Small Dealer Accuses NASD of Retaliation : Securities: Federal investigators are looking into whether a firm that narrowed stock spreads was punished.

Federal investigators are looking into whether the National Assn. of Securities Dealers has retaliated against a small firm that took the lead in narrowing the spreads on several of Nasdaq’s biggest stocks, government sources with direct knowledge of the inquiries said.

Although the NASD denies any harassment, the sources said investigators at the Securities and Exchange Commission and the Justice Department are concerned that the dealer in Nasdaq stocks, Domestic Securities, of Montvale, N.J., may have become a target for retaliation because it narrowed spreads and has been cooperating with pending investigations of Nasdaq by both agencies.

Spreads--essentially dealers’ profit margins--are the difference between the price at which a dealer offers to buy a stock and the higher price at which it offers to sell.

Among the matters that the investigators are probing is an NASD decision dated Feb. 17 to turn down Domestic’s long-pending request to make markets in many more than the 50 stocks it currently is allowed.

The NASD, which operates the Nasdaq stock market, usually grants such requests routinely. Its refusal to do so in this case is significant to investors because Domestic’s principal owner, Harvey Houtkin, has said he would narrow the spreads in more stocks if his request were granted.

Although Domestic has been asking permission to make markets in at least 500 Nasdaq stocks since July, the NASD delayed action on the request for months. It held repeated hearings, served Domestic with waves of requests for thousands of documents, sent in auditors and threatened Domestic with fines and other sanctions if it did not immediately comply with all of the NASD’s requests for information, Domestic executives said.

“It’s clear the NASD doesn’t want Domestic making more markets, because they’re annoyed that we’re breaking spreads,” said Linda Lerner, the firm’s general counsel. Lerner said Domestic has complied with all of the NASD’s requests.

In a letter sent last month to an outside lawyer for Domestic, the NASD strongly denied any retaliation.

“I can only give you my personal assurances that neither the New York District Office nor anyone here at the NASD (headquartered in Washington) is engaged in any type of retaliation whatsoever,” wrote John E. Pinto, the group’s executive vice president for regulation.

The NASD declined to answer questions from The Times about Domestic’s request to make markets in more stocks.

The government sources said the SEC and the Justice Department’s antitrust division are taking the allegation of retaliation against Domestic seriously and are looking into it as part of their separate investigations of Nasdaq. “It’s particularly troubling that Domestic is out there narrowing the spreads, and here (the NASD) won’t give it any more stocks,” one source said.

In a written statement, NASD spokesman James D. Spellman said he was not surprised that the SEC and the Justice Department are investigating Domestic’s charges that it is the victim of retaliation. Still, he said, “The NASD is confident that at the end of those investigations its conduct will be vindicated.”

In its decision rejecting Domestic’s request, the NASD made no specific allegations of wrongdoing against the firm.

But the committee that issued the ruling said it was concerned that too large a portion of Domestic’s business may be with a small brokerage firm that shares its offices and handles the personal accounts of Domestic’s owners. It also cited concerns of NASD staff about “questionable” trading by Domestic, including indications that the firm in October may have violated a regulation banning use of an NASD computer system for small customer orders to make a type of trade known as a short sale.

The decision acknowledges that this regulation is no longer in effect. But the NASD committee nonetheless urged the NASD’s disciplinary staff to open an investigation of Domestic.

Houtkin denied that his firm had violated any regulations and said Domestic will try to appeal the ruling directly to the SEC.

In October, both the SEC and the Justice Department said they had opened investigations into whether Nasdaq market makers illegally colluded to keep spreads wide, and a Times series detailed other alleged unfair practices on Nasdaq. The federal agencies have been looking into such violations of market regulations as deliberate late reporting of trades by dealers and failures by dealers to honor their quoted prices for stocks.

Domestic isn’t the only firm to accuse the NASD of retaliation. Staten Island-based Datek Securities, another small maverick firm that has unilaterally narrowed spreads in some stocks, filed a federal lawsuit against the NASD in December, accusing it of bringing disciplinary charges against Datek in an effort to harass and retaliate against the firm.

U.S. District Judge Constance Baker Motley in Manhattan threw the suit out last month, ruling that Datek must first exhaust all appeals to the NASD and the SEC before it can sue in federal court.

Since first becoming a market maker in Nasdaq stocks last May, Domestic has narrowed the spreads on several large stocks, including Biogen, Lotus Development, Applied Materials and Parametric Technology. While other firms quoted the stocks in price increments of at least 1/4 point, or 25 cents, Domestic quoted prices in increments of 1/8 point, or 12.5 cents.

Because Nasdaq market makers in many circumstances must match the best price offered by any dealer, cutting the spreads in more stocks could save investors millions of dollars. But it also would cut into the profits of bigger dealers, including well-known Wall Street firms. The NASD committee that decided Domestic’s request is mostly made up of representatives from these firms.

Each Nasdaq stock has several market makers, with some bigger stocks having more than 30. Some dealers make markets in thousands of Nasdaq stocks.

Houtkin says he cut the spreads in an attempt to lure business away from his bigger rivals. But he says his firm now is basically just breaking even, and to become truly profitable, he needs to make markets in at least several hundred stocks.

Both Domestic and Datek are part of a group of small trading firms that long have been a thorn in the side of the NASD and big market makers; at one time, the NASD labeled them “SOES bandits.” SOES is the NASD’s computerized small-order execution system, which allows small orders from retail customers to be executed automatically.

The NASD contended that Domestic and the other “bandit” firms abused SOES, using it to make profits at times when stock prices were moving rapidly by hitting the big, established market makers with SOES orders before they had time to update their prices.

The SEC recently publicly sided with the SOES firms, however, rejecting an NASD plan for a new computer system that would replace SOES.

The NASD has been quick to crack down on what it perceives as violation of the SOES rules. But it rarely has brought cases involving alleged major violations of its rules by major market makers.

For instance, the NASD took no public action on any of the more than 4,700 complaints last year of dealers allegedly failing to honor posted prices for stocks. It also brought no public cases against dealers for deliberately delaying the reporting of large trades, although critics have said this illegal activity is extremely common.

Nasdaq Investigation

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