Knight Securities Settles, Pays $79M in Disgorgement and Penalties
In addition to the payment of over $79 million, the Order requires Knight to cease and desist from committing or causing any future violations of the broker-dealer anti-fraud and books and records provisions of the Exchange Act, and censures Knight for its failure to reasonably supervise its institutional sales traders. Knight has also voluntarily agreed to retain an Independent Compliance Consultant to conduct a comprehensive review of (i) Knight's policies and procedures with respect to best execution obligations, trade reporting requirements, limit order requirements and books and records requirements, and (ii) Knight's supervisory and compliance structure.
"Customers have a right to expect they are getting fair treatment when they entrust their broker with orders to buy and sell securities," said Stephen M. Cutler, Director of the SEC's Division of Enforcement. "That expectation is betrayed when the broker handling the orders puts its own financial interests ahead of its customers' interests."
Paul R. Berger, Associate Director of Enforcement said, "Broker-dealers have a responsibility to build a supervisory system that protects investors, rather than one that is designed to fail. Broker-dealers cannot turn a blind eye to the fraudulent activities of their employees and expect to avoid the consequences."
The SEC's Order found that:
Between January 1999 and November 2000, Knight -- which was, at the time, one of the largest market-makers on the NASDAQ -- earned over $41 million in illegal profits by failing to provide best execution to its institutional customers. Specifically, Knight defrauded its institutional customers by extracting excessive profits out of its customers' not-held orders while failing to meet the firm's duty to provide best execution to the institutions that placed those orders. During the relevant time period, Knight, upon receipt of an institutional customer order, would acquire a substantial position in the firm's proprietary account. Rather than fill the order promptly on terms most favorable to the customer, Knight would wait to see if its proprietary position increased in value during the trading day. When the prevailing market price for the stock moved significantly away from Knight's acquisition cost, Knight then filled the customer's order and pocketed the difference as its profit on the transaction.
For example, on April 4, 2000, Knight received a customer market not-held order to purchase 250,000 shares of Applied Micro Circuits Corporation (AMCC). Over the next 18 minutes, Knight acquired 147,000 shares of AMCC at an average cost of $91.00 per share. Rather than promptly selling the stock to the institutional customer at Knight's cost (plus a reasonable profit), Knight sold the AMCC stock to the customer over a period of time at an average profit of approximately $2.00 per share. On the entire AMCC order, Knight realized a profit of over $1.1 million (or an average of $3.94 per share).
When the market moved unfavorably in relation to the position Knight had established to fill the institutional customer's order, Knight executed its remaining position in the order to the customer at prices that still generated a profit for Knight. By engaging in these trading practices, Knight extracted enormous profits - as high as $9.00 per share - by executing transactions that involved effectively no risk to Knight. Consequently, Knight improperly realized tens of millions of dollars in excessive per share profits from its institutional customers.
During the same period, Knight failed reasonably to supervise Knight's former leading sales trader who was primarily responsible for Knight's fraudulent trading (Leading Sales Trader). Knight's senior management not only allowed the Leading Sales Trader to be directly supervised by his brother but also permitted the two to evenly split the profits generated by the Leading Sales Trader's trading with institutional customers. The two brothers' relationship, their positions and responsibilities within the firm, and their profit-sharing arrangement created an inherent conflict of interest that contributed to a substantial breakdown in the supervision over the Leading Sales Trader.
Between 2000 and 2001, Knight failed reasonably to supervise Knight's institutional sales traders while they were systematically misusing Automated Confirmation Transaction Service (ACT) trade modifiers. Knight had no written procedures, no adequate systems in place and no supervisory personnel to prevent Knight's sales traders from consistently misusing the modifiers over a two-year period.
The misuse of ACT modifiers led to the sales traders' recording inaccurate execution times on the firm's trading blotters, in violation of the books and records provisions of the federal securities laws. By misusing the ACT trade modifiers, Knight sales traders were able to improperly input trades into Knight's trading system at prices that were different from the inside market at the time the trades were reported. The repeated misuse of the ACT modifiers also limited the ability of Knight's institutional customers to detect the fact that Knight was extracting excessive profits at their expense. By misusing ACT trade modifiers, Knight's sales traders avoided limit order protection protocols and filled more profitable institutional "not held" orders before certain resting limit orders placed by Knight's customers.
Additionally, Knight violated the books and records provisions of the federal securities laws by failing to (i) retain email communications relating to its business, (ii) maintain a purchase and sales blotter that contained accurate information concerning the time of execution of certain trades, and (iii) include required information on some order tickets and maintain certain order tickets for the time period required by the federal securities laws.
Accordingly, Knight willfully violated the broker-dealer antifraud provisions of the Securities Exchange Act of 1934 (Section 15(c)(1)(A)). Knight willfully violated multiple provisions of the books and records provisions of the Exchange Act (Exchange Act Section 17(a) and Rules 17a-3(a)(1), 17a-3(a)(7), 17a-4(b)(1) and 17a-4(b)(4) thereunder). Knight failed reasonably to supervise pursuant to Section 15(b)(4)(E) of the Exchange Act with a view to preventing violations of Sections 15(c)(1) and 17(a) of the Exchange Act and Rule 17a-3(a)(1) thereunder.
In the NASD proceeding, the NASD found that Knight violated the broker-dealer antifraud provisions of the Exchange Act. The NASD also found that Knight failed to supervise (i) the Leading Sales Trader's institutional trading, (ii) the use of ACT modifiers by Knight's institutional sales traders, and (iii) the use of proprietary "back book" accounts used by some Knight employees. In addition, the NASD found that Knight (i) improperly reported trades to ACT, (ii) failed to file accurate U5 terminations for the Leading Sales Trader and his brother, the supervisor of the institutional sales desk, and (iii) failed to provide documents to the NASD in a timely manner. Knight agreed to settle the NASD's parallel proceeding without admitting or denying the NASD's findings or allegations.
The SEC's investigation is continuing as to others.