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Experts on Wall Street Face Scrutiny

12/15/2010 --

Finance professor Nejat Seyhun weighs in as feds target unusual suspects in unprecedented Wall Street probe.

ANN ARBOR, Mich.—Federal prosecutors in New York, the FBI, and the Securities and Exchange Commission are sending arctic chills through the warm and cozy Wall Street relations. In an unprecedented probe, the feds are targeting networks of consultants, well-known hedge funds, mutual funds, and investment banks, as well as numerous analysts for illegal insider trading.

The fact that these usually competitive agencies are cooperating is newsworthy. The targets of this investigation are also unusual. These are established Wall Street entities rather than some rogue executives here and there. Finally, the nature and scope of this probe are also simply unprecedented. For the first time ever, the feds may be getting ready to charge not just some young trader or an isolated firm in a particular takeover but rather brand a decades-old Wall Street way of life as possibly illegal. This practice involves relations between investors, networks of experts, hedge funds, mutual funds, and investment banks. The feds may now be saying that Wall Street relationships are simply used to provide a cover for an illegal act.

What motivated the feds was the worst-kept secret on Wall Street. The only surprise is that it took them so long. In 2006, about 60 percent of the 27 big merger deals in the United States were preceded by increased trading activity in target stocks. Similarly, in the U.K, the regulatory authority FSA admits that a full one-third of takeovers are preceded by share price increases. Recently, takeover-related trading activity also spilled over to options markets, leading to increased volume of calls relative to puts and increased implied volatility estimates of calls relative to puts, especially for short-term, at-the-money call options — all tell-tale signs of insider trading prior to takeovers. The story also did not end with takeovers. In our own published research, we were surprised to discover that the stock price of firms about to be identified in an option backdating investigation started declining nine days before the backdating story ever became public by an impressive market-adjusted 6 percent. Following these events, there was usually some story in the financial press about some potential insider trading activity, some SEC investigation that followed the trading activity to some obscure bank in the Caribbean where the trail went dead cold. End of story.

It seemed for a long time that the feds were totally powerless in this age of the Internet against these sophisticated new players. You could see the clues, you could touch the victims, but not much else. This was the financial puzzle of the new century. Unlike the good old 1980s, takeovers no longer involved suitcases filled with cash, no brash billionaires touting a new trading technique such as the oxymoron 'risk-arbitrage,' and no Charlie Sheen-type of young associates in investment banks with dreams of quick riches, passing takeover information about their fathers' businesses.

If the feds are right, here is what was happening instead. The feds are claiming that Wall Street took it to a more sophisticated level. Suppose that hedge fund A wanted to get information about firm B. If hedge fund A were to simply offer a cash inducement to an officer of firm B in return for confidential corporate information about firm B, everyone would understand that this is a clear case of illegal insider trading. It would also be so 20th century—so easy to detect, prosecute, and put out of business. Instead, suppose that an investment bank that already has an established relation with hedge fund A hired the executives of firm B as experts to provide consulting services back to the hedge fund? Information would pass from the executive to the hedge fund while the hedge fund would then pay the investment bank out of its insider trading profits along with the usual execution and advisory services. The investment bank then pays the consultants for their expert services. Everyone is happy and there is no unusual trail of money.

Is there insider trading here? Some financial journalists, worried about their own news-gathering methods, are claiming there cannot and should not be any insider trading charges associated with providing expert opinions. This much is true. Insider trading does not apply to opinions. However, these journalists are missing the point. What is at stake here is not expert opinions. If it is illegal for the hedge fund to pay off the executive directly for material, nonpublic confidential information, it is also illegal to purchase inside information through additional layers of intermediaries. The fact that this arrangement is more complicated and is harder to detect does not make it any less illegal. The fact that perfectly legitimate business is done in exactly the same way also is not a protection. What the feds are claiming is that in this new arrangement, the experts disclosed not their expert opinions, but instead simply passed on material and nonpublic confidential information that belonged to their own firms. To make the charges stick, this is what the feds will have to prove. We will wait and watch. We will also watch the usual clues in the financial markets just to be sure.

1. See Wang, Xuewu, "Three essays on Insider Trading," University of Michigan dissertation, 2008. 2. See Narayanan, MP, Cindy Schipani and Nejat Seyhun, "The Economic Impact of Backdating of Executive Stock Options," Michigan Law Review, June 2007, 1597-1642.

Nejat Seyhun is the Jerome B. & Eilene M. York Professor of Business Administration and a professor of finance at Ross.



For more information, contact:
Bernie DeGroat, (734) 647-18476, bernied@umich.edu