Blocks untackled: After Morgan Stanley, is that it?

To read the breathless announcement on Friday from the US Securities and Exchanges Commission (SEC) of how it was punishing Morgan Stanley and the bank’s former US equity syndicate head, Pawan Passi, you might be forgiven for thinking that here was an example of regulators cracking down hard on malpractice on Wall Street.

Following a long-running investigation into block trading practices, the SEC was detailing how Passi and an unnamed colleague had on multiple occasions between 2018 and 2021 leaked details of upcoming equity block trades to certain buy-side contacts so as to allow those accounts to pre-position themselves by shorting the stocks in question.

As well as granting the investors a payday when they were subsequently able to cover their short positions through the deal, the arrangement also meant that Morgan Stanley could bid on blocks more aggressively than rivals because it had already laid off some of its risk.

As usual, the hubris looks awful. The investigation might not have found that anyone else in Morgan Stanley’s equity capital markets team was involved in the leaks, but the whole affair casts a rather different light on the bank’s regular claims to be conducting the blocks business more efficiently – and more honestly – than rivals, at least for the three-year period covered by the findings.

Transcripts of conversations between bankers never fail to embarrass, and those disclosed by the SEC and the Department of Justice do not disappoint, with talk of “bad boy slides” and the like. It sometimes seems that this industry will never learn to obey the simple rule of not writing down anything that might look bad in the black and white of a regulatory Statement of Facts.

And of course, the fact that Morgan Stanley was telling clients to do business with it precisely in order to avoid the kind of leaks that were supposedly routine on rivals’ deals now looks embarrassing.

It is worth reflecting on the language used by the authorities. The SEC’s statement plays to the tough-cop image that it likes the world to have of it, trumpeting first how it had “charged” Passi and Morgan Stanley. The DoJ’s rather more sober headline was of reaching “agreements” with them.

The DoJ’s take looks closer to the mark – and to the reality of the outcome. The SEC might want the conclusion to the block-trade affair to sound momentous and bold, but it is far from that.

Sure, there is plenty of salacious material gleaned from recordings of phone conversations – and that kind of stuff lends itself well to media coverage. But be in no doubt that, for all the supposed drama, this smacks of light-touch regulation.

The first question is how? The second is why?

First, the $249 million total penalty levied on Morgan Stanley hardly looks punitive. The DoJ itself said that the bank racked up $1.4 billion of revenues from its block trading business during the period in question, 2018 to 2021. The settlement involved the bank forfeiting the $72.5 million that investigators say were its profits on the block trades where it found malpractice. But the firm will have gained broader benefits from being a leader in this part of the ECM business.

Passi will now be out of the industry for some time but has escaped a criminal conviction through a deferred prosecution agreement. He has been penalised just $250,000 – chump change for a man in his position – with part of the justification being that he had already foregone millions in bonuses.

Now for the why – the reasons behind the apparently lenient approach.

Mitigating factors include not just the cooperation of Morgan Stanley with the investigation, but also the fact that the remainder of the bank’s ECM staff have not been implicated. Had authorities been able to show some kind of department-wide conspiracy to defraud selling shareholders and the wider market, the consequences for Morgan Stanley would presumably have been of a different order of magnitude.

Second is the difficulty in establishing truly who has been damaged by the violations and exactly to what extent. Yes, it seems obvious that selling shareholders might have secured lower sales proceeds if an investor trading on privileged information was able to move the market price – and some $64 million of Morgan Stanley’s penalty is restitution “representing the harm caused to sellers”, in the words of the DoJ.

But establishing in law the precise nature and impact of such behaviour would have been difficult, and defence counsel would have rightly tested prosecution theories to breaking point.

And in any case, there will be some sellers who would theoretically benefit from an enhancement to the market’s ability to digest a slug of stock, particularly in less-liquid names, an enhancement that could take the form of some healthy short interest. A slightly lower price might simply be the cost of doing business, the quid pro quo for banks being comfortable to bid for what are supposed to be on-risk transactions.

Much earlier in this investigation, I wrote about the way in which equity block trades are typically conducted and the grey areas in which they operate. Investment banks have conversations with buy-side contacts all the time about what stocks those accounts might be interested in – that is part of how they do their job, which is to understand the broad market appetite for different names and at what price that appetite might be satisfied.

Sometimes these are very vague exchanges. Sometimes they are more concrete, using the fact of publicly disclosed lock-up dates as an excuse to discuss a specific stock even if there has been no approach to banks by a seller.

The trickiest situations arise when banks have specific knowledge that a seller is considering a deal. Bringing potential buyers over the wall privately, with all the disclaimers and commitments that that involves, is a permitted – albeit still complex – way to do it.

Much more controversial is the practice of gauging a buyer’s interest in a list of hypothetical names that could be the subject of a deal. If a bank is doing this with specific knowledge of an impending transaction, then the ability to stay on the right side of the rules seems to rely on the buy side being unable to parse the clues.

How likely is that, really? Competent accounts should be well aware of the holders of large blocks and their likely intentions for them. Lock-up dates, as already mentioned, are public. Many on the buy side will be routinely shorting stocks into such expiries, even without being given any tip-off by nefarious syndicate officials.

With all that going on, it might be legitimate to ask whether this is an activity that can ever truly operate entirely above board – in the sense of being equitable to all market players and not unfairly favouring some over others.

The Morgan Stanley internal communications disclosed in the SEC and DoJ investigation show that its bankers think others in the market leak information about deals. And we know that the probe has involved collecting data from many firms across the Street. Might it therefore be a prelude to a wider scrutiny of block trading practices?

Perhaps, but such an attempt would face plenty of challenges. Just getting to this point in the case of Morgan Stanley has taken considerable time, and the result has hardly been earth-shattering.

For all that the SEC in particular is keen to dress up this case as a win for fearless regulators, it looks more like something that Morgan Stanley’s new chief executive, Ted Pick, can now put behind him with a bigger sense of relief than he might have expected.

Since the misconduct uncovered in this investigation, the SEC’s well-publicised crackdown on informal and unmonitored communication methods in banks has meant that the industry today operates with a very different set of practices than in the past.

Given the likely difficulty of making anything stick other than unusually explicit violations backed up with incontrovertible communications evidence, it may be that nothing more emerges elsewhere. That might mean that there is nothing to see in block trading. Or it might mean it is just too difficult to see.