Thursday, December 16, 2004

Self-Dealing on Wall Street

The government is delving rather energetically into the conduct of brokers who act for their own personal benefit to the detriment of their clients and the market.   A criminal complaint filed against a former managing director of SG Cowen (Dec. 13) alleges that he engaged in insider trading about companies about to undertake PIPE transactions, which are Private Placement in Public Equity sales that usually cause a companies stock price to drop because of the dilutive effect of the transaction.  According to a release from the U.S. Attorney's Office for the Eastern District of New York, GUILLAUME POLLET, has been charged in a criminal complaint with one count of conspiracy to commit securities fraud related to short sales of three companies who were using Cowen for PIPE transactions.  According to the complaint:

The complaint alleges that in furtherance of the scheme, POLLET, and others, obtained material non-public information concerning PIPE transactions that were being contemplated by Sorrento Networks, Inc., Aradigm Corp., and HealthExtras, Inc. (collectively, the "Subject PIPEs"), the securities of which were publicly-traded on the NASDAQ national market system. While SG Cowen operated as the placement agent for the Subject PIPES, POLLET obtained the material, non-public information concerning the Subject PIPEs from SG Cowen employees and from representatives of the Subject PIPE issuers. The information was disclosed to POLLET pursuant to confidentiality agreements to enable him to determine whether SG Cowen would participate as an investor in the Subject PIPEs. Notwithstanding the terms of the confidentiality agreements, POLLET caused SG Cowen to short sell the publicly-traded securities of the PIPE issuers before the Subject PIPEs were publicly announced, resulting in substantial decreases in PIPE issuers' stock prices. POLLET then covered these short positions by either purchasing discounted stock through an investment in the Subject PIPEs, or purchasing the PIPE issuers' publicly-traded securities at the deflated post-announcement market prices.

An article in the Wall Street Journal (Dec. 15) details a regulatory action by the New York Stock Exchange against a clerk for a floor broker who engaged in "front-running," which involves trading ahead of large orders to take advantage of the current price before the execution of the large order.  Front-running has been an issue of continuing concern to the NYSE and the SEC, and was the subject of a large-scale undercover operation at the futures exchanges in Chicago in the 1980s that resulted in multiple convictions of brokers. 

The temptation to take the "free money" available from the use (and misuse) of information is very strong, and one suspects that the number of cases is only a small fraction of transactions involving self-dealing and insider trading. A front page article in the Wall Street Journal (Dec. 15) discusses the problem of self-dealing in brokerage firms, with the following example:

When a mutual-fund company asked brokerage firm Knight Securities to get it 600,000 shares of a fiber-optic stock, traders at Knight quickly swung into action.

A half-dozen traders -- figuring the big order would push up the price of the stock -- quickly began buying some for accounts that benefited their firm and themselves, according to testimony in a National Association of Securities Dealers arbitration.

The buying may have affected the price the client ultimately had to pay for the stock, JDS Uniphase, according to people familiar with the trading records. They say the traders in some cases sold their newly bought stock to the client, Oppenheimer Funds. According to testimony, it was sold to the client at a markup, a move that may have taken money out the pockets of mutual-fund shareholders.

The NASD's regulatory arm has examined Knight's trading from the period in question, March 2001, and other periods. It and the Securities and Exchange Commission are expected to levy a penalty against Knight soon. Knight, which has since changed management, testified that the trades weren't improper, didn't disadvantage the client, and followed typical industry practice. Oppenheimer declined to comment.

The incident points to one of the hardest-to-eradicate conflicts of interest on Wall Street. Securities laws generally require brokerage firms to put the client first. But it's an open secret that they or individual traders sometimes take advantage of their role as middleman to profit, at clients' expense, from what they know about clients' investing intentions.

Notably, New York Attorney General Eliot Spitzer has not gotten involved in this area . . . yet. (ph)

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