The Securities and Exchange Commission has fined BNY Mellon $24 million and has banned a former manager of institutional trading at Mellon Securities from associating with any broker dealer firm after carrying out what it called an “eight-year best execution fraud.”
Banned is Mark Shaw, who was an institutional order desk manager at the former Mellon Securities from March 1999 until May 2008 when he was fired by BNY Mellon, the large asset management and securities services firms.
Shaw has been ordered to pay costs of $368, 591 and was “barred from association with any broker or dealer.” The SEC on Jan 14 also censured Mellon Securities for failing “reasonably to supervise the order desk manager and traders on its institutional order desk.” BNY Mellon shut down Mellon Securities in 2009.
BNY Mellon suspended cross-trading activity by Mellon Securities on 31 March, 2008 and launched an internal investigation which led to Shaw’s dismissal on May 2, 2008.
BNY Mellon, created through the merger of the former Bank of New York and Mellon, reported the investigation to the SEC on July 22, 2008.
Of the $24 million that must be paid by BNY Mellon, about $19.3 is for disgorgement and $3.7 million is for what the SEC called "pre-judgement." BNY Mellon, which reported full-year revenue of $7.7 billion in 2009, has also devised a plan to create a ‘fair fund’ 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,” BNY Mellon said, in a statement on the case.
Shaw stood to personally gain from the scam. according to the SEC. The level of Shaw’s annual bonus depended in part on the desk’s commission earnings, it said. 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 order desk’s annual bonus pool depended in part upon the commissions it generated, and the order desk manager [Shaw] determined how he and the traders under his supervision shared in the bonus pool,” wrote the SEC, Friday, January 14, 2011.
While at Mellon Securities, Shaw was responsible for executing orders on behalf of Mellon Investor Services (MIS), an administrator and transfer agent.
According to the SEC, he deprived many among MIS’s 600 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. NBBO refers to the SEC rule requiring brokers to guarantee that their customers receive the best prevailing ask price when they purchase securities.
Here is how Shaw perpetuated his scam, according to the SEC:
He manipulated the latency of a a regional U.S. exchange’s order management system. In December 2006, the regional exchange, added a functionality called the “validated cross window.”
The “validated cross window” allowed member firms of the regional exchange to freeze the NBBO for a security.
That’s how Shaw to obtain lower prices for hedge fund clients that wanted to cross-sell orders from customers of a plan or vice versa.
“The validated cross window validated a market, meaning the NBBO, by capturing and freezing a snapshot of the NBBO market for a security at the moment a member firm broker typed the security symbol into the system. At the same moment, a window expiration timer was initiated.
The timer gave the broker up to three minutes to fill in the required fields including quantity and price, and to submit the trade for execution and reporting.”
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, said the SEC which never identified the regional exchange.
Why didn’t Shaw’s superiors catch up to his scam sooner? According to the SEC, Mellon Securities did have a best execution committee and quarterly reports showed that Mellon Securities was executing orders substantially outside the prevailing NBBO but the committee did nothing to stop the practice. The SEC said that Mellon Securities did not establish procedures to evaluate its best execution exception reports or to determine whether Shaw, as an institutional order desk manager, was fulfilling his responsibilities. Shaw also happened to be a member of the best execution committee
“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.
If Mellon Securities did have such procedures in place, it would have discovered that the order desk manager never conducted such a review and likely would have prevented his violations.