SEC Charges Investment Bank and Former ECM Syndicate Banker with “Bought Deal” Fraud

On January 12, 2024, the Securities and Exchange Commission (“SEC”) charged Morgan Stanley (the “Investment Bank”) and the former head of its equity syndicate desk, Pawan Passi, with a multi-year fraud involving the disclosure of confidential information about bought deals (also known as and referred to as “block trades” and described below).  

Background 

The SEC also charged the Investment Bank with failing to enforce its policies concerning the misuse of material, nonpublic information(“MNPI”) related to bought deals. 

The Investment Bank agreed to pay the SEC $249mm to settle the charges. Passi was ordered by the SEC to pay a $250,000 civil penalty and was barred from the industry for one year and a further two years from serving in a supervisory capacity. 

In addition, the U.S. Attorney's Office, Southern District of New York, also announced a non-prosecution agreement (“NPA”) with the Investment Bank and a deferred prosecution agreement (“DPA”) with Passi.  

As one reads the details of the case it becomes clear the extraordinary measures the SEC, DOJ and FBI took leveraging communication to develop the prosecution’s case from multiple parties and piecing together market events in a novel case involving normal syndicate bought deal activities that combine Testing the Waters / Market Sounding, Non-Disclosure Agreements (“NDAs”), different types of bought deals, and Anticipatory Hedging / Front-Running. Quite the combination of elements for Compliance and Regulatory Personnel to focus on.  

Bought Deals / Block Trades 

A bought deal/block trade generally involves the sale of a large quantity of an issuer’s stock, privately arranged and executed outside of the public markets. According to the SEC’s order, from at least June 2018 through August 2021, Passi and a subordinate on the Investment Bank’s equity syndicate desk disclosed potential MNPI concerning pending block trades to select institutional “buy-side” investors despite the sellers’ confidentiality requests and the Investment Bank’s own policies regarding the treatment of confidential information.  

As the US Attorney describes in the Investment Bank’s “Statement of Facts” in this case: 

A bought deal or “block trade” involves the sale of a large amount of equity shares in a privately arranged transaction, typically with an investment bank. 

To achieve certainty in execution and mitigate market risks, selling shareholders (e.g., private equity firms, corporate insiders, or other large shareholders of the relevant security) may seek a bought deal or block trade. These transactions are typically priced at a pre-determined discount to the closing market price on the trade date. 

Seven different types of block trades  

1. A “primary block” refers to a transaction in which the seller is the issuer of the newly-issued stock. 

1. Whereas a “secondary block” refers to the re-sale of a block of previously issued stock. 

1. A “negotiated block” describes a scenario in which the seller negotiates the sale of a block with only one bank. 

1. Whereas a “competitive block” is one for which the seller has solicited bids from multiple banks, who are competing with one another to offer the most competitive price. 

1. A “registered block” requires registration of the shares under the Securities Act. 

1. Whereas an “unregistered block” does not have to be registered under the Securities Act, because the shares were previously registered or there is an applicable registration exemption.  

1. And finally, a “Rule 144 affiliate block” is a particular type of unregistered block, governed by SEC Rule 144. Rule 144 provides company affiliates with a safe harbor to sell restricted shares if certain requirements are met.  

Because the investment bank purchases the shares as a principal and is not merely acting as agent between the seller and another buyer, the investment bank assumes the risk associated with price fluctuations in these shares until it sells them to one or more investors on the “buy side” – thus the reference to a “Bought Deal”.  

• Profitability: Investment Banks facilitating block trades aim to buy shares at a discount and resell them at a smaller discount to the market price. This spread represents their profit. 
• Market Impact: Selling large quantities of shares (block trade) can depress the overall market price due to increased supply. Additionally, the discounted offering by the investment bank further exacerbates the price decline. 
• Pre-trade Information Leaks: If news of a block sale leaks, investors may exploit it through short-selling strategies. This anticipates the price decline and allows them to buy shares at a lower price during the block trade. 
• Negative Impact on Seller: Short-selling by informed investors can significantly drive down the market price, potentially harming the seller of the block by lowering the final sale price. 

In the US, underwriters and investors should consider amongst other things, Regulation FD, SEC Rule 163B, and SEC Regulation M Rule 101 and 102 and market participants should not overlook Reg M Rule 105 considerations. Violation of Rule 105 depends on the facts and circumstance of the bought deal and the timing of when the investor went short, but compliance teams should pay close attention to Reg M restricted periods.  

In the EU and UK, underwriters and investors should be concerned with the Market Abuse Regulation.  

“Testing the Waters” or “Market Sounding” 

In a March 2012 Client Alert issued by Lathan & Watkins, they describe the “Bought Deal” process. As Lathan states, when pre-marketing a bought deal to potential investors, the investment bank will need to be cognizant of non-disclosure agreements, selective disclosure, insider trading and market abuse concerns.  

Here's a breakdown of the key points: 

• Investment Bank’s Goal: Investment banks naturally seek to avoid situations where they can't sell the acquired securities at a profit (above the purchase price paid to the issuer). 
• Initial Interest Gauge: To gauge general investor appetite without specific commitments, investment banks may conduct anonymous inquiries about a particular industry sector. 
• Testing the Waters for a Specific Deal: For a material bought deal, investment banks might want a more precise picture of investor interest. Here, they may seek to "wall-cross" an investor willing to receive confidential information about a specific, unnamed issuer within the industry. 
• Confidentiality Agreement: The investment banks typically confirm the investor's agreement to confidentiality (regarding the issuer's identity) through email, though some may consider verbal confirmation sufficient. 
• Time-Bound Restrictions: Investors often negotiate an end date for the confidentiality restrictions ("wall-cross" period) before agreeing to such discussions. 
• Open Discussion After Agreement: Once confidentiality is established, the investment banks can disclose the issuer's identity and discuss the investor's potential participation in the upcoming offering, adhering to all relevant regulations. 

 Anticipatory Hedging / Front-Running 

The SEC’s found that the Investment Bank and Passi disclosed the pending block trade information with the understanding that those buy-side investors would use the information to “pre-position” by taking a significant short position in the stock that was the subject of the upcoming block trade. If the Investment Bank eventually proceeded with the bought deal, the buy-side investors would then request and receive allocations from the Investment Bank to cover their short positions.  

This “pre-positioning” (or anticipatory hedging / front-running) reduced the Investment Bank’s risk in conducting the bought deal. 

The SEC’s order found that the Investment Bank failed to enforce its information barriers to prevent MNPI involving certain bought deals / block trades from being conveyed by the Equity Syndicate Desk (which sits on the private side) to Sales and Trading Division (which is on the public side). As a result, the Investment Bank was unable to sufficiently monitor whether trades by the Sales and Trading Division, placed while the Equity Syndicate Desk was in discussions with selling shareholders regarding potential block trades, were based on such confidential discussions. 

While the conduct of the Investment Bank’s was serious and was discovered by the SEC, DOJ and FBI and was not self-disclosed, the Investment Bank’s NPA nonetheless recognizes:  

1. the Investment Bank provided extraordinary cooperation;  
2. the investigation has not uncovered evidence of corporate management’s complicity in or knowledge of the wrongdoing;  
3. the Investment Bank’s controls…were designed in part to detect misconduct in the block trades business and were applied in good faith;  
4. in 2022, the Investment Bank implemented a series of remedial measures to create clearer policies… and trained its employees…;  
5. the Investment Bank has no prior criminal history of any kind…; and  
6. the Investment Bank has accepted full responsibility for its... 

Concurrently, the DOJ entered a DPA with Passi. Passi admitted he promised sellers of certain block trades that the Investment Bank would keep information concerning their potential sales confidential, knowing that he would disclose that information to buy-side investors and that those investors would use the information to trade in advance of the block sales.   

Conclusion 

U.S. Attorney Williams stated:  

“… the Government’s investigation uncovered the misconduct at the Investment Bank.  This fact serves as a reminder that we are watching.  …we will continue to use all the tools at our disposal to root out fraud in our financial markets...” 

The ability for firms to adequately monitor ECM / DCM and Syndicate activities has always been a core bedrock to any Information Barrier / Control Room function.  This is a perfect example of the level of understanding and information a Control Room needs to adequately monitor ECM / DCM businesses.  

At StarCompliance, we work with clients to assist them in creating information barrier controls to monitor capital markets and syndicate activities, including: Watch & Restricted Lists, NDA’s, Testing the Water / Market Sounding, Wall Crossing and Insider Lists. We understand the challenges firms face and are here to help manage these market abuse and code of conduct risks.