The Securities and Exchange Commission settled an enforcement action against the New York Stock Exchange Inc., finding that the exchange, over the course of nearly four years, failed to police specialists, who engaged in widespread and unlawful proprietary trading on the floor of the NYSE.

At the same time, the SEC instituted administrative and cease-and-desist proceedings against 20 former NYSE specialists for fraudulent and other improper trading practices.

The commission found that the NYSE failed to enforce compliance with the federal securities laws and NYSE rules that prohibit specialists from “interpositioning” and “trading ahead” of customer orders. In Canada, Market Regulation Services Inc. recently reported the results of its own front-running investigation, which found that the activity is not widespread, despite industry concerns. However, RS is looking at reforms to broaden and clarify the rules.

In settling the SEC’s action, the NYSE consented, without admitting or denying the findings, to entry of an order imposing a censure and requiring the NYSE to cease and desist from future violations of the federal securities laws. The NYSE also agreed to several significant remedial measures designed to strengthen its oversight of specialists and other floor members.

The NYSE agreed to an undertaking of $20 million to fund regulatory audits of the NYSE’ regulatory program every two years through the year 2011. The NYSE has also agreed to implement a pilot program for video and audio surveillance on its trading floor for at least an 18-month period.

“Self-regulatory organizations like the New York Stock Exchange have been a critical part of the regulatory landscape for almost a century now,” Stephen Cutler, director of the SEC’s Division of Enforcement, said, in a statement. “When SROs don’t vigorously police and prosecute wrongdoing in their markets, investors suffer. As our investigation continues, we will be focusing on individuals who may have fallen down on the job and contributed to the failure that resulted in the case we bring today.”

Specifically, the commission’s order finds that from 1999 through 2003, various NYSE specialists repeatedly engaged in unlawful proprietary trading, resulting in more than $158 million of customer harm. The improper trading took various forms, including “inter-positioning” the firms’ dealer accounts between customer orders and “trading ahead” for their dealer accounts in front of executable agency orders on the same side of the market. From 1999 through almost all of 2002, the NYSE failed to adequately monitor and police specialist trading activity, allowing the vast majority of this unlawful conduct to continue. The illegal trading went largely undetected because the NYSE’ regulatory program was deficient in surveilling, investigating and disciplining the specialists’ trading violations.

The commission has previously brought settled enforcement actions against all seven specialist firms responsible for the unlawful proprietary trading at issue in this case. Today it also instituted administrative proceedings against 20 individuals, former specialists. And, the U.S. Attorney also brought criminal charges against 15 individual specialists.

The SEC alleges that between 1999 and mid-2003 these specialists pervasively executed proprietary orders for their firms’ proprietary accounts ahead of executable public customer or “agency” orders that were placed through the NYSE electronic trading system, known as the “DOT” system. Through these transactions, these specialists violated their basic obligation not to fill customer orders through trades from their firms’ proprietary accounts when those customer orders could be matched with other customer orders, the SEC says.

The order also charges that several of the specialists engaged in particularly egregious conduct. For example, in several instances of “interpositioning,” the specialists not only disadvantaged both a buy and a sell order, but also moved the price up or down from the last sale price to further advantage the specialist firm’ proprietary account. In other instances, several of the specialists punctuated their improper trading with statements such as “f—k the DOTs” and “screw the DOTs” as they were in fact disadvantaging agency orders.