Tuesday, August 16, 2005

Criminal and Civil Charges Against Four Brokers for Aiding "Front-Running" by Day-Traders

The U.S. Attorney's Office for the Eastern District of New York and the SEC filed charges against four brokers for allowing day-traders to listen in on market analysis and customer order information through the brokerage firms' internal communications systems, known as the "Squawk Box."  The brokers worked at major Wall Street firms:  Kenneth Mahaffy (Merrill Lynch and Citigroup), Timothy O'Connell (Merrill), Ralph Casbarro (Citigroup), and David Ghysels (Lehman Brothers).  By hearing what the firms' brokers were being told about upcoming orders, the day-traders could buy and sell stocks ahead of transactions that would affect the price of the shares being traded. According to a press release issued by the U.S. Attorney's Office (here):

As alleged in the indictment, between January 2002 and December 2003, the defendants routinely provided day traders at two New York City based day trading firms, A.B. Watley, Inc. ("A.B. Watley") and Millennium Brokerage, LLC ("Millennium"), with material, non-public customer order information, which was disseminated through internal speaker systems at Merrill, Citigroup and Lehman known as "squawk boxes." Specifically, the defendants placed telephone calls to the day traders and left the telephones off the hook next to squawk boxes at their respective brokerage firms so that the day traders were able to hear the customer orders that were being broadcast. In exchange for access to the squawk box information, the day traders paid substantial amounts of money to the defendants in the form commissions from "wash trades" (simultaneously buying and selling the same amount of a security at the same price for the sole purpose of generating commissions) that were generated through brokerage accounts that the day traders opened with the defendants at Merrill, Citigroup and Lehman. Some of the defendants also accepted cash bribes from the day traders in exchange for squawk box access.

The indictment alleges that the day traders profited from the scheme by trading in front of the large orders that were broadcast through the squawk boxes. For example, when the squawk boxes disseminated information concerning a large buy order for a particular stock, the day traders would purchase shares of the same stock before the larger order was executed. Alternatively, when the squawk boxes disseminated information concerning a large sell order for a particular stock, the day traders would "short sell" the same securities before the larger order was executed. In either circumstance, the day traders profited from the subsequent movement in price that the large customer order caused. The day traders generated profits of over $600,000 by engaging in this illicit trading activity through proprietary accounts at A.B. Watley and Millenium.

The case has already yielded guilty pleas by other former Merrill employeess related to obstruction of the government's investigation for lying investigators (see here).  The SEC's Litigation Release is here

Front-running presents an interesting issue for a securities fraud case because the information is available to the entire firm.  Even when the information is about a large order to buy or sell shares, it does not involve information received from the company that is otherwise undisclosed (i.e. classic inside information), and is based on the decision of a customer of the brokerage firm that is not related directly to the company's operations.  Is market information subject to the antifraud prohibition of Section 10(b) and Rule 10b-5?  The SEC has taken an aggressive view of front-running, in a case a couple years ago involving leaks of information about the sales of federal bonds.  The issue may get played out in the criminal prosecution with its heavier burden of proof.  For the defendants, however, arguing that they helped someone make "free money" to the tune of $600,000 but no one got hurt may not play well with a jury. (ph)


Fraud, Prosecutions, Securities | Permalink

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