Late-Day Trading: What It Is, How It Works, Regulations

What Is Late-Day Trading?

Late-day trading is the illegal practice of recording trades executed after hours as having occurred prior to a mutual fund's calculation of its daily net asset value (NAV). It is normally associated with hedge funds placing orders to buy, or redeem, mutual fund shares after the current period's (usually daily) NAV is officially calculated, but receiving a price, usually more advantageous, based on the prior period's NAV that has already been documented.

Late-day trading can dilute the value of a mutual fund's shares, harming long-term investors, and should not be confused with the completely legal and acceptable practice of after-hours trading.

Understanding Late-Day Trading

Late-day trading is the practice of placing orders to buy or redeem mutual fund shares after the latest NAV has already been calculated. These trades enable the investor to lock in the previous day’s NAV to their advantage, such as, for example, in the case when a large component of a mutual fund announces earnings after-hours that has a material impact on the fund’s value the next day. 

Illegal late-day trading schemes typically involve hedge funds setting up special relationships with mutual funds to buy and sell that mutual fund's shares after hours but having that trade recorded as being executed prior to the time when that mutual fund's NAV is calculated (normally 4:00 p.m. Eastern Time). This practice provides hedge funds with an opportunity, that is not available to all investors, to potentially profit from events that occur after the market closes. These hedge funds may then share a portion of the illicit gains with mutual funds in exchange for their cooperation.

Late-day trading violates federal securities laws regarding the price at which mutual fund shares must be bought or redeemed. The Securities and Exchange Commission (SEC) has concluded that this type of activity defrauds innocent investors in those mutual funds by giving the late-day trader an advantage not available to other investors.

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 customers 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 that was indicted for receiving trading instructions from its customers after 4:00 p.m. Eastern Time and executing those trades as if trading instructions had been received prior to that time. Phone conversations were undocumented and the advisor used a time-stamp machine to conceal late-trading activities.

The SEC made significant changes to late-day trading rules 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 NAV and increased mutual funds’ prospectus disclosures related to market timing. These rules shifted the responsibility to mutual funds to ensure enforcement.

Late-Day Trading Fines

The former United Kingdom hedge fund Pentagon Capital Management was fined $98.6 million dollars by the SEC 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. However, the courts ruled that deceitful intent is inherent in the act of late trading and that the hedge fund had the final say over the consent of communications even though the broker-dealer was ultimately responsible for placing the trades.