Brokers in stock-pricing probe

By Jenny Anderson in New York
November 9, 2004

The US Securities and Exchange Commission is investigating a dozen brokerage firms, including Morgan Stanley, Merrill Lynch, Ameritrade, Charles Schwab and ETrade Financial, on suspicion they failed to secure the best available price for stocks for their customers, according to people close to the inquiry.

At issue is the way the companies executed trades of Nasdaq-listed securities when the markets opened - a period of intense trading due to a backlog of orders from the previous day.

After examining data from the past four years, the inquiry found evidence that trades were often processed in ways that favoured the firms over their clients.

Securing the best price is one of the industry's obligations to investors. If investigators' suspicions are confirmed, these practices are not likely to add up to significant costs for individual investors - the difference would be cents per share traded - but in total they could represent substantial amounts of money for the brokers.

More important, the investigation opens another possible conflict of interest involving the big firms on Wall Street.

Brokers have a "best execution" obligation, defined by common law, fraud provisions of the Securities acts and market rules to get the best possible price for investors.

An SEC spokesman declined to comment on the inquiry, as did representatives from Ameritrade, Schwab, Merrill Lynch, Morgan Stanley and ETrade.

The investigation is examining two methods of executing trades - internalisation and payment for order flow. Both are permitted by the SEC and are illegal only if the customer does not receive the best price available.

With internalisation, the broker trades an order against its own inventory, either shares it owns or other buy and sell orders waiting to be executed. Internalisation becomes a problem if the broker chooses to trade against its own inventory when there is a better price available elsewhere.

With order flow, retail brokerage firms send aggregated small orders to market makers - firms that buy and sell stocks to maintain orderly trading. As a way to attract orders from brokers, some stock exchanges or market makers will pay for routing the order to them - perhaps a few cents a share.

Because the order is not exposed to the larger market, the investor may be missing out on the best price.

The investigation is looking only at those firms that deal directly with retail orders, then either internalise or ship the orders out. To make matters more complicated, some firms play multiple roles. Some retail brokerage houses, like Ameritrade, sell their order flow, focusing on customer service rather than trading itself. Others function both as market makers and selling their order flow.

The New York Times