National Securities Corp., based in Seattle, WA, was also fined $300,000 and ordered to pay almost $300,000 in restitution to the funds that were affected by the deceptive market timing. In addition, National was ordered to revise its supervisory systems to correct supervisory and email retention deficiencies. National's president, Michael A. Bresner, was fined $25,000 and received a one- month supervisory suspension for the firm's supervisory failures. David M. Williams, the firm's former chief operating officer, also was fined $25,000 and received a four-month supervisory suspension.
"This is an example of a firm whose management totally ignored repeated red flags that its brokers were facilitating deceptive and improper market timing in mutual funds by hedge fund clients," said NASD Vice Chairman Mary L. Schapiro. "This failure, and the harm it caused to long term investors, combined with the failures of supervision warrant the extraordinary remedy of temporarily prohibiting the firm from opening new mutual fund accounts."
NASD found that from January 2001 through August 2002, National helped four hedge fund clients engage in deceptive market timing practices aimed at 13 mutual funds that had restrictions and prohibitions against these practices. The hedge fund clients transacted at least 1,000 mutual fund trades, totaling nearly $400 million, after National had received notices that the fund companies considered the timing strategy of the clients to be disruptive and contrary to the interests of long-term investors. These notices were ignored as the hedge fund clients reaped profits of approximately $300,000 at the expense of long-term investors. This conduct was contrary to the high ethical standards required by NASD rules.
Despite the issuance of multiple notices by the mutual funds demanding that the hedge fund clients stop market timing their funds, National failed to prevent them from continuing to trade the funds through deceptive means. For example, after an account was restricted by a fund for market timing, the hedge fund client would evade subsequent detection by shifting the prohibited activity to another brokerage account that it controlled. In a few instances, the hedge fund client continued to time the fund through the very same account that had been restricted by the fund company. This resulted in the issuance of additional notices or warnings until the account finally complied with the market timing restriction.
At least two of National's senior officers, Bresner and Williams, failed to ensure that the firm had an adequate supervisory system designed to prevent and detect deceptive market timing practices. They also failed to respond to red flags that pointed to the deceptive practices. Bresner, Williams and other supervisors received multiple notices from the affected funds directing that the hedge fund clients stop the market timing activity. Additionally, prospectuses and selling agreements for the mutual funds contained explicit restrictions or limitations on market timing. Instead of placing limitations on the evasive activities of the hedge fund clients, however, National assumed a hands-off approach with respect to their deceptive practices.
"Market timing" refers to the practice of rapid trading of mutual fund shares in order to exploit inefficiencies in the pricing of mutual funds. While not illegal per se, market timing raises transaction costs for fund companies, which diminishes investor returns. Rapid and repeated redemptions also can force fund managers to sell winning investments, and/or cause managers, anticipating frequent redemptions, to hold a larger cash reserve than necessary and desirable. Consequently, mutual funds often maintain policies and procedures to detect and prevent market timing.
Inadequate Supervisory System for Detecting Late Trading
"Late trading" refers to the practice of placing mutual fund orders after the fund has calculated its daily net asset value (NAV) - typically when markets close at 4 p.m. Eastern time - but receiving the price based upon that earlier, 4 p.m. calculation. Firms that permit late trades for select customers provide them with an information advantage - by allowing them to trade based on news that breaks after the market close that could affect the value of the mutual fund's holdings, but which is not reflected in the NAV for that day. SEC and NASD rules prohibit late trading to ensure that all purchasers of mutual fund shares are on equal footing as to price and information on any given day.
National, acting through Bresner, Williams and the firm's compliance officer, failed to develop or implement a supervisory system that was reasonably designed to prevent or detect late trading, despite the fact that selling agreements National had with various mutual funds required the firm to monitor such activities to ensure fair pricing. Moreover, the volume of market timing business in question created significant risk of late trading, and mutual fund orders underlying the market timing in question were repeatedly transmitted to National's trading desk in Seattle after 4:00 p.m. Eastern Time, raising red flags of improper late trading.
During its investigation, NASD also found that National failed to preserve and maintain internal e-mail communications relating to the firm's business, as required by the federal securities laws and NASD rules.
In settling these matters, National, Bresner and Williams neither admitted nor denied the allegations or findings. The investigation of individual brokers and others involved in the misconduct is continuing.
Investors can obtain more information about, and the disciplinary record of, any NASD-registered broker or brokerage firm by using 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 BrokerCheck at www.nasdbrokercheck.com. Investors can also access this service by calling 1-800-289-9999.
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