By David Scheer
March 2 (Bloomberg) -- The U.S. government's accusations that Morgan Stanley, UBS AG and Bear Stearns Cos. employees were central figures in an insider-trading ring illustrate why regulators and lawmakers are suspicious of Wall Street's relationship with hedge funds.
Prosecutors in New York and Washington yesterday laid criminal charges against 13 people, accusing an executive at UBS and a former compliance lawyer at Morgan Stanley of tipping off traders and brokers to new analyst ratings and secret takeover talks. Bear Stearns was home to at least four professionals who traded on information leaked from inside the two firms, according to a complaint filed by the Securities and Exchange Commission.
``Incidents like this strengthen the hands of those who are urging greater scrutiny of hedge-fund activities and their sources of information,'' said David Becker, a former SEC general counsel now in private practice at Cleary Gottlieb Steen & Hamilton LLP in Washington.
Legislators such as Senator Arlen Specter, the Pennsylvania Republican, want market watchdogs to take action amid mounting evidence of rampant insider trading. At least two studies show that stocks and derivatives regularly rise ahead of takeovers, and in the past week trading of options to buy shares of TXU Corp. and Hyperion Solutions Corp. surged in advance of announcements that they agreed to be acquired.
Incentive to Trade
Hedge funds are private pools of capital that allow managers to participate substantially in gains on the money invested. That pay structure creates an incentive for employees to trade in non-public information. Hedge-fund managers also are under pressure to boost returns that since 2000 have averaged half the industry's gains in the 1990s.
The temptation to cheat extends to the securities firms, which collect $10 billion a year in fees for providing prime- brokerage services to hedge funds.
``The larger the pot of gold the more likely that you'll entice someone into stealing,'' said William Portanova, a criminal-defense attorney and former federal prosecutor based in Sacramento. ``Good people convince themselves over a cocktail that it's a victimless crime and that they're merely collecting a few crumbs from the feast that no one will ever miss.''
Earlier this year, the SEC asked at least 10 Wall Street firms to turn over stock-trading records for the last two weeks of September, seeking to determine whether they leaked details about big stock trades to favored clients.
Boesky, Levine
The government said yesterday that it broke one of the biggest insider-trading cases since the 1980s. According to the SEC, which brought a civil suit against 14 defendants, the scheme stretched over five years, included hundreds of tips and produced more than $15 million in illegal profits.
The arrests ended ``one of the most pervasive Wall Street insider trading cases since the days of Ivan Boesky and Dennis Levine,'' said Linda Thomsen, who heads the Securities and Exchange Commission's enforcement division.
At a meeting at the Oyster Bar in New York's Grand Central Station in 2001, Mitchel Guttenberg, an executive director in UBS's equity-research department, and hedge-fund trader Erik Franklin hatched one of the schemes, the SEC claims.
Guttenberg, 41, offered to settle a $25,000 debt to Franklin, 39, by slipping him analyst ratings in advance, the agency said. To avoid getting caught, the men used disposable mobile phones to send each other coded messages, according to the SEC's complaint.
Bear Stearns Officials
At the time, Franklin was working at Bear Stearns and managing money for Lyford Cay Capital out of the firm's New York offices, prosecutors said. He and his colleague, David Tavdy, 38, made more than $4 million on inside trades in brokerage accounts they controlled. Three Bear Stearns brokers also traded on Guttenberg's tips, the complaint alleges.
``The actions described in the complaint are clear violations of our policies and procedures,'' said Russell Sherman, a spokesman for Bear Stearns. ``We have and will continue to cooperate with the investigation.''
Lyford Cay's investors included ``certain senior officials'' of Bear Stearns, according to the SEC. Sherman declined to name them.
Prosecutors also accused Randi Collotta, 30, a compliance officer at Morgan Stanley, of telling her husband Christopher Collotta, 34, and Marc Jurman, 31, a broker in Florida, about deals in 2004 and 2005 including Johnson & Johnson's failed $24.2 billion bid for Guidant Corp., UnitedHealth Group Inc.'s $8.2 billion acquisition of PacifiCare Health Systems Inc. and ProLogis's $5.5 billion purchase of Catellus Development Corp.
Illegal Trading
Jurman traded on some of the information and passed it on to others, generating thousands of dollars in profits that were passed back to the Collottas and others, according to the SEC complaint. Two of the Bear Stearns brokers benefited from the leaks at New York-based Morgan Stanley, the world's second- largest securities firm.
A study by Measuredmarkets Inc. in August showed that insiders may have traded illegally in advance of 41 percent of the largest U.S. acquisitions the previous year. Two months later, Credit Derivatives Research LLC found that credit-default swaps based on the bonds of 30 takeover targets, including four of the five biggest leveraged buyouts by that point in 2006, rose before deals were announced.
More recently, trading in options to buy shares of TXU Corp. surged more than seven-fold on Feb. 23 before CNBC said the company would be acquired in the largest-ever leveraged buyout. This week, the volume of options trading to buy shares of Hyperion Solutions Corp. rose almost sixfold before Oracle Corp. yesterday said it will buy the company for $3.3 billion.
Guilty Pleas
Four of the criminal defendants have pleaded guilty. Eight, including Guttenberg, pleaded not guilty in Manhattan federal court and were released on bail of as much as $500,000. No firm was criminally charged. All the defendants declined to comment, as did attorneys for Guttenberg and the Collottas.
Lawyers for Franklin, Jurman and Tavdy didn't return calls seeking comment.
Morgan Stanley spokesman Mark Lake said his company is ``outraged that a former employee allegedly stole confidential information,'' and the firm is cooperating with investigators. UBS also is cooperating, said Rohini Pragasam, a representative in New York for the Zurich-based bank.
Bear Stearns, based in New York, is the fifth-largest U.S. securities firm by market value.
Charlotte, North Carolina-based Bank of America Corp., the second-biggest U.S. bank, also is cooperating with the government investigation after one of its brokers was accused of collecting kickbacks in exchange for shares of new stock offerings, spokeswoman Shirley Norton said.
The SEC case is SEC v. Guttenberg, U.S. District Court for the Southern District of New York (Manhattan).
To contact the reporter on this story: David Scheer in Washington dscheer@bloomberg.net .
Last Updated: March 2, 2007 03:55 EST
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