In a federal court in Trenton, N.J., this June, Kenny Pasternak, former chief executive of Knight Trading Group, now Knight Capital Group, and John Leighton, Knight’s former head of institutional sales, recently won a big victory against the Securities and Exchange Commission. The ruling brings some closure to a legal drama surrounding allegations of fraud at Knight that has dragged on for years, cost Knight $79 million, and ended the securities industry careers of three former Knight executives.
“I feel vindicated,” Pasternak told Traders Magazine. “But it’s unfortunate it takes five years and millions of dollars in legal bills to deal with the strong-arm tactics of the SEC.”
Nine years ago, Pasternak was riding high. His wholesaling firm was benefiting from an Internet stock-trading boom fueled by retail investors chasing the next big technology thing. Volume was up. Profits were up. Hiring was up.
Some of that hiring was done to boost Knight’s institutional business. Pasternak brought in John Hewitt from Goldman Sachs as president to broaden Knight’s reach overseas and into other products. Hewitt, in turn, hired a 30-year sales veteran from Goldman named Bob Stellato to run institutional sales.
That’s when the problems started. Within days of his hire, Stellato accused Knight’s most successful sales trader, Joe Leighton, of front-running customer orders. He also accused Joe Leighton’s brother John, in charge of the sales trading desk, of failing to do anything about it.
Nothing Wrong
Both men maintained they were doing nothing wrong, so Stellato took his charges to Knight’s legal department and to Hewitt. Knight’s chief counsel, Michael Dorsey, denied there was any wrongdoing, and so did Pasternak.
Within a year of his hire, Stellato was let go from Knight. Hewitt left the same month. Stellato decided his firing was a “wrongful termination” and took his case to NASD arbitration. Included in his charges was a “whistle-blower” charge of front-running directed against Knight.
That brought the regulators in. The NASD, now the Financial Industry Regulatory Authority, or FINRA, and the SEC began an investigation into Stellato’s claims that eventually resulted in charges against Knight, Joe Leighton, John Leighton and Pasternak.
By that time, in early 2002, Pasternak had been forced out of Knight because of the firm’s financial losses that accompanied the bursting of the Internet bubble. Tom Joyce, a Merrill Lynch veteran, took over as Knight’s CEO in May 2002.
For Pasternak, the troubles were just beginning. The regulators’ investigations culminated in charges against Pasternak and John Leighton. In early 2004, just before Knight would pay $79 million to settle SEC and NASD charges of trading misconduct, Pasternak and John Leighton received Wells Notices from the NASD and SEC, informing them of possible charges.
In March 2005, the NASD pounced, charging Pasternak and John Leighton with supervisory violations related to the alleged fraud. In August of that year, the SEC followed suit, charging the two men with complicity in the fraud, as well as supervisory violations. The SEC maintained that sales trader Joe Leighton had extracted excessively high profits from his trades with money managers.
The NASD hearing took place last year. A NASD hearing panel found the two men guilty. The SEC trial took place in federal court this spring, resulting in a decision of not guilty.
So what happened? Why did two different courts trying the same case produce two different results?
Underlying both trials was the contention that John Leighton’s brother, Joe, bilked Knight customers by selling stock to them at overly high prices or buying stock from them at overly low prices. In 2005, Joe Leighton settled fraud charges brought by the SEC and NASD for $4 million. He was not charged with the front-running that Stellato had alleged. Like Knight, Joe Leighton neither admitted nor denied the charges.
In this year’s trial, the SEC offered several examples of trades it considered fraudulent. On April 4, 2000, for instance, Joe Leighton received an order to buy 290,000 shares of AMCC from T. Rowe Price. Within 18 minutes of receiving the order, Knight’s market makers accumulated about 147,000 shares at an average cost of $91.
Knight did not immediately turn around and sell the stock to T. Rowe at $91 plus “a reasonable amount of compensation,” the SEC stated, but parceled it out to T. Rowe over the course of the day at an average price of $93. The SEC contended that Knight made too much money on the trade. Standard practice in 1999 and 2000 was to charge no more than 12 cents per share, it averred.
U.S. District Court Judge Joel Pisano disagreed. He decided Joe Leighton did not commit fraud. Because there are no rules limiting the profit a broker-dealer can make when trading on a net basis with a customer, Joe Leighton had the right to charge whatever he wanted, the judge decided. Judge Pisano ruled in favor of Pasternak and John Leighton.
But last April, the three-person NASD panel arrived at a different conclusion. It decided Joe Leighton should have taken into account Knight’s cost basis when pricing customer orders. The panel maintained that the prices the customers received were too high or low relative to the prices at which Knight traded. The panel ruled two-to-one against Pasternak and John Leighton, concluding that they failed to properly supervise the sales trading operation.
One case. Two trials. Two different verdicts. While the recent SEC decision appears to vindicate Pasternak and John Leighton, it also puts the events of the past in a different light. The allegations of the SEC and the NASD cost Knight $79 million and wrecked the careers of Pasternak and the Leighton brothers.
For its part, Knight would only say “The court decision marks a close to this chapter in Knight’s history.” Bob Stellato declined to comment.
Both the SEC and the NASD contended that Joe Leighton should have filled his customers’ orders at no more than 6 or 12 cents per share away from the price at which Knight’s market makers bought or sold the stock. Some of his trades generated profits of nearly $5 per share, the evidence shows.
Adverse Market Impact
Michael Dorsey, Knight’s general counsel during 1999 and 2000, notes Knight purposefully did not give its institutional customers over-sized fills right away because that would have tipped off other traders in the market to the large institutional orders Knight was handling. They could have used that information to run up or down the price of the stock, forcing the institutional customer to suffer “adverse market impact” on any subsequent executions.
“We were working the orders by filling them over the course of the day or morning or whatever period that was consistent with the customers’ wishes,” Dorsey explains. “We were hiding in the volume because the day traders were out there. In the process we obtained much better executions for our institutional customers.”
Knight used the FIFO (first in, first out) accounting method when it came to distributing the shares. It is the required methodology for securities dealers under Generally Accepted Accounting Principles (GAAP) as well as the SEC’s Uniform Net Capital Rule. “FIFO causes abnormally large profits in an inflationary time which is what we had in the stock market in the late 1990s and early 2000,” Dorsey says.
For Judge Pisano, the timing of the fills wasn’t the issue anyway. The issue was the magnitude of the profits. They weren’t “excessive” or “obscene,” as the SEC had charged, the judge held.
No Standard Rule
It is a very facile argument to simply call a profit excessive and then translate that into something sinister or fraudulent,” Pisano said during closing arguments at the U.S. District Court for the District of New Jersey in Trenton. “Profits are not regulated in magnitude. There is no standard rule or regulation that places a limit on profit. There is no industry custom which places a limit on profit.”
Pisano based his conclusions partly on testimony from James Cangiano, a former Nasdaq/NASD regulatory official and SEC witness at the trial. Cangiano, whom Pisano called “one of the most important witnesses in this case,” testified that there is no rule or regulation in the industry that specifically regulates the amount of profit on a trade.
The NASD panel was comprised of a former judge named Andrew Perkins and two industry professionals, one of whom was a former Nasdaq market maker.
Two of the three decided Joe Leighton should have taken Knight’s cost into consideration. Despite the absence of rules specifically limiting the amount of profit a sales trader or firm can take, they decided Joe Leighton’s prices were simply unfair. “Joseph Leighton gave no consideration at all to whether he had obtained the best price for the customer,” the panel concluded.
Joe Leighton had testified before the NASD that he priced his trades based on the volume-weighted average price (VWAP) of a stock, not Knight’s cost basis. He claimed his customers understood this. He claimed he met his customers’ expectations. “In his view,” Joe Leighton said, “his obligation was to make sure that he gave his customers, at the end of the day, a price that would not look foolish when compared to the prices the stock had traded during the day away from Knight.”
During the NASD trial, several buyside traders testified otherwise. They said they expected Joe Leighton to trade with them at the best possible prices.
The manager of the trading desk of Davis Select Advisors, for instance, testified that his objective was to get the best possible price, not an average price. The trader viewed working to a VWAP as “striving for mediocrity, which was not acceptable.”
No Mark-Up
The former head of equity trading at Trust Company of the West testified that he expected Joe Leighton to fill his orders at Knight’s cost plus a mark-up “in most cases between $0.05 and $0.06 per share, which he considered the industry norm in 1999 and 2000, and in no case above $0.12 per share.”
Legally speaking, there was no mark-up involved. A mark-up is based on “contemporaneous cost” and typically is used by broker-dealers when they are filling the orders of their retail customers of whom Knight had none, explains Dorsey.
Trading net went out of fashion when decimalization crimped spreads and dealer profits. But it simply means the dealer buys or sells stock out of its inventory at prices based on existing market prices. The reference price is the current market price, not the dealer’s basis.
“We were always selling to our institutional customers at or around the current market price,” Dorsey says. “There were no mark-ups or mark-downs.”
The federal court agreed with him. “Joseph [Leighton] handled not-held orders executed on a net basis,” Pisano said in his final opinion. “By definition, those trades do not include set mark-ups, commissions or fees.”
At the time the trades were done, the buyside traders were apparently pleased with their fills. They testified that, at the time of the transactions, “they believed they received best execution and fair prices on their trades.”
Out the Window
Pisano said: “No institutional customer testified that Joseph executed a trade that was not reasonably related to market conditions. In fact, the institutional customers never complained about the price paid or received for a trade executed through Joseph.”
In contrast to their testimony at the NASD panel, the buyside traders at the SEC trial all maintained that “they did not know or particularly care what [Joe Leighton’s] cost basis were,” Pisano said on the last day of the trial.
They all stated that given market conditions during the highly volatile Internet bubble period, the “six to 12 cent standard goes out the window.”
Testifying on behalf of the SEC were 10 buyside traders including Andy Brooks of T. Rowe Price, William Lawlor of Davis Selected Advisors, and Stuart George of Delaware Investments.
In the NASD case, Pasternak and John Leighton were each fined $100,000. Pasternak received a two-year bar from holding a supervisory role in the securities industry. Leighton was barred for life. Both men are appealing the panel’s decision to FINRA’s National Adjudicatory Council, a 14-person committee composed of seven industry and seven non-industry members.
Pasternak says he expects to be exonerated on appeal. He won the SEC case and lost the NASD case, he believes, because the fact finder in the SEC case, Judge Pisano, was a trained professional. The pair who found him guilty in the NASD case were not. Pasternak believes the dissenting opinion came from the retired judge.
“Judge Pisano used the kind of fact-finding oversight that a trained professional would to come to the right conclusion that I was innocent,” Pasternak says.
SIDEBAR #1: Knight’s Long Journey
> June 1999 John Hewitt joins Knight from Goldman Sachs as president
> July 2000 Bob Stellato joins Knight from Goldman Sachs as head of institutional sales
> November 2000 John Leighton, Knight’s institutional sales desk manager, and his brother Joe Leighton, a Knight sales trader, both leave the firm
> June 2001 Hewitt leaves Knight
> July 2001 Stellato leaves Knight
> December 2001 Stellato files $25 million arbitration claim with NASD against Knight over his alleged improper termination and a “whistleblower” claim of front running at Knight
> January 2002 CEO Kenny Pasternak leaves Knight in wake of earnings decline
> Early 2002 SEC and NASD launch investigations into allegations of improper trading practices at Knight
> April 2002 Pasternak joins hedge fund Chestnut Ridge Capital as a portfolio manager
> May 2002 Tom Joyce joins Knight as CEO
> January 2003 John Leighton joins Crown Financial as president and CEO
* April 2003 NASD Dispute Resolution commences arbitration hearings in case of Stellato vs. Knight
> March 2004 SEC and NASD separately issue Wells Notices to Knight, Pasternak and John and Joe Leighton, informing them the SEC was considering filing charges
> July 2004 Knight settles investigations with SEC and NASD for $79 million, including the disgorgement of $41 million in institutional trading profits
> September 2004 NASD Dispute Resolution rules for Knight in arbitration with Stellato
> March 2005 NASD charges Pasternak and John Leighton with supervisory violations in connection with fraudulent sales to institutional customers in1999 and 2000
> April 2005 Joe Leighton settles fraud charges with NASD and SEC. He is fined $4 million and barred from industry for life
> August 2005 SEC files civil fraud charges against Pasternak and John Leighton for their roles in a trading scheme that allegedly defrauded Knight’s institutional customers
> April 2007 NASD fines Ken Pasternak and John Leighton $100,000 each for supervisory violations in connection with fraudulent sales to institutional customers; NASD also barred Pasternak from any industry supervisory role for two years and Leighton for life
> June 2008 Federal judge rules in favor of Pasternak and John Leighton in SEC supervisory case
SIDEBAR#2: Guilty Conscience
Joe Leighton and his brother John may have done nothing wrong in the eyes of the U.S. District Court for the District of New Jersey, but Kenny Pasternak did have qualms back in 1999.
Following conversations with recently hired president John Hewitt, Pasternak concluded that Joe Leighton’s profits and the profit-sharing arrangement he had with brother John could present Knight with a “marketing problem.”
According to court documents, “Pasternak thought that Knight could be a target of heightened scrutiny merely because it was profitable.”
The Leightons, who controlled the largest accounts at Knight, took in between $20 million and $30 million they told Hewitt.
Hewitt told Pasternak he could not work with the Leightons so Pasternak gave him the okay to hire Bob Stellato from Goldman Sachs to oversee institutional sales. Stellato was offered the job in December 1999 and joined in July 2000.
Upon his hire Stellato immediately set to the task of examining Joe Leighton’s trading practices. He presented his conclusions to Pasternak and Knight’s legal department. Pasternak still concluded that nothing illegal had happened but that the profits could present Knight with an image problem.
Eventually, Hewitt told Pasternak he wanted the Leightons fired. Pasternak agreed. In September 2000, the Leightons left Knight.
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