SEC Plans Civil Charges in Its Nasdaq Probe
The Securities and Exchange Commission has found evidence of widespread violations of trading regulations on the Nasdaq Stock Market and is working toward filing a major, highly unusual disciplinary case against Nasdaq’s parent organization, sources familiar with the SEC investigation have told The Times.
Civil charges are expected to be filed as early as September against the Washington-based National Assn. of Securities Dealers, an organization of most of the nation’s securities firms, sources said in interviews over the past two weeks. The NASD owns and operates Nasdaq, the fast-growing, electronically linked network of dealers who trade over-the-counter stocks.
The charges expected to be filed will stem from findings that the NASD failed to take steps to halt illegal practices, many of which increased small investors’ costs for buying and selling Nasdaq stocks, the sources said. Such illegal practices include manipulation of stock prices, refusing to honor quoted prices, agreeing to illegally delay the reporting of big trades and harassing fellow dealers who break ranks to narrow “spreads.” Spreads are dealers’ profit margins on Nasdaq stocks.
The NASD says deliberate violations of its rules are rare and the market is fair to small investors.
In an interview last week, Richard G. Ketchum, the NASD’s chief operating officer, said he was not aware that the SEC planned to bring a case against the organization. “If they’re going to bring a case they haven’t told us,” he said. On Thursday, NASD spokesman Marc Beauchamp declined to comment on the possibility of SEC charges. But he said, “Obviously we believe we’ve done a more-than-adequate job of regulating the Nasdaq Stock Market.”
The prospect of a legal challenge against the NASD comes as the organization confirmed Thursday that it has experienced serious computer problems as a result of a recent surge in trading volume, causing the public “tape” displaying stock prices to be up to four minutes late during the first 20 minutes of the trading day. A spokesman said the NASD had not publicly disclosed the delay, but had notified the SEC. While such delays are in effect, investors have no way of knowing current prices for stocks.
The SEC’s probe of trading practices has singled out the NASD for disciplinary action because investigators are now convinced that rule violations have been endemic, rather than isolated instances, and that the NASD has not fulfilled its legal duty to police the market, the sources said. The SEC may also file charges against firms that deal in Nasdaq stocks and against individual traders, but no decision on that has been made yet, the sources said.
The SEC is likely to seek a formal censure of the NASD, as well as an order requiring numerous specific reforms, including closer supervision of Nasdaq dealers, the sources said. The commission could also seek a fine.
Sources said the SEC investigation is still in progress and has not yet been formally presented to SEC commissioners for approval.
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The SEC launched its investigation in October, shortly after The Times published an investigative series detailing how trading on Nasdaq was skewed against small investors.
The SEC’s resolve to bring a major case was bolstered after investigators subpoenaed and listened to hundreds of hours of taped telephone conversations of Nasdaq dealers. The tapes convinced investigators that rule violations are extremely commonplace, the sources said. Many brokerage firms routinely tape traders’ calls, mainly to refer to later if there is a dispute.
Government sources and outside lawyers contend that the tapes are replete with traders discussing illegal activities, such as stock price manipulation and refusing to honor quoted prices.
The NASD’s Ketchum said he had not listened to the tapes and would not comment. However, Catherine A. Ludden, a lawyer whose firm represents one of the largest Nasdaq dealers, Mayer & Schweitzer Inc., said she strongly doubts that the tapes contain any evidence of illegal activity. “I think what you hear is the aggressive ins and outs of trading every day, trying to get the best price for customers, trying to get the best execution,” she said.
Since last fall, the Justice Department’s antitrust division has been conducting a separate investigation of Nasdaq dealers, and has also obtained the tapes. A Justice Department spokesman declined Thursday to comment on that investigation except to confirm that it is still pending.
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SEC spokeswoman Jennifer Kimball, citing agency policy, declined to comment publicly on the pending investigation and would neither confirm nor deny that the NASD is a target. However, the SEC made clear Thursday that it intends to deal firmly with Nasdaq on another matter.
Kimball said the SEC has decided that it will not consider the NASD’s proposed new system for handling small customer orders until after both the SEC and Justice Department’s investigations are completed. After several modifications, the NASD has come up with a new proposed system, currently called N*Aqcess , which it has heavily promoted publicly as a boon to small investors. The NASD’s Board of Governors has been slated to approve it July 14.
However, sources said SEC officials are concerned that the proposal has been watered down after strong complaints by big Nasdaq member firms and may allow dealers too much leeway to reject small-customer orders.
Beauchamp said the NASD had no comment on the decision to delay consideration of N*Aqcess.
Only three times has the SEC brought disciplinary cases against so-called self-regulatory organizations, which include the NASD and the stock and options exchanges. These organizations under federal law must make and enforce rules for their members.
In addition to what investigators heard on the tapes, the SEC is said to be concerned that the NASD over a long period had evidence of numerous rule violations but took little action.
For example, the NASD over the last two years has received thousands of “backing-away complaints”--written complaints that dealers failed to honor their publicly quoted prices. But the NASD has taken no public disciplinary action in response to any of them. Ketchum contends that most of the complaints were filed by a handful of malcontent firms and that the flow of complaints has largely stopped. He also said firms have stepped up efforts to make sure traders honor quoted prices.
But sources said the SEC is continuing to receive a large number of backing-away complaints from Nasdaq dealers and customers.
The SEC is also said to be concerned that daily trading records clearly showed a pattern of large trades being reported late. But the NASD took little action in response to this until very recently. Rules require trades to be reported to the public “tape” within 90 seconds of execution. But in many instances traders waited until just after the close of the trading day to report large trades. By reporting late, they avoided influencing the market in a way that might be costly to them or their institutional customers.
As reported, the NASD in May told dealers it planned to crack down on late trade reporting.
Securities lawyers said it is likely that the NASD would attempt to reach a settlement with the SEC rather than risk lengthy and potentially embarrassing litigation. Ketchum said there have not been any negotiations yet. But Ketchum, a former head of the SEC’s division of market regulation, said: “We have no desire to have an adversary relationship with the commission.”
In addition to filing a case against the NASD, sources said the SEC also intends to propose rule changes that could greatly alter Nasdaq trading. Among the new rules, planned but not yet drafted, are ones that would ensure that individual investors get the best available prices for Nasdaq stocks.
On Wednesday, when the current bull market lifted the value of Nasdaq stocks above $1 trillion for the first time, NASD President Joseph Hardiman said in a written statement: “More than anything, passing the trillion-dollar milestone reflects the confidence investors and issuing companies continue to have in our market.”
However, NASD officials in interviews this week acknowledged that the surge in volume has caused a severe strain on its system. John M. Hickey, NASD senior vice president for production services, confirmed Thursday that in recent days the tape of stock prices has been running up to four minutes late for a number of big stocks, for up to 20 minutes following the opening of trading at 9:30 a.m. EDT.
He said this was because an unusually large volume of orders backed up overnight for execution when the market opened, and the NASD could not keep up. He said the NASD is working to fix the problem.
In addition, there has been a surge in recent weeks of complaints of other problems with Nasdaq’s equipment or snafus by Nasdaq personnel. Several brokerage firms said that Nasdaq unilaterally “broke” or canceled trades because of these problems, costing investors and dealers thousands of dollars, even though the problem was Nasdaq’s fault.
NASD’s Beauchamp said he was not immediately able to supply statistics on broken trades, requested by The Times on Wednesday.
