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SEC to Require Clearing Firms to Report Suspicious
Trading of Small Stocks
By Neil Roland
SEC Approves Rules Making Clearing Firms Report Suspect Trades
Washington, June 3 (Bloomberg) -- The Securities and
Exchange Commission approved rules that would require clearing
firms to report suspicious trading of small stocks, SEC associate
market-regulation director Larry Bergmann said today.
The new rules, which seek to combat manipulation of small,
thinly traded securities, come as the SEC's enforcement division
talks with Bear Stearns Cos. about a settlement in a two-year
investigation of the firm's clearing practices.
The commission's staff also is in the early stages of
drafting a second set of rules that would impose tougher fraud-
detection requirements on clearing firms, which process stock
trades for small brokerages, SEC market-regulation director
Annette Nazareth said in an interview. These preliminary
proposals already have drawn fire from clearing firms, who fear
increased legal liability.
''We're addressing early warning techniques that should
enable us to better tackle micro-cap fraud,'' said Nazareth,
whose staff has been refining both sets of new clearing rules.
''The rules are part of a multipronged SEC approach to the
clearing issue.''
The new SEC rules, which were quietly approved by commission
staff yesterday, take effect immediately, Bergmann said. One rule
requires clearing firms to report any customer complaints about
trading practices to the brokerage and to the New York Stock
Exchange or National Association of Securities Dealers, he said.
Another new rule would require clearing firms to provide
statistical indicators of possible stock manipulation and other
unusual activity to the brokerages whose trades they process,
Bergmann said. One such indicator, which would be reviewed by the
compliance divisions of the brokerages receiving these reports,
is frequent trade cancellations. Many cancellations could signal
that a brokerage is making unauthorized trades, he said.
Rule Approval
The commission, headed by Chairman Arthur Levitt, can
delegate rule-approval authority to its staff. The market-
regulation division, led by Nazareth, approved the clearing rules
yesterday, Bergmann said.
The rules were proposed by the NYSE and the NASD in late
1997. They generally are supported by the Securities Industry
Association, the brokerage trade group, SIA associate general
counsel Michael Udoff said.
Even as the SEC adopts these standards, Nazareth's staff is
crafting other, more stringent requirements that have drawn
criticism from clearing firms that fear increased liability.
The most controversial plan would prohibit clearing firms
from processing a brokerage's trade unless they determine -- on
the basis of monthly data provided by the brokerage -- that it
has enough net capital to do business. Another proposal that has
been acceptable to clearing firms would require them to forward
statistical fraud indicators not just to the trading brokerages,
but to securities regulators as well.
Clearing Practices
The SEC's new rules and a possible settlement with Bear
Stearns could alter long-standing clearing practices at the
handful of firms that dominate the profitable $18 billion-a-year
U.S. clearing business.
''This should make these firms more cautious about getting
in bed with the A.R. Barons of the world,'' Columbia University
law professor John Coffee said.
A.R. Baron & Co., a defunct penny-stock brokerage, has been
charged by the Manhattan District Attorney's office with
defrauding investors of $75 million through stock manipulation
and unauthorized trades. Thirteen former A.R. Baron executives
and brokers have pleaded guilty to or were found guilty of
securities fraud. The firm is one of several penny-stock firms,
including Stratton Oakmont Inc. and Sterling Foster & Co., to be
charged in recent years with massive manipulation of small
stocks.
Bear Stearns, one of the largest U.S. clearing firms, has
been under investigation by the SEC and criminal authorities on
allegations it ignored signs of stock manipulation while
processing trades for A.R. Baron. Bear Stearns, which had 500
brokers and $18.9 billion in capital at the end of last year, has
said none of its executives knew of improper A.R. Baron
activities.
A Bear Stearns spokeswoman declined comment on the case or
the SEC's rule-making activities.
Legal Exposure
New SEC rules wouldn't affect any case brought against Bear
Stearns in connection with the A.R. Baron investigation. An SEC
case against the firm, though, could set precedents under
existing securities laws, establishing standards of
responsibility for clearing firms and possibly increasing their
legal exposure, legal experts said.
''If Bear Stearns is charged, it will increase clearing
firms' liability, but none of them will leave the business
because it's too profitable,'' Southern Methodist University law
professor Alan Bromberg said.
Among the largest clearing firms, other than Bear Stearns,
are Donaldson Lufkin & Jenrette Inc.'s Pershing Division;
Fidelity Investments' National Financial Services Corp., and
Fiserv Inc.'s BHC Securities Inc.
The clearing business in the U.S. generated $18.2 billion in
revenue in 1996, according to Merrill Lynch & Co. data. None of
these companies break out their clearing units' earnings.
Settling Trades
Clearing firms settle trades of smaller brokerages, while
also sending out trade confirmations, keeping client records and
providing trading loans to brokerages. Most large brokerages
clear their own trades.
A second set of tougher SEC standards, such as the net-
capital proposal, are months away from formal consideration, she
said. ''The clearing firms are in the best position to detect the
most egregious misstatements in the (net capital) computation,''
said Nazareth, who has been a managing director at Salomon Smith
Barney, now part of Citigroup Inc.
The clearing firms argue that this proposal could expose
them to greater legal liability and require them to act as
regulators.
''We'd be asked to usurp the responsibilities of regulators
like the NYSE and the NASD, who could also second-guess our
determinations,'' said Thomas Franko, a Pershing Division
associate general counsel.
Further Proposals
Other rules being developed are less controversial. They
would require clearing firms to report to the NYSE and NASD on
statistical indicators of potential fraud, Nazareth said. Among
the possible signals of unauthorized trading that could be used
are excessive trade cancellations and frequent customer requests
for payment extensions. The SEC has asked the NYSE and NASD to
develop these rules in the next few months, she said.
The SEC also has secured the agreement of the National
Securities Clearing Corp., which ultimately settles all trades by
individual investors, to produce electronic reports analyzing
indicators of possible micro-cap fraud, Nazareth said.
The NSCC, which is jointly owned by the NYSE and NASD, said
one indicator it has agreed to provide to regulators is a list of
stocks traded by a single dealer or market-maker.
''These stocks turn out to be where there's at least the
potential for fraud or some sort of market manipulation,'' said
NSCC managing director Peter Axilrod.
The SEC plans to meet with the NYSE and the NASD in the next
few weeks about the developing proposals, Nazareth said. These
industry regulators, in turn, have been meeting with the SIA
trade group.
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