Las Vegas Sun

March 28, 2024

SEC steps up inquiry of broker trading

U.S. regulators stepped up a probe of at least 12 firms including Merrill Lynch & Co. and Charles Schwab Corp., examining whether the brokers profited at customers' expense when trading Nasdaq stocks, people familiar with the matter said.

The Securities and Exchange Commission's Office of Compliance Inspections and Examinations referred the firms to the SEC's enforcement unit for further investigation and possible sanctions after an audit earlier this year found that the brokers may have failed to get customers the best prices, said the people, who asked not to be identified.

"If the brokerage industry would actually quit pretending that they have the client's interests at heart, maybe they wouldn't get into trouble," said John Gavin, president of SEC Insight Inc., a Plymouth, Minn.-based corporate research firm. "Mainstream brokers want you to believe that 'Buyer, you can trust us,' but really the sign should say 'Buyer beware.' "

In some cases, the firms themselves took the other side of customers' trades, rather than offering them to buyers or sellers in the open market, the people said. In other cases, brokers routed trades to firms that paid for a steady flow of orders.

The firms, which also include Morgan Stanley, Ameritrade Holding Corp., and E Trade Financial Corp., were notified of the informal investigation in so-called deficiency letters sent by the SEC's compliance unit in the past month, the people said. The letters spell out the specific failings that the compliance examiners found and ask the firms to correct them.

"The SEC demands that orders get executed at the best price at the time an order is placed and it's investigating if that's happening," said Richard Bove, an analyst at Punk Ziegel & Co. in Pinellas Park, Fla. "If the SEC deems that orders aren't being executed at the best price, you could wind up with sizable fines, fees, new regulations and ways of doing business."

SEC spokesman John Heine declined to comment, as did Merrill spokesman Mark Herr, Schwab spokesman Greg Gable, Ameritrade spokeswoman Donna Kush, Morgan Stanley spokeswoman Melissa Stonberg and E Trade spokeswoman Pam Erickson.

The identities of the other brokers in the probe couldn't be determined. On Monday, the New York Times reported that the SEC had opened the review.

Herb Perone, a spokesman for Washington-based NASD, the group that regulates the Nasdaq Stock Market, didn't return a call seeking comment.

New York-based Merrill is a passive, minority investor in Bloomberg LP, the parent of Bloomberg News.

The SEC's compliance audit found that the brokers may have failed to obtain the best prices for customer trades in cases where the brokerages either "internalized" orders or were paid to route their orders to other firms, the people said.

Internalization occurs when a firm fills a customer's order from other pending orders or its own inventory of shares. Payment for order flow is the practice of accepting rebates from market makers, which those companies use to attract business. Both practices are legal, so long as they don't deprive customers of a trade that's available elsewhere in the market on better terms, former SEC lawyers said.

The probe marks a new phase in the regulatory examination of potential conflicts of interest in the financial industry.

In 2003, 10 big Wall Street firms, including Citigroup Inc. and Merrill Lynch & Co., paid $1.4 billion to end accusations they issued slanted stock research in order to win investment-banking business. In March the five biggest firms that make markets in stocks on the floor of the New York Stock Exchange, including LaBranche & Co. and Van der Moolen Specialists, agreed to pay a total of $242 million to settle SEC allegations that they short-changed clients on trades.

Since September 2003, when New York Attorney General Eliot Spitzer unveiled evidence that mutual funds had allowed favored customers to trade shares at other investors' expense, he and the SEC have imposed about $3 billion of penalties on the fund industry.

This latest SEC investigation is focused on Nasdaq trading at the beginning of each session, when volume builds up and brokers race to fill client orders, the people said.

Brokers are obligated by law to obtain the "best execution" of their customers' trade orders. While that often means finding the best price at the time the order is placed, brokers may legally consider other factors as well, such as a customer's desire to execute a large trade quickly, or gradually, to avoid alarming the market, according to Ralph Ferrara, a former SEC general counsel now in private practice at the Debevoise & Plimpton law firm in Washington.

"The question really is, 'What is best overall for this customer at this particular time,' " Ferrara said. "That is a subjective judgment, and I am sure that if you go look at the abuses that have crept in to the best-execution concept, there's room for revision there by the SEC."

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