In order to restore financial confidence in the American economic system after the massive impact of the Depression hit the country in the late 1920's, the newly elected President Roosevelt mandated the creation of the Securities Exchange Commission, part of the Commission's duties were now to reign in, and put an end to insider trading. Who did FDR appoint as the first SEC Commissioner - Joseph Kennedy? Old Joe Kennedy was one of the notorious insider traders that took advantage of any and all information that came his way.
In the same league as Jesse Livermore, Jacob Fisk, and Bernard Baruch, Joe Kennedy knew where the bones were buried. He quickly moved to create a series of laws, rules, and regulations that would outlaw the very practices that in past decades had enabled him, Kennedy to become one of the four wealthiest individuals in America. The practice of lawful insider trading had come to an end legally. To show you how effective these policies have been, whenever a real case of such trading comes to public light, it makes nationwide headlines. This is because of the relative rarity of such scandalous behavior being brought to public light.
During the 1980's, the biggest insider trading scandal which became public knowledge was Ivan Boesky, probably the premiere arbitrage player of his generation when he was accused of insider trading. Boesky was caught via tape recordings taking advantage of such information. His primary source was Dennis Levine, an affable investment banker working for Drexel Burnham Lambert; a now defunct banking firm whose primary asset was Michael Milken's junk bond capital raising unit.
The Latest Scandal
It looks like this current scandal followed two separate tracks occurring simultaneously. The profits generated amounted to $15 million dollars over a period of five years. Insiders were used at Morgan Stanley and UBS Securities. These individuals including Mitchel Guttenberg, who as an institutional client manager at UBS would be aware of research upgrades and downgrades taking place on a daily basis. He was given hundreds of thousands of dollars for his knowledge of non-public information. The men purchasing the information were David Tavdy, and Erik Franklin. Using the non-public information available to them, they were each able to amass $4 million in trading profits.
In a separate scheme running a parallel track, Randi Collotta a lawyer, was an employee of Morgan Stanley in their compliance department. Her husband Christopher Collotta was an attorney in private practice. Randi would come up with information on mergers and acquisitions that Morgan Stanley was involved with, and pass the tips to her husband Christopher. The husband would then sell the information on Wall Street for money that amounted to hundreds of thousands of dollars.
During the course of the schemes, information was sold to Erick Franklin who was a Bear Stearns Hedge Fund client. People like Franklin are use to doing 50 to 100 different trades per day, each day. Such individuals are able to bury their results in the sheer mass of trading that is done on a daily basis.
Although caught, the conspirators were sophisticated enough to use facilities outside the immediate firms that they each worked for. Meetings were held in the famous Oyster Bar in Grand Central Station. Disposable cell phones were utilized. Secret Codes were invented. Text messages on cell phones were employed. E-mail was OUT. Telephone calls with HOT TIPS were OUT. Nobody exchanged checks. CASH was the rule of the day, every day.
As of today, 13 people have been arrested with 11 of them facing SEC charges. Three Hedge funds have been charged with criminal behavior. Four of the 13 arrested have already pleaded guilty. The hedge funds are tough group to supervise because they don't have the degree of compliance that is present in a brokerage firm. They are also probably much harder to detect as to insider trading involvement. It will not be a surprise if many more people are arrested and charged, than the group currently mentioned.
The demand for performance among hedge funds where a tenth of a percentage point in performance can mean the difference of millions of dollars of additional compensation is already well known. Depending upon performance, hedge funds live and die by performance. There are 9000 basically unregulated hedge funds in operation today, managing $1.4 trillion dollars, plus 6 to 1 leverage. About a thousand of these same hedge funds go out of business every year, with a 1000 new start-ups coming on stream.
It is not beyond the realm of possibility, to see how a person under water with any kind of questionable character can succumb to the allure of insider trading if in fact; such trading will dramatically alter the performance of the fund he or she is managing. It is becoming apparent that hedge fund trading is unsupervised. This case is not going to be the last case involving insider trading.
Hedge funds are also becoming more heavily involved in the financing of Presidential elections in an attempt to curry favor with Presidential candidates. To what extent will the amount of money floating around among hedge funds lead to a lack of supervisory action by elected officials caught in ethical conflicts.
In this, the latest insider trading scandals, the government was able to pick up irregular profitable trading patterns in the merger and acquisition of two publicly traded companies. They were Adobe Systems, and its acquisition of Macromedia in 2005, and ProLogis, and its acquisition of Catellus Development.
Once the SEC saw the irregular trading, it was only a question of time and effort before the patterns revealed a conspiracy, and the conspiracy revealed insider trading. Now it's up to the court system to figure out the rest, but first, expect more arrests.
Goodbye and Good Luck
Richard Stoyeck
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