The firms are required to comply with certain undertakings, including the retention of an Independent Compliance Consultant to review procedures at the firms and issue a report to the firms, the SEC and the NYSE; the retention of an Independent Distribution Consultant to administer the distribution of the $250 million in disgorgement and penalty; the provision of effective training and education to certain directors, officers and employees at BSSC; the maintenance of a compliance and oversight infrastructure at BSSC; the establishment of a Compliance Hotline; and written certifications by the firms’ presidents that the firms are in compliance with the undertakings and with the recommendations of the Independent Compliance Consultant(s).
“It is disturbing how so many people in so many different units worked together to circumvent the blocks and restrictions set up by the mutual funds,” said Richard G. Ketchum, chief executive officer, NYSE Regulation, Inc. “By using deceptive practices, Bear Stearns enabled their clients to generate hundreds of millions of dollars in profits at the expense of mutual fund shareholders. This type of behavior is completely outrageous and unacceptable.”
“Once again, the NYSE is compelled to remind member firms that they must be diligent in detecting and preventing deceptive market timing and late trading in their mutual fund trading business,” said Susan L. Merrill, chief of enforcement, NYSE Regulation, Inc. “Firms that facilitate or tolerate such abuses do so at their own peril.”
This disciplinary action concerned violations of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 thereunder, Section 15(c) of the Exchange Act and Rule 15c1-2 thereunder, Section 17(a) of the Exchange Act and Rule 17a-3(a)(6) thereunder, Rule 22c-1(a), as adopted under Section 22(c) of the Investment Company Act, and NYSE Rules 401, 440 and 476(a).
This case involves two types of improper mutual fund trading practices: late trading and deceptive market timing. BS&Co. is an introducing broker-dealer whose customers buy and sell securities. BSSC is a clearing firm that clears trades for BS&Co., other introducing brokers and prime brokerage customers. Between 1999 and 2003, the firms facilitated a substantial amount of late trading and deceptive market timing.
“Late trading” is the practice of placing orders to buy, redeem, or exchange mutual fund shares after the time as of which mutual funds calculate their net asset value (“NAV”), typically 4:00 p.m., but receiving the price based on the prior NAV already determined as of 4:00 p.m. Rule 22c-1(a) of the Investment Company Act (the “forward pricing rule”) prohibits late trading. Late trading enables the trader improperly to obtain profits from market events that occur after 4:00 p.m., such as earnings announcements and futures trading, that are not reflected in that day’s NAV. By being able to late trade, customers of Respondents and correspondent firms obtained trading advantages over the other shareholders of the targeted mutual funds.
“Market timing” includes the frequent buying and selling of shares of the same mutual fund or buying or selling mutual fund shares in order to exploit inefficiencies in mutual fund pricing. Market timing can harm other mutual fund shareholders because it can dilute the value of their shares. Market timing, while not illegal per se, can also disrupt the management of the mutual fund’s investment portfolio and cause the targeted mutual fund to incur considerable extra costs associated with excessive trading and, as a result, cause damage to other shareholders in the funds. Market timing is illegal if deception is used to induce a mutual fund to accept trades that it otherwise would not accept under its own market timing policies.
At BS&Co., certain brokers in the Private Client Services Division (“PCS”) facilitated improper mutual fund trading by knowingly processing large numbers of late trades for certain market timing customers, predominantly large hedge funds, and by helping market timing hedge funds evade detection by mutual funds that did not want market timing business. Upon detecting market timing trades, mutual funds often blocked further trading by market timers by reference to the available identifying information accompanying the trade, such as the account number, registered representative (or “RR”) number or branch code. To evade these blocks, BS&Co. took affirmative steps to hide from mutual funds the identity of customers that were known market timers by, for example, assigning multiple account numbers to customers so that the mutual funds could not identify them as customers whose trades they had previously blocked, or by assigning multiple RR numbers to registered representatives at BS&Co. to try to conceal the identity of the traders.
BSSC, the clearing firm, cleared all of these trades through its Mutual Funds Operations Department (the “MFOD”), the department within BSSC that was responsible for all mutual fund clearing. In addition to clearing trades for customers of the PCS brokers, BSSC cleared trades for prime brokerage customers (i.e., hedge funds that cleared trades directly through BSSC) and for customers of its correspondent firms (i.e., introducing brokers that cleared customer trades through BSSC). BSSC facilitated deceptive market timing by its prime brokerage customers and customers of its correspondents by providing them with deceptive devices, such as multiple account and RR numbers, and alternative branch codes, to avoid detection by mutual funds.
At the center of BSSC’s mutual fund clearing operation was the MFOD “timing desk,” which the MFOD established in 1999 to manage the increasing flow of market timing trades through BSSC. Part of the purpose of the timing desk was to monitor and block accounts from trading in mutual funds that did not want market timing trades. But, in practice, the timing desk employees and their supervisors acted as consultants and troubleshooters for the PCS brokers, BSSC’s correspondent firms and BSSC’s prime brokerage customers engaged in market timing and late trading. The timing desk helped timers negotiate BSSC’s own blocking system and evade the blocks and restrictions imposed by the mutual funds, and, helped customers and their brokers understand how to ensure that their rapid mutual fund trades would not be detected by the mutual funds. The timing desk also knowingly processed thousands of late trades.
In settling these charges brought by NYSE Regulation, Inc., Bear, Stearns & Co., Inc and Bear, Stearns Securities Corp. neither admitted nor denied the charges.
About NYSE Regulation, Inc.
NYSE Regulation, Inc., is a not-for-profit corporation dedicated to strengthening market integrity and investor protection. A subsidiary of NYSE Group, Inc., NYSE Regulation’s board of directors is comprised of a majority of directors unaffiliated with any other NYSE board. Each director must also be independent from member organizations and listed companies. As a result, NYSE Regulation is independent in its decision-making.
NYSE Regulation protects investors by regulating the activities of member organizations through the enforcement of marketplace rules and federal securities laws. NYSE member organizations hold 98 million customer accounts or 84 percent of the total public customer accounts handled by broker-dealers. Total assets of NYSE member organizations are over $4 trillion. They operate from 20,000 branch offices around the world and employ 195,000 registered personnel. NYSE Regulation also ensures that companies listed on the NYSE and on NYSE Arca meet their financial and corporate governance listing standards.
NYSE Regulation consists of four divisions: Market Surveillance, Member Firm Regulation, Enforcement and Listed Company Compliance, as well as a Risk Assessment Unit and Dispute Resolution/Arbitration. For more information, visit our website at www.nyseregulation.com.
View the Hearing Panel Decision (pdf).
