A former institutional trading desk head at Mellon Securities has been banned and parent company BNY Mellon, the asset management and securities services giant, fined US$24 million for systematically chasing better prices for hedge fund clients at the expense of institutional customers over a period of more than eight years.
Mark Shaw, who was employed as an institutional order desk manager at Mellon Securities from March 1999 until his contract was terminated by BNY Mellon in May 2008, has been ordered to pay costs of US$368, 591 and was also “barred from association with any broker or dealer” by the US Securities and Exchange Commission (SEC). The regulator has also censured Mellon Securities for failing “reasonably to supervise the order desk manager and traders on its institutional order desk”. BNY Mellon closed down the operations of Mellon Securities in 2009 and none of the traders involved still work for the group.
According to the SEC, Shaw carried out a “more than eight-year best execution fraud” by manipulating time delays in systems for executing and reporting agency cross trades on a regional US exchange to the advantage of hedge funds clients and at the expense of accounts belonging to employee stock purchase plans, employee stock option plans, direct purchase and sale plans and other similar plans.
Mellon Securities was responsible for executing orders on behalf of Mellon Investor Services (MIS), an administrator and transfer agent, but routinely deprived many among MIS's 700+ plan clients of best execution by executing their orders at stale or inferior prices – often outside the US National Best Bid and Offer (NBBO) – in cross trades that gave better prices to hedge fund clients. Shaw also instructed traders under his supervision – who had authorisation from MIS to handle plan customer orders as ”market not-held orders', i.e. with discretion to execute within prevailing market prices – to pursue the same approach.
BNY Mellon suspended cross-trading activity by Mellon Securities on 31 March, 2008, three days after the SEC had charged a hedge fund client on an unrelated matter. The firm immediately launched an internal investigation which led to Shaw's dismissal on 2 May, 2008 and the matter being reported to the SEC on 22 July, 2008. Although it has ordered BNY Mellon to pay US$19,297,016 disgorgement and pre-judgment interest of US$3,748,431, the SEC said it had refrained from levying a civil penalty higher than US$1,000,000 due to BNY Mellon's cooperation with the investigation and enforcement action. BNY Mellon must also devise a plan to distribute a ”fair fund' established – in accordance with the 2002 Sarbanes-Oxley Act – to compensate plan clients “fairly and proportionately” for losses attributable to cross trades conducted by Shaw and his team.
“This settlement reflects a series of remedial actions already taken by BNY Mellon, including internal reviews that first identified the matter; voluntary self-reporting to the SEC; and cooperation with the SEC's subsequent investigation. BNY Mellon has taken the appropriate steps to ensure that this type of activity does not occur again,” said a statement issued by BNY Mellon.
Established in 2007 following the merger of Mellon Financial Corporation and The Bank of New York Company, New York-headquartered BNY Mellon has US$25 trillion in assets under custody or administration and US$1.17 trillion under management.
A best execution committee had been established under Mellon Securities' written supervisory procedures but its efforts to scrutinise the institutional order desk's trading activities were undermined by Shaw's membership of the committee. The SEC said Mellon Securities had failed to establish procedures either for dealing with ”red flags' in its best execution exception reports or for determining whether Shaw, as institutional order desk manager, was fulfilling his responsibilities. Quarterly reports prepared for the best execution committee showed that Mellon Securities was executing orders outside the prevailing NBBO at a rate greater than industry averages from as early as Q3 2003 – and at a rate two to three times peers from Q4 2006 onward – but the committee failed to act on this evidence. “The only ongoing monitoring and review of the effectiveness of these procedures in detecting or preventing violations was a daily best execution review by the order desk manager of executions on regional exchanges,” said the SEC. “The order desk manager never conducted such a review and Mellon Securities did not have procedures to determine whether he was fulfilling his responsibility to do so.”
In practice, Shaw used the ability of member firms of a regional exchange to capture and freeze the NBBO data for a security for up to three minutes to obtain lower prices to benefit hedge fund clients that wanted to cross sell-orders from plan customers (or vice versa). The regional exchange's ”validated cross window' gave a member firm three minutes to submit a cross trade for execution and reporting, but the window could also be refreshed to capture a subsequent NBBO snapshot. Thus if the price of a security fell after a member firm had initially captured the NBBO to cross a plan customer's sell order with a hedge fund's buy order, Shaw would instruct the member firm to continue to refresh the snapshot – sometimes several dozen times – to get the lowest possible price for the hedge fund client.
Although the validated cross window was only introduced by the regional exchange in 2006, Shaw and his colleagues had been following similar practices previously on a more manual basis. Mellon Securities' institutional order desk was paid two cents per share for executing orders for MIS's plan customers while hedge funds paid the firm between two and six cents per share. The level of Shaw's annual bonus depended in part on the desk's commission earnings.
Steve Wood, former head of trading at Schroder Investment Management and founder of Global Buy-Side Trading Consultants, welcomed the SEC's action as showing that regulators now had “more bite than bark”, but said the case also demonstrated the need both for greater internal monitoring of trading processes and for more rigorous training of buy-side traders.
“The expertise and robustness of the buy-side trader is really only evaluated internally via the annual appraisal process by the institution,” he said. “The exam process to get regulatory approval to trade is out of date and only really applies to rules and regulations with no focus on the way trading has evolved. There should be a more robust qualification with a focus on trading tools and techniques before the buy-side trader is authorised to trade.”
Wood also suggested that the trading performance and processes of institutional investment firms should be monitored by a committee comprising heads of department and chaired the CIO which reports regularly to senior management.