On trading desks across the country, the video screens of Nasdaq computer terminals glow with stock symbols and price quotes, displaying the list of market makers who deal in each stock and the prices at which they stand ready to buy or sell shares.
Federal regulation--what's known as the "firm quote rule"--requires market makers to honor the prices they display.
But Nasdaq market makers often do not.
Through Oct. 4, traders had filed 4,748 complaints this year alleging Nasdaq market makers "backed away" from their obligation to trade at posted prices. Over several months, a reporter visiting various trading desks witnessed more than two dozen instances in which market makers at least appeared to renege on this duty.
Backing away leaves small investors to buy at higher prices or sell shares for less than the posted quotes. And interviews with traders and officials of the National Assn. of Securities Dealers, which operates Nasdaq, as well as examination of scores of formal backing-away complaints, strongly suggest that the NASD is doing little to stop the practice.
While James M. Cangiano, the NASD's executive vice president for market surveillance, insists the group takes backing-away complaints "very, very seriously," the NASD confirms that it has taken no public action in response to any of the complaints filed this year.
Indeed, firms accused of backing away--and the NASD itself--contend that the vast majority of complaints are frivolous. NASD officials deny that backing away is widespread and note that most complaints are filed by a group of small, maverick market makers who, they contend, are simply out to harass the big, established market-making firms.
Selling at posted prices would seem to be a fundamental element of a stock market's operations. But just as Nasdaq's fragmented trading system often fails to make the market's best prices available to small investors, backing away means investors often aren't getting the market makers' quoted prices, either.
"It's like you go into a store and this has a $3 price tag on it," said Phillip A. Dina of Dina Securities in Wayne, N.J., picking up a tape dispenser from his desk to make the point. "What would you do if you walked up to the counter with it and the lady said, 'Oh, no, it's now $3.25'? That's what happens on Nasdaq all the time."
Veteran traders say backing away occurs because, with little risk of serious penalty, it enables market makers to pick and choose who they want to trade with. It also lets them concentrate on making money by buying and selling for their firms' own accounts, rather than honoring their obligation to trade with all comers.
Though the larger Nasdaq stocks--such as Apple Computer, Microsoft and MCI--have many market makers, few of the dealers are really interested in trading actively at any given moment, market professionals say. Most "are just interested in trading their own accounts," said Robert M. Gintel, chairman of the Gintel Group of mutual funds.
The dealers post quotes because Nasdaq rules require them to do so. But, said Gintel, "out of 20 market makers for a stock, maybe two are really interested in trading at any given time." The rest, he said, "will scurry like rabbits to get out of the way" of unsolicited trades, swiftly changing their quotes if an unwanted order comes in on which they cannot be sure of making a profit.
On Oct. 13, while a reporter was present on the trading floor of a New York market maker in Nasdaq stocks, a trader--on instructions from an individual investor--tried to sell 500 shares of Intuit Inc. This was hours before Microsoft Corp. announced its bid to buy Intuit, and the software firm's stock had been bouncing around in anticipation.
The trader offered to sell the shares to Morgan Stanley & Co., the giant Wall Street investment bank, which is also a major Nasdaq market maker. At that moment, Morgan Stanley had the best posted "bid" price for Intuit, offering to pay $49.25.
Morgan declined to fill the order. But for at least 12 minutes after, the firm continued to post the $49.25 price, seemingly indicating that it was ready to take any legitimate offer at that price, as the firm-quote rule requires.
Morgan Stanley spokeswoman Tracy Gordon declined to comment on the incident.
Though no formal complaint was filed in this case, Morgan Stanley has been the target of scores of formal backing-away complaints over the last 12 months. The firm says all the complaints are unfounded.
On the same morning, a reporter watched as another trader attempted to buy 1,000 shares of Apple stock from Prudential Securities at Prudential's posted asking price of $42.375. Prudential never responded to the computerized purchase offer, the trader said. She was forced to wait and try again with another firm, ultimately paying $42.75 per share, or a total of $375 more than if she had gotten the original price. The trader said the same thing happened to her at least six times that day, on orders involving several stocks and market makers.
Prudential spokesman Charles Perkins said he could not find out what happened in the Apple trade without more information.
In general, he said, "every firm is dealing with thousands of orders every day. The system recognizes that some trades may get lost on occasion." In this case, he noted, the trader did not file a complaint.
Some traders say backing away allows for preservation of what they refer to as "the club," an inside group of market makers who maintain wide spreads--the gap between the "bid" and "asked" prices that gives market makers their profit.
By backing away, critics say, these firms are able to trade primarily with other market makers they know, while refusing to honor their quoted prices for the customers of other firms with which they have no cozy rapport.
Meanwhile, small investors' orders sit unfilled for precious minutes, often while prices move to their disadvantage.
"It all has to do with whether or not you're in the club," said Arthur W. Goldsmith, chief executive of A.J. Michaels & Co., a market maker and trading firm on Long Island that has filed many backing-away complaints. "If you're not, they never take your order."
NASD officials call baseless the allegations that Nasdaq practices are anything but extremely competitive.
Nasdaq "is stringently overseen by both the (Securities and Exchange Commission) and the NASD, and neither we nor the SEC have ever found anti-competitive practices to exist in our market," NASD President Joseph R. Hardiman said in a memo written Thursday to market makers.
Still, Goldsmith spoke of the panicked frustration some traders feel when they are trying to sell stock for a customer. They send orders, one after another, to the market makers displaying the best quotes. Then they wait, usually several minutes between each attempt. In all, it can take 10 minutes or longer to execute a trade--during which time the price of the stock may move drastically.
"It's like you're holding a stock and there's no exit," Goldsmith said.
On the New York Stock Exchange, by contrast, trading of each stock is centralized in the hands of a single "specialist" firm. The specialist is obliged to see that all orders to buy or sell at the prevailing market price get filled. So backing away does not exist on the NYSE.
The NASD attributes the upsurge in backing-away complaints to a protest by a small group of market makers angry that the NASD cut into their living in January by sharply limiting Nasdaq's small-order execution system (known as SOES), which had been the basis for these firms' profits. The NASD says the firms abused SOES, unfairly using it to take advantage of big market makers who were not fast enough in updating their prices.
Indeed, a prodigious 85% of the complaints through late June were filed by a single small firm that heavily used SOES, Datek Securities of Staten Island, N.Y., the NASD says.
These small firms, in turn, allege that the NASD is ignoring abuses by big market makers who routinely violate the firm-quote rule.
When the NASD scaled back the small-order system, the firms said, they turned to using Nasdaq's mainstream trading system, known as SelectNet. But, they said, they have discovered that they frequently cannot get their orders filled. The reason, they allege, is that the bigger market makers won't honor their posted prices.
Executives at the complaining firms contend that the NASD does little or nothing to investigate.
"We have hundreds of backing-away complaints we've filed, but it becomes a futile effort," said Michael F. Frey, president of A.J. Michaels. "Nothing ever happens."
But it is not just the former SOES traders who are complaining.
For example, Keith Balter, head of Nasdaq trading at Weeden & Co.--and a vocal critic of the SOES traders--said he too has filed backing-away complaints when he believed fellow market makers failed to honor quotes. In each case, he said, the NASD seemed to do nothing. "We just don't hear anything," Balter said.
Judging by its public statements, the NASD--which has the power to impose large fines and suspend market makers--means to sternly enforce its regulations against backing away.
"The activity of backing away really goes to the heart of our business," said Cangiano, the NASD surveillance chief. "If you get somebody who reneges and is not fulfilling the obligations of a market maker, then obviously there are serious implications for the marketplace."
As of Oct. 4, out of the 4,748 complaints filed this year, the NASD said it had disposed of 4,257. Aside from the four fines, the only other action taken was to send 81 private warning letters, Cangiano said.
Cangiano said it took only the mildest action because it was persuaded that all of the cases were unintentional. Without evidence of repeated violations by a trader, he said, the NASD is likely to accept the explanation that the trader inadvertently missed seeing an order pop up on the computer screen.
"We'll let you go," he said. "We realize everybody is busy, and messages scroll off the workstation" without being seen, Cangiano said.
Traders say the SelectNet computer system indeed is flawed, making it easy for traders who are not paying attention to miss orders.
But Linda Lerner, general counsel for Domestic Securities, a Suffern, N.Y., firm that has filed reams of backing-away complaints, said the NASD is simply too willing to believe market makers' claims that unexecuted trades are accidental.
Brandon Becker, head of market regulation for the SEC, the federal agency that oversees the nation's stock markets, declined to comment on the NASD's handling of the complaints.
Copies of backing-away complaints obtained by The Times allege a litany of abuses, including foul language (a violation of NASD rules), telephones slammed down, traders refusing to give their names (also a violation), and lies by traders who claimed they had fulfilled their obligation to trade at quoted prices by trading with someone else first.
Domestic Securities' parent firm, All-Tech Investment Group Inc., filed more than 20 complaints against Morgan Stanley in the first six months of this year. In one, All-Tech charged that on March 23, it signaled via SelectNet that it wanted to sell 500 shares of Tele-Communications Inc. at Morgan Stanley's posted bid price of $23.50.
All-Tech alleged that Morgan Stanley simply ignored the order.
"We called after a minute of waiting (for a reply via computer) and they hung up on us," says the complaint, signed by All-Tech principal Mark Shefts. "We called a second time; the trader refused to give his name but stated: 'Take it up with our legal department. Don't bother us.' They also claimed that there was a market maker ahead of us."
But according to the complaint, Morgan Stanley did not change its quotes for another minute--an indication that the firm was still willing to buy TCI stock at $23.50, regardless of any earlier trade.
Florence A. Davis, Morgan Stanley's director of compliance, said her staff had investigated the allegations in this and all the other complaints and come up with solid proof that Morgan Stanley had fulfilled its obligation to trade at its posted prices.
"We're not scofflaws at Morgan Stanley," she said. "The documentary evidence is so black-and-white." But Davis declined repeated requests by The Times to see the evidence, saying the complaints had been thoroughly reviewed by the NASD.
Series Reprints: A compilation of this six-part series on Nasdaq will be available from Times on Demand upon completion of the series' publication next week. Price is $7.95, plus $2.50 for mail delivery. To order, call 808-8463 from the 213, 714, 818 or 909 area codes, then press *8630. Follow the voice instructions and select option 3. Allow two weeks for delivery.
A Glossary of Market Terms
* Backing away: The refusal by a market maker to honor the prices it posts in the Nasdaq computer system for buying or selling a stock.
* Bid: The posted price at which a market maker is willing to buy a stock.
* Asked: The posted price at which a market maker is willing to sell a stock.
* Spread: The gap between the bid and asked prices. This is essentially the market maker's profit margin for acting as a dealer in the stock. Market makers buy from investors at the bid and sell at the higher, asked price.
* Specialists: Firms that handle all orders for a particular stock on the New York, American and other stock exchanges. Specialists are obliged to see that all orders to buy or sell are filled at the prevailing prices.
* Market makers: Firms that put up their own capital to "make a market" in particular Nasdaq stocks, acting as dealers by continuously posting prices for the stocks on Nasdaq's computer and standing ready to buy or sell. Unlike NYSE specialists, which serve as the sole market maker for each stock, each Nasdaq stock has multiple market makers.
About This Series
The electronic Nasdaq market has grown into the nation's busiest marketplace for buying and selling stocks, with higher trading volume than the better-known New York Stock Exchange. Nasdaq is where investors trade shares of Intel, Microsoft, MCI, Apple Computer and other leading firms, along with those of hundreds of smaller companies.
Critics are questioning the fundamental fairness of Nasdaq's trading system, and the Justice Department has launched an antitrust investigation of possible price fixing and other illegal activities.
Other stories in this series:
* THURSDAY: Close examination of Nasdaq shows the market is biased against small investors.
* FRIDAY: Investors often cannot get the best available price for Nasdaq trades, because dealers ignore their orders.
* SATURDAY: What has happened to some of the reforms Nasdaq put in place after the October, 1987, stock market crash?
* TODAY: Dealers in Nasdaq stocks often refuse to make trades at their posted prices, leaving small investors in the lurch.
* MONDAY: Some Nasdaq market makers wait hours before reporting big trades, withholding basic information from investors.
* TUESDAY: How can the Nasdaq system be improved?