Government Brings Charges of Insider Trading
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MARGARET WARNER: Federal investigators announced multiple arrests and indictments yesterday in an insider trading scheme that was notable in both its scope and complexity.
The case goes back six years, involving more than a dozen people, more than $15 million in illicit profits, and includes employees of four of Wall Street’s biggest institutions, UBS, Bear Stearns, Morgan Stanley and Bank of America.
To tell us the story and the impact of all this are Jenny Anderson, who’s covering the story for the New York Times, and John Coffee, professor of securities law at Columbia Law School. For the record, he has advised Wall Street firms, stock exchanges and regulators, but has never been connected with this case or any participant.
Welcome, both of you. Thanks for joining us.
Jenny, first describe to us how this whole scheme worked. There was one young figure at the center of it, at the beginning of it, a young hedge fund manager at Bear Stearns named Erik Franklin. How did it operate?
JENNY ANDERSON, New York Times: Well, if we think about it from Erik Franklin’s point of view, we’ve got a trader who’s trying to get an edge, who’s trying to get ahead in the markets, and he’s looking for information that no one else has, material, nonpublic information, and he gets it from two different ways, two different streams of information.
One of them comes from UBS, from a friend of his, a man named Mr. Guttenberg, who works in the research department at UBS. He knows when stocks are going to be upgraded or downgraded. And when those stocks are upgraded or downgraded, there’s an impact on the stock.
An upgrade will likely push the stock higher and a downgrade the stock lower. He tips off his friend, Mr. Franklin, allegedly, as these cases outline, that there will be upgrades and downgrades in hundreds of stocks, and Mr. Franklin trades on that information, quickly in and out of the stocks and makes instantaneous profits.
The other one was a little bit more of an old-fashioned insider trading, back to the days of Ivan Boesky and Dennis Levine, where you had at Morgan Stanley, which is a major investment bank that does a lot of mergers and acquisitions.
There was a compliance lawyer, named Randi Collotta, who allegedly decided that she wanted in on some of the action. She wanted to make some money, so she and her husband asked a friend to do some trading on information about pending mergers and acquisitions.
She had this information as a compliance officer. She gave it to the trader. He made money, and they split the profits.
Through some of the people involved in that trickle down made it to Erik Franklin, as well, so he was able to trade on information about upgrades and downgrades, as well as information about pending mergers and acquisitions.
MARGARET WARNER: Explain, also, what methods they used to escape detection for at least five years.
JENNY ANDERSON: Well, again, some very tried and true, old-fashioned ways. They met in the Oyster Bar, and they hatched this plan. They met in prearranged places to exchange cash. But they also acquired disposable cell phones, and they texted one another with special codes as to which stocks would go up and down. And they developed their own language to convey the information to one another.
The extent of the problem
MARGARET WARNER: Professor Coffee, the SEC described this as the biggest insider trading case or illicit trading case since the days of Ivan Boesky in the '80s. How do you explain the fact that this kind of thing is still going on? And do you think it's just as pervasive as it was then?
JOHN COFFEE, Columbia Law School: I don't think it's just as pervasive as it was then. I do think that deterrence works.
But you should understand that there has not been a significant conspiracy like this or significant prosecutions in maybe 20 years. You have a whole new generation that's entered Wall Street since the time of Ivan Boesky, Michael Milken, and Drexel.
The young players who've come in haven't learned the lesson that their older generation saw, and they see immense profits. Also, this involved a hedge fund. Hedge funds today are under great competitive pressure to maintain extraordinarily high returns so they can charge extraordinarily high fees to their clients.
Those firms will offer, potentially, a great deal of money to people who possess material, nonpublic information. There has been speculation for some time that hedge funds were doing this. This is the first time that a hedge fund has gotten caught with its hand in the cookie jar, and there may be other examples like this out there that have not been caught.
MARGARET WARNER: And how do you explain the fact that it went undetected for so long?
JOHN COFFEE: Well, that's what's so serious here. This is not like the typical insider trading conspiracy, which is usually a one-shot conspiracy of marginal, low-ranking employees.
This involved high-ranking, sensitive, Wall Street professionals who were in exactly the wrong place to be corrupted. A compliance officer is the equivalent of your counterintelligence officer. This is a little bit like a senior officer at the CIA being caught selling information to Osama bin Laden.
So people at high levels and sensitive positions were corrupted. They were able to hide because they were professionals, and they were in charge of the counterintelligence, and they were dealing with professionals themselves, hedge funds, that didn't trade in manners that immediately alerted the market computers, which usually pick up the unusual trading activity of small individuals.
Changes since the '80s
MARGARET WARNER: Jenny, there is a lot more computerized, at least, oversight of these trades. How much has the system changed since the '80s? And does it make it easier or harder to get away with something like this?
JENNY ANDERSON: A lot has changed, and a lot has stayed the same. The value of the information has absolutely stayed the same. The way in which people have to convey it to one another really hasn't changed. You don't want to send an e-mail, because e-mails can be subpoenaed. If you talk on the phone, it's going to be much easier to say that conversation never took place.
It's why insider trading is so hard to catch, because usually it's one person who has to turn on the other. As Professor Coffee pointed out, computers pick up on this stuff, but that's the first step. Then the regulators go in and say, "Explain to me why you bought this Microsoft stock."
And a hedge fund trader can say, "Because I thought it was a great stock," and it's going to be very hard for the SEC, or whatever the regulatory body is, to disprove that, unless there is really hard information about where that material, nonpublic information was coming from.
So, again, a lot has changed. There is more program trading, computerized trading. But that's really not heart of this. The heart of this is still going to be individuals out there to get an edge, trying to cover their tracks, and trying to get information in person, on the telephone, in the most undetectable ways possible.
But I would say one thing that has changed significantly is the volume of trades that goes on, the types of products that are traded today, the amount of trading, and the types of players. Again, as Professor Coffee pointed out, 8,000, 9,000 hedge funds today controlling $1.4 trillion, everyone looking to get an edge.
There's a lot of concern that there is such a strong incentive to try to get ahead that insider trading will be more pervasive and will be more rampant.
MARGARET WARNER: So, Professor Coffee, what should Americans take away from this, if, by some accounts, more than 50 percent of adult Americans are now in the market, mostly through their retirement funds?
Back in the early '80s, from figures I saw, it was just about 20 percent. Are we or they being played for patsies in this system? Are there really just two tiers and the insiders are always favored?
JOHN COFFEE: Well, I think, of course, most insiders are honest, and I think most Wall Street investment banking firms are also honest. And I think some of these firms were the victim of this behavior. It was their confidential business information that was being stolen by these defendants, or at least allegedly stolen.
What has changed is this new actor, the hedge fund. It will trade, not in tens of thousands or hundreds of thousands of dollars, as individuals might trade. It will trade in hundreds of millions, in some occasions, not in this case, but possibly in others, and because it trades so frequently, that even if an investigator comes in and says, "Why did you do this?" You can say, "Listen, on that particular day, I traded $500 million in securities. I made 50 to 60 different bets on individual stocks. And this was this was just one of 60 bets that looked right to me."
That's very hard to break that down, whereas it's much easier if an individual, for the first time in his life, makes a $50,000 trade. So it's harder to penetrate the hedge fund that is playing tough.
Debate over the size of the problem
MARGARET WARNER: And, Jenny, very briefly, what are people on Wall Street saying to you about how pervasive they think this practice is?
JENNY ANDERSON: Oh, it's a very split issue. A lot of people would agree with Professor Coffee. Most of the market is -- most people are trying to do the right thing, and most people are terrified. They're not going to risk their entire career to make a quick and easy buck.
But there is a lot of evidence that there is incredible information leakage, another term that's used for insider trading, perhaps a kinder phrase for insider trading.
We've analyzed quite a bit of data ahead of mergers and acquisitions looking at aberrant trading, and it's pervasive. There is frequently unusual trading ahead of the announcement of deals, and that indicates that something is going on. Information is getting out into the marketplace.
MARGARET WARNER: All right, Jenny Anderson of the New York Times, and Professor John Coffee of Columbia, thank you both.
JENNY ANDERSON: Thank you.