. 399:22^05:23, 410:20-411:5, 416:19-423:18, 426:10^28:13, 429:14-430:2, 431:9-437:21). George also averred as to his interactions with, and orders executed by, Knight. (Tr. 405:24-410:13, 411:2-414:10, 414:24^16:18, 423:19-426:9, 428:14-429:12, 430:3-431:1).
On May 16, 2008, the SEC proffered the testimony of Thornton, (Tr. 767:8-19); (Exhibit 1103), Schubert, (Tr. 777:8-12, 778:3-4); (Exhibit 1104), and K. Smith, (Tr. 803:17-22); (Exhibit 1105). Thornton, during the relevant time period, was Portfolio Manager and Vice-President of Dimensional Fund Advisors (“Dimensional”), one of Knight’s customers. (Exhibit 1103 at 13-14). In his testimony, Thornton described his employer’s business, including how Dimensional placed its orders. (Exhibit 1103 at 15-18, 23-32, 43-48, 52-56, 59-65, 68-73, 76, 87-93, 95-96).
Schubert, Managing Director, Head of Equity Trading at Trust Company of the West (“Trust”), another Knight customer, testified similar to Thornton. (Exhibit 1104 at 17, 21). Schubert described the manner in which his company sought the execution of trades with firms like Knight and discussed his expectations in respect of those trades. (Exhibit 1104 at 35-37, 43-44, 46-47, 49-50, 75-77, 85-92, 108, 119-21, 123-27, 177-89). He also testified as to his personal trading experiences with Knight. (Exhibit 1104 at 63-65, 73-74, 78-82,117,128-29,198-99, 202-03).
K. Smith, an equity trader with Fidelity Investments (“Fidelity”), testified in accordance with the other buy-side witnesses. He explained his role in executing fund managers’ trades at Fidelity, (Exhibit 1105 at 9, 11-12), and how he chose a market maker to execute his trades, (Exhibit 1105 at 22-24). K. Smith also discussed how broker-dealers in general and Knight in particular executed his orders. (Exhibit 1105 at 28-30, 32-33, 37-44, 48-54, 71-82). In his testimony, he detailed his transaction with Joseph for a trade in Synopsys, Inc. (SNPS:NASDAQ) (“SNPS”) shares on August 9, 2000. (Exhibit 1105 at 62-66, 82-90).
On May 22, 2008, the SEC offered the testimony of two additional buy-side witnesses: F. Smith, (Tr. 1617:6-11); (Exhibit 1113), and Mace, (Tr. 1613:18-23); (Exhibit 1112). F. Smith, Trader and Vice-President of Trust, testified as to her trading practices in 1999 and 2000. (Exhibit 1113 at 21-22, 32, 46-53, 58-60, 64-65, 67, 69-73, 78-81, 100-02, 107-09, 117-18). She also discussed her relationship Joseph and Knight. (Exhibit 1113 at 81-82, SO-SO, 106-07, 109-10). Between 1999 and 2000, Mace was Head Trader at Pilgrim Baxter and Associates, Ltd. (“Pilgrim”). (Exhibit 1112 at 47). Mace testified in accordance with the other institutional customers, detailing her trading methodology and experiences with Knight. (Exhibit 1112 at 29-30, 36-38, 40-43, 51-52, 54-57, 72-73, 75-76, 83-84, 115-17, 127-28, 185-87,190-91,193-99, 210-14).
The Court also heard testimony from Marcotte, (Tr. 2285:18-22); (Exhibit 1117), on May 29, 2008, and Perry, (Tr. 2294:8-17; 2424:6); (Exhibit 1119), on May 30, 2008. Marcotte, an equity trader at T. Rowe, testified as to his trading practices and expectations from a broker-dealer executing his trades. (Exhibit 1117 at 30, 32-
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33, 36-37, 42-45, 52-66, 90-92, 94). He also provided testimony as to his transactions with Knight. (Exhibit 1117 at 51-52, 69-75, 85-86, 88, 92-93, 97-98, 102-07).
Perry was a trader at Putnam Investments (“Putnam”) in 1999 and 2000. (Exhibit 1119 at (1/17/2006) 56). In his testimony, Perry explained the manner in which he traded on behalf of Putnam’s customers, (Exhibit 1119 at (1/17/2006) 122, 128, 131-32, 134-35, 137-38, 195-96, 203, 213-16, 237-42, 248-52, 257-69, 272, 276-81, (1/19/2006) 6-8, 12-13, 15-16, 21-24, 26-27, 29-32, 135-36, 139, 143-44, ISO-52), and discussed his trading with Knight, (Exhibit 1119 at (1/17/2006) 82, 102, 118-19, 125-26, 208, 210, 216-19, 231-37, 245-47, 252). Specifically, he detailed his June 30, 2000 order with Knight to sell shares in Juniper Networks, Inc. (JNPR:NASDAQ) (“JNPR”). (Exhibit 1119 at (1/19/2006) 47-65, 69-95); (Exhibit 244); (Am. Cmplt. ¶ 53f). Perry also described his buy order with Knight in Efficient Networks (EFNT:NASDAQ) (“EFNT”) shares, (Exhibit 1119 at (1/19/2006) at 98); (Exhibit 395),
2
and his order with Knight in ETEK shares on March 16, 2000, (Exhibit 1119 at (1/1/9/2006) at 98-99); (Exhibit 391); (Am. Cmpltlffl 31-32).
The SEC also proffered a summary witness, Stephen P. Glascoe (“Glascoe”), to introduce into evidence certain calculations. The Court heard his testimony on May 20, 2008. (Tr. 1145:23-1171:18); (Exhibits 531-39). Glascoe is a market surveillance specialist in the SEC’s enforcement division. (Tr. 1146:1-9). He generated spreadsheets listing Joseph’s sales credit data for 1999 and 2000, as collected from Knight’s records, and his calculations of Joseph’s sales credit per share. (Exhibits 531-33). Glascoe then sorted the information by customer, date, and amount.
Exhibits 534, 535, and 536 set forth Glascoe’s percentage calculations of Joseph’s “payout from trades where the payout” per share equaled $0.25 or more, $0.50 or more, and $1.00 or more, respectively. (Exhibits 534-36). In Exhibit 537, Glascoe calculated Joseph’s “profits in millions of dollars, by quarter for 1999 and 2000[.]” (Exhibit 537). In Exhibit 538, Glascoe calculated, for the period of 1999-2000, the “Percentage of Institutional Department] profits [and] share volume attributable to Joseph[.]” (Exhibit 538). Finally, in Exhibit 539, Glascoe compared Joseph’s average profit per share with those of all other traders in Knight’s institutional group for the period of 1999-2000. (Tr. 1158:5-12); (Exhibit 539).
On May 15 and 19, 2008, the Court heard testimony from the SEC’s expert witness, James Cangiano (“Cangiano”). (Tr. 637:2-720:24, 865:5-1001:23). The SEC proffered Cangiano as an expert in the NASDAQ market and trading regulation, (Tr. 653:5-6), and the Court accepted Cangiano as an expert that field, (Tr. 670:6-20). Cangiano described the NASDAQ market during the time frame of 1999-2000, (Tr. 670:23-672:10), and the function and obligations of a market maker, including the handling of not-held orders and supervisory obligations, (Tr. 671:24-684:18, 712:13-718:20, 943:12-956:14, 966:8-974:16, 995:13-999:9). He also explained NASD-imposed regulations on market makers, such as the “best execution” requirement. (Tr. 684:22-720:20, 883:11-910:12, 956:15-964:19). In addition, Cangiano expressed his opinion as to Defendants’ conduct, assuming the facts alleged in the SEC’s Amended Complaint. (Tr. 872:11-878:10, 880:18-883:10, 910:24-925:24, 928:24-941:24, 964:21-966:7, 975:5-978:17, 982:9-25, 986:21-995:12).
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On May 22, 2008, the SEC sought to admit the testimony of Richard Gunter (“Gunter”) as an expert in the field of “market making and institutional trading” to explain standards and customs and to reconstruct Joseph’s trades. (Tr. 1497:23-1596:4-5). However, exercising its gate-keeping function, the Court found that
Daubert v. Merrell Dow Pharmaceuticals, Inc.,
509 U.S. 579 , 113 S.Ct. 2786 , 125 L.Ed.2d 469 (1993), precluded the admission of Gunter’s testimony. (Tr. 1606:6-1611:11);
S.E.C. v. Pasternak,
05-3905, Opinion (D.N.J. May 23, 2008). Nevertheless, the Court briefly sets forth here the substance of Gunter’s expert report. The Court notes that, had the Court admitted his expert testimony and had he testified in accordance with his report, Gunter would have reiterated much of the background information already provided via Cangiano’s testimony. Furthermore, Gun-ter acknowledged that, although he “analyzed” Knight’s data, that trade run data “speaks for itself.” (Tr. 1561:16-18).
Gunter would have averred as to his review of seven trades executed by Knight.
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Based on his review of the “trade runs,” Gunter concluded, in his report, that Joseph engaged in front-running, or interpositioning, whereby he would manipulate the printing of shares to a customer, either delaying the print or printing using a modifier that indicated that the execution to the customer occurred at an earlier point in time. Thereby, according to Gunter, Joseph was able to conceal his profits on the transaction. Furthermore, Gunter would have testified that Defendants must have known, or were reckless in not knowing, of Joseph’s trading practices.
Finally, on May 28 and 29, 2008, the SEC offered the expert testimony of Daniel Levy, Ph.D. (“Dr. Levy”), an expert in the “analysis of markets and profit calculations and computing.” (Tr. 2101:6-2131:20, 2175:22-2284:23). On May 30, 2008, the Court accepted Dr. Levy’s expert testimony. (Tr. 2433:25-2435:13). Dr. Levy testified as to his creation of “a program [used] to describe the trading patterns and the profits on a set of trades ... from Knight[.]” (Tr. 2106:18-20). He described the method used to create that program, which included an allocating of shares to Knight’s inventory for the purpose of executing an institutional order. (Tr. 2118:1-2130:2, 2176:4-2182:13, 2184:9-2194:3). Dr. Levy stated that the essence of his report was to calculate Joseph’s profit on forty-six trades by subtracting the average price at which the shares were purchased from the price at which the shares were sold, for each trade. (Tr. 2183:9-2184:8).
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In their case-in-chief, on May 30, 2008, Defendants offered the testimony of one witness: Leonard Amoruso (“Amoruso”). (Tr. 2322:17-2423:15). Amoruso joined Knight in October 1999, as the chief compliance officer. (Tr. 2326:12-21). Amoru-so testified as to the role of a compliance department generally, and of Knight’s compliance department specifically. (Tr. 2328:5-2330:12, 2332:21-2343:4, 2367:3-2382:21, 2390:24-2392:19). He also discussed how he fulfilled his obligations as chief compliance officer. (Tr. 2330:13-2332:19, 2343:5-22, 2359:10-2366:3). Amo-ruso averred as to his understanding of rules and regulations regarding the execution of, and profits earned on, not-held orders. (Tr. 2344:21-2348:18, 2382:22-2390:23, 2418:1-2420:8). In addition, Amo-ruso explained Pasternak’s support of the compliance department. (Tr. 2344:8-20). Amoruso further detailed the steps taken after Stellato and Hewitt raised concerns in respect of Joseph’s trading practices, which included a review of three trades of SNPS, JNPR, and TUTS shares executed by Joseph. (Tr. 2350:1-2359:1, 2392:20-2417:20, 2420:14-2423:10).
C. Credibility Determinations
Having had the opportunity to discern the demeanor of the witnesses, to hear their testimonies, and to review extensively the transcripts of the trial, the Court finds the testimony of all fact witnesses, in addition to the summary witness Glascoe, to be credible. Indeed, all witnesses appear to have testified truthfully and to the best of their recollections.
The Court underscores that it finds Pasternak’s testimony to be credible. His testimony was corroborated by all witnesses and rebutted only by the SEC’s conclusory allegations. Indeed, Pasternak’s testimony before the Court was his fifth opportunity in which he could attest to the facts giving rise to the action. Although the SEC attempted to impeach Pasternak with his previous sworn testimony, the Court finds that no material inconsistencies exist between Pasternak’s statements.
Moreover, the Court rejects the SEC’s argument that Pasternak’s statement that he believed Joseph’s trading caused a “marketing problem” is an admission that Pasternak had actual knowledge that Joseph engaged in fraudulent conduct. Rather, the Court finds this statement as establishing that Knight’s profitability and success in a volatile period generated “envy” among its corporate peers and had the potential to cause a perception that Knight, and Joseph, engaged in improper or sharp business practices. Such a belief and perception are corroborated by the testimony of Levinson and Brooks, who averred, respectively, that Knight was in “bubble” that caused it to be subject to stricter scrutiny and that Knight’s peers envied and scrutinized Knight because of its profitability. (Tr. 170:2-7, 1725:8-1726:12).
In respect of the expert testimony, the Court finds the testimony of Cangiano credible. The Court, however, reiterates its finding reached during the trial that Gunter could not properly testify as an expert in the field of “market making and institutional trading” for the purpose of explaining standards and customs or reconstructing Joseph’s trades.
Moreover, in respect of Dr. Levy’s testimony and proffered exhibits, the Court grants Dr. Levy’s calculations and analysis limited weight. Specifically, the Court finds that Dr. Levy’s allocation of shares
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to Knight’s inventory for the purpose of executing a particular institutional order, rather than for the purpose of executing retail orders — labeled in Dr. Levy’s documents as “current order inventory,” (Tr. 2186:15-22) — -is undermined by Dr. Levy’s reliance on Gunter for that process. (Tr. 2218:21-2219:16). In reviewing Knight’s trading data, to separate “intervening” trades caused by Knight’s retail order flow, Dr. Levy allocated shares acquired or sold by Knight’s market maker immediately after receipt of an intervening trade to retail order flow and segregated any profit derived therefrom. (Tr. 2187:19-2188:20).
However, Pasternak explained that it is “very difficult or virtually impossible” to determine “where the participation of the institution occurred in this continuum of low volume and price movements with all this retail interaction.” (Tr. 1809:23-1810:3, 1811:4-18). In addition, Amoruso testified that, based on a review of Knight’s trading records, it would be difficult to determine whether certain shares acquired or sold after receipt of an institutional order was actually allocated to that institutional order. (Tr. 2401:18-2402:11). For example, Amoruso specified that the accumulation of stock could be due to Knight’s “buying from retail sell orders ..., as opposed to actually going out in the market and buying stock on behalf of that institutional order[.]” (Tr. 2402:2-6, 2405:13-2406:7). Ackerman, one of Knight’s market makers, further explained that retail order flow would execute automatically to a certain point, but after reaching a threshold volume, the retail orders would enter a queue from which a market maker must manually execute the orders. (Exhibit 1108 at 31-33).
Furthermore, Mitrano, who, as Joseph’s assistant, would review trade runs on a daily basis to determine a profit and loss calculation, testified it was “extremely difficult” to distinguish between retail and institutional orders. (Exhibit 1111 at 61:22-62:16). In fact, Mitrano averred that there was no visual distinction between the two types of orders on the trade run data extracted from BRASS. Thus, four witnesses with experience reviewing Knight trade data testified that (1) it is almost impossible to allocate shares between institutional orders and retail orders, (2) Knight’s acquisition of a position of shares after receipt of an institutional order is not necessarily in response to an institutional order, but could be the result of executions for retail orders, and (3) not all retail orders would be executed immediately upon receipt of the order.
Importantly, Pasternak, Amoruso, Ack-erman, and Mitrano had experience in handling voluminous retail order flow and reviewing trade run data reflecting such order flow. In contrast, Gunter admittedly had no experience in handling any retail order flow, distinguishing retail order flow from institutional orders on a trade run, or determining how that order flow could affect executions of institutional orders. As a result, the Court finds Pasternak, Amo-ruso, Ackerman, and Mitrano more credible than Gunter in their ascertainment of the difficulty in allocating shares between retail orders and institutional orders. Because the testimony of Pasternak, Amoru-so, Ackerman, and Mitrano contradict Gunter’s analysis of separating out retail order flow from Knight’s trade run data, the Court finds Dr. Levy’s reliance on Gunter for allocation of shares to determine an institutional order’s inventory of shares undermines his ultimate calculation of the profitability of Joseph’s trades.
II. STATUTORY AND REGULATORY BACKGROUND
The Court must consider this case against the backdrop of the complex and intricate statutory and regulatory body of
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law applicable to the securities industry. For that reason, the Court sets forth at the outset the relevant statutes and regulations. In addition, the Court details the rules and notices promulgated by the National Association of Securities Dealers, Inc. (“NASD”) implicated by the SEC’s allegations.
5
A. Applicable Statutes under the Securities Act and the Exchange Act
The SEC’s Amended Complaint seeks to impose primary and secondary liability for alleged violations of the following statutes and regulations: Section 17(a) of the Securities Act, 15 U.S.C. § 77q(a); Sections 10(b), 15(c)(1)(A), and 17(a) of the Exchange Act, 15 U.S.C. §§ 78j(b), 78o(c)(l)(A), and 78q(a)(l); and Rules 10b-5 and 17a-3, 17 C.F.R. §§ 240 .10b-5 and 240.17a-3(a). Those statutes and regulations fall into two categories: first, statutes and regulations prohibiting fraudulent conduct — Securities Act Section 17(a), Exchange Act Sections 10(b) and 15(c)(1)(A), and Rule 10b — 5; and, second, the statute and regulation governing record-keeping by broker-dealer firms — Exchange Act Section 17(a) and Rule 17a-3.
Securities Act Section 17(a), Exchange Act Sections 10(b) and 15(c)(1)(A) and Rule 10b-5 all proscribe fraudulent conduct in connection with the purchase and/or sale of securities. Section 17(a) provides that
[i]t shall be unlawful for any person in the ... sale of any securities ... by the use of any means or instruments of transportation or communication in interstate commerce or by use of the mails, directly or indirectly
(1) to employ any device, scheme, or artifice to defraud[;] or
(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
(3)to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
15 U.S.C. § 77q(a). Similarly, Section 10(b) of the Exchange Act prohibits the use of mails or instruments of interstate commerce or “of any facility of any national securities exchange” for employing, in connection with the purchase or sale of any security, “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe as necessary or appropriate[.]” 15 U.S.C. § 78j(b).
Rule 10b-5, promulgated under Section 10(b) of the Exchange Act, also prohibits the use of mails or instruments of interstate commerce or “of any facility of any national securities exchange”:
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the fight of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security.
17 C.F.R. § 240 .10b-5. Section 10(b) and Rule 10b-5 aim “to prevent rigging of the market and to permit operation of the natural law of supply and demand[,]” resulting in a market price that “reflects as
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nearly as possible a just price.”
S.E.C. v. First Jersey Sec., Inc.,
101 F.3d 1450, 1466 (2d Cir.1996) (internal quotation marks omitted). Finally, Section 15(c)(1)(A) of the Exchange Act states that “[n]o broker or dealer shall make use of the mails or any means or instrumentality of interstate commerce to effect any transaction in, or to induce or attempt to induce the purchase or sale of, any security ..., by means of any manipulative, deceptive, or other fraudulent device or contrivance.” 15 U.S.C. § 780 (c)(1)(A).
The SEC also seeks to impose secondary liability on Defendants for alleged violations of Section 17(a)(1) of the Exchange Act and Rule 17a-3. Section 17(a)(1) of the Exchange Act requires registered broker-dealers to maintain certain records. 15 U.S.C. § 78q(a)(l). Rule 17a-3 lists the books and records that must be maintained. 17 C.F.R. § 240 .17a-3(a). Those records include blotters and ledgers providing data on a broker-dealer’s daily trading activity. 17 C.F.R. § 240 .17a-3(a). Although there may be limitations to a civil cause of action brought under Section 17(a) of the Exchange Act, the Court need not address here whether those limitations preclude the SEC’s claim against Defendants in this instance; indeed, neither party presented the issue to the Court.
See Touche Ross & Co. v. Redington,
442 U.S. 560, 569-571 , 99 S.Ct. 2479 , 61 L.Ed.2d 82 (1979).
6
In addition to seeking primary liability for Defendants’ alleged violations of Section 17(a) of the Securities Act, the SEC invokes Sections 20(e) and (a) to impose secondary liability for underlying violations of Sections 10(b), 15(c)(1)(A), and 17(a) of the Exchange Act, as well as Rules 10b-5 and 17a-3. 15 U.S.C. § 78t(a), (e). Section 20(e) governs aiding and abetting persons, while Section 20(a) governs controlling persons. The SEC claims that Defendants aided and abetted Joseph’s violations of the Exchange Act. Section 20(e) of the Exchange Act imposes liability upon those persons who aid and abet violations of the Act. 15 U.S.C. § 78t(e). That statute provides that
any person that knowingly provides substantial assistance to another person in violation of a provision of this chapter, or of any rule or regulation issued under this chapter, shall be deemed to be in violation of such provision to the same extent as the person to whom such assistance is provided.
Ibid.
The SEC also alleges that Pasternak is liable for the violations of Exchange Act
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Sections 15(c)(1)(A) and 17(a) and Rule 17a-3 committed by John, Joseph, and Knight.
7
Section 20(a) imposes joint and several liability on “control persons.” That statute provides:
Every person who, directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable, unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.
15 U.S.C. § 78t(a). The purpose of this provision is “to impose liability on persons who were able to directly or indirectly exert influence on the policy and decision-making process of others.”
Rochez Bros., Inc. v. Rhoades,
527 F.2d 880, 884 (3d Cir.1975).
B. Applicable NASD Regulations
The NASDAQ is a self-regulating market owned and regulated by the NASD.
Newton v. Merrill Lynch, Pierce, Fenner & Smith, Inc.,
259 F.3d 154 , 169 (3d Cir.2001). The SEC exercises oversight authority over the NASD. Ibid.; 15 U.S.C. §§ 78f, 78o-3, 78s. To regulate the market and its members, the NASD promulgates rules, policies, and guidelines.
Hoxworth v. Blinder, Robinson & Co., 980
F.2d 912, 914 (3d Cir.1992). The present case necessarily implicates some of those rules and regulations in effect in 1999 and 2000.
On all trading, the NASD requires “best execution.” NASD Rule 2320; (Exhibit 89). Subsection (a) of Rule 2320 states:
In any transaction for or with a customer or a customer of another broker-dealer, a member and person associated with a member shall use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. Among the factors that will be considered in determining whether a member has used “reasonable diligence” are:
(1) the character of the market for the security, e.g., price, volatility, relative liquidity, and pressure on available communications;
(2) the size and type of transaction;
(3) the number of markets checked;
(4) accessibility of the quotation; and
(5) the terms and conditions of the order which result in the transaction, as communicated to the member and persons associated with the member.
NASD Rule 2320(a); (Exhibit 89). Subsection (f) of that Rule further explains that the best execution obligation applies “where the member acts as agent for the account of his customer” and “where retail transactions are executed as principal and contemporaneously offset.” NASD Rule 2320(f); (Exhibit 89). However, “[s]uch obligations do not relate to the reasonableness of commission rates, markups or markdowns which are governed by Rule
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2440 and IM-2440.” NASD Rule 2320(f); (Exhibit 89).
To further explain Rule 2320, the NASD issued Interpretive Memo (“IM”) 2320, entitled “Interpretive Guidance with Respect to Best Execution Requirements.” IM-2320; (Exhibit 89). To also explain Rule 2320, the NASD issued Notice to Members (“NTM”) 97-57 in 1997, providing guidance on SEC order handling rules, NASD limit order protection rules, and best execution responsibilities. NTM 97-57 (Sept.1997); (Exhibit 84). NTM 97-57 explains that “the application of best execution concepts necessarily involves a ‘facts and circumstances’ analysis! ]” and that the best execution obligation “evolves as rules and systems change.” NTM 97-57 (Sept.1997); (Exhibit 84 at 457, “Questions and Answers”). In addition, this NTM specifically discusses how a market maker meets the best execution requirement when handling a discretionary, not-held order. NTM 97-57 (Sept.1997); (Exhibit 84 at 460, “Answer 8”).
The NASD also regulates prices and commissions where a market maker buys or sells for its own account from or to its customer. NASD Rule 2440; (Exhibit 944). Rule 2440 provides that, in those instances, a broker-dealer
shall buy or sell at a price which is fair, taking into consideration all relevant circumstances, including market conditions with respect to such security at the time of the transaction, the expense involved, and the fact that he is entitled to a profit; and if he acts as agent for his customer in any such transaction, he shall not charge his customer more than a fair commission or service charge, taking into consideration all relevant circumstances, including market conditions with respect to such security at the time of the transaction, the expense of executing the order[,] and the value of any service he may have rendered by reason of his experience in and knowledge of such security and the market therefor.
NASD Rule 2440; (Exhibit 944).
To further ensure fair dealing with customers, the NASD implemented a
“5%
Policy” applicable to commissions, markups, and markdowns. NTM 93-81 (1993). Pursuant to that policy, the NASD warns that “it may be conduct inconsistent with just and equitable principles of trade for a member to charge a commission that is not reasonable.” NTM 93-81 (1993). Fairness and reasonableness of a commission or markup “is determined by considering all relevant factors to the transaction!,] including market conditions with respect to such security at the time of the transaction, the expense of executing the order!,] and the value of any service he may have rendered by reason of his experience in and knowledge of such security and the market therefore.” NTM 93-81 (1993). To establish a general guide for determining fairness and reasonableness, the NASD finds that a commission or markup should not generally exceed five percent of the total transaction amount, “unless the member can show or document factors under the policy that justify a higher amount.” NTM 93-81 (1993). Essentially, “the percentage of commission on the transaction is only
one ”
relevant factor to determine if a commission is fair. NTM 93-81 (1993) (emphasis supplied).
In terms of reporting requirements, the NASD explained a then-recent rule change to reporting riskless principal transactions in NTM 99-65. NTM 99-65 (August 1999); (Exhibit 85). Essentially, the new rule, effective September 30, 1999, permitted market makers to report certain transactions once, rather than twice, where it executes a trade at the same price as the order. NTM 99-65 (August 1999); (Exhibit 85 at 429, “General Questions” 1 & 3). Significantly, neither the new rule nor any
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other rule prevented market makers “from accumulating a position at one price and executing the offsetting trade with the customer at another price (with no markup, markdown, commission equivalent, or other fee)[J” NTM 99-65 (August 1999); (Exhibit 85 at 430, “General Questions” 6).
NASD Rule 2110 requires “high standards of commercial honor and just and equitable principles of trade.” IM-2110-2; (Exhibit 1109). Based on this Rule, the NASD maintains a policy prohibiting “front running,” as expressed in IM-2110-3, as well as “trading ahead” on limit orders, as set forth in IM-2110-2. IM-2110-3; (Exhibit 1024); IM-2110-2; (Exhibit 1109). IM-2110-3 provides:
It shall be considered conduct inconsistent with just and equitable principles of trade for a member or person associated with a member, for an account in which such member or person associated with a member has an interest, for an account with respect to which such member or person associated with a member exercises investment discretion, or for certain customer accounts, to cause to be executed:
(a) an order to buy or sell an option or a security future when such member or person associated with a member causing such order to be executed has material, non-public market information concerning an imminent block transaction in the underlying security, or when a customer has been provided such material, non-public market information by the member or any person associated with a member; or
(b) an order to buy or sell an underlying security when such member or person associated with a member causing such order to be executed has material, nonpublic market information concerning an imminent block transaction in an option or a security future overlying that security, or when a customer has been provided such material, non-public market information by the member or any person associated with a member; prior to the time information concerning the block transaction has been made publicly available.
IM-2110-3; (Exhibit 1024).
Similarly, IM-2110-2 explains that, based on Rules 2110 and 2320, a member cannot “trade ahead” of customer limit orders. This policy states that NASD “members that handle customer limit orders, whether received from their own customers or from another member, are prohibited from trading at prices equal or superior to that of the limit order without executing the limit order.” IM-2110-2; (Exhibit 1109). As a result, the NASD requires its members to handle limit orders with all due care so that members do not trade ahead of customer limit orders. IM-2110-2; (Exhibit 1109).
III. FINDINGS OF FACT
Having summarized the testimony presented, accorded weight as deemed appropriate, and set the legal and regulatory lens through which the Court must analyze the facts presented, the Court now sets forth its findings of fact. The Court notes that it rejects the proposed findings of fact submitted on numerous occasions by the SEC. Rather, the Court finds that a preponderance of the evidence submitted supports the facts proposed by Defendants.
A. Background of the NASDAQ Market in 1999-2000 and Formation of Knight Securities
The presently complained-of trades executed by Joseph occurred in the NASDAQ stock exchange, an over-the-counter securities market. (Am. CmpltJ 13); (Tr. 56:5-10). The NASDAQ market operates through multiple market-making firms. (Tr. 671:16-17). Essentially, a market
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maker serves as a broker-dealer to execute sell and buy orders for traded stocks on behalf of its customers. (Tr. 1658:16-1659:13).
In so doing, the NASD requires market makers to buy or sell on behalf of a customer “at a price that is fair, taking into consideration all relevant circumstances[.]” NASD Rule 2440; (Exhibit 944). Thus, a market maker must find the best price of a particular stock, whether the best priced stock is from the market making firm’s own inventory of stock or from another source. (Tr. 1659:3-13). The best price depends on whether the order is to buy or to sell: the best offer price is the cheapest price at which one could buy a stock, whereas the best bid price is the highest price at which one could sell a stock.
8
(Tr. 1659:14-20). To find the best price, the market maker must consider the market conditions for the particular security, the expense of the transaction, and the market maker’s entitlement to a profit. NASD Rule 2440; (Exhibit 944); (Tr. 891:12-893:25). To ascertain if a price is “fair and reasonable,” one must compare that price with other prices in the marketplace, (Tr. 713:2-715:5), and conduct a trade-by-trade “facts and circumstances analysis[,]” (Tr. 893:10-25).
As part of their business, and to maintain an orderly market, these firms must necessarily commit their own capital, (Tr. 671:21-23), particularly in instances where the firm’s inventory of stock provides the best offer or bid prices, (Tr. 1659:21-1660:23). As a result, market making firms compete against each other by publicizing quotes on a particular stock in their inventory to attract order flow and volume. (Tr. 671:16-20,1659:21-1660:4).
In carrying out its business, a market making firm handles different types of orders. (Tr. 672:11-674:5). One type is the “market order,” which a market maker must execute “instantaneously against the best quoted market.” (Tr. 672:15-22). The purpose of a market order is immediate best execution. (Tr. 673:10-11). Another type of order is the “limit order,” where the customer specifically instructs the market maker to execute a trade when the stock reaches a particular price. (Tr. 672:23-673:1). The focus of a limit order is the price. (Tr. 673:11-12).
A market maker also executes “not-held orders.” (Tr. 673:2-677:16). A customer placing a not-held order provides the market maker with the volume of a particular stock sought to be bought or sold and grants the market maker discretion as to price and time of execution of that trade, with the goal of achieving “best execution.” (Tr. 673:2-9). On a not-held order, a market maker is not “held” to the immediacy and price requirements imposed in a market or limit order. (Tr. 673:2-16).
The NASD has defined a not-held, or “working,” order as “an order voluntarily categorized by the customer as permitting the member to trade at any price without being required to execute the customer order.” NTM 97-57 (Sept.1997); (Exhibit 84 at 460, “Answer 8”). When handling such an order, a broker-dealer “must use its brokerage judgment in the execution of the order, and if such judgment is properly exercised, the broker is relieved of its normal responsibilities with respect to the time of execution and the price or prices of execution of such an order.” NTM 97-57 (Sept.1997); (Exhibit 84 at 460, “Answer 8”). Although the customer bestows discretion to the broker-dealer, a customer nevertheless monitors the transaction and modifies the parameters of the order as it deems necessary. (Tr. 975:13-976:15).
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In the NASDAQ market, a trade in stock can be either on a principal or agency basis. (Tr. 917:18-918:20). The NASD defines a principal trade as “a trade in which the broker-dealer buys or sells for an account in which the broker-dealer has a beneficial ownership interestf,]” such as a proprietary account. (Tr. 917:24-918:9). In contrast, an agency trade is “a trade in which a broker-dealer ... acts as an independent intermediary for the account of its customer[]” and does not execute orders in a proprietary account. (Tr. 918:10-20). An agency trade is generally considered to be a riskless transaction for the broker-dealer. (Tr. 678:1-14).
A principal trade may also be riskless. (Tr. 678:1-22, 918:25-919:12). The NASD defines a riskless principal trade as a trade “in which a broker-dealer, after having received an order to buy [or] sell a security, purchases [or] sells a security as prin-eip[al] at the same price ... to satisfy that order.” (Tr. 919:2-12); NTM 99-65 (Aug. 1999); (Exhibit 85 at 429, “General Questions” 3). On a riskless principal trade, the broker-dealer charges its customer a disclosed mark-up, mark-down, or commission. (Tr. 678:15-22, 919:2-12).
Most market makers executing institutional orders between the years 1999 to 2000, executed net trades, “accumulating shares at one price and executing to customers at a different price.” (SEC Stipulated Facts, Final Pretrial Order 1/02/2008 (“SEC Stip.”) at 17 ¶ 48); (John Stipulated Facts, Final Pretrial Order 1/02/2008 (“John Stip.”) at 5 ¶ 16); (Tr. 678:19-679:5, 919:16-920:4). The NASD defines a net trade as one in which “a market maker, at the request of a customer[,] while holding a customer order[] to buy [or] sell executes a buy [or] sell as principal] at one price from the street or another customer and then executes an offsetting sell [or] buy from the customer at a different price.” (Tr. 919:18-22); (John Stip. at 5 ¶ 17); NTM 97-57 (Sept.1997); (Exhibit 84 at 460, “Answer 8”).
The market maker’s profit is then the difference between the price of the market maker’s transaction and the price of the transaction to the customer, or the “spread.” (Tr. 919:22-25). Such profit on net trades, generally, are not separately disclosed to the customer. (Tr. 919:22-920:8). Furthermore, apart from the fair and reasonable price requirement, no NASD rule or regulation, or industry standard, sets a maximum limit on the profit or spread generated on a net order. (Tr. 713:2-6, 2344:21-2345:4, 2027:21-2028:2).
However, the NASD specifically requires traders to provide “best execution” on not-held orders. (Tr. 684:22-686:8, 2346:15-2347:3); (Exhibit 89). According to NASD Rule 2320, a broker-dealer must “use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions.” NASD Rule 2320(a); (Exhibit 89). That Rule further sets forth various factors considered to determine whether “reasonable diligence” is met; those factors include: “the character of the market for the security” — such as, price, volatility, and liquidity; “the size and type of transaction;” “the number of markets checked;” the “accessibility of the quotation;” and “the terms and conditions of the order[.]” NASD Rule 2320(a)(l)-(5); (Exhibit 89). Thus, whether a broker-dealer provides best execution depends upon a plethora of factors, including, but not limited to: market conditions; the trade’s impact on the market; the ultimate price paid or received; the availability of anonymity to the customer; and the trade’s impact on the customer’s overall portfolio. (Tr. 684:24-685:23, 2346:17-2347:3, 2387:12-2390:23).
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In addition, Section II of NTM 97-57 explains that a market maker handling a not-held order “does not owe the same best execution obligations to [its customer] as it would if the order were a non-discretionary market or limit order.” NTM 97-57 (Sept.1997); (Exhibit 84 at 460, “Answer 8”). NTM 97-57 explains that the discretion granted in a not-held order “means that the firm may trade at the same price or at a better price than that received by the discretionary order[,]” provided the market maker seeks “to obtain the best fill considering all of the terms agreed to with the customer and the market conditions surrounding the order.” NTM 97-57 (Sept.1997); (Exhibit 84 at 460, “Answer 8”). To seek that “best fill,” the customer and market maker could agree that the market maker may, “if necessary to fill the entire order at an acceptable price, trade ahead of the institutional customer’s order.” NTM 97-57 (Sept. 1997); (Exhibit 84 at 460, “Question 8”).
Importantly, whether a market making firm meets the best execution requirement on a particular trade is based primarily on the customer’s assessment of the firm’s ability to follow instructions. (Tr. 2385:13-17). A customer generally focuses on the ultimate price received for the trade, comparing that price with the volume-weighted average price, or “VWAP,” to determine the quality of a trade. (Tr. 309:15-21, 334:6-335:17, 371:25-372:23). Essentially, the customer is in the best position to ascertain whether best execution is met, as the customer knows its instructions and specific trading strategy. (Tr. 2386:1-6). As a result, unless the customer raises a concern about the execution of a trade, it would be difficult for a trader or supervisor to determine that the customer was not satisfied with an execution. (Tr. 2386:21-2387:2).
During the time period relevant to this action, 1999 through 2000, the NASDAQ market reached a historical high point of volatility. (Tr. 122:24-124:16, 130:12-134:12, 307:13-21, 415:6^16:18, 2029:6-2031:6); (Exhibit 1106 at 100:5-15 (Miller)); (Exhibit 1111 at 19:6-8, 46:2-7 (Mi-trano)); (Exhibit 1104 at 35:7-36:11 (Schubert)); (Exhibit 1105 at 46:2-9, 48:24-50:24 (K. Smith)); (Exhibit 1113 at 41:22-44:12 (F. Smith)); (Exhibit 1119 at 135:14-21, 137:18-138:17, 178:23-179:15 (Perry)). The volatility of the market is exemplified by the trading that occurred on April 4, 2000, “the single most high volume day in the history of NASDAQ[.]” (Tr. 2030:15-2031:6). On that day, the market was both a bear and a bull market, resulting in about “a 20 percent correction and a recovery in the course of one day.” (Tr. 2030:15-23). Based on such volatility, Brooks characterized this period in the NASDAQ market as being unprecedented in the securities industry and causing “a real mania[.]” (Tr. 131:3-11).
Prior to this period of volatility and “mania!,]” in 1995, Pasternak, with Walter Ra-quet (“Raquet”), formed Knight Trimark Group (“Knight Trimark”),
9
Knight’s holding company. (Tr. 1980:5-1981:15); (Defendants Stipulated Facts, Final Pretrial Order 1/02/2008 (“Defs. Stip.”) at 5 ¶ 1). At that time, the business idea behind the formation of Knight was novel in the industry: it was “the next generation market maker.” (Tr. 1981:11-15). According to Pasternak, he realized the potential for technological advances, like the internet, to further promote what he saw as the “emerging democratization of individual investors!.]” (Tr. 1980:16-1981:15). Pasternak described Knight’s business as being “predicated on that self-directed investor! ] becoming] very, very active!,] and [Knight was to] provid[e] the execution capability
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so when [the investor] pushed the button, he expected to get back his fill in its entirety in a nano second.” (Tr. 1982:21-24). In addition to offering automatic executions on trades, Pasternak’s business plan also envisioned trading at higher volumes. (Tr. 2000:22-2001:3). Essentially, Pasternak and Raquet formed Knight with the anticipation that there would be a “boom” in retail order flow and the hope that Knight could capture that flow. (Tr. 1982:8-1983:1).
Indeed, that boom did occur. The “democratization” of investors, originally spurred by the availability of 1-800 telephone numbers for investment, resulted in higher volume retail transactions. (Tr. 1980:14-1982:24). To illustrate the change in volume, Pasternak testified that “retail transactions went from about ten percent of the market to nearly [fifty] percent five years later[.]” (Tr. 1982:15-17).
With that concept in mind, Pasternak and Raquet formed, in 1995, Knight Trimark and Knight, headquartered in Jersey City, New Jersey. (Tr. 1980:5-1981:15). Knight’s structure included an institutional sales desk composed of the sales traders and a market making desk composed of the market makers. (John Stip. at 4 ¶ 6). That same year, John joined Knight. (Defs. Stip. at 5 ¶ 3). Approximately one year thereafter, in 1996, John’s brother, Joseph, joined Knight as senior vice president of institutional trading. (SEC Stip. at 15 ¶ 22). Some point thereafter, John, upon becoming supervisor of the institutional sales desk, gave his largest accounts to Joseph. (SEC Stip. at 14 ¶ 8, 16 ¶ 31). To recognize that many of Joseph’s accounts originated from John, John “was given a percentage of the sales credits attributed to Joseph[’s] trades[.]” (SEC Stip. at 14 ¶9, 16 ¶ 31). Significantly, Joseph’s accounts included many of Knight’s largest institutional clients. (SEC Stip. at 16 ¶ 30). However, in March of 2000, Pasternak terminated the shared compensation agreement between John and Joseph. (SEC Stip. at 15 ¶ 28); (Tr. 1895:5-23).
In March of 1998, Knight became a publicly-traded company by making an initial public offering (“IPO”). (Tr. 1984:21-22). Knight made a secondary offering in 1999. (Tr. 1985:4-15). As part of its obligations as a publicly-traded company, Knight, through its Directors, filed the SEC-required Form 10-K in 1999 and 2000. (Exhibits 81-82). Those documents represented that Knight offered best execution to its customers. (Exhibit 82 at 04978 (1999)); (Exhibit 81 at 04966 (2000)).
Until January 31, 2002, Pasternak served as Chief Executive Officer (“CEO”) and Chairman of both Knight Trimark and Knight. (Defs. Stip. at 5 ¶ 1). As CEO and Chairman, Pasternak had various additional responsibilities throughout the IPO and secondary offering, including interviewing and recruiting board members and bankers and traveling for the “road show.” (Tr. 1986:8-22). During the relevant time period, Pasternak also held multiple securities licenses, (Defs. Stip. at 5 ¶ 2), and had a financial interest in a particular market making account, number 1002, over which Pasternak maintained decision-making authority, (Defs. Stip. at 7 ¶¶ 22-23); (SEC Stip. at 16 ¶ 29).
B. Knight’s Execution of Trades and Retail Order Flow
Considering the background of the NASDAQ market and the formation of Knight, the Court now turns to the methodology employed by Knight to execute institutional orders. Knight’s business goal was to commit capital, creating a risk, and to effectively manage that risk to generate a profit. (Tr. 2032:10-13). To further that goal, Knight handled both institutional orders and retail order flow, re-
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suiting in unique business practices. (Tr. 111:6-22, 162:22-163:9, 1272:17-1273:22, 1672:18-23, 1980:14-1983:1). At issue in this case is Knight’s handling of institutional orders. However, Knight’s traders executed those institutional orders in tandem with the retail order flow; thus, it is pivotal in this case to understand how Knight handled both types of orders.
1.
Institutional Orders
Between 1999 and 2000, Knight, on behalf of its institutional customers, primarily executed not-held orders, (Defs. Stip. at 7 ¶ 19), typically conducted on a “net basis[,]” (John Stip. at 5 ¶ 16). To generate institutional orders, Knight used the electronic medium, AutEx. (Tr. 2017:13-21). Through AutEx, Knight sent electronic advertisements to the buy-side, indicating that Knight could provide a natural trade of a particular volume in a stock. (Tr. 2017:13-21). Knight, as part of a mandatory protocol, required its traders to advertise over AutEx any order imbalance above 25,000 shares. (Tr. 2017:25-2018:2).
During the relevant time period, institutional orders streamed into Knight via an electronic message or the telephone. (Tr. 451:17-22). If the order came to Knight via telephone, then a sales trader, or his assistant, would complete an order ticket. (Tr. 454:14-25); (Exhibit 1106 at 45:6-51:3, 55:5-59:18 (Miller)); (Exhibit 1111 at 27:22-33:5 (Mitrano)). An order ticket specified the date and time of receipt of the order, the stock symbol, the volume of shares, whether the order is held or not-held, and whether the order is a short or long sale. (Tr. 454:19-22); (Exhibit 1106 at 45:6-51:3, 55:5-59:18 (Miller)); (Exhibit 1111 at 27:22-33:5 (Mitrano)).
Upon receipt of an order, a sales trader discussed the order with the customer to understand the customer’s goals for that order. (Tr. 452:15-453:5, 1183:16-1184:2). The customer would give the sales traders any particular instructions it had on the order, including how the trader should work the order, the price parameters, and size. (Tr. 452:17-19, 454:10-13, 1011:15-24). Such instructions could include a request for the staggering of the trade; that is, the customer gave the sales trader its ultimate volume goal, but instructed the trader to initially execute only a portion thereof. (Tr. 453:6-11). On net trades, the customer and sales trader would negotiate the final price of the stock bought by or sold to the customer. (Exhibit 1103 at 26:10-13 (Thornton)). Generally, order sizes ranged, during the 1999 to 2000 time period, from under one hundred shares to millions of shares. (Tr. 452:1-7).
After obtaining the instructions from the customer, the sales trader contacted the market maker who maintained an account, or “book,” on the particular stock included in the order. (Tr. 452:19-23). The sales trader passed the order on to the market maker, who would relay to the trader any relevant market information. (Tr. 452:19-23, 453:16-19). The sales trader then provided the customer with feedback and information obtained from the market maker, while the market maker began to execute the order, either buying or selling the stock. (Tr. 452:19-23).
As the market maker worked the institutional order, the sales trader monitored the market maker’s activity through Knight’s automated, computer-based trade and order management tool, the Brokerage Real Time Application Support System (“BRASS”). (Tr. 455:1-13). On BRASS, a sales trader can observe the market maker’s position in the stock and attempt to sift out the position taken on behalf of the trader’s institutional customer, rather than for another institutional order, retail order, or proprietary trading. (Tr. 455:12-22, 456:13-25); (Exhibit 1106 at 77:4-24 (Miller)). If anything appeared on
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BRASS that the execution of the order might not be going well, the sales trader would call the customer to determine how the customer would like to react. (Tr. 455:3-8). In addition, throughout the entire transaction, the customer would closely monitor the marketplace in respect of the ordered trade, observing price and volume fluctuations. (SEC Stip. at 13 ¶ 5). Based on the changes in the market, the customer may modify or cancel the order at any moment. (Tr. 75:17-76:4, 165:4-20, 309:7-14, 330:21-331:17, 333:2-5, 372:21-373:10, 416:21-417:2, 418:5-23).
As part of working a not-held order, a market maker fulfilling that order may commit Knight’s capital to facilitate that trade, resulting in a “risk trade.” (Tr. 468:2-473:3, 623:7-22, 1016:1-11, 1687:18-23). For example, a market maker may commit capital if the institutional order requires stock not readily available in the market. (Tr. 468:8-24). Although this practice is not required of a market making firm, it benefits customer relations. (Tr. 468:17-24). If he chooses to do so, a market maker may commit capital at any point in the working of the institutional order. (Tr. 469:7-15). In instances in which a market maker commits capital, a sales trader, as a matter of courtesy, not as a requirement, tells the customer that Knight committed capital on the particular trade. (Tr. 469:16-170:1, 549:12-16). Other times, a customer may specifically request that Knight commit capital, such as where the customer sought an immediate print. (Tr. 472:3-473:1).
The final step in executing an institutional order is “the print” to NASDAQ “tape[,]” the Automated Confirmation Transaction (“ACT”) Service — a consolidated record reflecting all transactions occurring in the NASDAQ market. (Tr. 462:7-12, 1673:14-22); (John Stip. at 5 ¶ 14); (Defs. Stip. at 10 ¶¶ 49-50). The print is essentially a confirmation to the customer and a record to NASDAQ of the trade conducted on behalf of the institutional customer. (Tr. 459:12-460:5). The print to the customer indicates the volume of the stock traded and the final price at which the customer bought the stock or at which the customer sold Knight the stock. (Tr. 462:1319, 1673:17-19).
A sales trader, or his assistant, would be the person responsible for the print. (Tr. 459:6-10, 1673:20-22); (Defs. Stip. at 10 ¶ 50); (Exhibit 1106 at 77:25-78:17 (Miller)); (Exhibit 1111 at 48:21-22 (Mitrano)). Once a print was made, the customer would receive acknowledgment of the print from its electronic order management system or by a telephone call from the Knight sales trader working the order. (Tr. 460:6-10).
Importantly, a customer could provide specific instructions on when it wanted the transaction printed, and those instructions varied from customer to customer. (Tr. 457:22-458:5). Based on customer instructions, or in the sales trader’s discretion in working the order, the complete execution of an institutional order could occur over a period of time and include multiple, piecemeal prints to the customer. (Tr. 461:2-21). If an order was for a large volume of shares or a highly-volatile stock, a sales trader or his assistant could print the transaction outside of the national best bid and offer price. (Tr. 2387:3-6). In those instances, Knight’s compliance department required the print to include an “ACT modifier,” such as “.SLD” or “.PRP[,j” indicating that the print was out of time sequence. (Tr. 1020:6-20); (Exhibit 1106 at 100:16-106:13, 108:19-21 (Miller)); (Exhibit 1111 at 55:12-57:20 (Mitrano)).
At Knight, in addition to the NASD requirements of fair price and best execution, the sales traders had a performance commitment to satisfy their customers’ expectations as to price. (Tr. 2033:3-17).
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Because the institutional customer “focused on the price [it] receive[d] against [its] instructions^]” the sales traded needed “to create an outcome that satisfie[d] the customer[J” (Tr. 2033:10-12). If the trader failed to create a satisfactory outcome, then Knight would “have to buy stock at inferior prices ... and essentially lose money.” (Tr. 2033:11-14). In such an instance, a sales trader would not discuss the issue with the customer, but, rather, would print the transaction to the customer at what the trader believed to be a fair price. (Tr. 2034:8-16). Indeed, all not-held institutional orders required a performance commitment. (Tr. 2035:16-20). At times, an institutional order could require both capital and performance commitments by Knight. (Tr. 2034:20-24). In those instances, capital commitments could occur at any point in the execution of an order and would be in addition to the performance commitment that is always existent. (Tr. 2035:2-2036:7).
Knight was also at risk during the overnight period. (Tr. 1720:22-1721:2, 2053:5-2054:19). Trading conducted the day before and various events occurring overnight would affect the value and actual price of stocks held by Knight. (Tr. 2053:5-2054:9). That inventory of stock held overnight could be the result of a not-held order executed that day or held overnight as part of the consummation of an earlier-placed order. (Tr. 2058:8-24).
2.
Retail Orders
In conjunction with institutional orders, Knight also handled retail orders. (Tr. 111:6-22, 162:22-163:9, 1272:17-1273:22, 1672:18-23, 1980:14-1983:1). Those orders were both buy and sell orders; thereby, Knight accumulated positions in a security by executing those retail orders. (Tr. 2402:2-6, 2405:13-2406:7).
Knight automatically executed much of that retail order flow to provide its retail customers with liquidity not otherwise available. (Tr. 1670:13-1673:3). Essentially, Knight would provide automatic execution on a stock based on its liquidity and volatility up to a certain volume in a particular period of time. (Tr. 1670:24-1671:2). Knight labeled that threshold volume and period of time as a “firewall.” (Tr. 1671:4-11). Theoretically, once retail order executions reached that firewall, Knight’s computer system prevented any further automatic execution of retail orders, which would then “go to a manual mode[.]” (Tr. 1671:2-3). The manual mode ensured that Knight did not provide non-existent liquidity for a particular stock. (Tr. 1671:2-3).
However, due to a computer or technical error in Knight’s system, the manual mode did not initiate once the actual firewall was reached; rather, the manual mode initiated when Knight was in a net position of the firewall. (Tr. 1671:4-18). In other words, the automatic executions would deplete Knight’s inventory in a particular stock and continue thereafter until reaching the volume set in the firewall. (Tr. 1671:12-23). Despite this issue, Knight’s provision of automatic executions was pivotal to its unique business practice. (Tr. 1672:18-1673:3).
Because of that firewall issue, however, the automatic execution of retail orders could deplete an inventory acquired to fill an institutional order. (Tr. 1671:12-1672:1). As a result, Knight’s market makers could protect positions built for an institutional order by moving those inventories to a “back book[J” (Tr. 1669:10-1670:4,1723:5-1724:2). Typically, the back book was used by market makers as a principal account; that is, an account used to take positions for the firm, rather than on behalf of customers. (Tr. 1669:6-24).
To distinguish itself from its competitors, Knight offered on its retail orders an “opening guarantee^]” which was general
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ly unprofitable to Knight, (Tr. 2000:2-21), but provided Knight with the opportunity to attract more volume to its business, (Tr. 2000:22-2001:3). Knight’s opening guarantee assured customers that Knight would execute both buy and sell trades at the midpoint of the opening national best bid price and national best offer price. (Tr. 2002:25-2003:12, 2004:1-3). Essentially, the opening guarantee guaranteed customers execution of trades at the same price, irrespective of the timing in which the customer placed the order. (Tr. 2001:4-2003:4).
3.
Sales Credit Data
Knight’s trading data collected both retail order executions and institutional order executions. (Tr. 2401:18-2402:11). The recorded data reflects the position held by Knight in a particular security and does not differentiate between the types of orders executed. (Tr. 1809:23-1810:3, 1811:4-18, 2401:18-2402:11); (Exhibit 111 at 61:22-62:16 (Mitrano)).
Knight used this trading data to compensate its institutional sales traders. Knight remunerated its institutional sales traders a percentage of the profit or loss on a particular institutional trade. (Tr. 473:4-10, 1876:19-1877:7). At the end of a trading day, each market maker would have a BRASS-generated profit and loss number, called “P
&
L[,]” attributed to all of the trades he executed that day. (Tr. 526:20-527:1). Generally, assistant traders would calculate manually, from the P
&
L number, a sales trader’s “sales credit”— that is, the allocation of the overall P & L on a particular stock to an institutional order transacted by the sales trader. (Tr. 524:24-528:14, 1876:19-1877:7, 1880:10-16); (Exhibit 1106 at 112:16-119:18 (Miller)); (Exhibit 1111 at 60:1-63:12 (Mitrano)).
Essentially, the calculation of a sales credit was “a negotiation of who would get what share of the profits for each day, based on what each party thought they contributed to that P
&
L[.]” (Tr. 528:11-14, 1877:11-21). This is because Knight’s trade run data did not differentiate between trades executed for retail orders, institutional orders, and proprietary trading. (Tr. 1809:23-1810:3, 1811:4-18, 2401:18-2402:11); (Exhibit 111 at 61:22-62:16 (Mitrano)). Such an allocation necessarily required an analysis of multiple factors that interacted throughout the daily trading of the particular stock. (Exhibit 1106 at 113:7-119:18 (Miller)). Knight did not maintain any internal written guidelines as to how to allocate sales credit to a sales trader. (Tr. 526:3-13).
C. Knight’s Supervisory and Compliance Structures
Knight maintained a system of supervisory personnel, as well as a compliance department. (Tr. 2334:15-16). At the top of that supervisory system, in 1999 and 2000, was Pasternak, under whom were varying levels of supervisors for both the market making desk and the institutional sales desk. (Tr. 2334:16-25).
Between 1995 and 2000, Pasternak was the supervisor over Knight’s market making desk. (John Stip. at 4 ¶ 2); (Tr. 2374:23-2375:8); (Exhibit 36 at KN 1265); (Exhibit 37 at 47198). As part of that responsibility, Pasternak, on a daily basis, received and reviewed spread sheets indicating each market maker’s positions and profit and loss information. (John Stip. at 4 ¶ 3); (Defs. Stip. at 6 ¶¶ 8-9). Pasternak also maintained an active market making account — number 1002. (John Stip. at 4 ¶ 9); (Defs. Stip. at 7 ¶¶ 21-23). Pasternak was able to observe all trades executed through that account. (John Stip. at 4-5 ¶ 12); (Defs. Stip. at 10 ¶ 48). To observe those trades, Pasternak would access periodically information on Knight’s BRASS system. (John Stip. at 5 ¶ 13);
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(Defs. Stip. at 7 ¶ 20); (Tr. 2376:20-2377:3).
From 1995 to August 2000, John supervised the institutional sales desk, including his brother Joseph, (Defs. Stip. at 5 ¶¶ 3-4); (SEC Stip. at 13 ¶¶ 2-3); (Tr. 2372:1-9, 2374:16-22), and directly reported to Pasternak, (SEC Stip. at 15 ¶ 26); (Tr. 2364:12-15). (Exhibit 36 at KN 1265); (Exhibit 37 at 47198). In addition, the sales traders were divided into sub-groups under team captains. (Tr. 2334:18-21). One particular team captain on the institutional sales desk, Jeffrey Hoobler, served as liaison between the sales desk and Knight’s legal and compliance departments. (SEC Stip. at 13-14 ¶ 6); (Tr. 2328:23-2329:2).
As part of his supervisory responsibilities, John was to conduct daily reviews of the institutional trading activity and what Knight labeled “trade allocation reports.” (Tr. 2373:8-2374:1, 2378:11-18); (Exhibits 49-68). John would review the reports of the trade runs, initial the documents, and submit them to another person, possibly someone within the compliance department. (Tr. 2378:11-18). In addition, John held regular meetings for the institutional sales desk where traders could discuss compliance issues. (Tr. 1062:1-22). Knight also required its sales traders to attend annual compliance meetings and continuing education sessions. (SEC Stip. at 14 ¶ 7).
Pasternak, as CEO of Knight, held ultimate supervisory responsibility. (SEC Stip. at 16 ¶ 35); (Tr. 2371:7-25); (Exhibit 36 at KN 1265); (Exhibit 37 at 47198). As a result, between 1995 and 2000, Pasternak regularly interacted with Knight’s sales traders and market makers. (John Stip. at 4 ¶ 10); (Tr. 2364:21-2365:4). He received and regularly reviewed month-end summary reports listing each sales trader’s gross sales credits and sales per share. (Defs. Stip. at 7 ¶ 18); (SEC Stip. at 14 ¶ 14). In addition, in 1999 and 2000, Pasternak conducted spot-checks of trading activity conducted by Knight’s sales traders, including Joseph. (John Stip. at 4 ¶ 5); (Defs. Stip. at 6 ¶ 10); (Tr. 1800:13-1805:1). Those spot-checks included a review of sales credits generated by the sales traders on particular trades, considering the volume and price movement of the particular stock traded. (Defs. Stip. at 6 ¶ 13); (Tr. 1801:21-1802:13). In reviewing trades in 1999 and 2000, Pasternak would note positive or negative sales credits in excess of $250,000 and $500,000, respectively. (Defs. Stip. at 6 ¶¶ 11-12); (Tr. 1803:19-1804:23).
In 1999 and 2000, Michael Dorsey (“Dorsey”) served as Knight’s General Counsel. (SEC Stip. at 16 ¶ 34); (Tr. 2327:1-2). In October of 1999, Amoruso joined Knight as its Chief Compliance Officer and operated in Knight’s compliance department. (SEC Stip. at 16 ¶ 34); (Tr. 2326:12-21). The compliance department served “to provide oversight over the supervisory process and controls of the firm, to help develop supervisory procedures, compliance procedures [and] controls, [and] to insure [the existence of] an adequate system of cheeks and balances within the firm[.]” (Tr. 2328:7-12, 2369:15-2370:4). In addition, the compliance department “provide[d] advisory assistance” in the form of NASD rule interpretations and guidance to senior management on potential new businesses. (Tr. 2328:12-16).
Knight’s compliance department, in 1999 and 2000, consisted of “a number of people who were former regulators, both at the SEC or the NASD.” (Tr. 2329:4-8). That department also employed people who had been employed by Knight for years and understood well both Knight’s business model and the applicable regulations. (Tr. 2330:7-12). In addition, to make the compliance department more accessible to
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Knight’s traders, and to help compliance personnel understand the trading methodology employed by the traders, compliance personnel sat amongst the sales traders and market makers during the day. (Tr. 2333:24-2334:14).
Amoruso kept abreast of new NASD rules and regulations. (Tr. 2330:17-19). In particular, Amoruso continually read notices and enforcement cases, attended industry conferences at which compliance issues were discussed, and formed an “informal working group” of compliance directors from large market making firms located in proximity to Knight. (Tr. 2330:17-2331:12). That working group, called by its participants as “the Jersey City compliance directors,” would regularly discuss industry trends, compliance issues relevant to the market making industry, and policies and practices that most effectively resolve any issues. (Tr. 2331:3-12, 2332:2-15).
At all relevant times, Knight maintained an updated Compliance and Supervisory Procedures Manual (“Compliance Manual”) to provide written procedures and policies to Knight’s employees. (Exhibits 36-38, 602); (Tr. 2335:11-17); (SEC Stip. at 17 ¶ 38). In 1999 and 2000, Knight’s Compliance Manual provided that “[t]he principal function of the Compliance Department is to supervise books and records and all market making, trading and institutional sales aetivities[.]” (Exhibit 36 at KN 1283); (Exhibit 37 at 47218); (SEC Stip. at 14 ¶ 10, 17 ¶¶ 39, 46). As a result, the compliance department, in accordance with the Compliance Manual, was responsible for conducting periodic reviews of a sampling of institutional customer accounts, including discussing the customer and trading activity with the sales traders. (SEC Stip. at 14 ¶ 12).
To effectuate its goals, the compliance department instituted written guidelines and used automated systems to aide the department’s review of Knight’s voluminous trading. (Tr. 2333:1-21). The department utilized BRASS to build into the trading system automated protocols that ensured compliance with requirements on order handling, short sales, and trade reporting. (Tr. 2336:1-16). In fact, Knight purchased a license to modify BRASS to implement additional controls into its system that were not readily available in the original system. (Tr. 2336:11-2337:23). Knight built these compliance processes and protocols around the market makers’ accounts through which all trades passed. (Tr. 2338:3-14).
In addition to the automated controls, the compliance department would manually draw a sampling of trades to ascertain whether the trades complied with the “short sale rule” and whether the order was displayed timely and properly in accordance with order handling rules. (Tr. 2338:15-24). Knight’s compliance department also conducted sampling reviews of order tickets. (Tr. 2379:20-2380:11). Notably, Knight’s compliance department did not monitor, or impose on any Knight supervisor the obligation to monitor, profits generated on institutional not-held orders. (SEC Stip. at 17 ¶¶ 40-41); (Tr. 2362:9-2364:10, 2391:12-18).
Believing its procedures to be adequate, the compliance department assured John and Pasternak that its compliance policies and procedures were effective and consistent with NASD rules and regulations. (Tr. 2342:16-2343:13); (SEC Stip. at 17 ¶ 39). Amoruso himself attended management meetings at which John and Pasternak were present to discuss any relevant compliance issue. (Tr. 2361:10-21). Moreover, Pasternak was positive and supportive of the compliance department and its efforts, and Amoruso felt free to implement procedures he found necessary. (Tr.
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2344:8-20, 1725:5-1726:12, 2041:10-2043:14, 2051:15-2053:3).
D. Joseph Leighton’s Trading Practices
Having considered the background of Knight’s trading practices and structure, the Court turns to the particular facts surrounding Joseph Leighton’s trading practices. Each sales trader at Knight had their own style and manner of conducting business. (Tr. 1051:3-7). A sales trader’s tactics would largely depend on his customers and types of stocks traded. (Tr. 1051:8-12,1052:8-11).
Significantly, Joseph’s particular trading practice involved high-volume, high-priced stocks. (Tr. 1052:2-7, 1052:21-25, 1688:7-22). He also held the largest institutional accounts at Knight, (SEC Stip. at 16 ¶ 30); (Tr. 1222:24-25, 1223:9-17, 1795:19-22), and had a reputation of being the trader that took the biggest risks by committing capital, having the most authority to do so, (Tr. 1222:11-23, 1719:20-1720:13). Indeed, the other sales traders at Knight believed that Joseph’s profitability derived from his client base. (Tr. 1223:1-17). His clients included: Putnam, Trust, T. Rowe, Delaware, Davis Selected, Fidelity, Dimensional, NY Investments, Capital Guardian Trust Company (“Capital Guardian”), Aesop Capital Partners, Columbia Management Advisors, Inc. (“Columbia”), Pilgrim, and Keystone. (Defs. Stip. at 8 ¶ 30).
Not only did Joseph have a coveted list of clients, but he also had a reputation as being a “talented” sales trader. (Tr. 1718:11-13). In fact, Levinson described Joseph as being “the most talented sales trader” with whom he had ever worked. (Tr. 1718:11-13). Levinson specified that Joseph “had a tremendous understanding of the marketplace, ... was totally competent about dealing with working ... orders, with how to get orders[, and h]e was very focused, ... insightful[J ... and phenomenal.” (Tr. 1718:16-23). Essentially, Joseph applied his understanding of the marketplace to realize opportunities in high-priced, high-volume trades in which he could take risks that other traders would not take. (Tr. 1719:25-1720:9).
On all of his trades, Joseph’s institutional customers “quarterbacked” their orders, (Exhibit 1119 at 36:13-23 (Perry)), monitoring the market, providing specific instructions throughout the transaction, and, in some cases, “doling out” the order — that is, giving Joseph an order in increments. (Tr. 75:17-76:4, 165:4-20, 309:7-14, 330:21-331:17, 333:2-333:5, 372:21-373:10, 416:21-417:2, 418:5-418:23, 911:14-912:10); (Exhibit 1103 at 47:7-48:18 (Thornton)); (Exhibit 1104 at 86:13-91:5, 108:10-13, 119:15-120:1 (Schubert)); (Exhibit 1105 at 32:17-33:11, 41:18-43:15 (K. Smith)); (SEC Stip. at 15 ¶ 23). It was common for institutional customers to keep their ultimately sought volume hidden from Joseph; rather, the customers preferred giving the traders “bite-size bits on working orders.” (Exhibit 1103 at 47:7-25 (Thornton)). Breaking up, or doling out, the orders left control over the trade in the hands of the institutional customer, rather than with Joseph. (Exhibit 1105 at 32:17-33:11 (K. Smith)).
Because the customers closely monitored the market after placing an order with Joseph, the customers continually communicated with Joseph throughout the execution of the order, and changed their instructions and strategies as the customer deemed appropriate in light of the market conditions. (Tr. 75:17-76:4, 165:4-20, 309:7-14, 330:21-331:17, 333:2-5, 372:21-373:10, 416:21-417:2, 418:5-23); (Exhibit 1104 at 91:6-10 (Schubert)); (Exhibit 1105 at 42:12-16 (K. Smith)).
Indeed, Joseph’s customers found, at the time that they transacted business with Joseph, that Joseph provided them with
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the best prices and volume in light of their instructions and market conditions. (Tr. 145:6-23, 325:7-11, 340:6-14, 342:13-19, 411:11 — 412:13, 413:20-414:5, 416:1-4, 415:17-22); (Exhibit 1113 at 59:25-60:3 (F. Smith)); (Exhibit 1117 at 70:22-71:18, 74:4-75:8, 88:4-13 (Marcotte)); (Exhibit 1104 at 67:6-11 (Schubert)). None of Joseph’s customers ever lodged a complaint against him for his trading. (Tr. 2347:24-2348:18). Generally, the institutional customers found Knight to be at the top of their “go-to list” for trading in high-volume, high-volatile stocks. (Exhibit 1104 at 73:6-74:19, 78:1-80:18, 117:6-9 (Schubert)).
Between 1999 and 2000, Joseph generated one of the highest gross sales credits each month amongst Knight’s sales traders. (Defs. Stip. at 6 ¶ 5); (Exhibits 1-3, 10-11). In 1999, seventeen of thirty trades executed through Joseph’s sales account generated a gross sales credit of $250,000 or greater. (Defs. Stip. at 6 ¶ 14); (Exhibit 9). In 2000, nine of thirteen trades executed through Joseph’s sales account generated a gross sales credit of $500,000 or greater. (Defs. Stip. at 6-7 ¶ 16); (Exhibit 9).
Some of Joseph’s trading occurred through market making account, # 1002, in which Pasternak had an economic interest and over which Pasternak exercised decision-making authority. (Defs. Stip. at 7 ¶¶ 21-25, at 10 ¶47); (Exhibits 13-14). In 1999, twenty-five of Joseph’s trades executed through market making account # 1002 generated a sales credit of $0.25 or more per share. (Defs. Stip. at 8 ¶ 28); (Exhibit 13). That same year, nine of Joseph’s trades executed through that market making account generated a sales credit of $0.50 or more per share. (Defs. Stip. at 8 ¶ 29); (Exhibit 13). Five of those nine trades were: (1) an April 15, 1999 trade of 40,000 EBAY shares on behalf of Fidelity, for which Joseph received a sales credit of $0.50 per share; (2) an April 15, 1999 trade of 25,000 EBAY shares on behalf of Delaware, for which Joseph received a sales credit of $0.50 per share; (3) a November 23, 1999 trade of 20,797 FDRY shares on behalf of Putnam, for which Joseph received a sales credit of $1.50 per share; (4) a December 9, 1999 trade of 20,000 LEAF shares on behalf of Aesop Capital Partners, LLC, for which Joseph received a sales credit of $0.58 per share; and (5) a December 14, 1999 trade of 261,700 SCOC shares on behalf of Columbia, for which Joseph received a sales credit of $0.56 per share. (Defs. Stip. at 8-9 ¶¶ 31-35).
In 2000, fifty-two of Joseph’s trades executed through market making account # 1002 generated a sales credit of $0.25 or more per share. (Defs. Stip. at 9 ¶ 37); (Exhibit 14). That same year, twenty-one of Joseph’s trades executed through that market making account generated a sales credit of $0.50 or more per share. (Defs. Stip. at 9 ¶ 38); (Exhibit 14). Eight of those trades are: (1) a February 11, 2000 trade of 125,000 OPTK shares on behalf of Pilgrim, for which Joseph generated a sales credit of $0.82 per share; (2) a February 14, 2000 trade of 37,200 OPTK shares on behalf of Pilgrim, for which Joseph generated a sales credit of $0.65 per share; (3) a February 28, 2000 trade of 30,700 CDTS shares on behalf of Keystone, for which Joseph generated a sales credit of $0.78 per share; (4) a February 29, 2000 trade of 46,000 OPTK shares on behalf of Pilgrim, for which Joseph generated a sales credit of $0.89 per share; (5) a March 7, 2000 trade of 68,300 FDRY shares on behalf of Trust, for which Joseph generated a sales credit of $1.32 per share; (6) a March 22, 2000 trade of 80,000 OPTK shares on behalf of Pilgrim, for which Joseph generated a sales credit of $0.65 per share; (7) an April 3, 2000 trade of 53,600 CDTS shares on behalf of Keystone, for which Joseph generated a sales
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credit of $0.54 per share; and (8) a May-30, 2000 trade of 85,000 AUDC shares on behalf of Putnam, for which Joseph generated a sales credit of $0.68 per share. (Defs. Stip. at 9-10 ¶¶ 39-46).
Joseph executed the following trades:
• a January 8, 1999 trade of 74,700 ATHM shares on behalf of Fidelity, (Defs. Stip. at 11 ¶ 57);
• a January 15, 1999 trade of 90,000 DBCC shares on behalf of Dimensional, (Defs. Stip. at 11 ¶ 58);
• a January 28, 1999 trade of 82,500 NSOL shares on behalf of Putnam, (Defs. Stip. at 11 ¶ 59);
• a January 29, 1999 trade of 142,000 NSOL shares on behalf of Putnam, (Defs. Stip. at 11 ¶ 60);
• a March 16, 1999 trade of 900,000 COOL shares on behalf of T. Rowe Price, (Defs. Stip. at 11 ¶ 61);
• an April 15, 1999 trade of 400,000 EBAY shares on behalf of Fidelity, (Defs. Stip. at 12 ¶ 80);
• an April 19, 1999 trade of 400,000 NSOL shares on behalf of Putnam, (Defs. Stip. at 11 ¶ 62);
• an April 20, 1999 trade of 817,060 NSOL shares on behalf of Putnam, (Defs. Stip. at 11 ¶ 63);
• an April 21, 1999 trade of 160,000 NSOL shares on behalf of Putnam, (Defs. Stip. at 11 ¶ 64);
• an August 5, 1999 trade of 135,000 YHOO shares on behalf of T. Rowe Price, (Defs. Stip. at 11 ¶ 65);
• a September 20, 1999 trade of 45,000 RAZF shares on behalf of Putnam, (Defs. Stip. at 10 ¶ 51);
• a September 27, 1999 trade of 65,700 ATON shares on behalf of Fidelity, (Defs. Stip. at 11 ¶ 66);
• an October 12, 1999 trade of 210,000 IWOV shares on behalf of Trust, (Defs. Stip. at 11 ¶ 67);
• an October 27, 1999 trade of 25,000 EBAY shares on behalf of Delaware, (Defs. Stip. at 12 ¶ 81);
• a November 8, 1999 trade of 751,250 QCOM shares on behalf of Putnam, (Defs. Stip. at 11 ¶ 68);
• a November 9, 1999 trade of 1,950,000 CHTR shares on behalf of NV Investments, (Defs. Stip. at 12 ¶ 71);
• a November 12, 1999 trade of 479,600 QCOM shares on behalf of Putnam, (Defs. Stip. at 11 ¶ 69);
• a November 15, 1999 trade of 525,310 QCOM shares on behalf of Putnam, (Defs. Stip. at 11 ¶ 70);
• a November 23, 1999 trade of 20,797 FDRY shares on behalf of Putnam, (Defs. Stip. at 12 ¶ 82);
• a December 9, 1999 trade of 20,000 LEAF shares on behalf of Aesop Capital Partners, (Defs. Stip. at 12 ¶ 83);
• a December 13, 1999 trade of 104,050 HBCCA shares on behalf of Trust, (Defs. Stip. at 10 ¶ 52);
• a December 14, 1999 trade of 261,700 SCOC shares on behalf of Columbia, (Defs. Stip. at 12 ¶ 84);
• a December 15, 1999 trade of 30,700 QCOM shares on behalf of Putnam, (Defs. Stip. at 12 ¶ 72);
• a December 21, 1999 trade of 227,500 MYPT shares on behalf of Trust, (Defs. Stip. at 12 ¶ 73);
• a January 18, 2000 trade of 72,700 VPHM shares on behalf of T. Rowe Price, (Defs. Stip. at 10 ¶ 53);
• a February 4, 2000 trade of 181,200 TWAV shares on behalf of Capital Guardian, (Defs. Stip. at 12 ¶ 74);
• a February 11, 2000 trade of 125,000 OPTK shares on behalf of Pilgrim, (Defs. Stip. at 12 ¶ 85);
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• a February 14, 2000 trade of 37,200 OPTK shares on behalf of Pilgrim, (Defs. Stip. at 13 ¶ 86);
• a February 28, 2000 trade of 30,700 CDTS shares on behalf of Keystone, (Defs. Stip. at 13 ¶ 87);
• a February 29, 2000 trade of 46,000 OPTK shares on behalf of Pilgrim, (Defs. Stip. at 13 ¶ 88);
• a March 7, 2000 trade of 68,300 FDRY shares on behalf of Trust, (Defs. Stip. at 13 ¶ 89);
• a March 8, 2000 trade of 250,000 CRFH shares on behalf of Fidelity, (Defs. Stip. at 12 ¶ 75);
• a March 16, 2000 trade of 138,800 ETEK shares on behalf of Putnam Investments, (Defs. Stip. at 10 ¶ 54); (Exhibit 1119 at (1/1/9/2006) at 98:3-99:14 (Perry)); (Exhibit 391);
• a March 22, 2000 trade of 80,000 OPTK shares on behalf of Pilgrim, (Defs. Stip. at 13 ¶ 90);
• an April 3, 2000 trade of 53,600 CDTS shares on behalf of Keystone, (Defs. Stip. at 13 ¶ 91);
• an April 4, 2000 trade of 290,000 AMCC shares on behalf of T. Rowe Price, (Defs. Stip. at 10 ¶ 55);
• an April 4, 2000 trade of 200,000 DIGX shares on behalf of Trust, (Defs. Stip. at 12 ¶ 76);
• a May 24, 2000 trade of 8,000,000 COST shares on behalf of Davis Selected Advisors, (Defs. Stip. at 12 ¶ 77); (Tr. 314:12-315:19, 326:2-339:24, 351:2-352:21, 384:13-388:8, 482:4-484:11, 528:15-535:2, 594:17-600:3, 607:22-608:9);
• a May 30, 2000 trade of 85,000 AUDC shares on behalf of Putnam, (Defs. Stip. at 13 ¶ 92);
• a June 9, 2000 trade of 1,250,000 CTXS shares on behalf of Trust, (Defs. Stip. at 12 ¶ 78);
• a June 30, 2000 trade of 255,000 JNPR shares on behalf of Putnam, (Defs. Stip. at 12 ¶ 79); (Exhibit 1119 at (1/19/2006) 69:3-95:21 (Perry)); (Exhibit 244);
• an August 9, 2000 trade of 150,700 TUTS shares on behalf of Delaware, (Defs. Stip. at 11 ¶ 56); (Exhibit 885); and
• an August 9, 2000 trade of 537,500 SNPS shares on behalf of Fidelity, (Exhibit 1105 at 62:17-64:12, 64:20-66:18 (K. Smith)); (Exhibit 1090).
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(Exhibits 10-11). Notably, on the August 9, 2000 trade on behalf of Fidelity, Joseph printed the 537,500 shares for a volume-weighted average price of $29.6467. (Exhibit 1090). That same day, Fidelity also placed orders for SNPS with six other market making firms. (Exhibit 1090). In sum, Fidelity received a total of 482,400 SNPS shares from those other firms. (Exhibit 1090). The other firms executed those trades at a combined volume-weighted average price of $29.6545. (Exhibit 1090).
E. The Leightons’ Departure from Knight
In the summer of 1999, Pasternak hired Hewitt as President of Knight. (SEC Stip. at 15 ¶ 19); (Tr. 1273:25-1274:12). At some point later that year, Hewitt and John had a business lunch together, in which Hewitt had difficulty understanding John’s explanation of how Knight operated and generated profits. (Tr. 1279:13-1282:14). At some point during their discussion, John told Hewitt that John and Joseph earned somewhere between $20,000,000 and $30,000,000. (Tr. 1281:8-
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1282:14). Hewitt’s experiences led him to interpret these earnings as improbable, causing Hewitt to raise concerns over the amount of profits earned. (Tr. 1282:13-1284:20). He raised these concerns with Pasternak. (Tr. 1282:13-1284:20). Hewitt told Pasternak that he was incredulous as to the profits earned by John and Joseph and that he thought, based on his lack of understanding the trading methodology and the amount of profits generated, the brothers must have engaged in a form of front-running. (Tr. 1283:21-1284:14).
In response, Pasternak did not believe that the brothers were front-running, (Tr. 1284:15-20), but, rather, felt he could have a “marketing problem.” (Tr. 1842:4-1859:24). Pasternak thought that Knight could be a target of heightened scrutiny merely because it was profitable; indeed, Brooks found Knight’s profitability caused “envy” among other firms, (Tr. 1851:18— 1852: 23, 170:2-7), and Levinson noted that, once the “bubble” of profitability in the industry bursted, people might scrutinize Knight for its profitability, (Tr. 1725:8-1726:12). Pasternak believed that those outside of Knight might perceive Joseph’s profitability as the result of improper trading practices — similar to Hewitt’s conclusion, upon learning of Joseph’s ability to earn higher-than-average profits, that Joseph engaged in improper front-running.
Nevertheless, understanding that Hewitt felt he could not work with John, Pasternak permitted Hewitt to recruit a former colleague, Robert Stellato (“Stellato”), to oversee the entire institutional sales desk, (Tr. 1285:20-1286:6, 2358:14-2359:1). (SEC Stip. at 15 ¶ 20). Hewitt also raised his concerns with other people at Knight, including the Board of Directors and Dorsey, Knight’s General Counsel. (Tr. 1282:15-1285:16, 1295:13-1296:19).
Indeed, in December 1999, Pasternak, through Hewitt, offered to Stellato the position of head of institutional sales. (SEC Stip. at 16 ¶ 33); (Tr. 1289:4-1290:1, 2350:1-17). However, Stellato did not officially join Knight until early August, 2000. (SEC Stip. at 16 ¶ 33). At that point, Hewitt assigned to Stellato the task of determining the manner in which Joseph executed his trades. (Tr. 1290:3-1291:13).
Shortly after his arrival, Stellato, at Pasternak’s direction, raised a concern with Amoruso over the profits Joseph earned on certain institutional orders and indicated that he felt Joseph could be engaged in front-running. (Tr. 1850:5-16, 2350:1-2351:15). At that point, Amoruso informed Stellato how NASD rules define front-running, which technically applied only to options, which Knight did not trade. (Tr. 2351:6-15). Amoruso inquired as to the source of Stellato’s concerns, and, in response, Stellato expressed that, although he could not point to a particular trade or instance on which to focus, he found, upon review of profit data, that Joseph made high profits. (Tr. 2351:23-2352:19). Amoruso then instructed Stella-to to bring to his attention specific trades executed by Joseph that the compliance department could review, and notified Dorsey. (Tr. 2352:25-2353:6).
Shortly thereafter, Stellato presented to Amoruso three spreadsheets reflecting trade runs in respect of three different securities: SNPS, JNPR, and TUTS. (Tr. 2353:7-13). However, those spreadsheets reflected the profit or cost of the position for either all the buys or all the sells of the particular stock; the data did not integrate both buys and sells to generate an average cost position. (Tr. 2354:20-2355:4). In any event, Amoruso conducted an in-depth review of those trades, considering the market conditions at the time Joseph worked the orders, the volume of both the institutional and retail orders passing through Knight on that day for those
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stocks, and the fact that the particular stocks were generally higher-priced stocks. (TV. 2355:6-2357:9). Based on his review, Amoruso concluded that Joseph provided his customers with fair prices. (Tr. 2355:22-23). Amoruso found that, considering the aggregate price the customers received over the course of the day in connection with the market activity, the volume of the order, and the dollar value of the trade, the prices to the customers were “very good.” (Tr. 2356:5-11).
Amoruso informed Stellato of his conclusion and advised Stellato that, if he was nonetheless still concerned over Joseph’s trading, he could implement additional controls or put a limit on profits by requiring the sales traders to stop trading on a net basis. (Tr. 2356:12-2357:6). Subsequently, Stellato never sought to add supplemental controls or to limit the sales traders’ profits. (Tr. 2357:4-9, 2358:4-10).
In August of 2000, Pasternak also independently reviewed Joseph’s trading practices, focusing on the trades in SNPS, JNPR, and TUTS. (Tr. 1848:22-1867:17, 1870:16-1871:21, 1911:19-1931:3, 1963:11-1966:2, 1968:24-1977:12, 2017:5-2022:17). Upon receiving the trade runs produced by Stellato, Pasternak felt that Stellato and Hewitt did not understand the interactions between the institutional orders and retail order flow or Knight’s “opening guarantee” system. (Tr. 1850:13-20). At this point, Pasternak realized that Stellato came from another firm that neither dealt with interacting retail order flow nor guaranteed liquidity on automatic retail orders. (Tr. 1850:22-1851:9).
Nevertheless, Pasternak reviewed the trade runs and spoke with Joseph about his trading practices. (Tr. 1852:24-1857:17, 1870:16-1871:21). Based on his review, Pasternak concluded that the profits earned by Joseph was part of a marketing problem, rather than the product of illegal conduct. (Tr. 1852:24-1857:17, 2023:13-19). He also consulted with Amo-ruso and Dorsey about Joseph’s trading, and both Amoruso and Dorsey told Pasternak that they did not find anything improper in Joseph’s trading practices. (Tr. 2023:20-24).
Pasternak ultimately left the resolution of the issue of Joseph’s profits to John, Stellato, and Hewitt, to the people who supervised the sales desk. (Tr. 1859:4-20). He instructed them to change any procedures and policies they felt would address their concerns, (Tr. 1859:8-11), and expressed his support for any such changes, (Tr. 1863:19-1864:6). At that time, Pasternak did not take affirmative steps in response to the issue, and did not disclose to Knight’s customers the profits Joseph generated on their institutional orders placed with Knight. (Tr. 1866:25-1867:17). Prior to and throughout the investigation, John never concealed any information relating to Joseph’s trading activities from Pasternak, Dorsey, or Amoruso. (SEC Stip. at 17 ¶ 45).
Eventually, Hewitt informed Pasternak that, based on continuing concerns, he wanted the Leightons terminated, (Tr. 1292:13-1293:14), to which Pasternak agreed, (Tr. 1293:14-1294:16). (SEC Stip. at 15 ¶ 20). Indeed, Pasternak and Amo-ruso observed a clash in management styles between John and Stellato. (Tr. 2024:11-2026:25, 2358:14-2359:1). Once Pasternak expressed his support of Stella-to and Hewitt, the Leightons responded with displeasure and began considering employment elsewhere. (Tr. 2024:11-2025:25, 2026:21-2027:20). On September 7, 2000, the Leighton brothers terminated their relationship with Knight. (SEC Stip. at 15 ¶ 21); (Tr. 2024:1-3).
IV. CONCLUSIONS OF LAW
Turning now to the Court’s conclusions of the law, the Court begins its analysis by
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setting forth the elements that the SEC must establish in order to succeed. Thereafter, the Court applies the preceding findings of facts to those elements. First, the Court considers whether Joseph committed securities fraud. Second, the Court evaluates whether Defendants themselves engaged in fraudulent activity for which they could be held primarily liable under the securities law. Finally, the Court addresses whether, assuming Joseph violated the various provisions of the Securities Act and Exchange Act, Defendants may be held secondarily liable for those violations.
A. SEC’s Burden of Proof and Requisite Elements
The SEC bears the burden of proving its case by a preponderance of the evidence.
Herman & MacLean v. Huddleston,
459 U.S. 375, 390 , 103 S.Ct. 683 , 74 L.Ed.2d 548 (1983). See
also S.E.C. v. Moran,
922 F.Supp. 867, 888-90 (S.D.N.Y. 1996) (discussing at length rationale for applying preponderance standard and rejecting clear and convincing standard of proof in securities action seeking monetary and injunctive relief). Thus, the Court must determine if its findings of fact establish by a preponderance of the evidence the elements of securities fraud under primary and secondary liability theories.
1.
Primary Liability
The Court begins its analysis by setting forth the elements required to establish securities fraud. As noted above, Securities Act Section 17(a), Exchange Act Sections 10(b) and 15(c)(1)(A), and Rule 10b-5 all proscribe fraudulent conduct in connection with the purchase and/or sale of securities. Based on the similar language of these three statutes and rules, and the underlying legislative intent, the elements required to prove violations of these statutes and regulations are essentially the same.
S.E.C. v. First Jersey Sec., Inc.,
101 F.3d 1450, 1467 (2d Cir.1996) (finding elements of Securities Act Section 17(a) mirror those of Exchange Act Section 10(b));
S.E.C. v. George,
426 F.3d 786, 792 (6th Cir.2005) (finding Sections 10(b) and 15(c)(1) of Exchange Act require same elements).
Those elements are: (1) the defendant made a misrepresentation, or an omission where there was a duty to speak, or used a fraudulent device; (2) that misrepresentation or omission was material; (3) the defendant made the misrepresentation or omission with scienter; (4) the defendant made the misrepresentation or omission in connection with the sale of a security; and (5) the defendant made the misrepresentation or omission in connection with interstate commerce or the mails.
First Jersey Sec., supra,
101 F.3d at 1467 .
Accord In re Burlington Coat Factory Sec. Litig.,
114 F.3d 1410, 1417 (3d Cir.1997);
George, supra,
426 F.3d at 792 .
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In other words, “[t]o prove a violation of § 10(b) and Rule 10b-5, the plaintiff must establish that the defendant, acting with knowledge or recklessness, made a misrepresentation or omission of a material fact on
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which the plaintiff reasonably relied and which resulted in damage.”
In re Tyson Foods, Inc.,
155 Fed.Appx. 53, 56 (3d Cir.2005) (citing
In re Westinghouse Sec. Litig.,
90 F.3d 696, 710 (3d Cir.1996)).
When the plaintiff asserts that the defendant failed to disclose information, the plaintiff must show the existence of a duty to disclose.
See, e.g., S.E.C. v. Zandford,
535 U.S. 813, 823 , 122 S.Ct. 1899 , 153 L.Ed.2d 1 (2002) (finding that “any distinction between omissions and misrepresentations is illusory in the context of a broker who has a fiduciary duty to her clients”);
Hoxworth v. Blinder, Robinson & Co.,
903 F.2d 186 , 200 n. 19 (3d Cir.1990) (“ ‘Silence, absent a duty to disclose, is not misleading under Rule 10b-5.’ ” (quoting
Basic Inc. v. Levinson,
485 U.S. 224 , 239 n. 17, 108 S.Ct. 978 , 99 L.Ed.2d 194 (1988))). In addition, an omission is material, meeting the second prong of the inquiry, “if there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.”
Id.
at 200 (internal quotation marks omitted).
Accord Ettinger v. Merrill Lynch, Pierce, Fenner & Smith, Inc.,
835 F.2d 1031, 1034 (3d Cir.1987) (“Rule 10b-10 only mandates the disclosure of information which can generally be expected to be material”).
It has been held that, to impose securities fraud liability for an omission of a “markup,”
12
the broker-dealer either (1) was in “a fiduciary relationship with the complaining party” or (2) charged an “excessive” markup.
Press v. Chem. Inv. Serv. Corp.,
166 F.3d 529 , 534 (2d Cir.1999).
See also Ettinger, supra,
835 F.2d at 1033 (finding that “charging undisclosed excessive commissions constitutes fraud”). To determine the existence of a fiduciary relationship in federal securities fraud actions, district courts generally look to state law.
See, e.g., Press, supra,
166 F.3d at 536 (determining existence of fiduciary relationship under New York law). In New Jersey, then, a fiduciary relationship “arises between two persons when one person is under a duty to act for or give advice for the benefit of another on matters within the scope of their relationship.”
F.G. v. MacDonell,
150 N.J. 550, 563 , 696 A.2d 697 (1997).
The Third Circuit has further found that the Supreme Court of New Jersey would likely follow the weight of the authority to hold that a broker is in a fiduciary relationship with a client, where that client maintains an account with the broker in which the broker, not the client, retains discretion.
McAdam v. Dean Witter Reynolds, Inc.,
896 F.2d 750 , 767 (3d Cir.1990).
Accord Estate of Parr v. Buontempo Ins. Serv.,
2006 WL 2620504 , *4 (N.J.Super.App.Div. Sept. 8, 2006) (stating that, “[w]hile New Jersey courts do not appear to have directly passed on the issue of whether a fiduciary duty exists when an investment account is discretionary, the clear majority of states hold that a non-
*500
discretionary account is necessary to impose a fiduciary duty[,]” and finding no fiduciary relationship where client maintained discretion as to account (citing
McAdam, supra)).
Significantly, in
Estate of Parr,
the Appellate Division of the New Jersey Superior Court found that a broker-dealer did not owe a fiduciary duty to a customer because the broker-dealer did not exercise “control of the account” where the customer made the ultimate investment decisions.
Estate of Parr, supra,
2006 WL 2620504 at *4.
Even in the absence of a fiduciary relationship, a duty to disclose a markup arises if the markup is “excessive.”
Press, supra,
166 F.3d at 534. This duty is premised on the notion that “[s]ales of securities by broker-dealers to their customers carry with them an implied representation that the prices charged in those transactions are reasonably related to the prices charged in an open and competitive market.”
First Jersey Sec., supra,
101 F.3d at 1469 . A markup “is excessive ‘when it bears no reasonable relation to the prevailing market price.’ ”
Grandon v. Merrill Lynch & Co.,
147 F.3d 184 , 190 (2d Cir.1998).
Accord Press, supra,
166 F.3d at 535 (same);
S.E.C. v. Zwick,
2007 WL 831812 , *7 (S.D.N.Y. March 16, 2007) (same);
Banca Cremi supra,
132 F.3d at 1033 (same (quoting
Bank of Lexington & Trust Co., supra,
959 F.2d at 613));
First Jersey Sec., supra,
101 F.3d at 1469 (noting that, under NASD rules, “a reasonable markup is generally not more than 5% over the prevailing market price”).
As a result, a court determining whether a markup is excessive must conduct a fact-sensitive inquiry.
Grandon, supra,
147 F.3d at 190.
See also Banca Cremi supra,
132 F.3d at 1033 (listing seven factors analyzed to determine reasonableness of markup). A fact-finder, thus, must consider various factors, such as: industry practice; nature of services provided; cost of transaction; expertise of broker-dealer; type and availability of security in the market; market conditions; and overall risk undertaken by the broker-dealer.
See, e.g., Press, supra,
166 F.3d at 535;
S.E.C. v. Feminella,
947 F.Supp. 722, 729 (S.D.N.Y.1996).
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Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/1894719. Public record. Not legal advice.