Criminal Probe Snares Morgan Stanley VP

A stock-loan investigation has prompted one executive to resign. Individuals at Bear Stearns and Janney Montgomery Scott are also under scrutiny

The fallout from a long-running criminal investigation into improprieties in the stock-lending business is starting to hit some of Wall Street's biggest firms. Earlier this week, a Morgan Stanley (MS) vice-president resigned after his name arose in conjunction with the inquiry into a complex kickback scheme involving the lending of stock to hedge funds and other short-sellers. Resignations at other Wall Street investment houses could soon follow as federal prosecutors get closer to filing criminal charges, according to people familiar with the matter.

In May, BusinessWeek reported that federal investigators are nearing the end of an 18-month probe of the murky world of stock lending. Investigators are examining allegations that employees working on the stock-loan desks of some of the biggest Wall Street firms accepted improper cash payment and other gratuities for referring work to so-called stock-loan finders—middlemen who help firms get their hands on hard-to-borrow shares (see, 5/17/07, "The Crackdown on Stock-Loan Schemes").

The investigators believe that many of these middlemen did little work to justify their fees. But to keep the referrals coming, the middlemen would split their fees with the employees of the Wall Street firms who had hired them.

Resignation Confirmed

So far, federal prosecutors have secured guilty pleas from three confidential witnesses in the case and are expected to file charges in July against as many as a dozen current and former Wall Street employees, say sources familiar with the investigation. The individuals drawing the most scrutiny are ones who either currently or formerly worked at Bear Stearns (BSC), Janney Montgomery Scott, and Morgan Stanley.

The Morgan Stanley vice-president, Peter Sherlock, a 13-year veteran, resigned on June 18, say people familiar with the investigation. Telephone calls for Sherlock were referred to a Morgan Stanley spokesman, who declined to comment. Sherlock's lawyer, John Wallenstein, a Mineola (N.Y.) criminal defense attorney, confirmed his client had resigned, but declined to say why. Wallenstein pointed out that Sherlock has not been charged with any wrongdoing. "I know there is an investigation by the Eastern District of New York," Wallenstein says, referring to federal prosecutors in Brooklyn, N.Y. "I know the SEC is looking at it too." A spokesman for Roslynn Mauskopf, U.S. Attorney for the Eastern District of New York, declined to comment. An SEC spokesman also wouldn't comment.

Stock Loans' Mysterious Ways

Securities lending is a large, but little-understood business for Wall Street. Investment banks rake in roughly $10 billion a year on the fees they collect for lending stocks and bonds to short-sellers, hedge funds, and other professional traders who bet on falling prices. But the prices charged by Wall Street firms for borrowing stock—particularly for shares of small-cap securities—has been something of a mystery. Hedge fund managers often complain about the lack of predictability in the prices big Wall Street firms charge for borrowing stock. Investigators believe the alleged kickback scheme drove up the borrowing costs for hedge funds and may have cost the funds millions of dollars in additional fees.

In a classic short sale, a trader borrows shares from an investment firm and sells them. If the stock falls as expected, the short-seller can pay back the loan and make a profit by repurchasing the shares at a lower price. When the investment firms don't have enough shares in their inventory, they sometimes seek out independent finders, who work the phones, calling friends, relatives, and buddies at other stock-loan desks to make up the difference. But investigators believe finders often aren't providing a legitimate service.