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SEC probes trading at hedge funds

Regulators seek data from brokerages on possible insider activity that hurts mutual funds.

February 07, 2007|Walter Hamilton | Times Staff Writer

NEW YORK — Underscoring the growing clout of hedge funds, federal regulators are seeking to determine whether Wall Street stock brokerages routinely leak sensitive trading information to people running these investment vehicles.

The probe by the Securities and Exchange Commission grows out of concerns by mutual funds that brokerage traders are tipping off hedge fund managers to upcoming orders to trade large quantities of stock, giving the hedge funds a chance to buy or sell ahead of the order, said a person with knowledge of the investigation.

Such "front running" hurts the mutual funds (and their individual investors) by making stocks they are selling less valuable, and stocks they are buying more expensive.

John Wheeler, former head of U.S. stock trading at American Century mutual funds, said the practice was widespread but difficult to detect. That's because a brokerage employee and a hedge fund trader can have secret agreements to swap information.

"All you've got to do is meet in a restaurant some time and say, 'Anytime I call you it means we've got a big order in a stock and to listen carefully to what I tell you,' " Wheeler said.

The investigation is another sign of the growing footprint that hedge funds -- the private investment pools known for their aggressive money-making tactics -- have on Wall Street.

As hedge funds have ballooned in size and power, they have become important customers of Wall Street investment banks, giving brokerages an incentive to keep them happy.

In the current case, the SEC is operating on the theory that the hedge funds repay traders who provide timely tips by steering future trading business their way, the person familiar with the probe said.

"Hedge funds have a lot of clout with Wall Street firms because they bring in a lot of profitable business," said James Angel, an associate finance professor at Georgetown University.

The probe by the SEC is in its early stages, and no accusations of wrongdoing have been leveled. The SEC sent letters three weeks ago to about a dozen Wall Street firms seeking stock and options trading data for the last two weeks of September.

Morgan Stanley, Merrill Lynch & Co. and Credit Suisse are among the firms that have received letters, say people familiar with the matter. The firms declined to comment.

Lori Richards, head of the SEC's examinations unit, confirmed the investigation, which was first reported by the New York Times on Tuesday. Brokerage stocks were little changed in the wake of the news.

"We're always concerned about information leakage in the markets that can harm investors," Richards said.

If Richards' team uncovers evidence of wrongdoing, the information would be forwarded to the SEC's enforcement unit, which would conduct a formal probe. The findings could lead to civil litigation.

Some outside experts said the agency would have a tough time detecting and proving wrongdoing.

To start with, the line between what constitutes proper information and what constitutes insider information is blurry, Angel said. Moreover, traders routinely share a wide array of information with clients in their normal course of business.

When mutual funds place large orders, for example, brokerage employees must find investors willing to take the other side of the trade. That gives them a legitimate reason to call clients to see whether they are interested in buying or selling shares -- information that also could be construed as a tipoff.

"The question is where is the dividing line between the good, legal information and the illegal insider information," Angel said. "The temptation is always going to be there, and for this reason there is always going to be another insider-trading scandal."

Mutual fund concerns about front running are one of the major factors behind the increasing use of electronic stock trading. In addition to greater speed and lower costs, mutual funds like computerized trading because it does away with human traders who could intercept their orders and trade ahead of them.

Computers are not a panacea, however, because the electronic data also offer clues about mutual-fund trading habits.

Insider trading first gained public attention in the late 1980s during the high-profile prosecutions of Wall Street figures such as Ivan Boesky.

Though it has receded from public consciousness in recent years, insider trading has remained a problem -- although the circumstances and participants have changed.

In the mid-1980s, most insider-trading cases related to people getting advance notice of planned corporate merger announcements, which often caused the stock of the company being bought to soar.

In the late 1980s and early 1990s, violations centered on corporate insiders selling shares before the public release of market-moving news about companies.

Recently, the agency has focused on concerns about hedge funds, SEC enforcement director Linda Chatman Thomsen told Congress in September.

Thomsen said at the time that insider trading comprised 7% to 12% of enforcement cases, and that the agency brought 300 cases since 2001.

But she also noted the difficulty of building insider-trading cases, pointing out that the agency must prove that someone had insider information and used it as the basis of a trade.

"They are unquestionably among the most difficult cases," Thomsen said.

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walter.hamilton@latimes.com

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