SEC, NASD Sanction Knight Securities $79 Million for Fraudulent Sales to Institutional Customers
Herb Perone (202) 728-8464
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 Knight’s 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 Knight’s 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. “Knight’s 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 customer’s order, and then waited until the price of the stock moved before executing trades to fill the customer’s order, creating greater profits for Knight at the expense of his customer. If the price of the stock moved in favor of Knight’s 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 Knight’s 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 trader’s trading. The sales trader’s supervisor and the former head of Knight’s 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 trader’s trading compensation. This profit-sharing arrangement created an inherent conflict of interest with the desk supervisor’s supervisory responsibilities for the sales trader’s 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 trader’s 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.
Knight’s 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. Knight’s 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 Knight’s 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 Knight’s 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 NASD’s 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. NASD’s investigation into the activities of particular individuals involved in this matter is continuing.
Investors can obtain more information and the disciplinary record of any NASD-registered broker or brokerage firm through NASD's BrokerCheck. NASD makes BrokerCheck available at no charge to the public. In 2003, members of the public used this service to conduct more than 2.8 million searches for existing brokers or firms and requested almost 180,000 reports in cases where disclosable information existed on a broker or firm. Investors can link directly to the program by going online to http://www.nasdbrokercheck.com/. Investors can also access this service by calling 1-800-289-9999.
NASD is the leading private-sector provider of financial regulatory services, dedicated to bringing integrity to the markets and confidence to investors through effective and efficient regulation and complementary compliance and technology-based services. NASD touches virtually every aspect of the securities business — from registering and educating all industry participants, to examining securities firms, enforcing both NASD rules and the federal securities laws, and administering the largest dispute resolution forum for investors and registered firms. For more information, please visit our Web Site at www.nasd.com.