Is Junk The New Front In The War On Insider Trading?Michele Galen
Is Junk The New Front In The War On Insider Trading?Michele Galen
When Care Enterprises, a nursing-home chain, fell into bankruptcy in March, 1988, its creditors set up a committee to negotiate with management. The committee's co-chair was an executive of R. D. Smith & Co., a New York investment firm and a large Care bondholder. Smith people helped craft a reorganization plan that gave bondholders a big equity stake in the company. Since Care's emergence from Chapter 11 in January, its stock has more than doubled.
But that's not the end of the story. BUSINESS WEEK has learned that the Securities & Exchange Commission is investigating Smith for possible insider trading violations. According to a source close to the probe, the SEC is asking whether Smith used nonpublic data gleaned from creditors' committee negotiations to trade Care's junk bonds. R. D. Smith's general counsel, Kenneth C. Schneier, says the firm made one bond purchase from another member of the creditors' committee with the committee's and company's knowledge. Otherwise, he says, it "didn't trade. Period."
The inquiry into Smith's trading is just one facet of what is said to be a broad, recently launched probe that represents the SEC's first major attempt to extend the insider trading laws beyond stocks into the $210 billion junk-bond market. The SEC is also inquiring aboutpossible illegal trading by S. N. Phelps & Co., a Greenwich (Conn.) brokerage firm controlled by Stanford N. Phelps, and Steinhardt Partners, a New York-based hedge fund headed by widely watched investor Michael Steinhardt. An SEC spokesman declined comment.
LOOSELY REGULATED. The agency is focusing on whether bondholders, through membership on creditors' committees or contacts with committee members, have been gleaning inside information. Since these committees negotiate with a company's management in bankruptcies and out-of-court restructurings, members are privy to confidential data. When the data become public, it often affects the price of the company's securities.
The SEC is said to be asking about the firms' activities in restructurings involving creditors' committees since at least 1985. Schneier says R. D. Smith usually avoids serving on creditors' committees, but when it does serve, it doesn't trade the company's securities. Stanford Phelps says his firm never trades the bonds when it sits on committees or possesses confidential data. Steinhardt partner Gary S. Fragin says suggestions of wrongdoing are "just not true."
The filing of charges by the SEC, while far from certain, could spur a flurry of new investigations and initiatives by the agency to overhaul the loosely regulated debt markets. SEC Chairman Richard C. Breeden has made the high-yield debt market a top priority. Says former SEC general counsel Harvey Pitt: "There's a fair amount of pressure for the SEC to come up with something."
Phelps is the best-known firm involved in the inquiry. Stanford Phelps has made a name--as well as millions of dollars--by snapping up a sick company's defaulted bonds and then telling the issuer either to pay the accrued interest on the bonds or face an involuntary bankruptcy petition. His firm has also been active on creditors' committees.
The SEC is said to be asking about numerous deals in which Phelps was involved since the early 1980s. In response to informal SEC inquiries, says Stanford Phelps, the firm has turned over about eight cartons of documents. The SEC, according to a source with knowledge of the probe, has been collecting information on restructurings involving NuCorp Energy, Itel, and Phelps-controlled Citizens Mortgage Investment Trust, now called Citizens Properties. Phelps was not on creditors' committees in these instances, but the SEC is asking whether the firm may have been fed inside data from a committee member. Phelps calls the charge "false."
Steinhardt Partners acquires positions in distressed securities and only occasionally seeks membership on creditors' committees, says partner Fragin. The SEC is expected to explore all deals in which the firm was a member of a creditors' committee. Recent examples were the out-of-court workout of KDI Corp. and the bankruptcy of Insilco Corp. And it is asking whether Steinhardt Partners may have traded on an illegal tip from someone on a creditors' committee for Eastern Air Lines Inc., which filed for bankruptcy in March, 1989. During this period, the hedge fund accumulated a 6.9% stake in the airline's junior preferred stock. The SEC is said to be studying whether the purchases resulted from inside information on proposed cash infusions or other deals that may have saved Eastern from liquidation. Fragin strongly denies any wrongdoing.
Six-year-old R. D. Smith has been a diversified boutique for investors in troubled companies. It conducts research, invests in the securities of these companies, and recommends them to clients. In looking into Smith's activities as a member of the Care Enterprises creditors' committee, the SEC is believed to be scrutinizing whether the firm traded the company's debt or tipped off its brokerage arm, which may have bought bonds.
Also said to be under study: whether Smith would routinely collect data as a creditors' committee member, resign from the committee--perhaps because it then would no longer be an insider--and use the data to trade the troubled company's securities. That's how some in the bankruptcy negotiations of utility Public Service Co. of New Hampshire remember it. Says one: "Some people felt Smith was trying to get on the committee for information, got it, and left." Replies Schneier: "With a few exceptions, it's not our policy to get on committees."
Since the SEC contacted R. D. Smith early this year, the firm has undergone a restructuring of its own. In the spring, it trimmed its ranks. In early June, founder Randall D. Smith sold the firm to some of its key managers. On Sept. 1, R. D. Smith will be renamed BDS Securities Corp. Schneier says plans for the changes predated and had nothing to do with the SEC investigation.
For all of the SEC's apparent suspicions, the probe is said to be in its early stages. Typically, before the agency can bring charges, private attorneys say, it will have to pore through trading records and try to match trades with key events in the negotiations between creditors and management.
UNTESTED AREA. Even if the SEC uncovers questionable transactions, the lawyers add, it may face an uphill battle establishing that trading junk bonds on inside information actually violates the law. Insider trading laws technically cover all securities, but so far they have been applied mostly to stocks. Executives and directors who trade stocks on inside information are usually prosecuted for breaching their fiduciary duty to shareholders. But they owe no such duty to bondholders. Insider traders are also often charged with "misappropriating," or stealing information. Courts haven't applied that theory to junk bonds, either.
The SEC has already set some policies for junk trading by firms involved in reorganizations. In the Federated Department Stores bankruptcy, some bondholders on the creditors' committee sought court permission to trade their bonds. The SEC argued--and the judge agreed--that trading by firms serving on creditors' committees is legitimate so long as the firms set up a Chinese wall between committee members and traders. And in July, a bankruptcy court in Delaware upheld a similar arrangement for bondholders of Harvard Industries.
Yet bondholder advisers such as Wilbur Ross of Rothschild Inc. say the SEC should issue much broader ground rules before bringing prosecutions. That way, he says, "people who are trying to do the right thing wouldn't have to guess."
Although the law on junk trading is still murky, and questions about trading by Smith, Phelps, and Steinhardt remain to be resolved, the "right thing" is still not exactly an elusive concept. Sooner or later, the SEC will almost certainly establish that junk-bond investors involved in bankruptcies or restructurings should follow one guiding principle: If you want to trade your junk portfolio, stay away from creditors' committees.
THE JUNK PROBE
The Securities & Exchange Commission's investigation, says a source with knowledge of the probe, centers on the activities of three investment firms:
The SEC is asking whether the Greenwich (Conn.) firm used inside information from creditors' committees for ailing companies to trade in the companies' junk bonds. Stanford N. Phelps, the firm's head, denies wrongdoing
R. D. SMITH
In the 1988 bankruptcy of Care Enterprises, the New York firm co-chaired a creditors' committee that helped craft a reorganization plan. The SEC is asking whether Smith used inside information gleaned from the negotiations to trade Care bonds. Smith says it didn't trade
The SEC is said to be looking into the New York hedge fund's membership on creditors' committees to see if it illegally traded the companies' junk bonds. Steinhardt disputes the charge