It's no secret that hedge fund managers are always looking for an edge before betting on a stock. Often that entails a lot of hard work such as digging through patent filings, scouring court records, and talking to former employees of a company. But in an effort to score an easy profit, some traders, it seems, may be willing to break the law by paying for confidential information.
Case in point: the allegation, first reported by BusinessWeek.com on Feb. 26, that federal authorities are on the verge of charging an employee in the New York office of Swiss investment bank UBS (UBS) with selling unpublished information about changes in analyst ratings on stocks to traders at two hedge funds. UBS declined to comment. Investigators also believe employees at another big investment firm got wind of the impending ratings changes at UBS and traded on them. The alleged inside information all but guaranteed a profit for the traders given the potential power of ratings changes to move stock prices. [On Mar. 1, after this story went to press, federal prosecutors made public the charges against a group of current and former employees from UBS and three other investment firms. (see BusinessWeek.com, 3/1/07, "The Century's Insider-Trading Bust").] The emerging insider trading scandal comes just four years after 10 Wall Street firms paid $1.4 billion to settle charges that some analysts had conspired with investment bankers to issue favorable ratings on certain stocks.
The possible misdeeds by a UBS employee are merely the latest variation on a long-running theme; for the right price, market-moving information can often be bought. Several former executives of day-trading firm AB Watley Direct Inc. (ABWG) will stand trial this month in a federal court in Brooklyn, N.Y., on charges that they orchestrated a scheme to eavesdrop on the chatter at the institutional trading desks of Merrill Lynch (MER), Citigroup (C), and Lehman Brothers (LEH). Joining the Watley executives at the defense table will be the former brokers who allegedly made the scheme work by selling access to their firms' "squawk box" communications systems, which allowed the day traders to listen to the conversations.
Regulators don't believe those are isolated cases. In fact, the Securities & Exchange Commission is so concerned about the misuse of confidential trading information that in early February it launched an inquiry to see if brokers at a dozen major Wall Street firms improperly tipped off hedge funds about big trades by institutional investors. Regulators are asking UBS, Merrill Lynch, Morgan Stanley (MS), Deutsche Bank (DB), and other banks to provide data on all stock and option trades for the firms and their customers from the last two weeks of September. The feeling on Wall Street is that the SEC is on a fishing expedition. Yet some securities attorneys say regulators may have been tipped off to specific incidents, given the targeted request.
It's easy to see why regulators are worried. Big trades can move prices dramatically, and a hedge fund with advance notice can make a killing. Mutual fund companies for years have complained to regulators that Wall Street brokers are passing on tips about such trades to their favorite customers. And when brokers let hedge funds trade ahead of other institutional investors, it usually means mutual funds and pension funds are getting inferior prices when they buy or sell shares.
Hedge fund advocates say regulators are overreacting. They argue that only a few bad apples resort to cheating or bribery, and contend that most of the hedge funds' information comes from good, old-fashioned detective work. "Regulators are suspicious of the hedge-fund industry and apt to jump to the conclusion that a manager's behavior violates the law," says Ron Geffner, a partner with Sadis & Goldberg, a New York law firm with a large hedge fund practice. While that may be, each new allegation of a hedge fund paying for trading tips only reinforces fears that the playing field is more unbalanced than previously thought.
By Matthew Goldstein