A Richmond-based stock brokerage agreed yesterday to pay $638,000 to settle allegations that its employees helped two Virginia hedge funds engage in predatory mutual fund trading, the first such settlement involving variable annuity life insurance policies.

Davenport & Co. LLC will pay $450,000 to NASD, the industry regulatory body, and return $288,000 -- the hedge funds' total profits -- to the mutual funds that were affected by the trading. NASD said Davenport also improperly placed orders to buy or sell mutual fund shares at that day's prices after the markets were closed. As is customary in such settlements, the firm neither admitted nor denied wrongdoing.

The case is part of a larger NASD investigation into abuses of variable annuities, said Barry R. Goldsmith, NASD's enforcement chief. A variable annuity is a life insurance policy in which premiums are invested in part in mutual funds. Regulators are looking at about a dozen brokerages of various sizes in connection with the use of such policies for a method of short-term trading known as market timing.

Market timing, which seeks to exploit short-term differences between a fund's daily price and the value of its underlying assets, is not illegal but many fund companies try to prevent it because it increases transaction costs and cuts into profits for long-term investors. Since last fall, more than a dozen fund companies have paid more than $2 billion to settle allegations that they allowed some customers to market-time.

Variable annuities were attractive vehicles for market timers who wanted to trade in funds that would ordinarily prohibit the practice, NASD said, because policyholders can move holdings among several different mutual funds without being detected. That's because the insurance company, rather than the mutual fund company, processes individual trades and gives only summary information about all of its clients to the funds.

Two Richmond hedge funds, James River Capital Management and TFS Capital Inc., used Davenport's brokers to buy millions of dollars in variable insurance policies for timing purposes, said Thomas J. McGonigle, Davenport's lead attorney. He said the firm turned itself in last fall after NASD ordered its members to report any short-term trading arrangements.

According to NASD, one of the hedge funds used Davenport to buy a policy from Western Reserve Life and made so many trades that in 2002 the insurance company began requiring it to submit trade requests by U.S. mail, effectively eliminating the timing. Life insurance companies also have rules against market timing. The brokers then helped the client sell that policy and buy another annuity under another name and tax identification number, according to NASD. The firm continued to sell the two hedge funds variable annuities even after receiving at least 10 letters from multiple insurance firms complaining about their rapid trading, NASD said.

"What makes this an interesting case is the lengths to which brokers were going to game the system," Goldsmith said.

NASD began its investigation of variable annuities last fall, and its concerns go beyond market timing to include possible use of the policies for money laundering, as well as brokers who recommend the investments to unsuitable clients, charge excessive management fees or improperly switch clients from one policy to another for increased commissions, officials said.

"We entered into what we think is a reasonable settlement," McGonigle said. "There's a new regulatory environment. It's a world which we're going to live in and respect, but it's a different world."