SEC, NASD Sanction Knight Securities $79 Million for Fraud
Million in Fines, $41 Million in ill-gotten Gains, $13 Million in Interest
NASD Investigation Into Activities of Individuals Involved in Scheme Continues
December 16, 2004, Washington, D.C., - The Securities and Exchange Commission (SEC) and NASD announced today that Knight Securities, L.P., now known as Knight Equity Markets, L.P. will pay over $79 million to settle charges that it defrauded its institutional customers. Under this joint settlement, Knight will pay a $12.5 million fine to NASD and a $12.5 million civil penalty to the SEC. Knight is also ordered to pay $41 million in ill-gotten profits and $13 million in prejudgment interest into a Fair Fund established by the SEC for compensating harmed investors.
The SEC and NASD found that Knights former leading institutional sales trader priced trades in a manner contrary to customers expectations and industry custom, using deceptive trading practices to disguise his pricing and the amount of Knights profits.
Every firm has a fundamental obligation to trade honestly and fairly with its customers, regardless of the customers level of sophistication, said NASD Vice Chairman Mary L. Schapiro. Knights fraudulent trading, extracting millions of dollars of excess profits from its institutional customers for two years, requires the strong sanctions imposed here.
During 1999 and 2000, the sales trader generated a total of approximately $41 million in illegal profits for Knight executing orders from his institutional customers, including managers of mutual funds. The sales trader had Knight acquire a stock position after he received an institutional customers order, and then waited until the price of the stock moved before executing trades to fill the customers order, creating greater profits for Knight at the expense of his customer. If the price of the stock moved in favor of Knights position, the sales trader delayed executions and traded with his customers at prices reflecting the positive price movement. If the price of the stock moved against Knights position, the sales trader executed trades with customers based upon prices at an earlier time, which were more advantageous to Knight. His customers did not know when, or at what prices, Knight acquired stock pursuant to their orders, and the sales trader took advantage of that in trading with them, making tens of millions of dollars in excessive profits at their expense.
The SEC and NASD also found that Knight failed to adequately supervise the sales traders trading. The sales traders supervisor and the former head of Knights institutional sales department (the desk supervisor) was his brother. The brothers had a profit-sharing arrangement, approved by Knight, which gave the desk supervisor half of the sales traders trading compensation. This profit-sharing arrangement created an inherent conflict of interest with the desk supervisors supervisory responsibilities for the sales traders trading. While the sales trader was generating extraordinary profits in his trading with institutional customers, neither the desk supervisor nor anyone else at Knight conducted a meaningful review of the sales traders trading. No one in a supervisory role questioned the extraordinary profits that the sales trader generated, or undertook any steps to see how he was making them.
Knights institutional sales traders were also found to have reported thousands of trades improperly to the Automated Confirmation Transaction Service (ACT) during the period from April 2000 through March 2001. Knights traders improperly reported trades with .SLD modifiers (indicating a late trade report) and .PRP modifiers (indicating an execution that was supposed to have occurred earlier, based upon the price at a prior time) so Knights trading system would accept trades that were executed at prices different from the inside market at the time the trades were reported. Despite the long-running problem, Knight did not take reasonable steps to educate traders about the use of ACT modifiers, or enforce a system to prevent the improper ACT reporting. The SEC and NASD sanctioned Knight for these supervisory failures.
NASD also found supervisory failures by Knight over trading in proprietary back book accounts used by some of Knights employees for speculative trading. Traders received a higher percentage of profits generated in back book accounts than for profits in their market making accounts, giving them greater incentive to generate profits in the back book accounts. Knight did not have specific written supervisory procedures governing the use and supervision of those accounts.
In addition, NASD found that Knight had failed to produce documents in a timely manner to NASD during NASDs investigation. Knight also improperly reported to NASD that the desk supervisor and the sales trader had terminated their employment voluntarily, instead of advising NASD that they had been permitted to resign. The desk supervisor and the sales trader left Knight after the firm notified them that it wanted to terminate their employment. Knight filed forms with NASD (Form U5) wrongly advising NASD that their terminations had been voluntary.
Knight agreed to the
sanctions while neither admitting nor denying the allegations. NASDs investigation
into the activities of particular individuals involved in this matter is continuing.
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