Case Study 3: Trading After Hours

Several years ago, Prudential Securities was charged with fraud for late trading. This was the first major brokerage house to be charged with the illegal practice of buying mutual funds after hours.

The regulators who accused Prudential Securities charged them with carrying out a large-scale, late- trading scheme that involved more than 1,212 trades that were valued at a remarkable $162.4 million. These trades were placed after hours in order to benefit favored hedge funds. The complaint did not contain information regarding any profits that were protected by the scandal.

The regulators who accused Prudential stated that Prudential should have noticed the considerable number of trades that were being placed after 4 p.m. and should have begun an internal inquiry. However, the complaint stated that Prudential possessed “no internal supervisory procedures” to detect trades placed after hours.

Market timing, often done in conjunction with late trading, involves rapid in and out trading of a mutual fund designed to take advantage of delays in marking up prices of securities in the funds. By buying before the markups and selling quickly after them, Prudential traders realized quick profits for the firm’s clients at the expense of others. A group of managers and top- producing brokers were charged last month  by  the SEC and/or state in separate civil actions related to market timing. The firm denies all wrongdoing.

Normally, orders to buy funds after 4 p.m. should be filled at the price set the next day. In late trading, which is illegal,orders instead get the same day’s 4 p.m. price, enabling investors to react to news a day ahead of other investors.

In order to accomplish late trading, the complaint stated  that  Prudential  clients  would  engage  in    the following activities: Prudential clients would submit a list of potential trades to brokers before the 4 p.m. deadline by fax, e-mail, or telephone. After 4 p.m., clients notified Prudential which of the long list of trades it wished to execute. Prudential brokers would take the original order, cross out the trades the  client didn’t want to execute, and then forward the order to the firm’s New York trading desk. The time stamp on the fax would often deceptively reflect the time it was received originally, not the time that the client confirmed the order. For example, in just one afternoon, at 4:58 p.m., Prudential’s New  York  office  executed  more  than 65 mutual fund trades, for a total of $12.98 million.

According to the complaint, Prudential did nothing to substantiate  the  orders  that  were  received  before 4 p.m. In early 2003, the brokerage firm issued a policy change requiring branch managers to initial a cover sheet for trades before faxing them to New York. Lists of trades could be received at Prudential’s New York trading desk as late as 4:45 p.m. Accusations against the firm state that, “The orders  were  never rejected and were always executed at same-day prices.”

The complaint further states that Prudential also al- lowed the brokers involved in the market-timing and late-trading scheme to have dedicated wire-room per- sonnel to execute trades. It has been suggested that the brokers compensated the wire-room employees  for their efforts, by sharing year-end bonuses. The state alleges that Prudential also authorized one broker to obtain special software that gave the employee “elec- tronic capacity to enter bulk mutual fund exchanges after 4 p.m.”32

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