Last October, a Franklin County (Ky.) Circuit Court grand jury accused Noble Donald Morse II and his father, Donald Morse, of a popular crime: insider trading. But unlike Ivan F. Boesky and Dennis B. Levine, who dealt in stocks, the Morses face the novel charge that they "misused confidential information" to trade state bonds.
The younger Morse, who was then secretary and treasurer of Kentucky's Infrastructure Authority, allegedly tipped off his father about the agency's plans to buy back some 1973 bonds on Aug. 1, 1990. The redemption plans were made known to a select group of investment firms that the agency had contacted for help in setting the buy-back price. The Morses bought $110,000 in bonds in July, allegedly expecting that the state would redeem them at a higher price. The maneuver turned a quick $6,000 profit. The Morses have pleaded innocent. Says J. Guthrie True, Donald's attorney: "None of the information Morse used was confidential."
Innocent or guilty of the charges, the Morses could well earn a spot in the history of securities law for having been defendants in the first insider-trading case involving municipal bonds. Their case, moreover, is just part of a broad--and unprecedented--campaign by regulators and other law-enforcement authorities on information abuses in markets for securities other than equities. "There is a bit of a shift going on in our focus," says Securities & Exchange Commission Chairman Richard C. Breeden. "We are likely to give greater attention to the various debt markets."
LITTLE OVERSIGHT. The result could be new insider-trading laws and broad disclosure rules in markets that historically have operated with little regulatory oversight and something of an anything-goes culture. A lot is at stake. The $3.3 trillion government-securities market is one of the world's largest, about the size of the stock market. Municipal and junk bonds, respectively, have some $840 billion and $230 billion outstanding.
When Congress wrote the securities laws 50 years ago, most of the attention was on stock abuses. No one much worried about the sleepy markets for corporate bonds and government or municipal debt. Commodity trading was but an agricultural sideshow, and financial futures didn't exist.
Now, trading in nonequity markets is exploding. As it has become riskier and more volatile, so has the opportunity to trade profitably on privileged information. The key reason is that there is little required disclosure of information about issuers or of trading data, such as price. Issuers, traders, and others often have a big edge over the public.
Insider-trading laws cover all securities, but so far have been applied mostly to stocks. Corporate executives and directors who trade on inside information are usually prosecuted for breaching their fiduciary duty to shareholders. But they have no such duty to bondholders. Other insider traders are usually accused of "misappropriating," or stealing, company information. Yet that theory hasn't been applied by courts to debt either. Although commodities trading is broadly regulated, there are no direct prohibitions against insider trading, which is widely regarded as integral to commodities markets.
The government hopes to change all this. The SEC is looking into debt abuses, especially in the junk-bond market. Congress is exploring insider-trading laws for commodities. These efforts will likely lead to much more disclosure, which would narrow the yawning gap between the information haves and have-nots.
Perhaps the most visible problems, as regulators see it, are in the market for junk bonds. They often trade like stocks, rising or falling on news about the issuers. The SEC has made the junk market its "greatest concern," says Breeden. His goals include boosting disclosure and making junk prices more available.
'FISHING.' Breeden also wants to nab insider traders. The SEC's New York regional office is conducting what it terms an "informal inquiry" into trading by members of creditor committees involved in negotiating debt restructurings for troubled, often bankrupt companies. The SEC apparently believes that some committee members may have traded on information about these negotiations, which often affect the price of outstanding bonds. One lawyer for a firm questioned by the SEC calls the effort "a fishing expedition."
The SEC is also probing investors who buy bank loans made to troubled companies. By buying such debt, the investors can often gain access to the companies' confidential information. The SEC suspects some investors use this data to trade in the companies' junk bonds.
Junk-bond prices are also affected by takeover negotiations, just as stock prices often are. Junk-bond price runups just before bullish announcements are confirmed by "lots of studies," says Professor Donald C. Langevoort of Vanderbilt University School of Law. On Jan. 24, for example, Harcourt Brace Jovanovich Inc. accepted a $1.4 billion takeover bid from General Cinema Corp. But on Jan. 23, HJB's 13% bonds jumped $50. The bid has since expired.
The information trickle to junk bondholders is a flood compared to the data flow to municipal bondholders. Unlike corporate debt, muni issuers are exempt from the SEC's financial-reporting rules. Much of the disclosure burden falls on bond trustees, who are supposed to represent bondholders. In practice, the trustees' allegiance sometimes lies with issuers, who pay their fees.
The once-placid muni market has acquired junklike turbulence as credit ratings plunge for deficit-ridden issuers, such as Philadelphia and New York. Many small issuers have defaulted: Bridgeport, Conn., even filed for bankruptcy. The result? "Opportunity for some market participants to adjust their positions ahead of the investing public; in other words, to trade on inside information," says Los Angeles bond lawyer Karen J. Hedlund.
Nancy and Theodore D. O'Hearn would probably agree. In mid-1989, the couple spent $80,000 on hospital-revenue bonds sold by Choate-Symmes Health Services Inc. in Arlington, Mass. They bought the bonds from a local office of Minneapolis-based brokerage Dougherty, Dawkins, Strand & Yost Inc. In a lawsuit, the O'Hearns and others allege that the firm and two brokers were trumpeting the bonds even though they knew the hospital was financially sick. The suit alleges that the firm was simply unloading its inventory of the bonds before Choate went belly-up.
Dougherty responds that the public had plenty of red flags, including Standard & Poor's Corp.'s credit downgrading of the bonds from A