Anatomy of a Day-Trading Fraud

Discussion in 'Trading' started by Josh_B, Jan 28, 2003.

  1. Josh_B


    Datek and Heartland racked up some major league profits from 1993-2001 by allegedly milking the SOES system for millions in unlawful gains. Some guess their take could have been over $250 million. But now it’s all come crashing down. The SEC has permanently barred and fined two former Datek and Heartland traders to the tune of $29.2 and $22.5 million and day-trading shop Heartland Securities will be censured and pay $7 million.

    Their alleged scheme was epic in proportion. Over a three year period from 1995, Datek accounted for an astounding 1/3 of all SOES executions, equaling about 12 million trades. Millions of these trades were allegedly illegal because Datek, as a broker-dealer (B-D), was prohibited from trading for its own benefit using SOES. SOES was built solely to execute small mom-and-pop orders.

    But Datek and its crafty cronies--Sheldon Maschler, Jeff Citron, and others--apparently wiggled around that requirement…for a while at least. Here’s how the SEC says they did it:..

    Sheldon Maschler was an “old-school” day-trader, having set up Datek’s day-trading business from his Staten Island basement in the late 1980’s.

    He and a group of “SOES bandits” began the scheme in the early 90’s using retail accounts and Watcher software.

    Maschler and his cronies used Watcher because, at the time, it was considerably faster than the Nasdaq workstations market makers used. Watcher was also able to analyze real-time order flow and allow the bandits to pick off market makers who were slow to update their price quotes.

    Datek could have made some decent commissions from this type of trading but apparently they weren’t satisfied with that. Instead, Datek under the direction of Maschler, Citron, and others, purportedly concocted a plan to apply their SOES trading techniques on a massive scale for Datek’s proprietary account.

    Accounts were set up and trades were made in the name of shills (nominees) to make the trades appear legitimate. Initially these nominees were friends and family of the alleged perpetrators. Eventually, though, these accounts grew to as many as 138 in number, lured by promises of a 16% annual return (which was in fact paid).

    The Datek bandits would pick off market makers all day using SOES, routinely violating maximum size rules in the process. Then, after the market closed each day, they’d illegally allocate these proprietary trades to the retail nominee accounts. Trades were allocated by matching the nearest chronological buys and sells in a stock so as to maximize their intraday buying power, which was limited to 2:1 at the time by Reg T.

    All this was possible because the defendants exploited a NASDAQ rule-making loophole that permitted them to execute trades without first having to specify a particular account.

    After illegally allocating the trades, the SEC says Datek entered them into their accounting and trade record systems, making them appear as if they were trades by retail customers.

    In 1994, the defendants apparently figured they had a good thing going so they decided to automate the process, enhancing their efficiency and stealth factor. Datek developed software, code-named “Wire”, to automatically allocate trades each day to the nominee accounts. The defendants figured this would remove incriminating paper trails that could link the trades with their actual accounts.

    In 1995 Datek took it one step further by creating “Real-time Wire” which allocated trades immediately after execution. This made it even harder for regulators to uncover any improprieties.

    In 1997 Real-time Wire was replaced by a process Datek called “mapping.” This meant that each investor account would now have its own assigned trader and no allocation was therefore necessary. Nonetheless, Datek continued to move trades among the accounts to generate commissions and ensure that a nominee never got more than his 16% rate of return.

    After this account mapping began, Maschler, Citron, and others began loaning money to nominees via unrelated entities. The unsecured loans, initially for $400,000, allowed them to trade more volume. Almost none of the nominees had the money to qualify for or repay the loans however. Though Maschler and Citron didn’t seem to care.

    By 1998 approximately 125 nominee accounts at Datek were funded with a total of $50 million in “loans.” Datek, and later Heartland, made themselves unrecorded beneficial owners of these accounts.

    Assorted other entities were used to pay out the profits from the scheme. Most of these payouts were falsely recorded in various companies’ financial statements as commission expenses, salaries, data processing expenses, or computer services.

    Datek sold its day-trading operation to Heartland in 1998 for $3.5 million. The scheme seemed to continue as if nothing happened with the only difference being the firm name.

    Heartland allegedly executed millions more illegal trades right up until June 2001 when the NASD changed its rules to allow B-Ds to trade on SOES their prop accounts. Shortly thereafter the SEC, New York district attorneys, and the FBI solidified their investigation.
    After reading all this planning and calculation, it tends to beg the question: How much could these guys have made if they applied all their creativity to more legitimate strategies? And how did they figure they’d get away with it? This wasn’t the first time these men ran amuck of the regulators either. In 1994 Maschler, Citron, Datek, and others were charged with violating SOES rules and fined several thousand dollars.

    Tales like this demonstrate how greed can cloud better judgment and how Wall Street still has some cleaning up to do. This is the second major settlement regarding proprietary trading violations in three months. In October the NASD settled charges against Swift Trade Securities for deceptive trading and non-bona fide “wash sale” trades in the QQQs.

    In the end, thankfully, regulators generally prevail in these cases and the odds of not getting caught are minuscule. Maschler, Citron and the other cronies have been nabbed. Although they may have money buried somewhere (hopefully for them they haven’t spent it yet), their reputations are a lot poorer…if that matters to them of course.

    * * * * * * *

    Please Note: Despite the entire investigation, the fines, and the revelations, the defendants neither admitted nor denied the SEC’s allegations. Thus the above information is based only on reports and allegations. (Reference: SEC)$242?mond=topic&y=2003&m=1&d=25

    ...the old soes bandits days..

  2. extremely interesting, josh. thanks for posting !

  3. Josh_B


    Not a bad take either.

    If they got away with 250 mill and only slapped on the hand by a total of around 60 mill... a very nice return, and they get to enjoy the rest free..

    Who says crime doesn't pay? hehe

  4. bone


    I guess once again, the moral (or immoral) of the story is that if you're going to steal... steal ALOT.

  5. I've got to hand it those boys, they did a great Job.

    If I were in their shoes I'd do the same.

    I read about this on traderbulletin a few nites ago. Good stuff!

  6. Wow ...
  7. cheeks



    Yes, it was dishonest. But given who they stole it from, I'm not going to hold it against them.:)
  8. hehe :D
  9. yeah i can tell all our hearts are bleeding for the MM's...
  10. With .01 increments and SuperSoes, what will the next scam be?

    PM me.
    #10     Jan 28, 2003