Who can you trust now? Evidently, not NITE>
This front-running business reminds me of the old ways at the CBOE...
Knight Faces Allegations
It Cost Investors Millions
SEC and NASD Investigate
Improper Trading Charges
By KATE KELLY
Staff Reporter of THE WALL STREET JOURNAL
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 Monday. 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 Monday 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. |
