Investors Should Benefit Eventually From SEC Rules Imposed on NASD

A regulatory crackdown on the National Assn. of Securities Dealers will have little immediate impact on individual investors who may wonder about manipulated spreads when they trade in small-company stocks, industry experts say.

However, rules that are expected to go into effect later this year may make trading prices more transparent and improve the ability of investors to get the best price for their shares.

In addition, there are a handful of simple steps that individual investors can take now--such as watching spreads and execution prices--to ensure they’re not being taken for a ride.

What is the Securities and Exchange Commission crackdown all about? Some answers:

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Q: What did the SEC do?

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A: The Securities and Exchange Commission, which is charged with maintaining order in the nation’s equity markets, is requiring the NASD to do a better job of policing the roughly 500 firms that make markets in over-the-counter stocks.

Specifically, the NASD will have to establish computerized audit trails to show how individual orders were handled and expressly forbid dealers from working together to manipulate prices. It will also require the NASD to spend about $100 million during the next five years to enforce rules aimed at ensuring investors are treated fairly and equally--and to hire independent examiners to review market practices.

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Q: Why is that necessary?

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A: The SEC and independent researchers say they have discovered a pattern of abuse in which NASD brokers have colluded to inflate dealer profit margins at the expense of individual investors by pushing down “bid” prices--the price an investor could get if they wanted to sell--and pushing up “ask” prices--the cost of a share when you want to buy. The difference between the two prices--the spread--is the dealer’s profit margin.

Although manipulating prices and spreads is--and always was--a violation of trading rules, the NASD failed to discipline the offending firms and individuals involved, the SEC alleged. The settlement announced Thursday is expected to help regulators police the industry. (The NASD neither admitted nor denied guilt.)

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Q: Why wouldn’t that have an immediate impact on individual investors? Won’t it stop abuses?

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A: The computerized audit system and increased enforcement is something that will be implemented during the next five years--not tomorrow.

In addition, it’s similar to putting more police officers on the streets. Although the presence of law enforcement may deter crime, it doesn’t preclude the possibility of getting mugged.

“You can go bankrupt waiting for the SEC to protect you,” said Scott S. Fraser, editor of a San Diego-based investment newsletter called the Natural Contrarian and author of “20 Ways You Lose Money on Your Way to the Stock Market.”

In addition, SEC officials say one of the problems with the NASD system is that trading prices are not immediately transparent to investors--and they won’t be until the SEC implements proposed rules that would give investors better access to computerized bid and ask prices, SEC officials say. The SEC is now weighing a series of proposed rules that would give individual investors better access to trading prices, but those rules are not likely to be implemented for several months--at best.

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Q: I guess I don’t understand how dealers can manipulate the prices--and how exactly they profit by it. Is this a problem that affects all stock trades or just those in over-the-counter stocks?

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A: First, some background on how the different stock markets work. When you trade shares in a company listed on the New York Stock Exchange, your order is sent to the floor of the exchange, where a trader physically walks over to a “specialist” desk where that company’s shares are traded. The trader shouts out his order--such as “buying 100 IBM at $102”--and the market specialist or other traders, who are milling about while trying to buy and sell, can buy at the stated price or barter for a better one.

However, there is no physical exchange with NASD stocks. Instead, brokers are linked together via computer terminals.

When you call a broker to buy an NASD share, the broker will check the Nasdaq’s electronic pricing system to find quoted buying (bid) or selling (ask) prices for that firm’s shares. At any given time, there may be a host of different prices offered by a variety of dealers. Nobody is physically standing over your trader’s shoulder to see which bid was taken--or even if your dealer, if a market maker, sold his company’s own shares.

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Q: How does the dealer profit by manipulating the prices?

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A: Because the dealer can (and does) buy at the stated bid price and sell at the stated ask, the difference between the two is the dealer’s profit margin. The wider the gap between the bid and ask prices, the more the dealer makes, said Lloyd Greif, president of Greif & Co., a Los Angeles-based NASD investment firm. The SEC alleged that some dealers worked together to keep these spreads artificially wide.

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Q: What precautions can I take to protect myself from paying too much for an NASD share?

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A: Check the spreads, suggests Greif. Before you trade, ask to get both the bid and ask prices. If there’s a big gap between the two--more than a quarter of a percentage point, for example--ask why. There are two possible reasons for a wide gap and both of them are bad signs for investors, he adds. One is that the stock is so thinly traded that a big gap is warranted--dealers are taking a big risk if they buy that they won’t be able to sell again any time soon.

Investors take the same risk when they buy such a stock.

“You end up in a room with no doors or windows,” Greif said. “It may be easy to get in, but you’ll have a heck of a time getting out.”

The other reason for a wide spread is that your market maker is making too big a profit. If that’s the case, use another firm to handle your trade.

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Q: What else should I look for?

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A: Execution prices, Fraser said. When you trade a stock, check the daily highs and lows the next day to see where in that range your trade was executed, he said. Say, for example, you asked to sell XYZ shares at the going market price and your trade was executed at $10. However, later you find that XYZ traded between $10 and $11 that day. (These figures are available on The Times’ stock quote phone service, TimesLine.)

If you consistently find that your sell orders are going in near the day’s low and your buy orders are near the day’s high, it’s an indication that your broker has a poor relationship with the firm’s trader or is simply not too concerned about your business. Either way, you ought to find a new broker, Fraser said.

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Q: I trade maybe a few thousand dollars’ worth of stock a year. Does it really matter if I lose an eighth of a percentage point on a particular transaction? Do I really need to bother tracking all this stuff?

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A: In terms of raw dollars involved, it’s true that you’re not losing a lot of money, Fraser said. However, learning how to monitor your account gives you good practice for the day you might have more money invested. Furthermore, even if there’s not a lot of money involved, it’s a bad sign when a broker takes advantage.

“If you are being exploited in little ways, it’s a sign that you’re dealing with a dishonest broker,” Fraser said. “You should move to a new firm before you have a lot of money at stake.”