Last week, New York Attorney General Eric Schneiderman announced a lawsuit against Barclays, alleging that the company had led clients to believe that the Barclays LX dark pool was a safe place to go swimming when, in fact, it was teeming with bloodthirsty, man-eating sharks (or “predatory high-frequency traders”, as A.G. Schneiderman put it).

The bombastic language (the word “toxic” appears in the complaint 24 times, one more than “predatory” but well behind the 41 mentions of “aggressive”) masks the fact that the underlying allegation at the heart of the lawsuit is that Barclays “misrepresented” the extent to which participants in Barclays LX were protected from “aggressive” HFT firms.

“Misrepresented” might not sound particularly bad. A.G. Schneiderman presents no proof that Barclays intended to defraud its clients or that clients suffered any losses as a result of Barclays’ misrepresentation. In fact, he doesn’t even accuse Barclays of lying. However, he doesn’t need to because he’s using the Martin Act, a 93 year old state law that redefines securities fraud using a far wider definition than federal securities laws, removing any need to prove intent to defraud or even that fraud took place. The Act gives the New York attorney general broad powers to investigate potential violations. According to Nicholas Thompson, writing in Legal Affairs:

The purpose of the Martin Act is to arm the New York attorney general to combat financial fraud. It empowers him to subpoena any document he wants from anyone doing business in the state; to keep an investigation totally secret or to make it totally public; and to choose between filing civil or criminal charges whenever he wants. People called in for questioning during Martin Act investigations do not have a right to counsel or a right against self-incrimination. Combined, the act’s powers exceed those given any regulator in any other state. 

In the wake of the dot-com crash, Eliot Spitzer used the Martin Act to subpoena Henry Blodget’s emails from Merrill Lynch and went on to extract a total of $1.4bn in settlements from Merrill and nine other Wall Street firms that had over-hyped Internet stocks. Other firms that have fallen foul of the Act include AIG, JP Morgan, Bank of New York Mellon and Ernst & Young.

Barclays is unlikely to put up much of a fight. Schneiderman’s announcement seems to have been timed to coincide with the two-year anniversary of Barclays’ settlements with British and American regulators over its role in the LIBOR scandal (which led to the resignations of both the Chairman and CEO), and comes barely a month after the company was fined by the FCA for failing to adequately manage conflicts of interest in relation to the London Gold Fixing.

Among the evidence presented by Schneiderman is a chart, taken from a Barclays marketing brochure, which claims to show the results of an analysis of the trading behaviours of participants in the Barclays LX pool (see right).

To quote the complaint:

36. Each circle in the chart represents one firm trading in Barclays’ dark pool. The  size of the circle corresponds to the level of trading activity conducted in the dark pool by that  firm. Different types of traders are assigned different color circles; the pale green circles are  “electronic liquidity providers” (“ELP”), which is the term Barclays used for high frequency traders. Within the chart are two color-coded regions, a green rectangle representing “passive” (i.e., safe, non-predatory) trading activity, and a red rectangle representing “aggressive” (i.e., predatory) trading. The x-axis, (“modified take percentage,” which is percentage of a trader’s orders that take liquidity), and the y-axis, (“1-second alpha,” which is the price movement in the one-second following each trader’s trades), are presented here as relevant measures of trading behavior on the dark pool.

37. The chart represents that very little of the trading in Barclays’ dark pool is  “aggressive.” As represented by the chart, most of the trading in the dark pool is “passive,” and  most of the ELP/high frequency activity is “passive.” In its entirety, the chart represents that Barclays’ dark pool is a safe venue with few aggressive traders.

38. Barclays’ sales staff heavily promoted this analysis to investors as a representation of the trading within the dark pool, and marketed that analysis as “a snapshot of the participants” in order to show clients “an accurate view of our pool.” In addition, certain Barclays marketing materials appended a notation to the chart explaining that it portrays the top 100 clients trading in the dark pool.

39. These representations were false. The chart and accompanying statements misrepresented the trading taking place in Barclays’ dark pool. That is because senior Barclays personnel de-emphasized the presence of high frequency traders in the pool, and removed from the analysis one of the largest and most toxic participants in Barclays’ dark pool.

Later in the complaint, the missing participant is identified as Tradebot Systems, a HFT firm. What’s missing from the complaint, however, is the original chart, showing Tradebot. I got curious, did some digging and turned up what I believe to be the original chart.

The 2012 chart clearly shows a large circle (marked X) representing a market participant whose size and position matches the complaint’s description of Tradebot as “the largest participant in Barclays’ dark pool, with an established history of trading activity that was known to Barclays as toxic.”

In the graph from Schneiderman’s complaint, the circle representing Tradebot appears to have shrunk and migrated to the left. You may also notice that a small purple (Internal) circle on the far right of the right-hand chart has been re-coloured blue (Institutional) on the left-hand chart.

According to emails quoted in the complaint (which appears to be largely based on the testimony of a whistleblower), Barclays justification for altering the chart is that it was intended to be a demonstration of Barclays’ ability to monitor and classify trading activity in the dark pool, rather than an accurate representation of the trading activity. Of course, it may yet emerge that the change reflected a real change in the nature of Tradebot’s trading (perhaps after having been challenged by Barclays) but, if that were the case, I would expect the rest of the chart to be updated as well..

A good rule of thumb when considering whether an action or behaviour is appropriate or not, is to imagine what would happen if it were observed by a tabloid journalist. If the journalist could come up with a headline and story that would be embarrassing to the firm, you need to rethink. With the current press focus on financial services, it’s not just enough to avoid breaking the law – banks must be whiter than white.

The whole incident is a setback to Barclays CEO Antony Jenkins’ mission to rebuild the bank’s reputation in the aftermath of the LIBOR scandal. The independent Salz_Review of Barclays after the LIBOR scandal found that there were “cultural shortcomings” and said that the bank needed to undergo “transformational change”.

Bringing about cultural change within financial services firms isn’t easy. Once a culture is established, it becomes self-reinforcing. Those who don’t conform get forced out. For the CEO, talking the talk – even walking the walk – is unlikely to be enough. Culture derives from people, and the processes and structures they form. Changing an organisation’s culture may well require disrupting the organisation first – replacing people, getting rid of the old ways of doing things, and ripping out old power structures, to make space for new ways of doing things. It’s not the sort of thing a CEO can direct from on high – he needs to roll his sleeves up and get his hands dirty.

It’ll be disruptive, it’ll be distracting and it’s be very expensive (both in direct costs and revenue opportunities that are missed during the disruption) but it’s what Antony Jenkins will need to do if he wants to bring about the transformational change Barclays needs.

Update: In February 2015, the judge presiding over the case ruled that the “chart is not materially misleading“, which effectively excludes it from evidence.