<OT>
Sir Vinny, the thought of a class action lawsuit in the event of earnings misrepresentation by a few analysts is an appealing thought. However, I have been involved in an arbitration on the PHLX for over a decade without any resolution in sight.
FWIW, here's my story:
A Case of Collusion within the Securities Markets:
The Philadelphia Stock Exchange
and the Farmers Group Matter
by
Mark A. Peterson CPA
January 21, 1997
Introduction
Stock exchanges these days, just like the companies listed there, find themselves in an increasingly competitive marketplace. Improvements in trading technology now offer the alternative of real-time, fully computerized markets at a fraction of Wall Street's ponderous overhead. Liquid markets, narrower spreads, and broader participation continue to attract capital, making our markets the most efficient in the world.
It is a vision for the future that is not so difficult to grasp, unless you work for a securities exchange.
Exchange officials, just like you, have mortgage payments, car lease payments, a taste for fine wines, and an eye for 17th century antiques or that second house at the shore. Behind all of the snap and pop in their promotional brochures, protecting the lifestyles to which they have grown accustomed and the jobs of exchange officials is their first order of business. It is a task made easier by the support of a few, really good customers.
The Case for Collusion
You can attract those kind of customers to your exchange by making it easy for clearing firms to participate on the floor of your exchange. Sure, there's a minimum capitalization requirement that must be met and a few rules most clearing firms have to follow, but at the highest level, protecting your job is no more difficult than partnering with your customers. You support those partnerships, the exchange, and your lifestyle by being a good listener.
Large customers bring with them enormous sums of capital. In a competitive marketplace, keeping those customers happy is critical to the economics of any exchange. Sometimes that means expanding floor space, upgrading cafeteria food service, investing in new technology to handle increased trading volume, or hiring additional support staff. Other times, it means bending a few rules.
And the Philadelphia Stock Exchange, in collusion with some very good customers, have gone to great lengths in the “let's protect our turf” department by stretching some rules to new levels of elasticity. Just ask the writers of the 1988 Farmer's Group June 60 puts that were exercised on Saturday, June 18, 1988.
The Facts of the Matter
Farmers Group is a California based insurance company that was targeted for acquisition by a London conglomerate early in 1988. News of that possible acquisition nicely elevated the price of Farmers Group stock. At 7:00 p.m. on Friday, June 17, 1988, California's insurance commissioner ruled that the acquisition would violate California law. Predictably, the stock slumped in aftermarket trading.
Now put sellers are the first to tell you that selling naked puts can be a risky business. When a stock's value decreases, naked put sellers lose money, sometimes in prodigious amounts. It is a risky strategy, but one that some traders are willing to accept given their preference for risk and return, the rules of our regulated financial markets, and enforcement of those rules by the Securities and Exchange Commission.
The decline in Farmers Group stock after the market closed on Friday, June 16, 1988 was no cause for concern to sellers of the June 60 puts. Since the stock had closed for the day at $62 per share, the sellers of the June 60 puts rightly believed the options would not and could not be exercised for two compelling reasons.
When Farmer's Group stock closed two dollars above the put's June 60 strike price, holders of those puts stood to lose $200 by exercising each June 60 put. Under those circumstances, only a trader bent on self-immolation would choose to exercise an out of the money put. The absence of any recent, comparable out of the money put exercises is ample confirmation of every trader's instinct for preserving investment capital. That survival instinct was no less in evidence nine years ago.
Of course, if you were omniscient or had advance knowledge about the contents of the 7:00 p.m. announcement, you may have been inclined to exercise the out of the money June 60 puts.
However you personally felt about exercising the June 60 puts that Friday, those feelings were forever laid to rest by 5:30 p.m. that evening. PHLX rules in effect at the time required that orders to exercise options to buy or sell stock be given before 5:30 p.m. that Friday. The clearing firm no less notable than Bear Stearns had even tighter requirements. In an internal memorandum attached to these remarks, Bear Stearns had a written policy requiring that option exercise orders to buy or sell stock be given before 4:30 p.m. on Friday. Knowing those were the rules, most traders took the trains home for the weekend.
Weekends, for some of us, can be wonderful. It is a time for being with family, running errands, coaching soccer games, working around the house, and in general, recovering from a week of frenetic options trading on the floor of the PHLX. But Saturday is not a day to exercise puts, unless you believe you are above the law or are a very good customer partnering with your clearing firm or your exchange. As a personal favor and in return for your future business, some firms have been known to step from their fiduciary high ground and break a few rules just for you.
Imagine the dismay of the June 60 put sellers to learn that a quantity in excess of 3,402 puts, worthless at Friday's market close and unexercisable by anyone's rules after 5:30 p.m. that day, had been called away and exercised on Saturday. It was enough to give you palpitations.
A Quest for a Fair Hearing
The June 60 put sellers were livid, and rightly so. PHLX rules and regulations had been flagrantly violated and the put sellers demanded a forum to redress their grievances. PHLX arbitration was one available alternative.
Now every securities firm requires their customers to sign an agreement that includes an arbitration clause. As the theory goes, arbitration is a quick, inexpensive alternative to resolving a dispute. And in theory, every professional football team also has an equal chance at wining the Super Bowl, real estate values always go up, and bumblebees cannot fly.
It is a fact that judging the ethical conduct of your good customers even in an arbitration forum is a thankless job. Irrespective of any sense of responsibility to your own rules and regulations, there is always a nagging thought that one day, as a result of any decision, your best customers may leave, your exchange will close, and you may be out of a job. And in 1988, Bear Stearns was the PHLX's largest customer.
Despite the PHLX's own requirement for arbitration, the bubbling conflict between the clearing firms, the put sellers, and the PHLX erupted into open hostility and multiple lawsuits. The clearing firms, who knowingly violated their own rules and regulations and those of the PHLX, were reluctant to agree to the selection of a panel of arbitrators who might rule against them. The PHLX was reluctant to force the arbitration issue on their largest customers upon whom their economic survival depended. The sellers of the June 60 puts were snagged in a Bermuda Triangle that to this date, has delayed arbitration nearly nine years.
It is a horrifying thought, but the clearing firms involved including Bear Stearns may have been guilty of exercising the options for their own account and keeping the profits. Could there be any other reason why these firms have declined to enforce their own written policies? Could there be any other reasonable explanation why these same firms have argued in the extreme that the PHLX is not entitled to enforce the exchange's rules and regulations?
One should not be holier than the Pope. But at what point does partnering with your customer to protect their interests at the expense of others become a charade? Or a violation of exchange rules and regulations? There is a culture strongly in evidence at the PHLX that refuses to bite the hand that feeds it. The PHLX evidently believes that the process of protecting the rights of the Farmers Group June 60 put sellers by noodling along “the arbitration that never was” is preferential to actually ever having an arbitration occur.
How this posture can be permitted in financial markets scrutinized by the SEC is baffling, to say the least.
What Has Occurred the Last Nine Years
This June 17 is the nine year anniversary of the Farmers Group dispute and a lot has happened in that time. There have been nine Super Bowls, three Presidential elections, and one Soviet Union meltdown. The Coalition Forces fought and won a war against the army of Iraq, the fourth largest in the world. The Trial of the Century took place in our living rooms and OJ was acquitted by a jury of his peers. There were several thousand initial public offerings reviewed and approved by the SEC. Intel grew from a fledgling stock to one with a market capitalization worth more than General Motors, Ford, and Chrysler combined. But nothing has happened to resolve the Farmer's Group matter.
Is justice delayed justice denied? The sellers of the 1988 Farmer's Group June 60 puts have an opinion on the matter. Of course, it is easier to become preoccupied with justice when it is wholly absent from the process.
The PHLX is still tight-lipped about the good show they have put on over these last nine years. The official response from PHLX officials including General Counsel Mr. Bill Uchimoto and Assistant General Counsel and Director of Arbitration Ms. Lydia Gavalis, can be summarized in two sentences: “We never comment on the Farmers Group matter. Besides that, we have no other comment.” Such a condescending position is arrogant, self-serving, vacuous, and hardly reassuring to the June 60 put sellers or the financial markets.
It is a time-tested principle that he who has the gold makes the rules. However, in regulated financial markets, it is a very slippery slope when securities exchanges believe they can selectively apply exchange rules to their largest customers. It crosses over that fine line of partnering with a customer to being in the customer's hip pocket. Unchecked “self-regulation” corrupts absolutely and nowhere has this been more evident than in the Farmers Group matter.
And Today, Here We Are
During the last nine years, I have learned that life is what happens while the PHLX is busy protecting my rights to an arbitration hearing. I have grown older and if I have grown a little harder, forgive me. My children are no longer toddlers, but soon to be teenagers with an agenda known only to themselves. In a few short years, the sellers of the 1988 Farmers Group June 60 puts will have a fourth Olympics under their belts, all the while waiting for an arbitration panel to be appointed.
Justice, perhaps, may yet be served if the facts in the Farmers Group matter have the opportunity to see blue sky and the faces of an impartial arbitration panel. And on that day, I will see horses fly.
Best Regards,
Mark A. Peterson |
