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Sophisticated crooks elude radar in trading probes
2007-08-08
Married couples swap illicit stock tips. Novice investors turn a huge profit on one well-timed market bet. A forklift operator at a printing plant steals advance copies of a market-moving business magazine. U.S. authorities have announced a wave of insider trading prosecutions like these recently, but many appear to be relatively textbook examples of trading schemes that are sloppily planned and not too hard to crack. What has become a much bigger challenge is tracking down unlawful buying and selling by sophisticated traders who are too smart to fall into predictable patterns and hardly leave a trail. Much of the suspicion surrounds traders at hedge funds and other institutions who routinely execute rapid-fire trades that can be tough to monitor. The U.S. Securities and Exchange Commission has made insider trading a priority, announcing some big busts this year as well as setting up a hedge fund unit within its enforcement division to combat unlawful trading. But experts say the commission cannot root out all the illegal trading amid the huge growth of hedge funds and only modest increases in its own enforcement staff. "They are definitely in catch-up mode at this point," Dan Small, a partner at law firm Duane Morris LLP who handles white-collar criminal matters, said of the SEC and other market cops. "Those inclined to commit fraud are constantly finding new ways to do it." Insider trading is considered particularly tough to prove because most cases are built on circumstantial evidence. Still, authorities often can track down unlawful trades that were based on confidential, nonpublic information by connecting the dots among people involved in a scheme and getting cooperation from some of the participants. Regulators generally get suspicious when someone brilliantly times a short sale of a stock or the purchase of out-of-the-money options that normally do not generate instant value. ELUSIVE PATTERNS But for a hedge fund that dips in and out of securities frequently, it's hard to pinpoint any special patterns. And these traders presumably have a lot more street smarts than market neophytes, refraining from sending incriminating e-mails or feeding tips to family and friends whose trades can be easily analyzed. A hedge fund that engages in unlawful trades might make only a small percentage profit, not a killing, relative to its total daily trades based on the inside information it obtained. That makes tracking their trades difficult, if not impossible, experts say. "A hedge fund trader may have had 50 bits of information from 50 different phone conversations, and maybe it turns out that one of those people he was talking to was saying more than he should have," said Emmett Stanton, a partner at law firm Fenwick & West LLP. "But to connect that one bit of information, and conclude it was the critical bit of information -- that's a very, very hard thing to prove," he said. Just how much insider trading is going undetected in the U.S. financial markets is impossible to know. Market monitors have developed computerized surveillance programs, but experts say it's not feasible for them to go after every case and that in many instances, savvy cheaters are several steps ahead. Suspicious trading has surrounded a wave of recent mergers. Almost 60 percent of 27 big deals announced in North America this year were preceded by unexplained spikes in the trading of the stock of the target company, according to data compiled by Toronto research firm Measuredmarkets for the Financial Times. That's up from 14 percent for the seven largest deals announced in 2003, according to the study. EXPLOSION As part of efforts to better police insider trading, the SEC has bolstered its enforcement staff to more than 1,100 people this year from fewer than 1,000 in 1997, but that is hardly on a par with the explosion of hedge fund activity. There are about 8,000 of these loosely regulated investment pools today, compared with a handful a decade ago, and they now account for anywhere from 30 percent to 50 percent of daily volume on the New York Stock Exchange, according to various industry estimates. Faced with that imbalance, the government knows it can't pursue every case and instead goes after the biggest and sexiest cases to send a message, experts say. "Part of the message in these cases is deterrence," said Jacob Frenkel, a former SEC enforcement official and criminal prosecutor who now handles white-collar criminal matters at law firm Shulman Rogers. "It's important from a program perspective for the agency to be able to bring cases of profile and to be able to deliver the message that they are still watching," Frenkel said. Two of the biggest recent cases were the April criminal conviction of ex-Qwest Communications (Q.N) CEO Joseph Nacchio for insider trading in company stock, and the 2004 conviction of homemaking expert Martha Stewart on criminal charges of lying to investigators about a suspicious stock sale. In March, the SEC and criminal prosecutors brought charges against more than a dozen people, including employees at Wall Street banks and hedge funds accused of participating in a far-reaching insider trading ring. Eight people have pleaded guilty in the criminal case. TO CATCH A CHEAT Savvy market crooks are well aware of what authorities look for when probing suspicious trading. The SEC and the financial exchanges patrol the markets for out-of-the-ordinary trades, especially ahead of a big event such as a merger announcement or government approval of a new drug in which it's clear that numerous people had inside knowledge of the pending news. When regulators and criminal prosecutors launch an investigation, they often assemble a timeline of how long a deal or other event was in progress, and then look at whether unusual trading activity coincided with particular meetings or developments. They also try to draw connections of who had access to information, and seek things like office seating charts from also show the locations of central printers or fax machines in an effort to track the flow of documents at a company, Stanton said. Traders who elude detection are careful not to make too large of a profit on any one trade. For regulators, "the bigger challenges are those involving modest trades and institutional trades by active investors," Frenkel said. And even though investigators routinely monitor trading ahead of buyouts, a hedge fund or other institutional trader might be able to avoid detection if it owned stock in the company before and frequently trades in the company's industry, making it possible to come up with a plausible defense. "In those cases, very few trades they make are aberrational. There tend not to be trades that stick out," said Scott Friestad, associate director in the SEC's enforcement division. "You try to get to the same result in other ways." When authorities probe trading ahead of deals, they also must confront the large amount of rumor that in some cases is manufactured by the parties themselves, said Abol Jalilvand, dean of the Loyola University Chicago School of Business Administration. He said that leaks sometimes are orchestrated to try to invite higher bids. It can be hard, then, to tell "whether the leak is due to human error or if it's strategically designed." Stock market commentator and CNBC television host Jim Cramer, an ex-hedge fund manager, recently boasted publicly that market manipulation was easy for funds that wanted to use shenanigans to boost performance. On an interview on TheStreet.com (TSCM.O) Web site, Cramer described how managers could push stocks higher or lower, saying one favorite tactic was to convey a rumor to an unwitting reporter and hope that it moved a stock in the direction the manager wanted. Some underperforming hedge funds also may be tempted to cheat because they need to improve returns to stay competitive, experts say. They say that despite the best efforts of authorities, in many cases the government lacks evidence and can only hope that the traders' greed will ultimately catch up with them. "The rule is 'anybody who gets caught, gets nailed,"' said S.P. Kothari, interim deputy dean at the MIT Sloan School of Management. "But that doesn't mean that everyone gets caught. The number of people who might have engaged in insider trading might be a larger number than we know." (Additional reporting by Karey Wutkowski and Rachelle Younglai in Washington, and Doris Frankel in Chicago)
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