Knight Trading Group

$1.5 Million Fine

• On January 7, 2002 the NASD issued a press release announcing that Knight would be required to pay $1.5 million for "market making and trading violations." $700,000 would be paid to the NASD and $800,000 would be paid to clients that traded OnSale Inc. with Knight as the trader. The NASD found that Knight had:
• "Failed to honor posted quotes." (Quotes are continually updated and tell the highest bid and lowest asking price on individual securities.)
• Failed to "promptly display limit orders." (A limit order is given to a broker by a client, and informs him or her of what price to sell a specific security at, and until what point to buy.)
• "Failed to report thousands of trades on a timely and accurate basis to the NASD." Violated the "locked and crossed markets rule." (Locked and crossed markets normally occur on the Nasdaq when orders have been entered before the official beginning of the day's trading [9:30 EST]. A market is locked when the ask price and the bid price of a stock are the same. A market is crossed when the bidding price of a stock is higher than its asking price. The "locked and crossed market rule," in part, requires market participants to quickly remedy locked or crossed markets they have created between 9:20 and 9:29:59 EST, by issuing Trade-or-Move-Messages. The recipients of the Trade-or-Move-Messages must respond within 30 seconds.
• Failed to execute 645 orders of OnSale, Inc. in accordance with "'just and equitable' principles of trade."

These violations were made between July of 1997 and May of 2001.

NASD and SEC Investigations on Stellato's Complaint

An earlier complaint, whose verdict it still pending, was filed by the former head of Knight's institutional trading desk, Robert Stellato. The complaint against the trading group and its former CEO, Kenneth Pasternak, alleges that the company overstepped numerous trading rules. Mike Dorsey, Knight's legal counsel, argued that the accusations were unwarranted when Stellato came before him and Pasternak. The formal arbitration complaint, filed late 2001 with the NASD, alleges that Knight's traders knowingly engaged in "front running" (see below), and that Pasternak knew the practice was pervasive throughout the company. In the complaint Stellato informed the NASD that, after being hired in 2000, he was warned of problems by two managers. Upon interviewing the department's institutional sales traders, Stellato discovered that executives were, as per the filing, "at the least, front running customer orders in concert with the traders and with the full blessing of Pasternak and the rest of Knight's management." According to the complaint, the violations cost investors millions of dollars.
The NASD, in concord with the SEC, began an informal investigation on Knight in March of 2002. In April it obtained a formal order of investigation. Information about the inspections, released by Knight on June 3, 2002, caused a dramatic drop in the market maker's share prices (28% by the following day). Regulators have yet to finish their review of the company's practices.

Front Running

Front running occurs when a broker purchases shares of a stock before executing his or her customer's order. The broker, because of the pending order, is able to predict the direction the stock will go, and benefit on that knowledge to the detriment of the client. Front running, also known as 'forward trading,' is a trading rule violation. The Knight shareholder class action suit alleges that "the Company's traders were engaging in an elaborate system of trading-rule violations known as 'front-running,' in which customer orders were delayed while defendants' traders made purchases in the same stocks ordered by customers, thereby benefiting themselves at the expense of the customer."

Class Action Suit

A class action suit, which was filed by Knight shareholders on June 27, 2002, echoed concerns over "front running." The lawsuit alleged that Knight shareholders accrued damages because financial performance and trading practice statements issued by Knight were "materially false and misleading." Although the outcome of the federal investigation is still pending, shareholders have pursued compensation, holding that such an omission from financial and trading statements would have placed shareholders at risk and violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The class action period dates between February 29, 2000 and June 3, 2002.