NASD Fines Davenport & Co. In First Case Of Deceptive Market Timing In Variable Annuities
Washington, D.C.—In the first case ever brought against a broker-dealer for facilitating deceptive market timing in variable annuities, NASD announced today that it has fined Davenport & Co. LLC of Richmond, VA $450,000 and ordered the company to pay more than $288,000 in restitution to the affected funds. The fine also includes Davenport's failure to establish and maintain a reasonable supervisory system and written supervisory procedures designed to prevent late trading of mutual funds.
"Deceptive market timing in variable annuity sub-accounts can dilute the value of those shares, raise transaction costs and thus harm other annuity investors," said Mary L. Schapiro, Vice Chairman of NASD. "This is an improper and objectionable trading practice that rises to a higher level of abuse when the firm not only knows that its clients intend to deceive the variable annuity companies, but is complicit in carrying out that deception."
From at least April 2002 through September 2003, Davenport helped two hedge funds carry out deceptive market timing in the sub-accounts of variable annuities. The brokers handling the accounts and managers at the firm were aware that the clients were engaging in market timing techniques and that the annuities' prospectuses stated that they were designed for long-term investors, and not for professional market timers. Nevertheless, Davenport enabled these clients to carry out frequent transfers among variable annuity sub-accounts without being detected by the affected insurance companies and mutual fund managers, who were attempting to enforce restrictions on market timing to protect the interests of long-term investors.
Moreover, Davenport continued to sell variable annuity policies to the clients' investment partnerships even after receiving notice that some of the variable annuity companies considered the clients' trading strategy to be disruptive and contrary to the interests of long-term investors. As a result, Davenport's clients were able to realize profits in excess of $288,000, at the expense of long-term investors. This conduct was contrary to the high ethical standards required by NASD rules.
For example, one of the hedge fund clients purchased a Western Reserve Life "Freedom Access" annuity on June 10, 2002. The limited partnership engaged in market timing in the sub-accounts of the Freedom Access annuity until, on July 26, 2002, Western Reserve Life required all future transfer requests to have an original signature and to be transmitted by standard United States postal delivery service. In a letter, Western Reserve Life cited concerns about the "disruptive" effects of the market timing and transfers of "very large dollar amounts." Western Reserve Life's action had the practical effect of precluding continued market timing, since market timing cannot be accomplished effectively without the ability to trade rapidly.
After one of the Davenport brokers informed the client that its market timing activity had been restricted, the client instructed that Davenport broker to submit an application using a different entity and tax identification number. An email from the client to the Davenport brokers dated July 26, 2002 stated:
We will plan on liquidating. Also, let's put them [Western Reserve Life] on our hit list once we get the new investment partnership set up with the new tax ID and registration. We would like to get back in there ["smiley face" icon omitted].
On October 31, 2002, Davenport purchased another Western Reserve Life "Freedom Access" annuity on behalf of another hedge fund managed by the same client, with a virtually identical name and a different tax identification number. Davenport did not disclose the fact that the new account was managed by the same investment advisor that had previously been restricted by Western Reserve for engaging in market timing, that the investment partnership would be engaging in the same type of excessive market timing, or that the client had put Western Reserve Life on a "hit list" for such improper trading activity. Davenport's client then engaged in market timing in the sub-accounts of the Freedom Access annuity using the new account until it, too, was detected by Western Reserve Life and similarly restricted.
Davenport similarly facilitated deceptive practices by its hedge fund clients regarding variable annuities offered by other insurance companies, agreeing to change the annuitants, brokers of record, or the particular name of the hedge fund on the account in order to evade the attempts of the insurance companies and mutual funds to detect and prevent excessive market timing.
Davenport was also cited for supervisory deficiencies regarding excessive market timing. After April 2002, Davenport received at least 10 letters from insurance companies expressing concern about excessive trading in the sub-accounts of variable annuities and restricting the trading in annuities held by Davenport's clients. Davenport management did not take effective steps to stop market timing activity on the part of its representatives or clients. Davenport in fact had no clear procedure to ensure that designated departments or personnel would receive copies of these letters from insurance companies. Davenport's supervisors also failed to respond to clear "red flags" that would have alerted them to the improper practices carried out by the hedge fund clients and Davenport's brokers - such as references in emails by those brokers and their clients to using different entities with different account numbers, tax ID numbers, and annuitants in response to letters from insurance companies.
Failure to Supervise Late Trading
Late trading occurs when a broker-dealer receives and executes mutual fund orders after 4 p.m. Eastern Time, without observing the "forward pricing" requirements of Section 22(c) of the Investment Company Act of 1940, and Rule 22c-1. Beginning on or about July 2002, Davenport converted its trading platform to a new system. In an effort to lessen the impact of certain disruptions associated with the conversion, the firm decided to set the new system to accept mutual fund trades until 4:30 p.m. Eastern Time. During the 30-minute period after the close of the market, the firm placed no restrictions on the ability of its representatives to enter orders, regardless of when such orders were received. This permitted and enabled Davenport's retail customers to enter trades after the close of the market at the previous day's net asset value (NAV).
Despite these opportunities for late trading presented by Davenport's flawed system, the firm did not establish, maintain or enforce any reasonable procedures to prevent such misconduct. In fact, the firm's written procedures did not even instruct representatives that late trading was prohibited. The firm's written procedures also did not require representatives to enter orders promptly after receipt, nor did they prohibit the cancellation and modification of orders after the close of the market, thereby enabling the firm's customers to potentially manipulate their mutual fund trading activity based on information received after the close of the market.
Between at least July 2002 and September 2003, Davenport routinely received trading instructions from customers after 4 pm EST and executed those trades as if the instructions had been received prior to 4 p.m. EST. On hundreds of occasions, trades received and executed after 4 p.m. EST received the previous day's NAV.
In settling these matters, Davenport neither admitted nor denied the allegations or findings. The investigation of individual brokers and other entities involved in this market timing activity is continuing.
Investors can obtain more information about, and the disciplinary record of, any NASD-registered broker or brokerage firm by calling NASD's BrokerCheck. NASD makes available BrokerCheck at no charge to the public. In 2002, members of the public used this service to conduct more than 2.5 million searches for existing brokers or firms and requested almost 200,000 reports in cases where disclosable information existed on a broker or firm. Investors can link directly to the program by going online to www.nasdbrokercheck.com. Investors can also access this service by calling 1-800-289-9999.
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