Chopping blocks: What the SEC’s probe means for ECM

When does public become private, and are equity capital markets bankers routinely blurring that line? That, in a nutshell, is what the Securities and Exchange Commission (SEC) has been grappling with since it kicked off its investigation into equity block trades in 2018.

Galvanised by a flurry of recent media reports of the SEC’s probe, with talk of the Department of Justice now joining the fray and seeking recordings of communications between bankers and clients, equity professionals across the Street are speculating about exactly what ammunition authorities might already have.

To those watching from the outside, regulatory investigations are typically opaque until the moment when they are the exact opposite. Then comes the torrent of damning documents, with the inevitable penalties, dismissals of 'bad apples' and the occasional 'mea culpa'.

It has ever been thus.

Block trades happen everywhere, but their US iterations have particular characteristics – and risks. Wall-crossing – the practice whereby investors are explicitly brought into private-side discussions on the condition that they do not trade on the information – is not quite as widespread in the US as in Europe, for example.

That means that there is more reliance on the kind of less formal, hypothetical conversation that gives rise to that very worst of regulatory bugbears, the 'grey area'. This is a term that we can expect to hear a lot more before the SEC reaches anything approaching a conclusion.

In the meantime, bankers are wondering about the precise focus of the inquiry. One theory is that it might be more about the building of shadow books rather than any pushing of the limits of wall-crossing in the sense that European bankers understand it.

At its worst, it will be about deliberate leaks of deals.

The regulatory risks of shadow book-building – where a bank puts together a hypothetical book of demand without a sale having been formally launched – depend on the situation.

At one end of the scale would be stocks that are subject to lock-ups, whose expiry dates are a matter of public record. After all, the fact that a trade could follow a lock-up expiry hardly counts as the kind of privileged information that would give one investor an unfair advantage over another.

Conversations about such situations are common.

“You might have noticed that there is a lock-up expiry coming up in X stock,” a syndicate banker might say to an investor client. “If a deal were to come after that, how interested do you think you would be?”

There is – again – a grey area here, but it’s less treacherous. The investor cannot be told that a deal is coming in a certain size and on a certain date. But the situation is transparent enough for bankers – in theory – not to need to be more explicit.

Might they still do so anyway? Competitive pressure is certainly high in block trades. And there is an outsized reliance on a small number of big buyers, typically hedge funds.

In their eagerness to get deals away as smoothly as possible, are some bankers crossing that line? Do some investors get a little more than a reminder that a lock-up is about to expire? Are bankers – even unwittingly – conditioning the market a little too much ahead of a possible trade?

It is not hard to see how that could happen. A clutch of short positions would be quite useful if you had taken on a slug of stock to offload, particularly if those shorts – and their effect on secondary prices – were in place before you were even on risk yourself.

Has the SEC noticed unusual trading patterns ahead of deals? If it has, it is not saying so publicly. Yet.

Murkier are those situations where there is no public lock-up to expire – or where there are plans for it to be waived early by the managers of a previous deal, as frequently happens.

The murkiest of all might be blocks being sold by institutional clients. Many times, these will go through trading desks, but sometimes they are big enough to warrant the involvement of equity syndicate.

Wall-crossing in the traditional way is a formal affair. A bank will offer to 'cross' a buy-side participant, the investor may or may not agree to it, but if they do then every interaction from that point onwards should be logged on both ends.

Within a buy-side firm, there will be – in theory – yet more rules governing how that information can be disseminated further. The recipient of the private information might decide to do nothing with it, if it turns out that it is a situation they have no interest in pursuing.

They may bring colleagues over the wall themselves, in which case whole parts of the firm may be closed off from dealing in a stock. Staff not directly involved may be unaware of that until they attempt to deal in a stock, at which point their systems will prevent it.

This, at least, is the theory. It is how big firms that have resources to deploy in compliance will tend to operate. But, ultimately, it is incumbent on those at the start of the information trail – the sell-side bankers – to ensure that they are not skirting around the spirit of regulations in their dealings with clients.

The problem for bankers is that while the rules are straightforward – you must not communicate any material price-sensitive information – every situation is different. Your radar, says one ECM veteran, has to be super-strong. But staying on the right side of the line is as much a part of the job as getting the deal away smoothly.

For those less familiar with the business of equity block trades, the key thing to understand is that it has changed a lot over the last 10 years. There is a world of difference now, both in terms of the communication that the sell side has with the buy side on these kinds of deals and in the resources that certain pockets of the buy side now dedicate to them. Some ECM bankers now spend as much as a third of their time talking to the buy side directly.

In the good old days, blocks would be seen by the traditional long-only community as an invaluable opportunity to grab some stock at an appealing discount to market. How old-fashioned this now looks.

One financial services professional who has worked on both the sell side and the buy side tells me of his amazement when he realised years ago just how much the blocks business was changing. He was meeting a US hedge fund client who laid out in stark terms its strategy for blocks, which was to get as much clarity as possible on precisely when a particular deal was going to come to market, short it in advance of that, and aim to be completely out of its position within a day of the trade.

The hedge fund expected this strategy to be seen as helpful.

All this doesn’t mean it is impossible to have legitimate informal conversations that get the information that bankers want without giving investors the information that they shouldn’t have.

One popular approach is the portfolio discussion. This will typically see a syndicate trader run a client through a list of stocks to see if the investor cares about any of them, even though the banker knows that only one is the subject of a potential trade.

But it is equally easy to see how such conversations could drift into difficulties. Pressing a client on their likely reaction if a deal were to happen in this stock today would seem to be a step too far.

Beyond that, there is the still more extreme end of the behaviour spectrum: the outright leaking of plans for a deal to favoured clients.

If the SEC gets hold of firm evidence of this, the results could be explosive.

As usual, for the regulators there is the slight whiff of Casablanca’s Captain Renault being “shocked, shocked to find that there is gambling going on” in the casino. UK authorities such as the Financial Conduct Authority (FCA) have periodically been outraged to find that investment banks might occasionally appear to prioritise some clients over others.

But it seems beyond question that there is enough opacity around block-trade practice to warrant a dose of clarity. How to get that is a thorny question. Is the answer to ban all non-deal conversations?

This is not merely an academic question, although, as it happens, it is that too. Just this month a paper published in the American Finance Association’s Journal of Finance looks at the practice of non-deal roadshows and concludes that not only do they create a “substantial information advantage” for the institutional investors that attend them, but also conflicts of interest for the analysts that organise them.

And all this comes, let’s not forget, 20 years after the $1.4 billion Global Analyst Research Settlement secured by the sheriff of Wall Street, Eliot Spitzer.

The US, unlike elsewhere, is a gigantic flow market when it comes to blocks. With so much business to be done, and with such a reliance on a relatively small number of buyers when it comes to anchoring many of these trades, the pressure is intense.

Banning all conversations that bridge the private and public sides could be tempting. It’s not unreasonable to argue, as many do, that if you are a bank that is in the business of buying block trades to distribute to investors, then you really ought to be doing that on the basis of your expertise in assessing market appetite and risk, not because you have de-risked the trade from your perspective by over-preparing the market to digest it – something that would obviously result in a worse price outcome for the original seller.

And in another echo of Spitzer in 2003, there is a further rabbit hole for the SEC to peer into by looking for connections between IPO allocations and investor participation in blocks.

How far could this go? The simple answer is that it could be catastrophic for anyone found to have been involved in serious misconduct. The way the supervisory winds are blowing in the US, particularly under the SEC chairmanship of Gary Gensler, it is clear that cracking down on malpractice is high on the agenda.

As they conduct their probes, regulators will face the tricky task of ensuring that they do not end up stifling the market’s ability to operate efficiently, but without being seen to be willing to let bad behaviour that is endemic be passed off as merely the sins of a handful of individuals.

The relationship between investment banks and big hedge funds facilitates the provision of much useful liquidity. But if the price of that liquidity is a routine contempt for market integrity, that relationship needs rethinking – and fast.