'Dark Pool' trading platform pays $1M SEC penalty

The following is from the SEC...

Washington, D.C., Oct. 24, 2011 – The Securities and Exchange Commission today charged Pipeline Trading Systems LLC and two of its top executives with failing to disclose to customers of Pipeline’s “dark pool” trading platform that the vast majority of orders were filled by a trading operation affiliated with Pipeline.

Pipeline, without admitting or denying the findings of an SEC administrative order, agreed to pay a $1 million penalty to settle the matter. Pipeline’s founder and chief executive officer, Fred J. Federspiel, and its chairman and former chief executive, Alfred R. Berkeley III, a former president and vice chairman of the NASDAQ Stock Market, each agreed to pay $100,000. In settling the matter, Federspiel and Berkeley did not admit to or deny the SEC’s findings.

New York-based Pipeline was launched in 2004 as an SEC-registered alternative trading system, a privately operated platform to trade securities outside of traditional exchanges. Alternative trading systems that display little or no information about customer orders are known as “dark pools.” Institutional investors use these venues to hide their trading intentions from others and avoid moving the market with large orders to buy or sell stock.

According to the SEC’s order, Pipeline described its trading platform as a “crossing network” that matched customer orders with those from other customers, providing “natural liquidity.”

Pipeline’s claims were false and misleading because its parent company owned a trading entity that filled the vast majority of customer orders on Pipeline’s system, the SEC found. It said the affiliate, most recently known as Milstream Strategy Group LLC, sought to predict the trading intentions of Pipeline’s customers and trade elsewhere in the same direction as customers before filling their orders on Pipeline’s platform. The SEC’s order found that Pipeline generally did not provide the “natural liquidity” it advertised.

Pipeline took certain steps to address the conflict of interest it created, including by paying the affiliate’s traders using a formula that rewarded them in part for giving favorable prices to Pipeline’s customers. The SEC’s order found that Pipeline failed to disclose the compensation formula or Milstream’s activities to its customers or in its filings to the SEC.

“However orders are placed and executed, be it on an exchange floor or in an automated venue, whether dark or displayed, one principle remains fundamental – investors are entitled to accurate information as to how their trades are executed. Pipeline and its senior executives are being held to account because they misled their customers about how Pipeline’s dark pool really worked,” said Robert Khuzami, Director of the SEC’s Enforcement Division.

George S. Canellos, Director of the SEC’s New York Regional Office, added, “Today’s action underscores the importance of full disclosure by those who operate alternative trading systems about their operations and the execution services they provide.”

The SEC’s order also found that, although Pipeline represented that all users were treated the same, it provided Milstream with certain advantages over other users, including special access to certain information about the operations of the dark pool and to data connections that made it easier for Milstream to track history and activity in the dark pool.

The SEC’s order also found that Pipeline failed adequately to protect customers’ confidential trading information, allowing access to it by the research director at Pipeline’s parent company, who acted as the manager for the affiliated trading entity from 2004 to 2006. The order does not allege that the research director sought to take advantage of the customer information.

The SEC’s order found that Pipeline violated:

  • Section 17(a)(2) of the Securities Act of 1933, which prohibits the use of false or misleading statements in the sale of securities.
  • Rule 301(b)(2) of Regulation ATS under the Securities Exchange Act of 1934, which requires an ATS operator to disclose certain information in required filings with the SEC.
  • Rule 301(b)(10) of Regulation ATS, which requires an ATS operator to implement safeguards and procedures for protecting ATS users’ confidential trading information.

The SEC’s order found that Federspiel and Berkeley caused Pipeline to violate Section 17(a)(2) of the Securities Act and Rules 301(b)(2) and 301(b)(10) of Regulation ATS. Without admitting or denying the findings, Pipeline, Federspiel, and Berkeley consented to the SEC’s order, which requires Pipeline to pay a $1 million penalty and Federspiel and Berkeley each to pay $100,000. It also requires Pipeline, Federspiel, and Berkeley to cease and desist from committing or causing any violations of Section 17(a)(2) of the Securities Act or Regulation ATS.

Gerald Gross, Daniel Walfish, Stephen Larson, and Alexander Janghorbani of the SEC’s New York Regional Office conducted the investigation. Mr. Walfish is a member of the SEC’s Market Abuse Unit.

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