It's the intent that counts

Experts on securities law are united in opinion: The Israel Securities Authority will have great difficulty proving in court that two former management-level employees at Psagot fraudulently manipulated asset prices.

On Sunday night TheMarker broke the news that the Israel Securities Authority had arrested David Edry, 35, and Shai Ben David, 33, on suspicion of systematically manipulating stock and mainly bond prices from 2007 to late 2009 using Psagot's proprietary portfolio. The goal: to increase Psagot's profits and their own bonuses.

Edry was vice president at Psagot subsidiary Psagot Securities and Ben David, working under him, managed the trading room. Given the elephantine proportions of Psagot's proprietary portfolio, they had the means to significantly sway asset prices. The portfolio had about NIS 400 million under management, an amount that Psagot leveraged to about NIS 2 billion.

Now the securities watchdog suspects that the duo deliberately and fraudulently set out to manipulate asset prices. The snag is that almost all similar cases have ended in exoneration.

"Securities transactions that people carry out in the marketplace can be interpreted in different ways," says Ronen Adini, a lawyer who specializes in securities law. "A transaction can look innocent when it isn't, and vice versa. A transaction that may look dubious may be perfectly legal."

The question of legitimacy boils down to state of mind, Adini explains. The crucial question is whether the trader intended to artificially influence the asset price or whether that was simply the outcome of the transaction. Since a transaction can be interpreted in different ways, fraud is very hard to prove, and it's not a good idea to leap to conclusions.

As for the fact that the transactions under scrutiny were carried out in Psagot's proprietary portfolio, Adini suggests that investors might want to worry about the brokerage's internal controls and supervisory mechanisms because of the ramifications their conclusions might have for the brokerage's broader activities. If an investment firm falls short in controls in one area, it may also fall short in another that does affect the wider public of investors.

Even if a brokerage does have strong controls, Adini begs to point out, it may be all but impossible for management to discover fraud if it's done well.

Yael Grossman, another expert on securities law, says there's a legislative proposal in the making that would prohibit front-running - when someone tries to make a profit from knowing in advance about a securities transaction that someone else is about to carry out.

"If a brokerage knows that a big client is about to buy a large amount of a certain share, which will lift the share price, it could hasten to buy into the stock ahead of the client's transaction," Grossman explains. That boils down to making illicit profit based on pre-knowledge.

A matter of patter

When it comes to proving fraud, it isn't enough to prove that somebody bought or sold large amounts of shares over time. It's a question of pattern and intention.

Everybody who invests does so in order to profit. The question is how they go about it.

Say some ordinary Yossi takes a chunk of his salary the day it's paid and puts it into Levi et Levy Construction and Strawberries. That is a pattern. But unless Yossi is making more money than Croesus, he won't be able to move that company's share price and he isn't trying to. He just thinks that LLCS is a great company that will increase in value.

Edry and Ben David on the other hand had billions of shekels to play with and carried out massive transactions daily. They had a pattern - buying small amounts of securities shortly before closing at oddly high prices, which changed the closing level of the asset, then selling larger amounts of that same asset the next morning at the higher price. But prosecutors will have to prove they weren't getting in and out of securities by the merit of those securities. They had, the enforcers suspect, deliberate intention to manipulate prices.

However, there are no anguished journal entries showing criminal intent. The evidence is circumstantial. Investors under the microscope would do well to watch their patter.

"Often when people are questioned by the Israel Securities Authority, they don't realize the importance of how they present things," warns Grossman. "If they say things indicating that they did intend to influence the price, they're in trouble. If they have a rational economic explanation and had pure intent in their investment, no case can be proved against them."

In short, the prosecution has to prove the alleged miscreants' state of mind beyond doubt, which in the absence of telepathy is tricky.

For their part, defendants Edry and Ben David are struggling to explain their actions in a way other than a deliberate attempt to move asset prices.

Stock (or bond) manipulation cases usually wind up pitting expert against expert in court. The defendants try to show they were merely adhering to normal practice in the capital market. The prosecution tries to prove fraud. The gray area between legitimate exploitation of the systems and criminal activity is vast. And the courts tend not to convict.

'Suspicion is not evidence'

As the case surrounding Psagot came to light this week, many were reminded of the famous case in 2001 involving shares in Partner Communications.

On the last trading day of July 2001, Partner stock suddenly spiked 49% in the last seconds of trading following the acquisition of 28,000 shares. 'Twas the eve of Partner's addition to the benchmark TA-25 index on August 1. Market players figured that some speculator in options on the TA-25 index (popularly called "Maof options" for historical reasons) was trying to influence Partner's share price in order to make a killing on options.

In short, market animals and investigators figured that the last-second Partner transaction was not a genuine investment in the mobile services company, but rather fraud.

It took the prosecution four years to indict. The prosecution claimed that Golan Cohen and Ronen Reshef had abused the system and their heavy buying power to manipulate Partner's share price. (As major players in Maof options, they were eligible for hefty bank loans.)

The case meandered through the court system for five more years, only after which Cohen and Reshef could breathe easy. Three months ago the two were cleared by the president of the Tel Aviv District Court, Judge Dvora Berliner.

There is no doubt that if a share price shoots up drastically because of a buy order in the last seconds of trade, this begs suspicion that the transaction was designed to manipulate the price, Berliner wrote. The watchdogs were right to investigate, "But suspicion is not a substitute for actual evidence," she wrote.