Last week, it was reported that a portfolio manager for a major asset manager has agreed to plead guilty to defrauding investors in closed-end funds for which he executed option trades. One major newspaper described this as an “option scheme”. However, it may also be viewed as a scheme that was best effected by using options. There is a difference.
Bernard Madoff was well known for his “split strike conversion” strategies. Here, a complex option strategy obscured how the investments actually performed. Defendant Kevin Amell is alleged to have merely engaged in self-dealing, using trades which were most effectively executed to his advantage because of the structure of listed option markets.
In essence, it is alleged that Amell:
- Created personal brokerage accounts which were not disclosed nor trades reported to his employer;
- Failed to disclose his employment as a portfolio manager to the (personal account) brokers;
- Executed at least 265 sets of transactions in which the three legs below were sequenced:
1) Placed personal buy limit orders for call options at a bid just above the national best bid (thus giving his orders first priority for a matching offer)
2) Placed fund sell orders for these options at limit prices matching his (personal) bid price, which resulted in immediate fills, and
3) Liquidated his newly acquired personal call options by selling at or near mid-market.
In this manner, the mid-market sale would earn approximately half the bid-offer spread. The two examples cited in the complaint had a total duration of under 10 minutes. While there were other versions of the transaction sequence, they all allegedly involved using the closed-end funds for which Arnell traded to provide liquidity at prices disadvantageous to the funds and advantageous to the hidden personal accounts.
Overall, it is claimed these transactions netted close to $2 million, for which Arnell’s funds will likely be liable to investors.
The trades described could have been executed using stocks, futures, or any asset with reasonable liquidity. The use of options, however, facilitates several attributes of these transactions.
- Exchange-listed options were used: Between the second and third legs, the position is long call options. Even having purchased them near the bottom of the bid-offer spread, this is still a risk position should AMZN move significantly. Conditions enabling a quick mid-market sale of these calls, thus earning the bid-to-mid spread, is a critical aspect of the scheme.
- The National Best Bid Offer (NBBO) option market spread convention ensures that the personal account (leg 1) buy order will be filled first when a matching (leg 2) offer is received. The aggressive seller closely following this bid was Arnell’s fund, thus allegedly channeling the benefit of the low sales prices to Arnell’s personal accounts.
- Options are liquid, but many are not too liquid: One of the 265 alleged schemes involved options on Amazon.com (AMZN). AMZN volume was 4.4 million shares on the day in question. Options on such a busy name trade frequently. However, there were 2,582 different options on AMZN that day, with widely varying levels of activity and bid-offer spread. This better permits selection of options with sufficiently wide spreads to make the transactions lucrative.
- Finally, with the enormous diversity of strike prices and expiration periods ranging from 2 to 842 days, it was easier to select an option contract whose price movement during the executions would be more muted, at least relative to underlying stock AMZN. This may be the sole component which relies on the characteristics of options themselves, rather than that of the market structure.
While all the price, volume and open interest data is available, stitching it together to create an effective preventative net would be difficult. There would certainly be valid reasons for the fund to take a position in call options on AMZN, so distinguishing self-dealing from legitimate activity is a challenge. Absent knowledge of the personal accounts obscures the self-dealing aspect as well. Therefore, this may have to be looked at as a case of best execution.