Ordinarily, the Courts presume the validity of the SEC’s interpretations of its own Rules. A recent decision of the U.S. District Court in Manhattan proves that there are limits to this deference, and that it can only occur when the SEC has widely published its interpretation and has done so prior to the events in controversy. In SEC v. Lyon, 529 F. Supp. 2d 444 (S.D.N.Y. January 2008) (Stein, J.), the SEC faced a motion to dismiss its claim that the purchase of privately issued PIPE shares, followed by short sales of the corresponding public shares, all with the potential that the short sales with be covered with stock obtained upon issuance of the PIPE shares, would be regarded as a violation of Section 5 of the Securities Act. In a rare repudiation of the SEC in the interpretation of its own Rules, the Court found this theory to be unsupported by clear and widely published interpretations, and therefore unenforceable.

First, we will define terms. A "PIPE" transaction (meaning "Private Investment in Public Equities") is a private offering of new shares of an issue of which other shares have been registered and are currently outstanding. Investors in a PIPE typically acquire the shares at a discount, with the understanding that the issuer will, within a short time, register the PIPE shares with the SEC for public sale. Then the PIPE investors can resell the shares at a profit.

But registration and public sale of the new shares frequently causes the price of the public shares to fall. Accordingly, upon purchasing the PIPE shares, the investors are expected, after acquiring the shares, to hedge against potential loss on the shares by selling other, publicly traded shares of the same issue, short. Later, the PIPE investors may cover their short sales with publicly traded shares. To facilitate the cover, the short seller will, at the time of the short sale, perform a "locate" -- locating publicly traded shares that they can borrow and deliver against the short sale.

Sometimes, according to the SEC, the investor plans to cover the short sale only after the public registration of the PIPE shares. In Lyon, the SEC argued that this happened with four of the defendants’ PIPE investments, and that the defendants, in effect, sold their privately acquired shares to the public at a time when the shares were not yet registered. Their so doing, alleged the SEC, violated Section 5 of the Securities Act, the statute that prohibits the public sale of stock unless the stock has been registered or either the stock or the sale is exempt from registration.

In Lyon, the Court found that the SEC had not given unequivocal and public utterance to this theory of liability, and therefore could not enforce its interpretation as though it had the force of law. According to the Court:

To support its claim, the SEC cited a "concept release" on short selling that the SEC issued in 1972. It stated "concerns" for the propriety of transactions somewhat resembling those before the Court, but did not express a clear prohibition. A 1974 Rule Proposal Release by the SEC suffered from the same infirmity.

In Lyon, moreover, the Court found no "preconceived plan" to distribute unregistered shares.  The use of converted "distribution shares" to cover the short sale, the Court noted, had been possible, but not inevitable.  Accordingly, the Court dismissed that part of the SEC's case, finding that, on the law, the SEC's case was not plausible." 

The SEC has been similarly constrained in other cases, notably that of Upton v. SEC, 75 F.3d 92-98 (2d Cir. 1996), where the Second Circuit declared that:

(Citations omitted.)

The United States District Court in Manhattan, in CFTC v. Amaranth Advisors, ---- F. Supp.2d ----, 2008 WL 2123323 (S.D.N.Y. June 10, 2008) (Chin, J.), has defined the elements of attempted manipulation of a commodity futures contract, addressing an issue of doubt and sustained controversy. The Court considered what type of action a plaintiff must prove to establish a claim of attempted manipulation under Section 9(b) of the Commodity Exchange Act ("CEA"). Defendants had contended that, besides manipulative intent, the claim required proof of an "unlawful, fraudulent" act, rather than what they described as legitimate, speculative trading. Id. at *9. The CFTC argued, on the other hand, and the Court agreed, that the claim required only an "overt act committed by defendants in furtherance of their intent to manipulate the settlement prices of natural gas futures." Id. at * 9 (emphasis added). The Court found manipulative intent to have indicated in some of the trader’s e-mails, and identified the concurrent overt acts as follows, finding them sufficient to establish the claim:

"Specifically, the CFTC alleges that shortly before the closing range on February 24, the expiration day for the March 2006 natural gas futures, defendants reversed their overall position from short to long in more than 3,000 futures contracts. Defendants then placed orders to sell those contracts during the closing range when prices would be affected by the large volume of trades. (Compl.¶¶ 33, 35).

"The CFTC alleges that defendants perpetrated the manipulative scheme again on April 21. Defendants allegedly instructed NYMEX brokers to sell a total of 1,044 natural gas futures contracts in the last eight minutes of trading. (Compl.¶¶ 55-58). Eight minutes before the end of trading, Hunter allegedly placed another order with a NYMEX broker to sell 2,000 futures contracts. (Compl.¶¶ 59-61). These allegations sufficiently meet the overt acts requirement of an attempted manipulation claim."

The Court found support for its analysis in another case of alleged market manipulation, in the same District but under a different statute, the Securities Exchange Act:

"Defendants, however, contend that to state a claim for attempted manipulation, the CFTC may not simply allege any overt act, but must allege an unlawful, fraudulent act. Without an allegation of fraud or deception, defendants argue, there is no manipulative conduct, but merely "legitimate speculative trading." (Amaranth Mem. at 5, 6). Quoting a recent Second Circuit decision, defendants assert that "short selling-even in high volumes-is not, by itself, manipulative." (Amaranth Mem. at 9, quoting ATSI Comm'ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 101 (2d Cir.2007)). At bottom, defendants raise the issue whether manipulative intent alone can support liability for otherwise legal, open-market transactions.

This question, however, has already been addressed in the context of federal securities laws. In Securities and Exchange Commission v. Masri, Judge Holwell expressly "decline[d] to adopt defendants' proposed per se rule that open-market activity cannot be considered manipulative based solely on manipulative intent, that is, without additional deceptive or manipulative conduct." 523 F.Supp.2d at 371. Instead, he held that "if an investor conducts an open-market transaction with the intent of artificially affecting the price of the security, and not for any legitimate economic reason, it can constitute market manipulation." Id. at 372.

"The open-market transactions at issue in Masri involved a specific type of trading strategy known as "marking the close"-the same trading activity at issue in this case. Marking the close refers to the execution of purchase or sale orders at or near the close of the market to affect the closing price of a security. Sec. & Exch. Comm'n v. Schiffer, No. 97 Civ. 5853(RO), 1998 WL 226101, at *1 n. 3 (S.D.N.Y. May 5, 1998).  Although "transactions made at the close of the day are not prohibited," the timing of such transactions is not only "suspicious," but also "more capable of artificially affecting the price of the security." Masri, 523 F.Supp.2d at 370.  The Masri court thus concluded that allegations of "'end-of-day' transactions, accompanied by evidence sufficiently indicative of manipulative intent, stated a claim for market manipulation in violation of section 10(b) of the Securities Exchange Act of 1934. Id. at 372."