DEFINITION of 'Late-Day Trading'

Late-day trading, or late trading, occurs when hedge funds place orders to buy or redeem mutual fund shares after the time at which the net asset value is calculated, but receive the price based on the prior NAV already determined that day. These trades violate federal securities laws and defraud innocent investors.

BREAKING DOWN 'Late-Day Trading'

Late-day trading is the practice of placing orders to buy or redeem mutual fund shares after the net asset value has already been calculated. These trades enable the purchaser to profit from information released after the mutual fund price is fixed each day, but before it can be adjusted the following day. For example, a large component of a mutual fund may announce earnings after-hours that may have a material impact on the fund’s value the next day. Late-day trading can dilute the value of a mutual fund's shares, harming long-term investors. 

Illegal late-day trading schemes involve hedge funds working out special relationships with mutual funds to buy and sell shares after hours but record the trades at 4:00pm Eastern Time. The practice provides hedge funds with an opportunity to profit when new information is released after market close. These hedge funds may then share a portion of the illicit gains with mutual funds in exchange for their cooperation.

Late-Day Trading Regulations

Late-day trading is illegal under several federal securities laws, including Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10B-5.

The original late-day trading rules required broker-dealers and investment advisors to verify when trades were placed. If mutual funds received orders after calculating NAV for the day, they could still execute trades after-the-fact if they were certified as being placed earlier. The idea was to enable customer to place batch trades, but the drawback was that mutual funds had no way of knowing if any illicit trades were being placed.

These rules caused many issues in the past. For instance, Geek Securities is a broker-dealer and investment advisor was indicted for receiving trading instructions from its customers after 4:00pm Eastern Time and executing those trades as if trading instructions had been received prior to that time. The advisor used a time-stamp machine to conceal late-trading activities and using undocumented phone conversations.

The Securities and Exchange Commission made significant changes to late-day trading rules in proposed amendments in 2003 and 2004. The new rules required that mutual fund purchase and redemption orders be received by the fund prior to the time it calculates net asset value and increased mutual funds’ prospectus disclosures related to market timing. These rules shifted the responsibility to mutual funds to ensure enforcement.

Example of SEC Fines for Late-Day Trading

The former United Kingdom hedge fund Pentagon Capital Management was fined millions of dollars by the Securities and Exchange Commission for late-day trading violations occurring between February 2001 and September 2003. The hedge fund placed late-day trades through its broker dealer, Trautman Wasserman & Co., to illegally profit from information released after mutual funds prices were fixed at the end of each day.

The hedge fund argued that the trades did not involve fraud or deceit under federal securities laws and that it couldn’t be held liable as an investment advisor since it didn’t communicate directly with mutual funds. But, the courts ruled that “deceitful intent is inherent in the act of late trading” and that they had final say over the consent of communications even though the broker-dealer was ultimately responsible for placing the trades.

The Bottom Line

Late-day trading is the practice of placing orders to buy or redeem mutual fund shares after the net asset value has already been calculated. The practice is illegal under several different federal securities regulations and there have been several documented cases of indictments and fines resulting from late-day trading.

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