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December 16, 2004 Dow Jones WebReprint Service®
Head of the Line
Client Comes First?
On Wall Street,
It Isn't Always So
Investing Own Money, Firms
Can Misuse Knowledge
Of a Big Impending Order
Mischief in the 'Back Books'
By ANN DAVIS
Staff Reporter of THE WALL STREET JOURNAL
When a mutual-fund company asked brokerage firm Knight Securities to get it 600,000 shares of a fiber-optic stock, traders at Knight quickly swung into action.
A half-dozen traders â figuring the big order would push up the price of the stock â quickly began buying some for accounts that benefited their firm and themselves, according to testimony in a National Association of Securities Dealers arbitration.
The buying may have affected the price the client ultimately had to pay for the stock, JDS Uniphase, according to people familiar with the trading records. They say the traders in some cases sold their newly bought stock to the client, Oppenheimer Funds. According to testimony, it was sold to the client at a markup, a move that may have taken money out the pockets of mutual-fund shareholders.
The NASD's regulatory arm has examined Knight's trading from the period in question, March 2001, and other periods. It and the Securities and Exchange Commission are expected to levy a penalty against Knight soon. Knight, which has since changed management, testified that the trades weren't improper, didn't disadvantage the client, and followed typical industry practice. Oppenheimer declined to comment.
The incident points to one of the hardest-to-eradicate conflicts of interest on Wall Street. Securities laws generally require brokerage firms to put the client first. But it's an open secret that they or individual traders sometimes take advantage of their role as middleman to profit, at clients' expense, from what they know about clients' investing intentions.
The potential harm to investors has risen as securities firms step up so-called proprietary trading: investing the firm's own money in stocks, bonds or other instruments. Firms say they have firewalls to divide this trading from operations that pick up sensitive client information. But pressure to relax those barriers has grown as margins have shrunk in Wall Street's traditional business of handling trades. Commissions on big institutional trades, once 15 cents a share, now are less than a nickel.
To compensate, securities firms increasingly look to proprietary trading. Analysts estimate that business provides 10% of profits at many top firms, and 20% or more at Goldman Sachs Group Inc., double the percentage five years ago. Goldman declines to comment on the figure.
Most proprietary trading is quite legitimate. But traders are constantly learning about major clients' investment plans â big enough plans to move markets. And though it's clearly illegal to misuse this knowledge, some on Wall Street "have come to believe it's their God-given right to use information about orders to make money," says Mark Loehr, former co-head of Schwab Soundview Capital Markets, now part of Switzerland's UBS AG.
One area where abuses can occur is in prearranged securities sales.
Some firms in the brokerage business are essentially "just paying an entry fee to get access to a lot of smart people," said David Williams, who runs a trading firm that serves as an alternative to big Wall Street brokers, at an industry panel last spring.
The SEC hasn't weighed in yet on some of the most controversial proprietary-trading activities. But as part of a stepped-up review of Wall Street conflicts of interest, it has asked firms for their internal reports on any incidents involving potential misuse of client data, according to Wall Street legal officials.
Several kinds of brokerage behavior potentially harmful to clients have grown more pervasive in recent years, according to traders, firms' compliance officials and regulatory cases. Here are three of them:
Trading Ahead
Sometimes, brokers fill a customer's order only after making their own trades in the same security. Doing so, called trading ahead, delays execution of the order and leaves the client vulnerable to price swings, at a time when its order should have already been satisfied. Trading ahead may be for the benefit of a securities firm or an individual broker or trader at the firm.
This year, the New York Stock Exchange censured Goldman Sachs and one of its former brokers, Karl Zachar. It said his trading resulted in potential gains for himself of over $600,000 "to the detriment of Firm customers."
Mr. Zachar, as part of a high-profile team in Boston, helped manage billions of dollars for hundreds of wealthy clients. With some of this money, 30 to 40 of the clients authorized Goldman to make discretionary investments in securities.
Mr. Zachar sometimes placed trades with a Goldman trading desk but waited several hours to identify for whom he was acting, according to the NYSE regulatory actions. The exchange said he used this tactic for five months ended in May 2001, enabling him to allo-cate trades that came out well to himself or his family, and less-favorable ones to clients.
Goldman and Mr. Zachar settled the NYSE actions without admitting or denying wrong-doing. Goldman paid a $175,000 fine. It says it fired Mr. Zachar after discovering his trading activity. Mr. Zachar, who didn't respond to phone calls or an e-mail, was barred from the securities business for 15 months.
A person familiar with the case says Goldman later told clients it was crediting them for "incorrectly booked" trades. Goldman says that "any clients who potentially suffered harm were made whole" and that what happened with Mr. Zachar isn't relevant to its trading practices with institutional clients.
A broker's job, in effect, is to stand in line for a customer to get sought-after merchandise. But it's easy to take some of that merchandise for oneself first â and hard for a client to know when this has happened. Even when regulators catch up with such behavior, the penalties sometimes are light.
In a case brought this year, the NASD cited five instances in May 2002 when Cantor Fitzgerald filled stock orders on the Nasdaq for its own account while it left the clients who wanted to make the same trade exposed to potential market swings. One client had to wait seven minutes â a long time in an electronic market â for its order to be filled.
In this instance, the Cantor customers still got the price they had sought. So the NASD levied a fine of just $8,000 for that portion of a broader case, says Steve Luparello, a market-regulation official with the NASD. Cantor declined to comment.
In September, the NYSE censured Royal Bank of Canada's RBC Dain Rauscher brokerage unit for entering proprietary orders for itself while it had client orders that weren't yet filled. The NYSE fined RBC $80,000 for that and other violations occurring in 2001 and 2002. RBC declined to comment.
The NASD in recent months has moved to tighten rules concerning self-dealing when filling client orders. It has suggested that the SEC bar firms from allocating better prices on a given trade to themselves rather than to a client, even if the client ends up getting the price it wanted.
Predicting Trades
Some securities firms use sophisticated analysis and software to try to anticipate customer moves and profit from that knowledge before customers act.
Firms or individual traders sometimes know about stock positions that clients have built up, as well as when these clients periodically reassess their holdings. The traders some-times make educated guesses as to what such a client will do next and try to jump into the market ahead of time. "Pre-hedging," this tactic is sometimes called.
This can benefit a client if the firm is merely buying stock to be in position to fill an anticipated order. But if the securities firm is buying for its own account, the client may end up the loser, later getting a poorer price than otherwise.
The problem often arises when an institutional client asks several brokerage firms to bid on a big trade it is planning, without disclosing the actual transaction. There's a lag before the client actually places the order. In the meantime, the brokers approached have some idea of what's about to happen.
In April 2002, a fund manager contacted Deutsche Bank AG to sound out its interest in handling a large stock trade. The manager wanted to know how much the bank's Morgan Grenfell securities unit would charge to handle a trade on the London Stock Exchange of £65 million, or about $125 million, worth of stocks, according to a regulatory order. The money manager was soliciting a "blind bid." It provided limited information, including that the trade would involve 55 stocks in the FTSE 100 Index. Until the money manager chose a broker, it wouldn't identify the stocks or say whether it was a buyer or a seller.
But Morgan Grenfell traders correctly guessed the identities of seven stocks and that the fund manager was going to buy them, says the regulatory order, from the U.K.'s Financial Services Authority. It says that for 18 minutes before Morgan Grenfell won the bid, its traders â armed with the belief that a big buyer was poised to push up demand for those stocks â purchased them for its own account. Their actions drove one issue, Daily Mail & General Trust, 10% higher before the client's order for that stock was filled, says the FSA.
