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NYSE Regulation, Inc. announced today that, as the result of parallel regulatory action with the U.S. Securities and Exchange Commission (“SEC”), the United States Attorney's Office for the District of Massachusetts, the Massachusetts Securities Division, NASD, the New Jersey Bureau of Securities, and the New York Attorney General’s Office, it has censured and ordered Prudential Equity Group, LLC (formerly known as Prudential Securities, Inc.) of New York, New York (“Prudential”), a member firm, to disgorge $270 million, which shall be satisfied via payment in the related SEC proceeding, for fraudulent market timing in connection with the trading of mutual fund shares. Prudential is also required to retain an Independent Distribution Consultant to administer the distribution of the disgorgement funds.
“It is absolutely unacceptable to see the level of knowledge and acquiescence by senior managers of such pervasive deception by Prudential’s market-timing brokers,” said Susan L. Merrill, chief of enforcement, NYSE Regulation, Inc. “The disgorgement of $270 million will compensate the funds’ shareholders. The action is also evidence of tremendous cooperation by securities regulators working together to ensure that a brokerage firm cannot profit from condoning fraud.”
Pursuant to a global settlement with the SEC, Prudential has been ordered to pay a total of $600 million. Under the terms of the global settlement, $270 million will be paid to a distribution fund administered by the SEC for the benefit of those harmed by the fraud, $325 million will be paid to the U.S. Department of Justice, and $5 million will be paid as a civil penalty to the Massachusetts Securities Division.
“Market timing” includes frequent buying and selling of shares of the same mutual fund or buying or selling of mutual fund shares in order to exploit inefficiencies in mutual fund pricing. Though not illegal per se, market timing can harm mutual fund shareholders because it can dilute the value of their shares, if the market timer is exploiting pricing inefficiencies, or disrupt the management of the mutual fund’s investment portfolio and can cause the targeted mutual fund to incur costs borne by other shareholders to accommodate frequent buying and selling of shares by the market timer.
To prevent market timing, mutual funds have placed restrictions on excessive trading in their prospectuses and monitor for excessive short-term trading by reviewing brokers’ and customers’ account numbers, trade size, principal amount, and branch codes.
From September 1999 and continuing through at least June 2003 brokers at Prudential (including brokers in its New York City, Garden City and Boston offices) used deceptive trading practices to conceal their identities, and those of their hedge fund customers, in order to evade prospectus limitations on market timing. At least 50 mutual funds and their long-term shareholders were defrauded. The firm profited from this misconduct because the brokers generated approximately $50 million in gross commission revenues as a result of this misbehavior.
The deceptive practices included the use of: 1) multiple broker identifying numbers; 2) multiple customer accounts; 3) accounts coded as “confidential”; and 4) “under the radar” trading. The practice of “under the radar” trading refers to the splitting of one trade into numerous smaller ones to avoid detection.
As early as the fourth quarter 1999, several mutual fund companies identified the use of deceptive trading practices and notified Prudential. In May 2002, the firm itself determined that its top-producing broker used deceptive practices to avoid notice by mutual funds. Ultimately, the firm received hundreds of notices from mutual fund companies that identified the misconduct and asked Prudential to take steps to curtail the activity.
Despite increasing awareness of the brokers’ fraudulent activities, including internal e-mail and notifications to and from senior officers, the firm elected to continue the business of market timing. Instead of disciplining or sanctioning any of the brokers, or even curtailing their ability to open additional accounts for their market timing customers, Prudential failed to prevent their misconduct from continuing and actually began to track the brokers’ gross revenues.
For example, in 2001, the brokers generated more than $16 million in gross commission revenues for the firm, most of which was in danger of being eliminated had the firm phased out market timing at that time. Similarly, approximately $23 million in gross commission revenues were generated in 2002, and comparable revenues continued to be generated until June 2003.
The firm’s policies and procedures were ineffective and largely not enforced. Even in situations where the firm purportedly enforced any of these policies, its senior officers undermined the policies by granting exceptions for the largest producing brokers. Additionally, Prudential repeatedly failed to prevent the inappropriate use of hundreds of broker identifying numbers, even though the use of multiple numbers was the primary means of concealment by which the brokers carried out their fraud. Prudential finally issued a market timing policy in January 2003, but the firm did not fully enforce procedures in that policy to end the scheming.
The regulatory action announced today also requires the firm to retain an independent distribution consultant who will develop a proposed plan for the distribution of the disgorgement ordered in this decision, and any interest or earnings thereon. After SEC approval of a final plan of distribution, the consultant shall take all necessary and appropriate steps to administer the final plan for distribution of the funds. To access the full text of Hearing Board Decision No. 06-156, click here .
This disciplinary action concerned violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 thereunder, Section 17(a) of the Exchange Act and Rules 17a-3 and 17a-4 thereunder, and NYSE Rules 342, 401, 476(a)(5) and 476(a)(6). In settling these charges brought by NYSE Regulation, Inc., Prudential Equity Group, LLC neither admitted nor denied the charges.
