Commentary: The Street's Next Big Scandal

Are traders and hedge funds colluding to profit from privileged information?

When the Supreme Court ruled in June that investment banks were immune to lawsuits that alleged collusion in the way they underwrote stocks in the 1990s, the news was met on Wall Street with a thunderclap of...utter indifference. For all the outrage when Eliot Spitzer was digging up smoking-gun e-mails, the scandals of yore are as relevant now as The Starr Report. The fact that the court has effectively sanctioned those old practices doesn't much matter now. The game has changed.

One look at the Street's response to the near-implosion of two Bear, Stearns & Co. (BSC ) hedge funds shows that collusion is alive and well, and is constantly evolving in ways that defy black-or-white judgments. Don't expect the high court to catch up with this current wave until Paris Hilton turns 40.

The next big scandal will most likely involve brokerage activities and proprietary trading, which long ago surpassed investment banking to become Wall Street's chief profit center. Investment houses have made vast sums trading for their own accounts—buying and selling stocks, bonds, collateralized debt obligations, and all sorts of securities. They've also minted money processing such trades for hedge funds, a business known as prime brokerage. Some of the profits from both, it will one day be shown, have been ill-gotten.

At the heart of the new collusion is the practice of "front-running"—essentially, trading ahead of big buy and sell orders to profit unfairly from the resulting ups and downs in prices. The concern is that prime brokers are not only tipping off their own traders about big mutual fund orders on deck but also giving the heads-up to their hedge fund clients. The banks' rewards are twofold: instant, easy trading profits and fat commissions or outright cash payments from hedge funds. Meanwhile, mutual funds unwittingly subsidize the scheme by buying stocks at higher prices or selling at lower ones than they otherwise would. "It's a slippery, slimy slope," lamented a mutual fund manager, adding that all these leaks make peer-beating returns harder to achieve.

Regulators have been slow to crack down on what's quickly becoming an open secret. The U.S. Attorney's Office and the Securities & Exchange Commission have accused brokers from Lehman Brothers (LEH ), Merrill Lynch (MER ), and Citigroup (C ) of allowing clients to listen in on their internal speaker systems, over which traders announce their desire to move huge blocks of stock. Those clients then allegedly kicked back commissions and cash. A former Merrill broker pled guilty. "Any disclosure of confidential information is a violation of policy," says a Merrill spokesman. "We cooperated with the government." Citigroup and Lehman declined to comment.

In most cases, however, front-running is vexingly hard to prove. "It's a gray world," says New York University professor Lawrence J. White. "But cooperating to protect high prices and fees is where regulators and plaintiffs are ready to pounce."

If front-running is gray, what about other types of collusion? Short-sellers, for instance, often conspire to swarm a company to drive down its stock and hasten its demise. One could argue that the strategy is nefarious. Another might say the economy benefits from the culling of the weak.

The Bear Stearns situation is just as cloudy. Banks have every incentive to keep one another going and prevent a systemic meltdown. In the Bear case, JPMorgan Chase (JPM ), Goldman Sachs (GS ), and Bank of America (BAC ) each agreed with Bear to settle their losses without forcing a liquidation of the fund's assets, which would have sent the subprime mortgage market lower still. Such mutually assured destruction could have subsumed the entire credit market and choked off all of Wall Street, and possibly the rest of the world. Or are the firms punting on something that will only be uglier down the road?

Two things are certain. For better and for worse, collusion will always exist on Wall Street. And when it gets out of hand, a case will make it to the Supreme Court—years too late to matter.

By Roben Farzad

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