Brokerage giant Wachovia Securities said Tuesday that it was investigating stock trading, including the possible use of fictitious accounts to reap short-term gains, at one of its Westlake Village offices.
The NASD, the brokerage industry's self-regulatory agency, also has opened a probe into the office, according to people familiar with the matter. The NASD declined to comment.
These people said an anonymous letter sent to Wachovia alleged that brokers used fabricated accounts to take advantage of company stock-purchase plans in which shares are sold directly to investors at discounts of as much as 5% off the market price.
The brokers allegedly sought to play the so-called arbitrage opportunity in such transactions: By buying the shares at a discount, then quickly selling the stock in the open market, they could profit from the "spread" between the two prices.
Companies that offer such discount purchase plans typically have used them as a way to raise capital from smaller investors who the companies hope will hold the shares for a long time. The companies generally place limits on the amount of stock that can be purchased at a discount -- often $5,000 to $10,000 a month per investor.
Brokers in the Wachovia office allegedly used fictitious accounts to buy and sell such stocks in volumes exceeding typical discount program limits, according to people with knowledge of the probe, who spoke on condition of anonymity.
The use of fictitious accounts would run the risk of violating securities industry "rules of fair practice," attorneys say. Such accounts could also violate the terms set by the companies issuing the discounted shares.
The trading at the Wachovia branch was known as "the program" among brokers and clients in the office at 4550 E. Thousand Oaks Blvd., one of two Wachovia offices in Westlake Village, sources said.
"There is an internal investigation into these issues," said Tony Mattera, a spokesman at Wachovia's headquarters in Richmond, Va. He said the probe was "wide-ranging" and sought to determine "how long this has been going on" and the extent of the trading.
Ron Goldman, the manager of the office that is under investigation, directed questions to Wachovia's headquarters.
Wachovia is one of the nation's largest brokerages, with 3,200 offices. The firm is owned by Charlotte, N.C.-based banking titan Wachovia Corp.
Wachovia Securities' probe of the Westlake Village office predated the company's receipt of the anonymous letter this year, Mattera said.
Many of the stocks involved in the trading were real estate investment trust shares, the sources said. REITs are companies that own and manage property or mortgage portfolios.
Federal law requires REITs to pay nearly all of their earnings each year to shareholders in the form of dividends. Because they retain so little of their profits, many of the companies must regularly raise money to expand their operations. Some have turned to discounted stock-purchase plans as one way to raise fresh capital.
"Their whole business is built around getting more money to invest," said Charles Carlson, a money manager at Horizon Investment Services in Hammond, Ind., and an expert on such plans.
Besides offering a discount off the market price of their shares, REIT companies make such plans appealing to small investors by allowing the purchases to be made directly from the companies. That avoids a brokerage commission on the shares.
However, brokers who help facilitate such purchases for their clients would earn a commission when the shares are sold in the open market.
Although REITs generally place limits on the amount of stock that can be bought through the programs by any one investor each month, some REITs also are willing to waive the limits upon request, said Leanne Gallagher, vice president of investor relations at Thornburg Mortgage Inc., a Santa Fe, N.M.-based REIT.
But she said Thornburg rarely used its waiver allowance.
Although one goal of discount purchase programs is to attract long-term investors, REIT companies generally don't restrict the sale of their shares, and the companies know that arbitrage trading is a risk inherent in the programs, Gallagher said.
Such trading could potentially hurt long-term investors in the stocks involved, because as a REIT company issues more shares it dilutes the ownership of existing holders. If there is rapid flipping of new shares, one risk is that the selling could put downward pressure on the stock price.
For the NASD, a key concern would be the allegation that Wachovia brokers might have used fictitious accounts to engage in stock transactions, said Henry Hu, securities law professor at the University of Texas at Austin.
NASD rules bar the "establishment of fictitious accounts in order to execute transactions which would otherwise be prohibited," Hu said.