Charles Schwab & Co. agreed last Tuesday to pay $350,000 to settle charges that it improperly permitted investment advisor customers to alter mutual fund orders after the closing bell.

The San Francisco-based broker/dealer is accused of allowing customers that had their pre-close orders rejected, to buy into alternate funds after the market close, yet still receive that day's price. Fund orders received after the 4 p.m. Eastern close are supposed to receive the next day's price. Schwab says the original orders, which were all submitted prior to the market's close, were rejected by the firm's electronic trading system. However, the Securities and Exchange Commission, which brought the charges, said the original trades were not accepted because they were for funds that were closed to new investors or were placed by customers banned from purchasing shares in a particular fund.

To rectify the situation, Schwab allowed customers who had earlier failed purchase attempts, to submit a substitute order for a different mutual fund after the market close had passed, yet still receive that day's price. Often, the advisor submitting the original purchase was not notified that it was rejected until after the market close.

The settlement documents indicate the replacement orders were treated as if they were received at the same time as the originally rejected order, in violation of Rule 22c-1(a) of the Investment Company Act of 1940 and Schwab's internal policies.

The Commission contends that this practice took place hundreds of times between January 2001 and October 2003, when Schwab eventually halted the activity. However, in a release posted on its Web site, Schwab notes that the hundreds of occurrences were out of its more than 34 million mutual fund trades over that time period. Additionally, the instances were discovered by Schwab during an internal investigation that kicked off last fall and reported to the SEC by the firm. In October, the firm altered its cut-off policy.

Potential Abuse'

The Commission did not find that Schwab entered into any improper agreements or sought to circumvent internal controls, hence the small amount of the settlement. Rather, the fine was levied because Schwab exposed certain customers to potential abuses. "Although the SEC found that the practice at issue created a risk of potential abuse,' it did not find any instances where Schwab customers or employees actually placed trades based on the use of post-close market information," Schwab wrote in a release.

Furthermore, Schwab pointed out that the SEC concluded the substitutions "were not the product of any formal or informal agreements" and that "Schwab personnel did not receive any additional compensation in exchange for processing the substitute orders." The SEC also found that senior management at Schwab was unaware of the practice.

However, the SEC found that during the period in question, supervisors at Schwab's services to institutional managers unit trained traders in that group that these types of substitutions were allowed. "Schwab failed to ensure that their personnel knew and understood the mutual fund pricing rules," said Marc Fagel, assistant district administrator for the SEC's San Francisco office.

The firm's internal controls prevented senior management from learning of this policy, according to the settlement. "The Commission requires diligent compliance with mutual fund pricing restrictions to maintain fairness to all mutual fund investors," said Helane Morrison, district administrator for the SEC's San Francisco office. "Schwab's improper practices created an unacceptable risk that certain customers would be disadvantaged."

Schwab has also enhanced its mutual fund processing systems, policies, procedures and internal controls. The firm has restructured and reorganized the trading functions at its services to institutional managers unit so that it can better oversee order-processing activity. It has also increased the documentation and reporting of mutual fund trade-processing activity, in addition to issuing supplemental training for its mutual fund related workers.

Intense Scrutiny

While the Schwab settlement is not anywhere near the same magnitude or in the same league as the monumental deals seen from the likes of Janus Capital, Putnam Investments, Invesco Funds and Bank of America, it does illustrate the impact the trading scandal has had on all the firms in the industry as well as the intense scrutiny regulators have placed squarely on the backs of those in the fund industry.

While the circumstances in each case are different and vary in degree of egregiousness, there is a common theme among firms that were fined not for their complicit participation in illegal trading activity, but rather for their failure to maintain proper controls.

In February, State Street Research (SSR), a unit of MetLife, was slapped with a $1 million fine and ordered to pay shareholders more than $500,000 in restitution by the NASD for failing to do enough to prevent market timing. SSR was not charged with being in cahoots with timers. However, the firm was accused of having inadequate supervisory systems in place, which allowed timers to circumvent the rules.

In the SSR case, the firm had sufficient reason to believe certain clients were simply using new accounts to market time certain funds once timing activity was stymied in other accounts but did not do enough to prevent the activity.

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