This article first appeared in the International Securities Finance magazine. It is reprinted here with permission.
On April 13, 2006, the U.S. Securities Commission initiated a long awaited civil enforcement action titled SEC v. Ramy El Batrawi, et al., in a federal court in Los Angeles. In its complaint the SEC charged Ramy El Batrawi, Adnan Khashoggi and others, including employees of certain banks and broker-dealers, with conspiring to manipulate the stock price of GenesisIntermedia, Inc. (GENI) a now-defunct public company. The alleged scheme, which took place between September 1999 and September 2001, resulted in the misappropriation of more than $130 million, the collapse of several broker-dealers, and the largest bailout in the history of the Securities Investor Protection Corporation, prosecutors say. The unique aspect of the alleged scheme was that, unlike typical market manipulations, this one was perpetrated through securities lending.
In general terms, the alleged perpetrators loaned GENI shares to unsuspecting broker-dealers in exchange for cash collateral and then obtained additional cash collateral as the price increased and the shares were marked-to-market by the broker-dealers. While the stock loans were open, the defendants are alleged to have manipulated the share price by devices such as falsely touting the company and actively trading in GENI stock.
The SEC action and the many pieces of private civil litigation that preceded the government’s case contain other lessons for participants in securities lending. The victims of the GENI scheme were broker-dealers, both borrowers and lenders of securities. The case reveals how parties with knowledge of standard securities lending protocols could exploit gaps in a lender or borrower’s control policies and procedures.
The GENI transactions involved long sequences of conduit loans. Once the purported beneficial owner loaned the shares into the lending stream the shares were lent on in a series of borrows and loans from one broker-dealer to another until they were delivered to the ultimate borrower. Likely, the alleged perpetrators believed that the security itself, though thinly traded, would not be an impediment to the success of the scheme because the intermediate broker-dealers would rely on the creditworthiness of their immediate counterparties rather than the liquidity of the borrowed GENI shares.
The case reinforced the notion that in any lending transaction an evaluation of counterparty risk is only part of the required analysis. Market risk must also be evaluated. In a worst case scenario, as occurred in the GENI transactions, a lender may refuse return of collateral. The borrower may then sell the position to cover. In the GENI transactions, when the scheme collapsed so did the market for GENI stock. Numerous unsuspecting broker-dealers were unable to return the borrowed shares for their cash collateral and were also unable to mitigate their losses by selling the shares. Their recourse became litigation.
When the alleged GENI scheme unraveled, intermediate broker-dealers refused the return of GENI shares they had loaned, contrary to obligations contained in the standard Master Securities Loan Agreement. Firms asserted that they were merely agents and not principals in the subject transactions, taking advantage of potentially ambiguous language in older versions of the Master Securities Loan Agreement. The refusal of the conduit lender to accept return of the GENI shares was due, of course, to the fact that the lenders’ own lender either also refused the return or, in the case of firms like MJK Clearing and Native Nations Securities, had been rendered insolvent and had been taken over by SIPC.
The large number of lawsuits arising out of the failure or refusal to unwind transactions highlights another fundamental point: the provisions of lending agreements must be clear and unambiguous in defining each party’s capacity. It is imperative to know the capacity in which your counterparty is acting in every single transaction. Such clarity can be achieved on the principal and agent definition by use (at least in the U.S.) of newer form annexes to the Master Securities Loan Agreement, such as the new Agency Disclosure Annex I-A, released by the NASD in June 2005.
The GENI case points out that, it may be necessary to know the identity of your counterparty’s counterparty. If your direct counterparty is engaging in the transaction with a party with whom you would not deal directly, due to credit risks, concentration risks or reputational risks, you may decide not to participate. The risk to which you see your direct counterparty exposed may become your own.
In an environment free of fraudulent behaviour securities lending transaction are nearly risk free. Where, however, a participant engages in behaviour intended to manipulate the market, control procedures are the first defense against loss. Risk can be mitigated by adherence to simple but fundamental checks.