Established in 1832, Janney Montgomery Scott is a Philadelphia, Pennsylvania based FINRA broker-dealer. Janney Montgomery Scott has from time to time drawn the attention of securities regulators, including FINRA, as a result of its trading practices and supervisory systems.
Back in 2005, FINRA (then the NASD) announced that it had fined Janney Montgomery Scott $1.2 million for permitting improper market timing and related violations. In addition, FINRA ordered the Philadelphia-based firm to pay nearly $1 million in restitution to the affected mutual funds.
FINRA also suspended Kenneth Rosato – the former branch manager of Janney Montgomery Scott’s Brooklyn office and the broker responsible for the misconduct – for one year and fined him $370,000, which included disgorgement of $185,000 in commissions he received as a result of the improper market timing activities. FINRA also barred Linda Rosato the former branch operations manager of Janney Montgomery Scott’s Brooklyn office and Kenneth Rosato’s sister-in-law, for refusing to testify in FINRA’s investigation of this misconduct.
FINRA found that from May 2000 through September 2003, Janney permitted two hedge fund customers to evade attempts by mutual fund companies to block or restrict their market timing transactions. The hedge fund accounts were customers of Kenneth Rosato. Rosato opened 19 different accounts for the two hedge funds and allowed them to engage in approximately 1,600 exchange transactions with mutual funds after receiving close to 200 block notices from those mutual funds prohibiting further trading.
FINRA also found that Rosato undertook a number of efforts to assist the hedge fund customers in evading the restrictions placed on market timing by mutual funds. Among other things, Rosato opened multiple accounts for the hedge funds to enable them to market time mutual funds without detection; used different broker numbers and different addresses in an effort to shield the true ownership of the accounts, and placed trades in related accounts to escape detection by the mutual funds.
Significantly, FINRA’s investigation showed that Janney Montgomery Scott was aware that the hedge funds were engaging in market timing activity. The firm had received numerous notices from the mutual funds prohibiting future market timing by these customers. Despite this, the customers continued to engage in extensive market timing activity through Janney Montgomery Scott – earning approximately $1 million in profits at the expense of long-term investors in those mutual funds.
By permitting the market timing activities of the hedge fund customers, Janney Montgomery Scott and Rosato violated FINRA’s rule requiring adherence to just and equitable principles of trade and high standards of commercial honor. Janney Montgomery Scott also failed to respond adequately to red flags that market timing was occurring, and failed to establish and maintain an adequate supervisory system to prevent or detect deceptive market timing practices.
FINRA’s investigation uncovered other violations as well. FINRA found that Janney Montgomery Scott did not have an adequate supervisory system to ensure an accurate response to regulatory inquires. In October 2003, Janney Montgomery Scott responded to a FINRA request for information by stating that no one at the firm had promoted or otherwise encouraged market timing activities and that the author of the letter was not aware of communications between mutual funds and Janney Montgomery Scott regarding market timing. In fact, extensive market timing activities had occurred and the firm had received numerous communications from mutual funds concerning market timing.
In settling this matter Janney Montgomery Scott, Kenneth Rosato and Linda Rosato neither admitted nor denied the allegations, but consented to the entry of FINRA’s findings.
Away-from-market Stock Loan Transactions
In 2007, NYSE Regulation, Inc. that it had censured and fined Janney Montgomery Scott LLC $2.5 million for engaging in away-from-market stock loan transactions, making payments to finders who performed no legitimate business function, and related supervisory deficiencies and books and records violations.
“When a stock loan finder is inserted into a transaction without any business purpose, it directly harms the counterparties involved and increases the cost of stock lending,” said Richard G. Ketchum, chief executive officer, NYSE Regulation, Inc. “That’s what happened in this case against Janney Montgomery. In some instances, payments were made to relatives or friends who did nothing at all. Firms must have independent controls to verify that services paid for have actually been performed.”
In a typical stock loan transaction, one financial institution communicates with another and establishes the form and amount of the collateral, as well as the lending fee. The lender invests the cash collateral, retains part of the interest, and rebates the remainder to the borrower. When the securities are readily available, the lender keeps only a very small portion of the interest. Conversely, when the security is scarce or otherwise “hard-to-borrow,” the lender retains most or all of the interest. Supply and demand determine the price the borrower pays to borrow the stock.
Finders are third parties to stock loan transactions who, for a fee, assist a borrower or, less frequently, a lender, to locate a counterparty. Electronic mail and facsimile transmissions have eliminated, in most cases, the need for finders. The insertion of a finder in a transaction where the services of a finder were not required has the effect of unjustifiably increasing the cost of the transaction to the borrower and/or depriving the lender of income it might otherwise have received.
From January through December 2004, certain former employees of Janney Montgomery Scott’s stock loan department caused the firm to engage in certain stock loan transactions at away-from-market rebate rates that were disadvantageous to the counterparties to those transactions and made payments to finders who performed no legitimate business function in connection with the transactions.
In addition, the stock loan traders caused the firm to participate in several transactions referred to as “daisy chain” or “swing” transactions in which the traders entered into initial borrows (or loans) at below-market rebate rates, passed the securities through one or more broker-dealers in pre-arranged transactions at successively higher prices, and eventually re-borrowed (or reloaned) the same securities on the same day at higher rebate rates.
The difference between the below-market rebate rates at which the stock loan traders borrowed the securities and the higher rates at which they loaned the securities to the ultimate borrower is referred to as the “spread.” The effect of these “daisy chain” or “swing” transactions was that portions of the “spread” were diverted away from Janney to other firms participating in the transactions. There was no legitimate basis for the “daisy chain” or “swing” transactions. The effect of these transactions was to deprive the original lender of proceeds to which it was entitled and to redistribute those proceeds among all the other broker-dealers in the chain and any purported finder.
During this period, the stock loan department generated gross revenues of over $11.2 million and made a net profit, after compensation, of over $6.4 million. The firm paid 24 finders approximately $1.4 million in connection with stock loan transactions, even though it had no written agreements defining the services to be provided by the finders and the firm never received invoices for services rendered by any finder.
In certain of these transactions, there was no apparent justification for the payments, and the firm’s books and records do not include evidence or specific information reflecting that finders had in fact provided any services.
Janney Montgomery Scott generated revenues on every “daisy chain” or “swing” transaction, away-from-market stock loan transaction, and stock loan transaction on which it made a payment to a purported finder. In connection with certain transactions, the firm paid several finders as much as 500 to 1000 basis points when most finders would normally receive 25 basis points.
In some instances, these payments were made to purported finders who were relatives or friends of employees of Janney Montgomery Scott’s stock loan department and/or relatives or friends of the employees of the counterparties to the away-from-market stock loan transactions. The stock loan desk manager’s sister owned one finder firm that was paid approximately $220,000 during this period.
The firm failed to reasonably supervise the activities of its stock loan department in that it did not have adequate supervisory procedures to detect and deter these improper transactions. The firm’s supervisory procedures were inadequate in that they did not include any procedure to determine whether transactions were being effected at market rates or whether the payments to finders were legitimate.
In settling this matter, Janney Montgomery Scott also consented to an undertaking to record the telephone conversations of its stock loan department and retain the recordings for a period of no less than one year.
This disciplinary action concerned violations of Section 17(a) of the Securities Exchange Act of 1934 and Rules 17a-3 and 17a-4 thereunder, and NYSE Rules 342, 440 and 476(a)(6).
In settling these charges brought by NYSE Regulation, Janney Montgomery Scott LLC neither admitted nor denied the charges.
Auction Rate Securities
In 2009, FINRA announced that it has entered into final settlements with four firms to settle charges relating to the sale of Auction Rate Securities (ARS) that became illiquid when auctions froze in February 2008, including settling such charges with Janney Montgomery Scott.
The settlements announced by FINRA were with NatCity Investments, Inc. of Cleveland, which was fined $300,000; M&T Securities, Inc. of Buffalo, which was fined $200,000; Janney Montgomery Scott LLC of Philadelphia, which was fined $200,000, and M&I Financial Advisors, Inc. of Milwaukee, which was fined $150,000. All four firms agreed to initiate or complete offers to repurchase auction rate securities sold to their customers where the auctions for the auction rate securities had failed.
Concerned about your investments with Janney Montgomery Scott?
If you have questions about investments you made with Janney Montgomery Scott, The White Law Group may be able to help. For a free consultation, call the firm at 312-238-9650.
The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Boca Raton, Florida. With over 30 years of securities law experience, including experience working at FINRA (f/k/a the NASD) and the SEC, The White Law Group has the expertise to help investors defrauded in securities, investment and financial business transactions.
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