Exhibit 10.1

 

UNITED STATES OF AMERICA

before the

SECURITIES AND EXCHANGE COMMISSION

 

SECURITIES EXCHANGE ACT OF 1934

Release No.

 

ADMINISTRATIVE PROCEEDING

File No.

 

    : In the Matter of   : ORDER INSTITUTING     : ADMINISTRATIVE AND CEASE-AND-
    : DESIST PROCEEDINGS, MAKING     : FINDINGS AND Knight Securities L.P.,   :
IMPOSING REMEDIAL     : SANCTIONS PURSUANT TO Respondent   : SECTIONS 15(b)(4)
AND 21C OF THE     : SECURITIES EXCHANGE ACT OF 1934     :

 

I.

 

The Securities and Exchange Commission (“Commission”) deems it appropriate and
in the public interest that public administrative proceedings be, and hereby
are, instituted pursuant to Sections 15(b)(4) and 21C of the Securities Exchange
Act of 1934 (“Exchange Act”) against Knight Securities, L.P. (“Knight” or the
“Firm”).

 

II.

 

In anticipation of the institution of these proceedings, Knight has submitted an
Offer of Settlement (the “Offer”), which the Commission has determined to
accept. Solely for the purpose of these proceedings and any other proceedings
brought by or on behalf of the Commission, or to which the Commission is a
party, and without admitting or denying the findings herein, except as to the
Commission’s jurisdiction over Knight and the subject matter of these
proceedings, which Knight admits, Knight consents to the issuance of this Order
Instituting Administrative and Cease-And-Desist Proceedings, Making Findings and
Imposing Remedial Sanctions Pursuant to Sections 15(b)(4) and 21C of the
Securities Exchange Act of 1934 (“Order”), as set forth below.

 

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III.

 

FINDINGS

 

On the basis of this Order and Respondent’s Offer, the Commission finds that1:

 

A. OVERVIEW

 

From January 1999 through November 2000, Knight defrauded its institutional
customers by extracting excessive profits out of its customers’ “not held”
orders2 while failing to meet the Firm’s duty to provide “best execution”3 to
the institutions that placed those orders.4

 

On numerous occasions during the relevant time period, Knight, upon receipt of
an institutional customer order, would acquire a substantial position in the
Firm’s proprietary account. Rather than fill the order promptly on terms most
favorable to the customer, Knight would wait to see if its proprietary position
increased in value during the trading day. By delaying execution with the
customer, Knight executed stock to the customer when the prevailing market price
had moved significantly away from its acquisition cost – thereby yielding Knight
greater profit at the expense of its customer. When the market moved unfavorably
in relation to the position Knight had established pursuant to the institution’s
order, Knight executed trades with the customer at prices that still generated a
profit for Knight. By engaging in these trading practices, Knight improperly
realized

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1 The findings herein are made pursuant to Knight’s Offer of Settlement and are
not binding on any other person or entity in this or any other proceeding.

 

2 In “not held” institutional orders, an institutional customer grants the
broker-dealer the discretion with respect to the time and price of the
transaction.

 

3 The duty of best execution requires a broker-dealer to seek to obtain for its
customer’s order the most favorable terms reasonably available under the
circumstances. See, e.g., Newton v. Merrill, Lynch, Pierce, Fenner & Smith,
Inc., 135 F.3d 266, 270 (3d Cir. 1998). The duty of best execution requires
broker-dealers to execute customers’ trades at the best reasonably available
price. Id. Other terms in addition to price are also relevant to best execution.
In determining how to execute a customer’s order, a broker-dealer must take into
account order size, trading characteristics of the security, speed of execution,
clearing costs, and the cost and difficulty of executing an order in a
particular market. Id. citing Payment for Order Flow, Exchange Act Release No.
33,026, 58 Fed. Reg. 52934, 52937-38 (Oct. 13, 1993).

 

4 The NASD, in its Notice to Members 97-57, states that once the customer has
granted the broker-dealer the discretion to work a “not held” order, the
broker-dealer, as agent, has a clear responsibility to work to obtain the best
fill considering all of the terms agreed to with the customer and the market
conditions surrounding the order. According to The Report of the Special Study
of Securities Market, “The integrity of the industry can be maintained only if
the fundamental principle that a customer should at all times get the best
available price which can reasonably be obtained for him is followed.” H.R. Doc.
No. 95, 88th Cong., 1st Sess. Pt. II, 624 (1963). See, In re E.F. Hutton & Co.
(“Manning”), Securities Exchange Act Release No. 25887 (July 6, 1988). See also,
Payment for Order Flow, Exchange Act Release No. 34902, (Oct. 27, 1994), 59 FR
55006 (Nov. 2, 1994) and Order Execution Obligations, Securities Exchange Act
Release No. 37619A, (Sept. 6, 1996), 61 FR 48290 (Sept 12, 1996).

 

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from its institutional customers tens of millions of dollars, in excessive per
share profits on transactions that involved effectively no risk to Knight.

 

Throughout the time period, Knight failed reasonably to supervise Knight’s
former leading sales trader who was primarily responsible for Knight’s
fraudulent trading (“Leading Sales Trader”), with a view to preventing his
violations of the federal securities laws by failing to establish procedures to
prevent him from aiding and abetting Knight’s fraud against its institutional
customers. The Leading Sales Trader managed the vast majority of Knight’s
largest institutional accounts, handled approximately 50 percent of the trade
volume on the institutional desk and generated the highest profits per share of
any trader at Knight.

 

Moreover, from January 2000 through December 2001, Knight failed reasonably to
supervise Knight’s institutional sales traders, including Knight’s Leading Sales
Trader, who repeatedly misused ACT trade modifiers.5 Knight’s sales traders’
misuse of ACT trade modifiers limited Knight’s customers’ ability to assess the
execution quality they were receiving from Knight. Knight’s failure to prevent
the traders from repeatedly misusing the ACT trade modifiers also limited the
ability of the Firm’s institutional customers to detect the fact that Knight was
extracting excessive profits at their expense — and resulted in Knight’s
institutional orders trading ahead of certain limit orders placed by Knight’s
customers.

 

Knight also violated the books and records provisions of the federal securities
laws from January 2000 through May 2002. Specifically, Knight did not retain
email communications relating to its business. In addition, Knight’s purchase
and sales blotter (also referred to as a trading blotter) contained inaccurate
information regarding time of execution of certain trades. Finally, Knight
failed to include required information on some order tickets and failed to
maintain certain order tickets for the time period required by the federal
securities laws.

 

B. RESPONDENT

 

Knight Securities, L.P., now know as Knight Equity Markets, L.P., is a
registered broker-dealer headquartered in Jersey City, New Jersey. Knight is a
subsidiary of Knight Trading Group, Inc., a Delaware corporation headquartered
in Jersey City, New Jersey. The common stock of Knight Trading Group, Inc. is
registered with the Commission pursuant to Exchange Act Section 12(g) and trades
on the NASDAQ National Market (“NASDAQ”). During 1999 through 2001 Knight was
one of the largest NASDAQ market makers.

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5 “ACT” refers to the automated system owned and operated by The Nasdaq Stock
Market, Inc. which, among other things, transmits reports of transactions to the
National Trade Reporting System for dissemination to the public and the
industry.

 

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C. FACTS

 

  1. Knight Defrauded Institutional Customers by Failing to Provide Best
Execution

 

  a. The Flow of Institutional Orders Through Knight

 

From 1999 through 2001, Knight’s institutional sales traders were responsible
for the relationship between Knight and its institutional customers. For
example, sales traders at Knight (i) solicited business directly from
institutional customers, (ii) served as the liaisons between Knight and the
institutions, and (iii) directly took buy or sell orders from the institutional
customers.

 

Nearly all institutional orders Knight’s sales traders received during the
1999-2001 time period were handled on a “not held” basis. In “not held”
institutional orders, the institutional customer grants the broker-dealer the
discretion to work the order. Because “not held” orders are worked on a
discretionary basis, the orders did not — by their terms — require execution at
any specific time or price.

 

Once Knight’s sales traders received “not held” orders from their institutional
customers, the sales traders communicated those orders to the traders in
Knight’s market-making group (“market-makers”). Knight’s market-makers then
proceeded to either fill those orders with stock in Knight’s own inventory
accounts or acquire a position in the market (through other market-makers or
Electronic Communications Networks). Although Knight’s market-makers were
responsible for establishing the Firm’s positions in the stock to fill an
institutional order, Knight’s sales traders were responsible for the execution
of institutional customer transactions and had discretion as to when — and at
what price — to execute the stock to the customer (i.e. pass the stock along to
the customer).

 

Knight’s institutional customers expected Knight to work their orders to obtain
“best execution” on their behalf. While the institutional customers were
sophisticated firms that could view general components of the market — such as
the inside bid and ask quotes, the volume traded and the average price during
the life of the order — they could not see the size of Knight’s position in the
stocks that were the subject of their orders, the timing of Knight’s positioning
in the stocks and Knight’s cost basis, all of which limited the customers’
ability to ascertain execution quality. Knight took advantage of its customers’
inability to view the timing, size and cost of Knight’s positions and, as a
result, made excessive profits at their expense.

 

Additionally, Knight’s sales traders misused modifiers when reporting trades —
which camouflaged the disparity between Knight’s execution price and the current
market price. This affected the ability of the firm’s institutional customers to
monitor the quality of the execution they received from Knight. Knight’s sales
traders often executed trades to Knight’s institutional customers at prices that
were significantly away from the market

 

4

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price. By misusing the ACT trade modifiers, Knight sales traders reported those
trades to ACT as executed at a different point in time — often a point when the
market price more closely correlated to the prices actually given to Knight’s
customers. Further, by misusing ACT trade modifiers and changing the execution
times of customer trades, Knight’s sales traders avoided limit order protection
protocols and filled more profitable institutional “not held” orders before
certain resting limit orders.

 

  b. The “Best Execution” Fraud

 

From January 1999 through November 2000, Knight engaged in a pattern of fraud by
trading for its institutional customers in a manner that involved effectively no
risk to Knight for the purpose of deceptively generating excessively high
profits. By working “not held” orders in a manner designed to yield Knight the
greatest possible profits, Knight failed to meet its duty to provide “best
execution” for orders placed by the firm’s institutional customers.

 

Knight, through certain institutional sales desk personnel, engaged in fraud for
the purpose of improperly generating excessive profits in the following manner:
after receipt of the institutional orders, but prior to executing the orders,
Knight’s sales desk had Knight’s market makers acquire long or short positions
in the market pursuant to the customer’s order. In instances where the market
was moving in a favorable direction in relation to the value of Knight’s
position in the stock, certain members of Knight’s sales desk executed
relatively small portions of the position to the customer, while retaining the
rest of the position. Knight’s sales desk delayed executing the customer’s order
— ultimately filling the order at prices substantially greater than Knight’s own
costs. Knight thereby maximized its own profit at the expense of the Firm’s
institutional customers.

 

In the instances where the market was moving in an unfavorable direction in
relation to Knight’s position in the stock, certain members of Knight’s sales
desk reduced the Firm’s position by executing its remaining positions in the
order to the customer at prices that generated a profit for Knight — thereby
virtually eliminating the risk that Knight would incur losses on the execution
of a customer’s order.

 

Knight defrauded its institutional customers on thousands of occasions during
the relevant time period. Knight’s handling of the following three institutional
orders exemplifies the manner in which it defrauded its institutional customers
by improperly working both buy and sell orders to deny institutional customers
“best execution.”

 

  i. April 4, 2000 Buy Transaction: Applied Micro Circuits Corporation

 

On April 4, 2000, Knight pocketed a profit of over $1.1 million — or an average
of $3.94 per share — over a period of less than 90 minutes by executing a market
not-held order on behalf of an institutional customer to purchase 290,000 shares
of Applied Micro Circuits Corporation (AMCC)6 that involved effectively no risk
to Knight.

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6 AMCC traded on the NASDAQ.

 

5

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At approximately 12:49 p.m., Knight received the first part of the market
not-held order from the customer with instructions to buy 250,000 shares of
AMCC, which was later increased to an order to buy 500,000 shares.7 At the time
Knight received the first part of the order, Knight was short 1,239 shares of
AMCC in its proprietary account. Knight began purchasing shares of AMCC almost
immediately upon receipt of the institutional order. Over the next 18 minutes,
Knight acquired a long position of approximately 147,000 shares at an average
cost of approximately $91.00 per share.

 

Rather than promptly selling the 147,000 shares to the institutional customer at
Knight’s own cost basis of $91.00 plus a reasonable amount of compensation,8
Knight sold them to the customer over a period of time at an approximate average
price of $93.00 per share — yielding Knight an average profit of approximately
$2.00 per share.9 Throughout the day, Knight continued to hold a significant
position in the stock in anticipation of filling the institutional customer’s
order. However, instead of passing those shares on to the institutional customer
to fill its order at or around the price Knight had acquired the shares, Knight
continued to sell portions of its AMCC position to the institutional customer at
prices significantly higher than Knight’s own costs. In fact, at one point in
working the order, Knight sold shares to the institutional customer at a profit
of over $8.00 per share. Knight finally executed the last part of the order at
14:10:59.10

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7 However, Knight only filled 290,000 shares of the 500,000 share order to buy
AMCC. The balance of the order was cancelled by the customer.

 

8 During the relevant time period, Knight generally traded with its
institutional customers on a “net basis.” A firm trades “net” with an
institution when the firm accumulates a position at one price and executes the
offsetting trade with an institutional customer at another price, so that the
firm’s compensation for trades are embedded in the price that institutional
customers paid for trades. In accordance with the custom and expectation in the
industry, Knight’s institutional customers believed that the net prices they
paid for trades with Knight were based upon Knight’s cost in acquiring (or
selling) shares pursuant to their orders, plus a reasonable amount of
compensation. Knight’s profit per share during the relevant time period was far
in excess of its customers’ expectations.

 

9 While handling the AMCC order, Knight was at times reporting executions
improperly through the misuse of ACT modifiers —giving the customer the
impression that the executions took place at a different point in time — a point
when the market price more closely correlated to the prices actually given to
Knight’s customer. For example, during the AMCC order there was a period of time
in which the market moved against Knight’s position. Knight was able to profit
even as the share price went down by attaching ACT modifiers and executing to
the customer based on prices at an earlier time.

 

10 The table below sets forth the relevant data underlying Knight’s executions
for the AMCC buy order described above.

 

Time Trade Reported to
ACT

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Time Trade

Executed

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Quantity

of Shares Executed to
Customer

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Execution Price

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Knight’s Buy Avg. Cost

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Knight’s Profit per
Share

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13:07:24

  12:49:00   35,000   94.06   91.56   2.49

13:10:53

  13:00:00   75,000   93.25   91.56   1.68

13:13:26

  13:02:00   55,000   92.75   90.75   1.99

 

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Knight’s average profit per share for the institutional customer’s order was
approximately $3.94 per share — for a total of over $1.1 million in profit on a
transaction for which Knight bore effectively no risk of loss.

 

  ii. January 18, 2000 Sell Transaction: ViroPharma, Inc. (VPHM)

 

On January 18, 2000, Knight pocketed a profit of over $350,000 — or an average
of $4.81 per share — by executing a market not-held order on behalf of an
institutional customer to sell 72,700 shares of ViroPhama Inc. (VPHM)11 that
involved effectively no risk to Knight.

 

At approximately 9:10 a.m., on January 18, 2000, Knight received a market
not-held order from an institutional customer to sell 72,700 shares of VPHM.
Knight’s proprietary position in VPHM at the time it received the order was long
about 300 shares. Within minutes of the opening, Knight built a short position
of 102,380 shares at an average sell cost of almost $80.00 per share. Knight’s
first execution with its institutional customer was a purchase from the customer
of 41,000 shares. Even though Knight — with the customer’s sell order in hand —
sold VPHM stock for almost $80.00 per share, the Firm covered its short position
by purchasing stock from the institutional customer at $75.00 per share.12 In
approximately 25 minutes, Knight made three purchases from the institutional
customer, all at the same execution price of $75.00. 13 Knight’s average profit
per share for the entire order was $4.81.14

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13:38:43

  13:31:00   50,000   99.75   94.55   5.20

13:39:52

  13:33:00   15,000   101.13   94.55   6.57

13:43:53

  13:43:52   20,000   109.50   100.77   8.73

14:10:59

  14:10:59   40,000   119.50   112.31   7.19

 

11 VPHM traded on the NASDAQ.

 

12 Knight misused modifiers throughout the VPHM order — which again camouflaged
the disparity between Knight’s execution price and the current market price —
making it difficult for the customer to assess the quality of execution they
were receiving from Knight.

 

13 The table below sets forth the relevant data underlying Knight’s executions
for the VPHM sell order described above. Knight initially reported the following
executions to ACT at an earlier point in time. However, the chart below reflects
data contained in a subsequent report submitted to ACT by Knight.

 

Time

Trade

Reported

to ACT

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Time

Trade

Executed

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Quantity

of Shares

Executed

to Customer

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Execution

Price

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Knight’s

Sell

Avg.

Cost

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Knight’s

Profit per

Share

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10:02:07

  9:30:00   41000   75   79.81   4.81

10:09:46

  9:33:00   11700   75   79.81   4.81

10:09:55

  9:35:35   20000   75   79.81   4.81

 

14 Knight again misused modifiers on a number of occasions throughout the ETEK
order — reporting execution times improperly and hindering the customer’s
ability to monitor the quality of the execution they received from Knight.

 

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  iii. March 16, 2000 Sell Transaction: E-Tek Dynamics, Inc. (ETEK)

 

On March 16, 2000, Knight pocketed a profit of over $971,000 — or an average of
$7.00 per share — by executing a market not-held order on behalf of an
institutional customer to sell 138,800 shares of E-Tek Dynamics (ETEK)15 that
involved effectively no risk to Knight.

 

At approximately 9:20 a.m., Knight received a market not-held order from an
institutional customer to sell 138,800 shares of ETEK. At the time of the order,
Knight’s proprietary account was long 20,000 shares of ETEK. Knight quickly
reduced its position from long 20,000 shares to flat within the first 5 minutes
of trading as it sold ETEK aggressively. Knight sold approximately 75,000 shares
of ETEK at an average sell cost of $239.51 per share, to establish a short
position of about 55,000 shares — within about 50 minutes after receiving the
order. Over the next two hours, Knight continued to sell to the market while
incrementally purchasing shares from the institutional customer. Even though
Knight — with the customer’s sell order in hand — sold ETEK for an average sell
cost of approximately $239.51 per share, Knight covered its initial short
position by purchasing the stock from the institutional customer at prices that
ranged from $229.00 per share to $239.00 per share. At one point in the ETEK
order, Knight was purchasing stock from its customer at a profit to Knight of
$19.72 per share. Knight executed the last part of the order at 11:44:00 a.m.,
more than two hours after receiving the order to sell. 16 Knight’s average
profit for the sell order was approximately $7.00 per share — an excessively
high profit for handling an order that involved effectively no risk to Knight.

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15 ETEK traded on the NASDAQ.

 

16 The table below sets forth the relevant data underlying Knight’s executions
for the ETEK sell order described above.

 

Time Trade
Reported to ACT

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Time Trade

Executed

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   Quantity of Shares
Executed to Customer

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   Execution Price

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   Knight’s Sell Avg. Cost

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   Knight’s Profit per
share

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10:11:56

   10:11:56    25000    239.00    239.51    0.51

10:17:44

   10:17:44    15000    235.00    238.68    3.68

10:18:45

   10:18:44    8800    230.00    238.68    8.69

10:21:23

   10:21:22    15000    229.00    238.68    9.69

10:33:12

   10:33:11    10000    227.25    235.92    8.67

11:04:26

   11:04:23    15000    218.00    222.82    4.81

11:06:17

   11:00:00    10000    207.00    218.50    11.51

11:07:21

   11:07:19    1200    206.94    217.11    10.18

11:14:35

   11:00:00    2500    204.00    215.45    11.46

11:40:15

   11:31:00    12500    215.25    221.72    6.47

11:41:24

   10:55:00    8000    202.00    221.72    19.72

12:42:58

   12:42:39    5000    229.13    233.48    4.35

14:53:10

   11:44:00    10800    224.86    234.68    9.82

 

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  iv. Additional Examples of Defrauding Institutional Customers

 

While the transactions described above typified Knight’s fraudulent trading
practices during 1999-2000, they were just three orders among many in which
Knight’s customers were defrauded. Other examples of orders in which certain
Knight sales desk personnel fraudulently failed to provide “best execution” to
their institutional customers in order to generate excessive profits included:
(1) a 250,000 share order of Coronet Metals, Inc. (CRFH:NASDAQ) executed by
Knight on March 8, 2000 in which Knight took in an average profit per share of
$2.92 and realized a total profit of $730,000.00; (2) a 25,000 share order of
Adaptive Broadband Corp (ADAP:NASDAQ) in which Knight’s average profit per share
was $9.63 and realized a total profit of $240,750.00; and (3) a 200,000 share
order of Digex Inc (DIGX:NASDAQ) executed by Knight on April 4, 2000 in which
Knight pocketed an average profit per share of $6.22 and realized a total profit
of $1,244,000.00. In each instance, the institutional customers had no
expectation that Knight was taking such excessive profits and profits per share
out of their institutional orders.

 

  c. Knight Failed to Reasonably Supervise Its Leading Sales Trader

       With a View Towards Preventing the Best Execution Fraud

 

From January 1999 though November 2000, Knight failed to establish procedures to
prevent its Leading Sales Trader from intentionally depriving institutional
customers of “best execution” and thereby taking excessive profits from these
customers’ orders. Specifically, Knight failed to maintain an effective review
system in the form of exception reports or some other mechanism to reasonably
monitor and prevent the violations caused by its Leading Sales Trader and its
institutional sales business.

 

During the same period, Knight’s Leading Sales Trader was directly supervised by
his brother, the head of the institutional sales desk who had overall
supervisory responsibility for the desk (the “Desk Supervisor”). In addition to
being his brother and supervisor, the Desk Supervisor had a unique financial
interest in the Leading Sales Trader’s trading. From January 1999 through at
least April 2000, the brothers had a profit-sharing arrangement, approved by
Knight’s CEO and senior management, by which the Desk Supervisor received half
of the Leading Sales Trader’s payout on profits generated by his trading with
institutional customers. As the head of the institutional sales desk, one of the
Desk Supervisor’s designated responsibilities was to assign institutional
customer accounts to the sales traders within the institutional sales desk. As a
result, the Desk Supervisor assigned most of Knight’s largest institutional
customers’ accounts to his brother. Their relationship, their positions and
responsibilities within the Firm and their profit-sharing arrangement created an
inherent conflict of interest that contributed to a substantial breakdown in the
supervision over Knight’s Leading Sales Trader.

 

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  2. Knight’s Misuse of ACT Trade Modifiers

 

  a. Books and Records Violations Relating to Knight’s Sales Traders’

       Inaccurate Use of ACT Trade Modifiers

 

During 2000-2001, Knight’s sales traders generally used two types of ACT trade
modifiers to identify late trade reports and executions: “.SLD” (‘Sold’ Late)
modifiers and “.PRP” (Prior Reference Price) modifiers. The National Association
of Securities Dealers (“NASD”) requires that firms use .SLD trade report
modifiers when transactions are reported to ACT “late” (i.e. if the transactions
were not reported within 90 seconds after execution). The NASD requires that
firms use the .PRP trade report modifiers when they execute a transaction that,
although, reported to ACT timely, actually related to an obligation to trade
that arose at an earlier point in the day or that referred to a prior reference
price. At Knight, the sales traders were responsible for attaching the .SLD and
.PRP trade modifiers to specific transactions and manually entering the
execution time.

 

Throughout the relevant time period, Knight’s sales traders misused the .SLD and
.PRP modifiers in connection with over 12,000 trades. Knight’s sales traders
routinely reported transactions late with the .SLD trade report modifier even in
cases where the execution time was within 90 seconds of the report time. In
addition, during the same period, a number of Knight’s sales traders improperly
reported transactions with a .PRP trade modifier, indicating that the execution
was supposed to have occurred earlier, based upon the price at the prior time,
when in fact, there was no such obligation. By misusing the ACT trade modifiers,
Knight sales traders were able to improperly input trades into Knight’s trading
system at prices that were different from the inside market at the time the
trades were reported. Further, through the misuse of modifiers, Knight’s sales
traders avoided limit order protection protocols and filled institutional “not
held” orders before certain resting limit orders placed by Knight’s customers.

 

The misuse of the modifiers by Knight’s sales traders resulted in inaccurate and
untimely reporting of its trades to ACT. This resulted in the recording of
inaccurate execution times on Knight’s purchase and sale blotters. Thus, as a
result of Knight’s sales traders’ misuse of the .SLD and .PRP modifiers during
this period, Knight’s sales traders were recording inaccurate execution times on
Knight’s books and records (specifically, on Knight’s purchase and sale
blotters). Accordingly, Knight violated the books and records provisions of the
securities laws.

 

  b. Knight’s Failure to Supervise and Books and Records Violations

       Relating to the Sales Traders’ Modifier Misuse

 

During 2000-2001, Knight had no written procedures, no adequate systems in place
and no supervisory personnel to prevent Knight’s sales traders from misusing ACT
modifiers. The misuse of ACT modifiers led to the sales traders’ recording
inaccurate execution times on the firm’s trading blotters. During the relevant
time period, Knight did not take reasonable steps to establish or implement a
system to prevent the misuse of

 

10

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modifiers and the recording of inaccurate execution times on the firm’s trading
blotters. Additionally, Knight’s inadequate supervisory system failed to provide
for follow-up when Knight’s personnel became aware that the institutional sales
traders were repeatedly misusing the modifiers and recording inaccurate
execution times on the firm’s trading blotters. Knight failed to supervise
reasonably its sales traders in order to prevent or detect the traders’ conduct
in connection with the firm’s books and records violations.

 

  3. Knight Failed to Properly Retain E-mails and Order Tickets

 

From January 2000 through May 2002, Knight stored employees’ e-mails on a
back-up tape drive for a period of only 30 days — notwithstanding the fact that
the federal securities law required the Firm to retain e-mails for a three-year
period. After the 30-day period passed. Knight re-used the tape drive and
wrote-over the prior e-mails. The e-mail data was not otherwise retained. In
addition, Knight’s backup system only captured e-mails that were present at the
time of the backup and thus would not capture any e-mails that might have been
deleted during the day.

 

In the period from 2000 through 2002, Knight also failed to retain certain order
tickets generated from its institutional sales desk and, of the order tickets
Knight did retain, numerous order tickets failed to contain information required
by rule including the order receipt time, execution time, terms and conditions
and modifications related to specific orders.

 

IV.

 

VOLUNTARY UNDERTAKING

 

In determining whether to accept the Offer, the Commission has considered
Knight’s voluntary retention of an Independent Compliance Consultant
(“Independent Consultant”). The Independent Consultant’s review includes, but is
not limited to, a comprehensive review of (i) Knight’s policies and procedures
designed to ensure compliance with federal securities laws and the NASD rules
with respect to best execution obligations, trade reporting requirements, limit
order requirements, and books and records requirements; (ii) Knight’s procedures
for implementing such policies and procedures, and systems; and (iii) Knight’s
supervisory and compliance structure.

 

V.

 

VIOLATIONS

 

As a result of the conduct described above, the Commission finds that:

 

Knight willfully violated Section 15(c)(1)(A) of the Exchange Act as defined in
Rule 15c1-2, in that it, while acting as a broker-dealer, effected transactions
in the purchase and sale of securities by means of manipulative, deceptive, and
other fraudulent devices

 

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or contrivances.17 Specifically, Knight fraudulently failed to give its
institutional customers “best execution” on those orders, thereby generating
excessive profits for the firm.

 

Knight failed reasonably to supervise its Leading Sales Trader pursuant to
Section 15(b)(4)(E) of the Exchange Act with a view towards preventing him from
aiding and abetting Knight’s violation of Section 15(c)(1)(A) of the Exchange
Act against its institutional customers. Specifically, Knight failed to maintain
an effective review system in the form of exception reports or some other
mechanism to reasonably monitor and prevent the violations caused by Knight’s
Leading Sales Trader and its institutional sales business. Knight also failed to
establish a system for applying procedures that would reasonably be expected to
prevent and detect violations by its Leading Sales Trader. Specifically, Knight
designated the Leading Sales Trader’s brother to supervise him, while allowing
the brother to share in half of all of the net proceeds derived by the Leading
Sales Trader from his institutional trading.

 

Knight failed reasonably to supervise its institutional sales traders pursuant
to Section 15(b)(4)(E) of the Exchange Act while they were systematically
misusing ACT modifiers. Knight had no established procedures or system in place
to prevent its sales traders from consistently misusing the modifiers over a
two-year period. As a result of Knight’s failure to reasonably supervise its
sales traders on the use of ACT modifiers, Knight’s sales traders routinely
recorded inaccurate execution times on the Firm’s daily trading blotters, and
thereby aided and abetted Knight’s violation of Section 17(a) of the Exchange
Act and Exchange Act Rule 17a-3(a)(1). Exchange Act Rule 17a-3(a)(1) requires
that a broker-dealer make and keep current, among other things, blotters (or
other records of original entry) containing an itemized daily record of all
purchases and sales of securities.18

 

Knight willfully violated Section 17(a) of the Exchange Act and Exchange Act
Rule 17a-4(b)(4) by failing to maintain originals of all communications received
and copies of all communications sent by the broker-dealer relating to its
business as such for a period of not less than three years. Specifically, Knight
failed to retain e-mails relating to its business for three years as required
pursuant to Rule 17a-4(b)(4).

 

Knight willfully violated Section 17(a) of the Exchange Act and Exchange Act
Rules 17a-4(b)(1) and 17a-3(a)(7) by failing to properly maintain order tickets
and by failing to record certain required information on its order tickets. Rule
17a-4(b)(1) requires that,

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17 Rule 15c1-2 under the Exchange Act provides that the term “manipulative,
deceptive or other fraudulent device or contrivance,” as used in Section
15(c)(1)(A) of the Exchange Act, is defined to include “any act, practice, or
course of business which operates or would operate as a fraud or deceit upon any
person.”

 

18 Information contained in any required record, filing or report must be
accurate. U.S. v. Sloan. 389 F.Supp. 526, 528 (S.D.N.Y.1975); Merrill Lynch,
Pierce, Fenner & Smith, Inc., Exchange Act Rel. No. 33367 (Dec. 22,1993), 55 SEC
Docket 2281.

 

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among other things, a broker-dealer preserve for a period of not less than three
years, the first two years in an accessible place, all records required to be
made pursuant to Rule 17a-3(a)(7). Rule 17a-3(a)(7) requires that certain
information be recorded on order tickets including order receipt time, order
execution time, and the terms and conditions and modifications relating to an
order. Knight failed to preserve a number of order tickets from the 2000 through
2002 time period and, of the order tickets Knight did preserve, a number of the
tickets failed to contain order receipt time, execution time, terms and
conditions and modifications related to the orders.

 

Knight willfully violated Section 17(a) of the Exchange Act and Exchange Act
Rule 17a-3(a)(1) by recording inaccurate execution times on the Firm’s daily
trading blotters. Exchange Act Rule 17a-3(a)(1) requires that a broker-dealer
make and keep current, among other things, blotters (or other records of
original entry) containing an itemized daily record of all purchases and sales
of securities. Information contained in any required record, filing or report
must be accurate. 19

 

VI.

 

SANCTIONS

 

In view of the foregoing, the Commission deems it appropriate and in the public
interest to impose the sanctions agreed in Respondent Knight’s Offer.

 

Accordingly, it is hereby ORDERED that:

 

A. Pursuant to Section 21C of the Exchange Act, Knight shall cease and desist
from committing or causing any violations and any future violations of Sections
15(c)(1) and 17(a) of the Exchange Act and Rules 17a-3(a)(1), 17a-3(a)(7),
17a-4(b)(1) and 17a- 4(b)(4) thereunder.

 

B. Knight is hereby censured pursuant to Section 15(b)(4) of the Exchange Act.

 

C. Monetary Relief

 

1. Knight shall pay disgorgement in the total amount of $41,146,663.50,
representing disgorgement of ill-gotten gains obtained by Knight as a result of
the conduct described in Section III, above;

 

2. Knight shall pay prejudgment interest on its disgorgement obligation, in the
amount of $13,195,068.00;

 

3. Knight shall pay a civil money penalty in the amount of $12,500,000.00;

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19 Id.

 

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4. Knight acknowledges, pursuant to Knight’s agreement with the NASD in a
related proceeding, that Knight shall pay a fine in the amount of $12,500,000.00
to the NASD;

 

5. There shall be, pursuant to Section 308(a) of the Sarbanes Oxley Act of 2002,
a Fair Fund established for the funds described in Section VI.C.1, 2 and 3.
Regardless of whether any such Fair Fund distribution is made, amounts ordered
to be paid as civil money penalties pursuant to this Order shall be treated as
penalties paid to the government for all purposes, including all tax purposes.
To preserve the deterrent effect of the civil penalty, Knight agrees that it
shall not, in any Related Investor Action, benefit from any offset or reduction
of any investor’s claim by the amount of any Fair Fund distribution to such
investor in this proceeding that is proportionately attributable to the civil
penalty paid by Knight (“Knight Penalty Offset”). If the court in any Related
Investor Action grants such an offset or reduction, Knight agrees that it shall,
within 30 days after entry of a final order granting the offset or reduction,
notify the Commission’s counsel in this action and pay the amount of the Knight
Penalty Offset to the United States Treasury or to a Fair Fund, as the
Commission directs. Such a payment shall not be deemed an additional civil
penalty and shall not be deemed to change the amount of the civil penalty
imposed against Knight in this proceeding. For purposes of this paragraph, a
“Related Investor Action” means a private damages action brought against Knight
by or on behalf of one or more investors based on substantially the same facts
as those set forth in the Order;

 

6. Distribution of Disgorgement, Penalty and Interest

 

a. Knight has agreed to retain, within 30 days of the date of entry of the
Order, the services of an Independent Distribution Consultant not unacceptable
to the staff of the Commission. The Independent Distribution Consultant’s
compensation and expenses shall be borne exclusively by Knight. Knight shall
cooperate fully with the Independent Distribution Consultant and shall provide
the Independent Distribution Consultant with access to its files, books,
records, and personnel as reasonably requested for the review. Knight shall
require that the Independent Distribution Consultant develop a Distribution Plan
for the distribution of the disgorgement, penalty and interest set forth in
Section VI.C.1., 2. and 3., according to a methodology developed in consultation
with Knight and acceptable to the staff of the Commission.

 

b. Knight shall require that the Independent Distribution Consultant submit a
Distribution Plan to Knight and the staff of the Commission no more than 100
days after the entry of the Order. The Distribution Plan developed by the
Independent Distribution Consultant shall be binding unless, within 130 days
after the date of entry of the Order, Knight or the staff of the Commission
advises, in writing, the Independent Distribution Consultant of any
determination or calculation from the Distribution Plan that it considers to be
inappropriate and states in writing the reasons for considering such
determination or calculation inappropriate.

 

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c. With respect to any determination or calculation with which Knight or the
staff of the Commission do not agree, such parties shall attempt in good faith
to reach an agreement within 160 days of the date of entry of the Order. In the
event that Knight and the staff of the Commission are unable to agree on an
alternative determination or calculation, the determinations and calculations of
the Independent Distribution Consultant shall be binding.

 

d. Knight shall require that within 175 days of the date of the entry of the
Order, the Independent Distribution Consultant submit the Distribution Plan for
the administration and distribution of disgorgement and penalty funds pursuant
to Rule 1101 of the Commission’s Rules of Practice [17 C.F.R. §201.1101].
Following a Commission order approving a final plan of disgorgement as provided
in Rule 1104 of the Commission’s Rules of Practice [17 C.F.R. §201.1104], Knight
shall require that the Independent Distribution Consultant, with Knight, take
all necessary and appropriate steps to administer the final plan for
distribution of disgorgement and penalty funds.

 

c. Knight shall require that the Independent Distribution Consultant, for the
period of the engagement and for a period of two years from completion of the
engagement, not enter into any employment, consultant, attorney client, auditing
or other professional relationship with Knight, or any of its present or former
affiliates, directors, officers, employees, or agents acting in their capacity
as such. Knight shall require that any firm with which the Independent
Distribution Consultant is affiliated in performance of his or her duties under
the Order not, without prior written consent of the staff of the Commission,
enter into any employment, consultant, attorney client, auditing or other
professional relationship with Knight, or any of its present or former
affiliates, directors, officers, employees, or agents acting in their capacity
as such for the period of the engagement and for a period of two years after the
engagement; and

 

7. Knight shall, within 20 days of the entry of this Order, pay the
disgorgement, prejudgment interest and civil penalty described in Section
VI.C.l., 2 and 3 into an interest bearing escrow account at a federally insured
banking institution with deposits of not less than $100 billion pursuant to an
escrow agreement not unacceptable to the staff of the Commission. Such agreement
shall, among other things: (1) require that all funds in escrow be invested as
soon as reasonably possible and to the extent practicable in short-term U.S.
Treasury securities with maturities not to exceed six months; (2) name an escrow
agent who shall be appropriately bonded; and (3) provide that escrowed funds be
disbursed only pursuant to an order of the Commission. Respondent shall be
responsible for all costs associated with the escrow agreement.

 

By the Commission.

 

Jonathan G. Katz

Secretary

 

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