So you thought the market timing scandal was over. Think again. While nearly all the mutual fund shops nabbed in the Eliot Spitzer-led trading investigation have settled with regulators, brokerage firms are still being put through the wringer for their involvement in illicit trading activity. Individual brokers who were involved in abusive trading may also be punished.
NYSE Regulation, the regulatory arm of the New York Stock Exchange, handed down a stiff penalty to Smith Barney yesterday—a $50 million fine—for failing to supervise mutual fund and annuity trades, specifically market timing by its financial advisors, and failing to keep adequate books and records. Smith Barney neither admitted nor denied any wrongdoing as part of the settlement. But the firm did say, “We cooperated fully with the regulators and are very pleased to resolve these matters, all of which happened prior to September 2003. Since that time, we’ve completed the implementation of business practices around this issue that meet or exceed industry standards.”
According to NYSE Regulation findings, between January 2000 and September 2003, more than 150 brokers using 200 broker id numbers in 60 branches engaged in roughly 250,000 market timing exchanges in over 1,500 accounts on behalf of more than 1,100 customers. This activity generated approximately $32.5 million in gross revenues, according to the settlement documents. “That’s a lot more than we usually see,” says Linda Riefberg, vice president of enforcement at NYSE Regulation and lead attorney in the case against Smith Barney, referring to the number of brokers and branches involved in market timing practices. “Most of the cases focus on the main market timers, but in this case there was more widespread activity than in some of the other cases.”
Regulatory officials also say that there will be more settlements with brokerage firms, two of which will be announced within the next few months. And the individual brokers (Smith Barney and the others) may face separate charges for their conduct. “There is potential for more cases,” says Riefberg. “We continue, at the conclusion of a firm case like this, to look at individuals.” When asked if there would be additional firm-wide enforcement actions against Smith Barney for market timing, Riefberg said, “We’re not going to bring another case based on the same facts.”
The $50 million fine includes $35 million in disgorgement of ill-gotten gains, a $10 million penalty to be paid to the NYSE and a $5 million payment to the State of New Jersey related to a separate matter connected with the same conduct. The $35 million in disgorgement and half of the $10 million penalty will be placed in a distribution fund to reimburse harmed Smith Barney customers who invested in the affected mutual funds, according to the settlement.
The fines in these cases are determined by taking into consideration the frequency of the illicit trading, the amount of revenue gained from it, whether or not senior management was involved and whether there was late trading, an illegal offense. NYSE regulators determined that Smith Barney’s transgressions were worse than that of UBS, which settled for $49.5 million last year, but not as bad as other firms because they did have policies and procedures in place to stop market timers. Bear Stearns and Prudential Securities got hit with heftier fines from the NYSE, having paid $250 million and $270 million, respectively.
Unlike the SEC’s Fair Fund, NYSE Regulation doesn’t hold on to the money for distribution to harmed customers, rather the money is held in escrow by the firm. UBS is “far along” in the process of distributing reimbursements to market timing victims, Riefberg says but concedes that the process is time-consuming. The firms must work with an independent consultant approved by regulators to decide on whether to credit accounts, establish a claims process or some other method of reimbursement.
Market timing, while not illegal per se, can have an adverse effect on mutual fund shareholders by diluting the value of their shares, disrupting the portfolio manager’s strategy and incurring added costs for excessive trading. However, if financial advisors are using deceptive measures to conceal market timing, then it may violate securities laws. At Smith Barney, brokers put through hundreds of thousands of market timing trades, some of which were executed through deceptive practices, thus enabling them to avoid detection, NYSE Regulation says.
Among the nefarious practices employed by these reps included the improper use of multiple branch codes, multiple ID numbers, multiple customer accounts, multiple limited liability companies and multiple tax ID numbers just to name a few. A quid pro quo arrangement was also set up between the firm’s brokers and the market timers under which the clients agreed to pay the brokers higher fees. After receiving hundreds of complaints about the practice, Smith Barney stopped market timing in its proprietary funds by early 2002, but allowed it to continue in non-proprietary funds.
Despite having policies in place deterring such conduct, Smith Barney was not diligent enough to thwart their efforts, according to NYSE Regulation’s top cop. “The issuance of internal policies and memoranda is not enough: they must be effectively enforced. Actions must follow words,” said Susan Merrill, chief of enforcement, in a prepared statement.
For more on this topic, check out these stories, here and here: