The NASD is poised to unleash a wave of enforcement actions against mutual fund firms for failure to supervise and implement systems and policies sufficient in preventing market timing and late trading, according to sources familiar with the matter.
This flurry of cases would not necessarily target firms for complicit deals with rogue investors trying to make a quick buck rapidly trading in and out of a fund or with those scoffing at the trading deadline at the closing bell. Rather, the enforcement actions would take aim at firms whose systems were not in compliance with federal securities laws and may have simply allowed for potential abuses.
The recent NASD case against Richmond, Va.-based broker/dealer Davenport & Co. largely focused on the misconduct of the firm. Davenport found itself in trouble for several reasons, the most highly publicized of which was helping some of its clients market time variable annuities. For its sins, Davenport was ordered to pay more than $288,000 in restitution and fined $450,000.
However, Davenport was also cited for a supervisory failure in relation to late trading at the firm, an inkling of things to come from the agency.
In the summer of 2002, Davenport changed its trading platform to the Beta System, and according to the settlement documents, the firm experienced problems with the new system following the conversion. Trying to nullify the effects of the disruptions it was having, the firm bumped the deadline for the system to accept mutual fund trades from 4 p.m. to 4:30 p.m.
"Firms have had a lot of administrative issues that they have to be aware of in processing," said Neil Lang, an attorney with Sutherland Asbill & Brennan, headquartered in Washington, and former chief trial attorney for the division of enforcement at the SEC. "Frankly, the SEC and the NASD have not paid much attention to this stuff in the past."
It appears that is all about to change. Tony Evangelista, a partner at PricewaterhouseCoopers in New York and a former assistant chief accountant in the SEC division of investment management, said using the "failure to supervise" theory to bring cases is an "option that's taken on momentum" at both the NASD and the SEC. "If you listen to folks at the SEC and NASD, they'll tell you that the enforcement pipeline is very robust," Evangelista said.
Nancy Van Sant, a partner at Miami-based law firm Sacher, Zelman, Van Sant, said regulators should have plenty of firms to bring actions against since, in general, no problem is unique. "About the only problem in the industry that is unique to a particular firm is when some broker is stealing customer money," Van Sant said. "The other stuff, if it's back-office related, tends to be endemic and systemic, and you find it across the street and not just in one house."
The Davenport Files
Davenport was having "processing issues" with the new system it put in place, explained Thomas J. McGonigle, partner at LeClair Ryan, headquartered in Richmond, Va., and a lawyer representing Davenport. "There are always bugs in a new system that have to be worked out. The system would go down for periods of time." The firm felt that one way to handle the traffic it was receiving in light of these systems problems was to extend the deadline by half an hour.
"When they did that, the people who made those decisions didn't focus on the fact that they had that 4 p.m. pricing issue they had to deal with. It was the best of motivations," McGonigle said, adding the firm was simply trying not to disadvantage its customers for issues it was having with its technology. But, some unintended consequences happened.
"The system didn't adequately capture the time of acceptance for some trades. When it came in after 4 o'clock, the system couldn't recognize post-4 p.m. trades and give them the next business day's price," McGonigle said. "There was nothing deliberate about it. It had nothing to do with facilitating market timing or anything like that."
However, the actions were illegal, according to the NASD. Between July 2002 and September 2003, the firm "routinely received trading instructions" after the close, and executed hundreds of those late trades as if they were placed before the 4 p.m. cutoff.
In addition to the delayed deadline, the NASD cites the firm for failing, in its written procedures, to instruct its employees that late trading is illegal. It also did not require employees to enter orders promptly upon receiving them or notify workers that modifying or canceling orders after the closing bell is illegal.
While Davenport may have been aiming to sidestep a problem, it was extremely misguided in its thinking. Evangelista said the firm's erred ways sound like a combination of a lack of oversight and unsuitable systems. "If you are going to have a business and run that business, you ought to have the capability to run that business in accordance with the federal securities laws."
A lot of firms have technology issues and deal with them in a legal manner, he said, adding that there are several ways to get around the technological or backlog problems. "But, to move the time by which you'll accept trades to 4:30, I don't think is a reasonable option."
The increased attention on strong systems and good compliance, however, should give firms yet another reason to self-examine, experts say. "I would think that most firms that are in this business now are having to take a hard look at their systems to make sure they don't have any elasticity in them so that market timing can be used against them," said Lee Pickard, a partner at Washington based Pickard & Djinis, and the former director of the division of market regulation at the SEC from 1973 to 1977.
uman factor" and better assessment of cultural integration.
Copyright 2004 Thomson Media Inc. All Rights Reserved.