DJ: Regulators Are Investigating a Big Nasdaq Trader --- Knight Trading Faces
(Wall St. Journal Full Text 06/04 01:50:07)
Allegations That It Violated Rules and Cost Investors Millions of Dollars ----
By Kate Kelly
FIRST, THE ACCOUNTANTS came under fire, then many of the stock analysts.
Now, the biggest trader of Nasdaq stocks during the technology-stock boom is
in the investigator's spotlight.
The Securities and Exchange Commission and the National Association of
Securities Dealers are investigating Knight Trading Group Inc. following
allegations from a former senior executive that the company engaged in
improper trading during the tech market's heyday, according to people
familiar with the matter.
Though Knight isn't well known outside of Wall Street, the scope of the
probes nevertheless could raise eyebrows among investors throughout the
country. At one point during the market's peak two years ago, New
Jersey-based Knight handled more than 11% of all the buy and sell orders for
Nasdaq-listed stocks, meaning it was more than likely that individual orders
for companies ranging from Microsoft Corp. to eBay Inc. eventually went
through Knight.
The allegations play on some investors' fears about what happened during the
Internet-stock craze -- that instead of looking out for investors' welfare,
traders on Wall Street were instead protecting their own profits, even if
their investor clients suffered.
The government inquiry stems from a sealed arbitration complaint filed late
last year by Robert Stellato, the former head of Knight's institutional
trading desk. In the complaint, filed with the NASD, Mr. Stellato alleges an
elaborate system of trading-rule violations at the company that cost
investors millions of dollars.
The alleged violations involve so-called front running, in which Knight
traders are accused of placing their own orders for stock before placing the
same orders for customers of the firm -- meaning Knight and its employees
profited in advance from customer orders they knew would push the stock of a
company up or down.
In a practical sense, here is how such a trade would work: If an investor
wanted to buy, say, 1,000 shares of Intel Corp., that person would call
their stockbroker, who would arrange to have Knight place the order. But
before doing that, Knight's trader allegedly would at times buy Intel stock
for his own Knight account, presumably getting in at a cheaper level than
what the price would be when the customer order was finally filled. In some
cases, the trader's buying could even drive up the stock price, making it
yet more expensive for the customer who placed the order in the first place.
If proved true, Mr. Stellato's allegations go well beyond the findings of an
earlier NASD investigation, which culminated in January in a $1.5 million
fine against Knight for trading-rule violations.
The latest allegations against Knight also are apparently unrelated to a
three-hour interruption of trading in Knight's own stock on the Nasdaq Stock
Market yesterday. Less than an hour before the markets' morning open, Nasdaq
officials halted the trading of Knight shares in anticipation of company
news. Knight later announced a glitch in its trading software had generated
a large number of false sell orders in its own stock -- which drove down
Knight's share price in premarket trading. Nasdaq intends to cancel the
affected trades.
In a written response to the NASD, the company disputes Mr. Stellato's
allegations, asserting there was no illegal trading at Knight. In fact, the
company says Mr. Stellato drummed up the front-running stories in order to
mask his own failings as a manager, which led ultimately to his termination.
While Knight acknowledges it asked two senior traders whom Mr. Stellato
accused of front-running to resign, the company claims those departures
weren't the result of unlawful activity, but rather personality clashes
between the traders and Mr. Stellato.
Neither Mr. Stellato nor his attorney would comment on his complaint, and
the SEC and NASD declined to discuss the matter.
Knight's tiff with a former senior manager comes as the company is facing a
rough time. Kenneth Pasternak, the firm's co-founder, longtime CEO, and
mercurial public face, left the company in January, six months before his
contract was set to expire. Last week, Knight announced the appointment of a
chief executive, Thomas Joyce, a former Merrill Lynch & Co. head of trading.
While firms across Wall Street have been hurt by the down market, Knight's
lock on Nasdaq trading volumes has made it worse off than its competitors.
Knight reported a net loss in the first quarter, and revenue was down 41%.
Knight's stock, which soared along with the Nasdaq, hitting a high of $78 a
share in the spring of 1999, closed yesterday at $5.92, down nearly 7% in
Nasdaq Stock Market 4 p.m. trading.
Knight's business model is simple: match buyers and sellers of stock and
charge a fee for each transaction. If there is no match, Knight steps in and
becomes a buyer or a seller itself to help the deals along. The larger the
number of orders, the more money the firm makes.
But there is an additional benefit to big volumes -- one that has since been
underscored in the NASD complaint. By controlling such a big chunk of the
business, Knight traders could easily get a good sense of what investors
were thinking on a given day, enabling them, quite legally, to trade
intelligently for the firm's own stock accounts and make money that way,
too.
In its past scrapes with regulators, Knight has been cited for fairly
routine trading shortcomings. Between late 1996 and 2000, Knight was named
in 10 NASD regulatory actions, according to filings, including attempting to
trade a halted stock, failing to keep adequate trading records, and not
being prompt enough in executing customer orders. Knight has neither
confirmed nor denied any of those allegations, though it has paid fines
ranging from $1,000 to $50,000 as a result of the citations.
Regulatory experts say the allegations from Mr. Stellato go well beyond
anything Knight has faced before. The complaints go to the heart of Knight's
dealings with its clients, and to whether profits that should have been
going to individual investors were instead being siphoned off by the firm
and its brokers for their own profit.
Mr. Stellato, who is in his early 60s, arrived at Knight in the middle of
2000. A 25-year veteran of Goldman Sachs Group Inc., where he was co-head of
Nasdaq trading before leaving, joined Knight as the chief overseer of
stock-trading for large institutional customers such as mutual funds.
According to his arbitration complaint, which was reviewed by The Wall
Street Journal, he soon was warned of problems in the department by two of
the company's own managers. "These warnings prompted [Mr.] Stellato to
interview the rest of the institutional sales traders," alleges the
arbitration filing, "who each told him that [company executives] were, at
the least, front-running customer orders in concert with the traders and
with the full blessing of [Mr.] Pasternak and the rest of Knight's
management."
The filing claims most of the questionable trading was being done by two
employees, whom Mr. Stellato said he wanted fired.
Having gathered evidence about the alleged front-running, the filing states,
Mr. Stellato confronted Knight's in-house regulators, its chief in-house
lawyer, and finally Mr. Pasternak with his concerns.
In the claim, Mr. Stellato summarizes the reactions of Mr. Pasternak and
Knight's chief legal counsel, Mike Dorsey: "Dorsey told Stellato that he did
not see any evidence of front-running, although he admitted that `you can
make a very compelling case for price manipulation.'" According to the
filing, Mr. Dorsey went on to say it was the responsibility of regulators,
and not of Knight itself, to keep tabs on the legality of the company's
trading practices.
Messrs. Pasternak and Dorsey declined to discuss Mr. Stellato's allegations.
But the company's response to the NASD says Mr. Stellato's allegations were
false.
The company said in the filing no illegal activity was uncovered, and Knight
officials came to believe Mr. Stellato's accusations of front-running were
based on his own confusion about Knight's trading practices, which permit
traders to buy and sell stock for company accounts at certain times. Still,
the filing adds, Mr. Pasternak acknowledged the salaries the accused
employees made from their trading activity "raised a potentially legitimate
concern from a marketing standpoint" in that "if Knight had a reputation for
making more per trade than others in the industry," that might discourage
additional business. For that reason, and in order to show support for Mr.
Stellato as the manager of institutional trading, Mr. Pasternak asked the
employees to resign, says the filing, which they did.
Less than a year later, in July 2001, Mr. Stellato would follow them out the
door -- a departure the company attributes to lackluster performance, but
that Mr. Stellato equates in his filing to a penalty for highlighting the
firm's alleged front-running practices. Mr. Stellato remains unemployed.
As for Mr. Pasternak, he stepped down on Jan. 31, though he remains a
consultant to the firm and, with more than seven million shares, or a 5.7%
stake in Knight, is one of its largest shareholders.
Mr. Pasternak, who was paid $4.2 million by Knight last year, recently
opened the doors of a New Jersey hedge fund called Chestnut Ridge Capital,
named after a section of northern New Jersey near his home.
This time, he says, he'll be doing most of the trading. |
