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Mystery Quotes

About a year ago, the broker began to take a close look at small-cap stock charts. With a client base mainly of individual stock traders, he'd grown frustrated at price moves that didn't jibe with trading volume. The broker, who works for a wirehouse in Florida, documented what market observers have known for a long time: Market makers in small-cap stocks are relatively free to control prices to meet

About a year ago, the broker began to take a close look at small-cap stock charts. With a client base mainly of individual stock traders, he'd grown frustrated at price moves that didn't jibe with trading volume. The broker, who works for a wirehouse in Florida, documented what market observers have known for a long time: Market makers in small-cap stocks are relatively free to control prices to meet their own needs. When brokers make a trade for their clients, the broker found, they often have to deal with prices that move up or down 10% or more on any given day contrary to buying and selling pressure.

"If a company comes out with news, trading volume comes in, but the stock does nothing," says the broker.

A Canadian broker active in OTC issues complains that small-cap stock spreads are still wide. "The other day SMTC [Semtech Corp.] was 401/4 to 42, a 5% spread," he says. "That's a bit much. There's the theory that the new rules have narrowed spreads; then there's the reality." This broker also sees price moves on very little volume.

"The problem is both sides of the market are made by traders, not customers," the Canadian rep says. "As a result, I won't sit on a bid very long as I might with a listed stock. It's frustrating because I trade some $500,000 stock positions. If I did it all at once, I'd move the market considerably, so I have to put orders in one at a time and do it over time."

Brokers are even being held responsible by regulators for small-cap market maker abuse of markup rules, says Bill Singer, a New York City attorney and Nasdaq critic. NASD guidelines say market makers shouldn't charge more than 5% over their cost on a trade, but how that's computed varies depending on whether a market is liquid or illiquid.

"In illiquid small-cap stocks, a market maker is supposed to set the markup on what he paid for the stock, not on what it is selling for in the market," says Singer. But market makers sometimes compute their markup on the market selling price anyway and tell their brokers to add the 5%, he says. The result: A $1 stock ends up selling for as high as $1.10 or $1.15. "The SEC says markups above 10% are fraud, and over the past three years they've brought charges against individual brokers for following their firm's violation of the markup rule," Singer says.

Even as securities regulators are forcing big changes in market maker behavior in the OTC markets (see "On the Hit List," Page 108), there are plenty of complaints that market makers in small-cap stocks are still below the radar screen. The SEC's August 1996 21(a) report documenting wrongdoing by the NASD and Nasdaq didn't go far enough, say some market observers. The investigation of trading activity only addressed certain market maker abuses in the top-tier OTC stocks.

The SEC's 21(a) report made a big point about spreads, says a California wirehouse broker and former CBOT floor trader, but wasn't tough enough. "They gave market makers six months to clean up their act on spreads, when they could have done it in one day," he says. "Just say, 'Hey guys, you can't do this anymore.'"

Big Stick? Here's what the Florida broker saw in small-cap stock charts: On Feb. 14, 1997, he noticed that theprice of Vacation Break USA (VBRK) came down on small sales, but held on big sales. On April 15, 1997, he found that the ask on Pelican Properties International (PELP) was raised gradually throughout the day from 15/8 to 23/4.

"They raised the ask, but no one buys to make the ask go up," he says. "Nor do they buy after the ask goes up, so why does it go up?"

Market makers often raise their bids after sales, the broker says. On Nov. 25, 1997, the bid for LS Capital Corp. (CHIP) was at 84 cents at the market open. It stayed there until two sell orders at 84 cents hit. Then the market maker immediately raised the bid to 86 cents. "Sells don't raise a bid; they should lower it," the broker claims (see time and trade reports, Page 106).

Daily stock charts frequently show "flat tops," which this broker believes indicate the market maker is holding the stock price down. Why? "The market maker has shorted the stock and as the price goes higher, his shorts get hurt," the broker says. "He doesn't want that to happen, so even when buying volume comes in, he won't let it go higher."

On Sept. 24, 1997, shares of Nona Morelli's II Inc. (NONA) rose from 24 to 28 cents, stayed at 28 in the face of numerous buys, dropped to 27 on a sale, then immediately topped out again at 28 amidst buy after buy. The pattern repeated once more during the day, and the stock closed at 28 cents.

The rep adds that on Dec. 1 of last year, in trading of Noise Cancellation Technologies (NCTI), virtually all trades between 11:09 a.m. and 11:12 a.m. were buys, immediately before and after news was released about a licensing agreement. Yet the market maker did not raise the ask at all.

On any given day, Singer says, you'll see an upward move on a bid with no volume. About 70% of the time, an overzealous market maker is trying to attract attention to a stock or someone is wanting to unload a big position all at once, he says.

To some market observers, market makers are simply pursuing self-preservation in an inefficiently structured market. "The mere fact that thinly traded stocks in this volatile market move on no apparent news doesn't indicate that a market maker is getting together with other market makers and agreeing to manipulate prices," says Junius Peake, a finance professor and market researcher at the University of Northern Colorado in Greeley, and a former NASD governor. "Market makers are adjusting prices to make sure they don't get their clocks cleaned. I won't condemn a market maker for not wanting to go broke."

Jeff Ricker, a San Francisco-based investment strategist for the institutional market cautions brokers that illiquidity is the big problem: "Market makers carry little or no inventory," he says. "If they get hit with a lot of trades, it may take a long time to cover them."

To the Florida broker, what small-cap market makers are doing points out the ineffectiveness of the SEC. "Market makers are saying to the SEC by their actions, 'you made us narrow our spreads, but you said nothing about what we need to do up and down the scale" of moving bids and offers together. "We'll let you do this, but we still have the big stick,'" that is, the sole ability to set quotes.

Restructuring Debate Some market observers believe the answer to small-cap market inefficiencies is to set up a new type of market. Singer advocates developing Internet stock exchanges. They would provide direct links to investors, eliminating markups, and be closely regulated by the SEC. A complete automated audit trail for all OTC stocks is a good suggestion, he says, but the more you have to monitor, the more you have to review.

"The SEC says the average investigation now takes two and a half years," says Singer. "By the time they stop an offending market maker, he's already moved on or is bankrupt."

Until changes come to the small-cap market, brokers can take some steps to help themselves, Ricker says. With non-Bulletin Board stocks, the new order handling rules protect limit orders from market maker manipulation, he says. "If brokers just put a limit order in the middle of a spread, I think they'll be pleasantly surprised." But Ricker admits that some brokers may not want to bother and may not get trades done. He also cautions that even if a broker's limit order is the first one in, Nasdaq can't force market makers to fill it first.

For Bulletin Board stocks, brokers should consider calling the issuer, Ricker advises. Sometimes a company's CFO runs an informal matching service for the stock, he says. If a stock is doing well and the broker wants to sell, some issuers will even buy back the shares directly.

The small-cap stock markets rank high on regulator hit lists. Yet market observers say efforts to better police market makers still don't eliminate everyday market inefficiencies that hurt investors.

The SEC's order handling rules, in place more than a year, have narrowed spreads in both large and small Nasdaq stocks about 30%, Nasdaq officials say. The rules require market makers to make publicly available any superior prices that it offers privately through ECNs. The recent switch to quoting in 16ths has narrowed them even more, say market observers.

What about OTC Bulletin Board spreads? Brokers report they haven't narrowed.

The NASDR will begin phase-in next summer of an automated order audit trail (OATS), mandated by the SEC's 21(a) report. Market makers will have to time-stamp all customer orders when entered, instead of just at execution. But regulators still won't get a complete audit trail for all small-cap stocks: OTC Bulletin Board stocks aren't included in OATS.

A complete audit trail for small-cap stocks would make it "much less attractive" to artificially inflate prices, argues Junius Peake, a finance professor and market researcher at the University of Northern Colorado in Greeley. "If Nasdaq has a better audit trail, why not use it for stocks that trade infrequently? The stock with a thin market needs the greatest amount of publicity."

But the NASDR is talking tough about improving standards for companies to be included on the OTC Bulletin Board, and educating investors about the Bulletin Board's risks. Barry Goldsmith, NASDR enforcement director, told compliance professionals at an NASDR conference in November that his department would be targeting micro-cap stock fraud over the next several months.

What about improving Bulletin Board market maker behavior? Maybe. In Sept. 22 testimony before the Senate Permanent Subcommittee on Investigations, Goldsmith offered this: "We will determine if there is a need for increased regulation on the operation of the OTC Bulletin Board, such as the authority for the NASD to halt trading under certain circumstances. ... "

The NASDR also is taking aim at backing-away complaints with an automated surveillance system, introduced this fall. Backing away occurs when a market maker refuses to fill an order at the firm's published quote. The NASDR now can track complaints on a real-time basis to identify firms that demonstrate a pattern of backing away.

"We're looking to move more from focusing on individual problems to more of a pattern-of-practice approach," said James Cangiano, senior vice president of market regulation at the NASDR, at the November conference. But if a firm has a very low rate of missing SelectNet orders, Cangiano said, the NASD won't pursue individual backing away situations.

To handle individual complaints, firms with a complaint now call a hot line within five minutes of the alleged violation. NASDR market regulation staff then contact the market maker to resolve the complaint.

The new system has its critics. An owner of a small Florida broker/dealer says it actually protects backing-away violators.

"When market regulation calls the firm with my complaint, the firm takes anywhere from an hour to the end of the day to call me back and agree to fill the order," he says. Usually, it no longer makes sense to take the firm up on its offer to fill at the original price, says this trader, since by then, prices have moved. "I've lost from one-eighth to as much as one point on trades because of backing away," he says. "Just the fact that the firms offered the print lets them off the hook with regulators."

An NASDR Notice to Members explaining the complaint process only specifies the market maker's obligation to make an offer to fill, saying nothing about an obligation to satisfy the complainant.

The SEC is pushing for small-cap market maker accountability from the broker/dealers who clear for them. SEC Chairman Arthur Levitt, in his Sept. 22 testimony before the Senate subcommittee, said that SEC examination staff is "looking at the procedures" of these clearing firms. Both the NYSE and the NASDR have proposals at the SEC that would require clearing firms to send copies of customer complaints about introducing brokers to regulators.

Small-cap market makers may have a hard time in the coming year maintaining questionable business-as-usual practices. Trading desks will have regulators looking over their shoulders like never before. The NASDR is asking firms to present written supervisory procedures for their trading desks and is readying "report cards" for market makers that will track trade-reporting compliance and response to SelectNet orders.

"An interesting exercise would be for regulators to look at the trading characteristics of a stock and have someone drop in unannounced on each market maker simultaneously," suggests a wirehouse broker who does a lot of OTC business. "They can see what the trading pattern looked like for that day compared to the historical pattern. When the market makers change quotes, ask why. This would stop any pricing collusion for that day."

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