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U.S. Securities and Exchange Commission

United States of America
before the
Securities and Exchange Commission

Securities Exchange Act of 1934
Release No. 48261 / July 31, 2003

Administrative Proceeding
File No. 3-11200


In the Matter of

DWARKA P. RATHI and
CHARLES H. PENNINGTON,

Respondents.


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ORDER INSTITUTING PROCEEDINGS PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934, MAKING FINDINGS AND IMPOSING A CEASE-AND-DESIST ORDER

I.

The Securities and Exchange Commission ("Commission") deems it appropriate that proceedings be, and hereby are, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Dwarka P. Rathi ("Rathi") and Charles H. Pennington ("Pennington").

II.

In anticipation of the institution of these administrative proceedings, Rathi and Pennington (the "Respondents") have each submitted an Offer of Settlement that the Commission has determined to accept. Solely for the purposes of these proceedings and any other proceedings brought by or on behalf of the Commission or to which the Commission is a party, and without admitting or denying the findings contained herein, except that the Respondents admit the jurisdiction of the Commission over them and over the subject matter of these proceedings, the Respondents consent to the issuance of this Order Instituting Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings and Imposing A Cease-and-Desist Order ("Order").

III.

The Commission makes the following findings:

RESPONDENTS

Dwarka P. Rathi, age 49, is a self-employed physician. He is an Indian citizen and resides in Scarsdale, New York.

Charles H. Pennington, age 39, has a Ph.D in physics and is a professor in the Department of Physics at The Ohio State University. Pennington resides in Columbus, Ohio.

IV.
FACTS

A. SUMMARY

The Respondents separately employed a fraudulent trading scheme designed to create artificial tax losses by executing, in the aggregate, 155 wash sales between taxable and tax-sheltered accounts. 152 of these wash sales were executed in the after-hours market. Each of the Respondents placed near-simultaneous matching limit orders to buy and sell the same security in their respective taxable and tax-sheltered accounts. Often these matching limit orders were placed at prices that were far away from the existing market price in order to create tax losses while still retaining ownership of the stock being traded. Each of the Respondents was able to match up his respective orders at artificial prices by choosing highly illiquid stocks and by trading those stocks in the less liquid after-hours market using the Island ECN — and thereby taking advantage of the fragmented nature of the after-hours market.

The Respondents each engaged in this scheme during the last quarter of 1999. Rathi and Pennington have no connection to each other and independently came up with the idea. Each of the Respondents acted on his own in making the trades described in this Order. Although they acted independently, the Respondents engaged in a similar scheme. In its basic form, the scheme called for each of them to maintain two on-line brokerage accounts with Datek Online Brokerage Services, LLC (which has since merged with Ameritrade, Inc.) — a regular taxable account and a tax-sheltered account such as an IRA or pension account. First, each of the Respondents typically acquired stock in the open market through his regular account. Next, after the market's 4 p.m. (EST) close, each electronically placed two, near-simultaneous limit orders to both sell the stock out of the taxable account and buy the same number of shares in the tax-sheltered account. At this stage, both limit orders were typically placed at identical prices that were significantly below the existing market price. Datek routed these limit orders through the Island ECN, which displays all unexecuted limit orders for a particular stock and matches up those placed on its system. Because each Respondent typically traded highly illiquid stocks and traded during the after-hours market, the Island usually matched up his matching limit orders. As a result of the wash trade, there was no real change in ownership. However, each Respondent had purportedly "sold" the stock in his taxable account for less than he had paid for it, thereby creating a short-term capital loss in that account. Later, he either sold the stock in the tax-sheltered account back into the market at the market price or continued to engage in a series of wash sales between his two accounts.

As a result of this strategy, during the fourth quarter of 1999, Rathi and Pennington created artificial tax losses in their taxable accounts of $221,698 and $77,662, respectively.

B. RATHI'S TRADES

Rathi engaged in 132 wash sales involving 28 different stocks from November 23, 1999 through December 23, 1999. Rathi executed 130 of these sales in the after-hours market. His transactions in K-Swiss, Inc. (KSWS) illustrate his scheme. On December 7, 1999, before the market closed, Rathi bought 500 shares of KSWS at the market price of $13 1/4 in his taxable account and bought another 500 shares of KSWS on December 8, 1999 at $13 in that same account. Thereafter, Rathi orchestrated four wash sales in the stock, as follows:

  • On December 10, 1999, after KSWS closed at $13 1/8, Rathi submitted a limit order to sell the 1,000 shares of KSWS in his taxable account at $12 1/8 and submitted a matching order to buy the 1,000 shares in his pension account at $12 1/8. These matching buy and sell orders were executed at 16:44:16.
     
  • On December 13, after KSWS closed at $ 14 9/16, Rathi submitted matching orders to sell the 1,000 shares of KSWS in his pension account at $15 3/4 and to buy 1,000 shares in his taxable account at $15 3/4. These matching buy and sell orders were executed at 16:36:02.
     
  • On December 15, after KSWS closed at 17 3/16, Rathi submitted matching orders to sell the 1,000 shares of KSWS in his taxable account at $13 3/8 and to buy 1,000 shares of KSWS at $13 3/8 in his pension account. These orders were executed at 18:53:00.
     
  • On December 16, after KSWS closed at 17, Rathi submitted matching orders to sell the 1,000 shares of KSWS in his pension account at $19 3/8 and to buy the 1,000 KSWS shares at $19 3/8 in his taxable account. These orders were executed at 19:25:02.

The following day, at 13:44:26, Rathi sold the 1,000 shares of KSWS in his taxable account into the open market at $17 5/16. For this series of transactions in KSWS, Rathi created losses of approximately $5,437 in his regular account and gains of approximately $9,625 in his pension account.

C. PENNINGTON'S TRADES

Pennington engaged in 23 wash sales with seven different stocks from October 29, 1999 through December 15, 1999. Pennington conducted 22 of these sales in the after-hours market. His wash sale scheme is illustrated by his trading in shares of Lincoln Bancorp (LNCB). On October 29, 1999, before the close of the market, Pennington bought 1,700 shares of LNCB in his taxable account at the market price of $11 1/8. Thereafter, Pennington executed three wash sales in LNCB, as follows:

  • On October 29, 1999, after LNCB closed at $11 3/16, Pennington submitted a limit order to sell the 1,700 shares of LNCB in his taxable account at $10 and submitted a matching order to buy the 1,700 shares in his IRA account at $10. These matching orders were executed at 17:05:48.
     
  • Less than five minutes later, at 17:10, Pennington submitted a limit order to sell the 1,700 shares in his IRA account at $14 and then submitted a matching order to buy the 1,700 shares in his taxable account at $14. These matching orders were executed at 17:13:04.
     
  • The next day, at 14:02:08, Pennington sold the 1,700 shares in his taxable account into the open market at the market price of $11 1/8.
     
  • On November 10, 1999, before the 4 p.m. close of the regular market, Pennington bought an additional 100 shares of LNCB in his IRA account at $12.
     
  • Later that day, at 18:55, after LNCB closed at $12, he submitted a limit order to sell 100 shares of LNCB at $16 in his IRA account and submitted a matching order, at 18:56, to buy 100 shares of LNCB at $16 in his taxable account. These matching orders were executed at 18:56:05.

The next day, Pennington sold the 100 shares of LNCB in his taxable account in the open market for $11 13/16. The total gains from these trades of LNCB in Pennington's tax-sheltered account are $7,200. The total losses from these trades of LNCB in Pennington's taxable account are $7,218.75.

D. RESULTS OF RESPONDENTS' SCHEME

As a result of this wash sale trading scheme, Rathi created losses of $221,698 in his taxable accounts and gains of $245,174 in his tax-sheltered accounts. Pennington created losses of $77,662 in his taxable account and gains of $74,940 in his tax-sheltered account. The prices at which the Respondents effected their wash sales were frequently outside of the prevailing bid/ask spread (or national best bid and offer — "NBBO") and also frequently represented either the highest or lowest price paid for the stock between 4 and 6:30 p.m. on the particular day in question.

Each of the Respondents typically traded the shares of relatively illiquid stocks. While Rathi traded stocks that were already in his account, Pennington typically scanned the stock page looking for low volume stocks to trade. Each of the Respondents typically also executed his wash sales during the after-hours trading market. Each Respondent chose the after-hours market due to the relatively lower volume of trading after the regular market close at 4 p.m. (EST). Each Respondent also placed his matching buy and sell limit orders close together in time. All of these factors were designed to maximize the likelihood that their matching limit orders would be paired so as to effect a wash sale.

The after-hours wash sales executed by the Respondents, along with the artificial prices at which they traded, were publicly reported as a result of NASD Rules 4632 and 6620, which obligated Island to report its participants' trades within ninety seconds of execution to NASDAQ through the Automated Confirmation Transaction Services. In a number of instances, the wash trades effected by the Respondents constituted the only after-hours trade in a particular stock. In other instances, the Respondents' trade constituted over 50 percent of the after-hours trading volume of a particular security.

V.
LEGAL DISCUSSION

Section 10(b) of the Exchange Act and Rule 10b-5 thereunder prohibit the use of "any manipulative or deceptive device or contrivance in connection with the purchase or sale of any security." Wash sale transactions involve no change in beneficial ownership and have long been recognized as manipulative devices within the meaning of Section 10(b). Edward J. Mawood & Co. v. SEC, 591 F.2d 588, 595 (10th Cir. 1979) (citing Ernst & Ernst v. Hochfelder, 425 U.S. 185, 206 (1976) and Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 476 (1977)).

The Respondents' wash sales created an appearance of market activity, were effected at contrived prices, and did not reflect the supply and demand for the stocks in which these individuals were trading. See In the Matter of the Application of Michael B. Jawitz, Admin. Proc. No. 3-9941, Securities Exchange Act Release No. 34-44357 (May 29, 2001); In re Sharon Graham, Securities Exchange Act Release No. 34-40727 (Nov. 30, 1998). In the aggregate, Rathi and Pennington separately placed 152 wash trades in the after-hours market, where a lower volume of shares is traded and where even the trading of a small number of shares can constitute a large percentage of the after-hours trading volume and have a disproportionate impact on the market by creating the appearance of false market activity. In a number of instances, the Respondents' wash trades constituted the sole or a majority of the after-hours activity in the stock. Furthermore, often the Respondents' wash trades were effected at prices away from the NBBO. Because of the Island's reporting obligation under the Automated Confirmation Transaction System, the trades were publicly reported to the market. Such information could have prompted investors to sell or purchase the stock, or refrain from taking any action, based on a misapprehension of the market activity represented by the wash sales.

Additionally, each Respondent engaged in the wash sale strategy for the purpose of manufacturing tax losses. Although none of them has claimed these artificial losses on his tax returns, each of them originally intended to claim the losses and thereby pay less tax than he was otherwise required to pay. The use of wash sales for this purpose is prohibited by Section 1091 of the Internal Revenue Code. I.R.C. § 1091. Furthermore, most of the gains each Respondent realized in his tax-sheltered account constituted contributions to that account that exceeded the annual contribution limits applicable to those accounts under the Internal Revenue Code. I.R.C. §§ 402(g) and 408A. As set forth in Section 2 of the Exchange Act, federal regulation of the securities markets is necessary to, among other things, "protect . . . the federal taxing power" by prohibiting practices intended to "hinder the proper appraisal of the value of securities and thus prevent a fair calculation of taxes owing to the United States and to the several States by owners, buyers, and sellers of securities . . . ." Exchange Act, Section 2(3).

VI.
FINDINGS

In view of the foregoing, the Commission finds that the Respondents violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.

VII.
ORDER

Accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act, that Rathi and Pennington each cease and desist from committing or causing any violation and any future violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.

By the Commission.

Jonathan G. Katz
Secretary

 

http://www.sec.gov/litigation/admin/34-48261.htm


Modified: 08/01/2003