Was Knight errant on insider stock sale?

Top executives at the Nasdaq’s leading market maker have a $50 million question to answer: What did they know and when did they know it?

At a time when its stock is getting clobbered in the market, Knight Trading Group Inc., of Jersey City, N.J., is getting hammered just as hard in federal court.

At least five lawsuits seeking class-action status have been filed charging that company insiders unloaded stock in advance of a bad earnings report after misleading analysts about the company’s financial health.

smoking gun

Lawyers involved in the cases believe that trades by three Knight executives, who sold large blocks of company stock shortly after giving guidance to analysts, constitute the smoking gun.

According to court filings, Steven Steinman, Knight’s co-founder and former chairman, sold more than a million shares between July 21 and Aug. 30 for $31.3 million.

Peter Hajas, a director, sold about 500,000 shares between July 26 and Aug. 18 for $13.3 million.

And director and executive vice president Robert Lazarowitz sold 225,000 shares July 21 for $6.8 million.

“The biggest clue there’s something there is selling before the announcement,” says Maxine Goldman, shareholder relations manager at Barrack Rodos & Bacine, a Philadelphia law firm that is handling one of the suits.

“We’ve been doing this litigation for 25 years, and there’s a pattern to these things. When people sell their stock and later make an announcement where all the little people are hit hard – and they made huge profits – you have to say to yourself, `What went on?”‘ she says.

The company declined to comment but said in a Securities and Exchange Commission filing last Thursday that it has “meritorious defenses” to those suits and a separate case that claims the company improperly traded in securities for its own account before trading on behalf of broker-dealer clients.

Whatever the merits of the lawsuits, they highlight the woes that Knight and other financial services firms face in a stock market that has been anything but kind to them lately.

merit questioned

Its stock has plummeted along with other online financial firms such as E*Trade, Ameritrade and Charles Schwab Corp.

Knight’s stock had been trading as high as $60 a share over the past year but hit a new low last week of $15.63 before rebounding to close at $17.56 on Friday.

The story has been much the same for other firms. E*Trade’s stock, which peaked at $52 earlier this year, also hit a new low last week, trading at $7.12 before rebounding to close at $8.31.

Ameritrade fell to a low of $7.37 last week before rebounding to $8.75 on Friday, while Schwab held steady, trading between $27 and $29.

Several equity analysts doubt the pending class action has merit since the company’s upbeat forecasts were shielded by disclaimers under the federal safe-harbor provision, which protects forward-looking statements.

no safe harbor

But Richard Koppes, a consulting law professor at Stanford University and former general counsel for the California Public Employees’ Retirement System, says safe harbor does not protect against knowingly false statements.

Such lawsuits are becoming more common, particularly by institutional investors, he says, and are more often than not yielding negotiated settlements. No institutions have joined the pending suits so far.

“There is still fraud out there, people trying to manipulate the market,” Mr. Koppes says, “and it’s the institutional investors, not individuals, who have huge ownership in these companies who get burned so badly. They are pursuing these lawsuits, and these lead plaintiffs – these institutions – are being more successful.”

In one of the class-action complaints filed in U.S. District Court in New Jersey, Knight is charged with violating securities law by issuing “false and misleading” statements to analysts and investors.

In a conference call with analysts July 19, the company said it was “comfortable with estimates of 20% to 30% growth” in earnings per share during the third quarter over 1999 figures. The company’s targeted range was 22 to 27 cents per share.

Lawyers charge Knight officials knew the projections were not achievable because of declining trade volume and the costs related to its international expansion.

Knight revealed the bad news in an Oct. 4. news release.

The company said it expected that third-quarter earnings would range from 13 to 16 cents, with an adjustment of approximately 7 cents per share related to international expansion.The release blamed the negative results, in part, on “a seasonally slow third quarter, lower market volatility” and “individual investors moving to the sidelines.”

In the wake of the news, the company’s stock price fell 14% to $28.40, from $32.18 the previous day.

“Things don’t change that drastically in such a short period of time,” says Ms. Goldman.

“You have statistics, projections, you know what’s happening in the markets. We believe they made statements without a reasonable basis and had problems, most likely, and didn’t tell anybody,” she says.

The stock recovered much of the loss and closed at $31 on Nov. 3.

On its website, Knight notes that company employees can buy or sell company stock only during a four-week period each quarter – starting with the second business day after the previous quarter’s earnings are made public.

It also states that senior executives often follow sound financial advice and diversify their personal financial portfolios, which they can do only during the four-week window each quarter.

Most of the trading in question appears to have taken place during that time.

Analysts are less suspicious than the lawyers about the company’s statements and the insider stock sales.

Ken Worthington, an analyst for CIBC World Markets in New York, says Mr. Steinman, who retired in mid-July, had earlier announced his intent to reduce his Knight holdings to below 5% of outstanding shares.

Also, Mr. Worthington notes, Mr. Hajas was CEO of a company – Arbitrade Holdings LLC – acquired by Knight in a January stock deal, and it is not unusual for such executives to liquidate shares after the expiration of the waiting period following pooling of interest transactions.

“You don’t like to see insiders selling, but in the end they’re trying to diversify their portfolio,” he says. “It’s not unusual to see insiders sell shares at certain times of the year.

“My guess is the lawsuit is without merit,” adds Mr. Worthington, who participated in the July conference call. “I’m not a lawyer, but they did disclose the typical disclaimer at the beginning of the conference call.”

Greg Smith, a senior research analyst with Chase H&Q in San Francisco, says Knight is operating in an extremely volatile business. “Knight’s revenue and earnings depend on market conditions, which can change extremely quickly,” he says.

“It’s always difficult to pinpoint how they are going to come out.”