NYSE Targets Brokers & Supervisors

Although Prudential Financial has agreed to pay $600 million in penalties and admit wrongdoing to settle charges related to mutual fund market timing, it appears that the New York Stock Exchange is not ready to close matters just yet. According to the Wall Street Journal on Sept. 14, Susan Merrill, chief of enforcement for NYSE regulatory arm, still has many individuals in her cross hairs. Ms. Merrill was quoted recently saying,

"Now, we're beginning to focus on the individual brokers who were facilitating
market timing of customers, and we're looking at supervisors of those
brokers,"

GO MS. MERRILL!

The mutual fund market timing scandal first came to light in 2003 and has resulted in settlements, before the Prudential settlement, of more than $3.5 billion. Market timing costs long term holders of mutual funds through dilution of share value and increased transaction costs.

Following is an edited copy of the NYSE news release

NEW YORK, August 28, 2006 – NYSE Regulation, Inc. announced today that it has censured and ordered Prudential Equity Group, a member firm, to disgorge $270 million for fraudulent market timing in connection with the trading of mutual fund shares.
“It is absolutely unacceptable to see the level of knowledge and acquiescence by senior managers of such pervasive deception by Prudential’s market-timing brokers,” said Susan L. Merrill, chief of enforcement, NYSE Regulation, Inc. “The disgorgement of $270 million will compensate the funds’ shareholders. The action is also evidence of tremendous cooperation by securities regulators working together to ensure that a brokerage firm cannot profit from condoning fraud.”
Prudential has been ordered to pay a total of $600 million. $270 million will be paid to a distribution fund administered by the SEC for the benefit of those harmed by the fraud, $325 million will be paid to the U.S. Department of Justice, and $5 million will be paid as a civil penalty to the Massachusetts Securities Division. “Market timing” includes frequent buying and selling of shares of the same mutual fund or buying or selling of mutual fund shares in order to exploit inefficiencies in mutual fund pricing. Though not illegal per se, market timing can harm mutual fund shareholders because it can dilute the value of their shares, if the market timer is exploiting pricing inefficiencies, or disrupt the management of the mutual fund’s investment portfolio and can cause the targeted mutual fund to incur costs borne by other shareholders to accommodate frequent buying and selling of shares by the market timer.
To prevent market timing, mutual funds have placed restrictions on excessive trading in their prospectuses and monitor for excessive short-term trading by reviewing brokers’ and customers’ account numbers, trade size, principal amount, and branch codes.
From September 1999 and continuing through at least June 2003 brokers at Prudential used deceptive trading practices to conceal their identities, and those of their hedge fund customers, in order to evade prospectus limitations on market timing. At least 50 mutual funds and their long-term shareholders were defrauded. The firm profited from this misconduct because the brokers generated approximately $50 million in gross commission revenues as a result of this misbehavior.
The deceptive practices included the use of: 1) multiple broker identifying numbers; 2) multiple customer accounts; 3) accounts coded as “confidential”; and 4) “under the radar” trading. The practice of “under the radar” trading refers to the splitting of one trade into numerous smaller ones to avoid detection.
As early as the fourth quarter 1999, several mutual fund companies identified the use of deceptive trading practices and notified Prudential. In May 2002, the firm itself determined that its top-producing broker used deceptive practices to avoid notice by mutual funds. Ultimately, the firm received hundreds of notices from mutual fund companies that identified the misconduct and asked Prudential to take steps to curtail the activity.
Despite increasing awareness of the brokers’ fraudulent activities, the firm elected to continue the business of market timing. Instead of disciplining or sanctioning any of the brokers, or even curtailing their ability to open additional accounts for their market timing customers, Prudential failed to prevent their misconduct from continuing and actually began to track the brokers’ gross revenues.
For example, in 2001, the brokers generated more than $16 million in gross commission revenues for the firm, most of which was in danger of being eliminated had the firm phased out market timing at that time. Similarly, approximately $23 million in gross commission revenues were generated in 2002, and comparable revenues continued to be generated until June 2003.
The firm’s policies and procedures were ineffective and largely not enforced. Even in situations where the firm purportedly enforced any of these policies, its senior officers undermined the policies by granting exceptions for the largest producing brokers. Additionally, Prudential repeatedly failed to prevent the inappropriate use of hundreds of broker identifying numbers, even though the use of multiple numbers was the primary means of concealment by which the brokers carried out their fraud. Prudential finally issued a market timing policy in January 2003, but the firm did not fully enforce procedures in that policy to end the scheming.