NYSE Regulation, Inc., announced today that it has censured and fined Janney Montgomery Scott LLC (“Janney”), a member firm, $2.5 million for engaging in away-from-market stock loan transactions, making payments to finders who performed no legitimate business function, and related supervisory deficiencies and books and records violations.
“When a stock loan finder is inserted into a transaction without any business purpose, it directly harms the counterparties involved and increases the cost of stock lending,” said Richard G. Ketchum, chief executive officer, NYSE Regulation, Inc. “That’s what happened in this case against Janney Montgomery. In some instances, payments were made to relatives or friends who did nothing at all. Firms must have independent controls to verify that services paid for have actually been performed.”
In a typical stock loan transaction, one financial institution communicates with another and establishes the form and amount of the collateral, as well as the lending fee. The lender invests the cash collateral, retains part of the interest, and rebates the remainder to the borrower. When the securities are readily available, the lender keeps only a very small portion of the interest. Conversely, when the security is scarce or otherwise “hard-to-borrow,” the lender retains most or all of the interest. Supply and demand determine the price the borrower pays to borrow the stock.
Finders are third parties to stock loan transactions who, for a fee, assist a borrower or, less frequently, a lender, to locate a counterparty. Electronic mail and facsimile transmissions have eliminated, in most cases, the need for finders. The insertion of a finder in a transaction where the services of a finder were not required has the effect of unjustifiably increasing the cost of the transaction to the borrower and/or depriving the lender of income it might otherwise have received.
From January through December 2004, certain former employees of Janney’s stock loan department caused the firm to engage in certain stock loan transactions at away-from-market rebate rates that were disadvantageous to the counterparties to those transactions and made payments to finders who performed no legitimate business function in connection with the transactions.
In addition, the stock loan traders caused the firm to participate in several transactions referred to as “daisy chain” or “swing” transactions in which the traders entered into initial borrows (or loans) at below-market rebate rates, passed the securities through one or more broker-dealers in pre-arranged transactions at successively higher prices, and eventually re-borrowed (or reloaned) the same securities on the same day at higher rebate rates.
The difference between the below-market rebate rates at which the stock loan traders borrowed the securities and the higher rates at which they loaned the securities to the ultimate borrower is referred to as the “spread.” The effect of these “daisy chain” or “swing” transactions was that portions of the “spread” were diverted away from Janney to other firms participating in the transactions. There was no legitimate basis for the “daisy chain” or “swing” transactions. The effect of these transactions was to deprive the original lender of proceeds to which it was entitled and to redistribute those proceeds among all the other broker-dealers in the chain and any purported finder.
During this period, the stock loan department generated gross revenues of over $11.2 million and made a net profit, after compensation, of over $6.4 million. The firm paid 24 finders approximately $1.4 million in connection with stock loan transactions, even though it had no written agreements defining the services to be provided by the finders and the firm never received invoices for services rendered by any finder.
In certain of these transactions, there was no apparent justification for the payments, and the firm’s books and records do not include evidence or specific information reflecting that finders had in fact provided any services.
Janney generated revenues on every “daisy chain” or “swing” transaction, away-from-market stock loan transaction, and stock loan transaction on which it made a payment to a purported finder. In connection with certain transactions, the firm paid several finders as much as 500 to 1000 basis points when most finders would normally receive 25 basis points.
In some instances, these payments were made to purported finders who were relatives or friends of employees of Janney’s stock loan department and/or relatives or friends of the employees of the counterparties to the away-from-market stock loan transactions. The stock loan desk manager’s sister owned one finder firm that was paid approximately $220,000 during this period.
The firm failed to reasonably supervise the activities of its stock loan department in that it did not have adequate supervisory procedures to detect and deter these improper transactions. The firm’s supervisory procedures were inadequate in that they did not include any procedure to determine whether transactions were being effected at market rates or whether the payments to finders were legitimate.
In settling this matter, Janney also consented to an undertaking to record the telephone conversations of its stock loan department and retain the recordings for a period of no less than one year.
This disciplinary action concerned violations of Section 17(a) of the Securities Exchange Act of 1934 and Rules 17a-3 and 17a-4 thereunder, and NYSE Rules 342, 440 and 476(a)(6).
The violations were first detected by NYSE Regulation’s former Member Firm Regulation Division during special examinations that were then referred for further investigation to the Division of Enforcement. Former NYSE Regulation Enforcement staff that were responsible for this case have now transferred to the Financial Industry Regulatory Authority (FINRA).
In settling these charges brought by NYSE Regulation, Janney Montgomery Scott LLC neither admitted nor denied the charges.
