Broker-dealer Bear, Stearns & Co., and Bear, Stearns Securities Corp., a clearing entity, agreed yesterday to pay $250 million and take several remedial actions to settle Securities and Exchange Commission securities fraud charges for facilitating unlawful late trading and deceptive market timing of municipal and other mutual funds by its customers and the customers of other dealers.
The SEC said the $250 million fine, which is one of the largest imposed by the commission for mutual fund related-abuses, includes $160 million of ill-gotten gains that Bear Stearns is to disgorge. That money will be put into a Fair Fund and distributed to mutual fund shareholders that were harmed by the firm’s actions. The remaining $90 million is a civil penalty. NYSE Regulation also censured and fined Bear Stearns, but the fine will be deemed satisfied by the firm’s $250 million payment, the SEC said.
Bear Stearns disclosed it was settling with the SEC in its annual financial statement in December, but the SEC documents detail the abuses and terms of the settlement.
Market timing is the frequent buying and selling of shares of the same mutual fund, often to exploit inefficiencies in mutual fund pricing. It is not illegal per se, but can be if it is not disclosed and runs counter to a fund’s policies. In addition, it can disrupt the management of a fund’s portfolio and cause damage to shareholders.
Late trading is the practice of placing orders to buy, redeem, or exchange mutual fund shares after the time that the fund calculates its net asset values, typically at 4:00 p.m. The trader then receives the price based on the prior NAV calculation, despite any market changes.
“For years, Bear Stearns helped favored hedge fund customers evade the systems and rules designed to protect long-term mutual fund investors from the harm of market timing and late trading,” Linda Chatman Thomsen, the SEC’s enforcement division director, said yesterday. “As a result, market timers profited while long-term investors lost. This settlement will not only deprive Bear Stearns of the gains it reaped by its conduct, but also require Bear Stearns to put in place procedures to prevent similar misconduct from recurring.”
Mark K. Schonfeld, director of the SEC’s northeast regional office in New York, said: “Bear Stearns was the hub that connected the many spokes of market timing and late trading — hedge funds, brokers, and the mutual funds. Tape-recorded phone calls of its employees made plain the two roles played by Bear Stearns that were fundamental to mutual fund trading abuses. Bear Stearns made it possible for hedge funds and brokers to submit orders long after the 4:00 p.m. cut-off. [The firm] made it easier for the hedge funds and the brokers to engage in market timing, and harder for the mutual funds to detect and stop it.”
According to the SEC, the Bear Sterns clearing entity established a timing desk in 1999 to manage the increasing flow of market-timing trades. The trading desk helped customers enter late trades and even cancel unprofitable ones the following day. The desk also advised customers and brokers on how to evade the blocks and restrictions imposed by the mutual funds and how to negotiate BSSC’s own blocking system. Some market timers, in return, gave timing desk employees gifts such as spa gift certificates, tickets for events, and meals.
At the broker-dealer, meanwhile, certain brokers actively facilitated late trading by knowingly processing a large number of late trades for certain of their market-timing customers. In some cases, the brokers and employees of Bear Stearns’ mutual fund operations department falsified order tickets by recording orders as received at 3:59 p.m. or 4:00 p.m., when they were actually received after 4:00 p.m., the SEC said.
On the clearing side, BSSC gave brokers and prime brokerage customers with mutual fund trading business direct access to its mutual fund order entry system so that they could enter orders until 5:45 p.m. and still have them processed as if they had been received before 4:00 p.m.
Between 1999 and 2003, BSSC received thousands of letters and e-mails from mutual funds complaining about abusive trading and requesting that it be stopped, the SEC said. In response, BSSC developed a system that was supposed to stop unwanted market timing, but in reality the system was designed to stop only the specific account identified by a particular mutual fund as an unwanted market timer from trading in that fund. In fact, the system permitted the same market timer to continue timing the same fund by opening new accounts, the SEC said. Only if a fund threatened to terminate its dealer agreement with Bear Stearns would the firm put a stop to all market timing in that fund.
The remedial actions the firm is required to take under the settlement include hiring an independent consultant to review the policies and procedures of the broker-dealer and clearing entity and making recommendations to avoid such abuses in the future. BSSC also agreed to maintain a director of compliance and to establish an Internal Compliance Controls Committee, both of which will report to a committee of the firms’ board of directors.
BSSC also will provide training and education to its employees to minimize the possibility of future securities law violations. Finally, the firm will establish a compliance hotline where employees can anonymously report conduct concerns or obtain answers to questions.
Bear Stearns chief executive James Cayne said: “As one of the leading financial services providers, we take our responsibilities to our clients very seriously. We believe that seeking to resolve this issue is in the best interests of our shareholders, clients, and employees.”
