BY MICHAEL BRUSH
Money Magazine
August 20, 2006

 

A Risk for the Economy

Wall Street Still Plays Dirty

Despite a massive cleanup to stomp out the worst Wall Street corruption in decades, it looks like plenty of privileged insiders are still routinely swindling the little guy. This fleecing of everyday investors has nothing to do with the complex financial structuring found at twisted operations like Enron and WorldCom. It's just good, old-fashioned insider trading -- perhaps the hoariest and simplest Wall Street scam in the book.

As the takeover market has warmed up over the past six months, time and again the shares of buyout targets have jumped on big volume before acquisition news. The unavoidable explanation: Individuals familiar with corporate dealings are trading on their privileged knowledge. The unfortunate result: Honest investors selling to crafty buyers-in-the-know during those rallies are getting cheated out of hefty gains that they could have enjoyed following the buyout news.

Imagine, for example, that you held shares of SPS Technologies last week. It’s a small company that makes fasteners used in the aerospace industry. You would have felt great watching while the stock, seemingly for no reason, suddenly climbed by 15% in a single week.

And by Friday, you might have felt good selling your shares in the suddenly trendy SPS Technologies for more than $34 apiece.

But your joy would have turned into bitterness Monday morning as you opened the papers to read of a buyout offer at $43 a share from Precision Castparts.

Or how about the tiny Mercator Software? It moved a breathtaking 66% to $2.50 by Aug. 1, from $1.50 on July 15. Any news that might explain the gain was nowhere to be found. Lots of people clearly knew something was up, though. In the 14 trading days leading up to news of the deal, average volume leapt 800% to 844,970 shares per day. Sure enough the next trading day, Aug. 4, news broke that Mercator was being taken out for $3 a share by Ascential Software.

It’s not just happening at obscure software companies. A look at the charts of many of the takeover targets in the past few months -- from Airborne and Neuberger Berman to Overture Services, OfficeMax and Circuit City Stores-- shows big price and volume moves on no apparent news in the days preceding a takeover.

If you’re an investor, the sting of selling shares just ahead of a pop from buyout news is compounded by the thought that the person who bought your shares had inside knowledge of the deal. Given the unusual volume and price action in targets right before takeover news, it’s safe to assume some of those buyers knew something. Does this pattern suggest Wall Street is as corrupt as ever?

“It smells bad,” says Michael Garland, who analyzes corporate takeover deals in the AFL-CIO's office of investment. “Certainly it is a serious concern any time you have the risk that insiders are benefiting at the expense of outside shareholders.”

“Insider trading is fundamentally theft,” says finance professor Jim Angel of Georgetown University's McDonough School of Business. “You have people misusing information they have been entrusted with.” That could mean anyone from lawyers or investment bankers who become “temporary insiders” because they're working a deal, to senior managers inside a company. “They are basically committing fraud,” says Angel.

The damage from that fraud goes beyond investors who hand over their shares too cheaply to potential illegal insider traders. A more ominous risk hangs in the air. If too many investors think the markets are still crooked, they’ll simply put less cash in the stock market. That, in turn, harms one of the main engines of our economic system, a well-oiled market machine that efficiently transfers capital from investors to the managers with the best business plans.

To be sure, while no one has been convicted in any of the cases cited above, trading could well be under investigation by the SEC, which brings civil charges against insider traders. “You don’t know that those cases aren’t being investigated,” says one SEC attorney who works in enforcement.

But the chances of the SEC taking action in any single circumstance are painfully low. That's partly because the entire national enforcement team at the SEC numbers about 1,000. To put that number in perspective, consider this: It's less than the number of staffers managing legal issues and compliance at just three or four top brokerages.

Sure, the market cops are trying. Every day, they watch trading patterns, hunting for suspicious price and volume moves. Even when there's no unusual trading, they check out buyers ahead of a deal. Market cops collect their names from brokerage houses and circulate them among the parties involved in the deals, asking if anyone recognizes any buyers.

Ross Albert of the law firm Morris, Manning & Martin notes that the SEC goes after insider-trading infractions of all sizes. The idea is to keep potential wrongdoers off balance and reluctant to take a risk. “Our efforts are deliciously random,” says the SEC attorney.

What isn't so delicious is the end result. The actual number of insider-trading cases brought by the SEC each year is a mere 50 to 60. That’s about 10% of the total number of securities cases initiated by the SEC overall -- and it's clearly only touching the tip of the iceberg.

“That does sound low to me,” says Michael Malloy, a former SEC attorney who now teaches at the University of the Pacific, McGeorge School of Law.

One major problem, predictably, is understaffing. The SEC is getting a budget increase of around 50% that will take its annual spending over $700 million this year. But that's only increasing enforcement staff by 17% to 1,174 in 2004. “The market and the market participants are so much bigger than the SEC,” says Malloy.

Malloy, who also has worked in banking regulation, points out that the ratio of banking to stock-market watchdogs is a whopping 20-to-1. “That ratio is not proportional to the number of banks versus the number of market participants. We are talking about a problem of staff power, and the recent increase in the SEC budget is not enough. Inevitably, what you end up with is triage.”

Here’s another way to grasp the depth of the problem. The losses for shareholders of Enron, a company that had a market cap of $60 billion at its peak, outweigh the SEC budget in the entire history of its existence, says Georgetown’s Angel.

Lawyers working in the trenches at the SEC admit they're outnumbered. “If your goal is 100% compliance, then I fail every day,” says the SEC attorney.

To be sure, not every price and volume spike ahead of a deal implies wrongdoing. For one thing, there’s a lot of public disclosure that tips off observers, like filings with antitrust authorities or the SEC itself, says John Coffee, a professor at Columbia Law School.

And refreshingly, some deals are actually kept secret. Shares of Roadway hardly budged in the days leading up to a July announcement that it was going to be taken over by Yellow, another trucking company. The news sent Roadway stock up for a 50% one-day gain to over $45 from $30.

Sometimes rumors of takeovers drive stocks up, or investors even get blatant advance notice of deals in the form of press releases straight from the company. Shares of IGEN International, a medical testing company, shot up to $40 from $35 in mid-July when the company confirmed rumors it was in talks to be purchased by Roche. Two days later the stock leapt above $55 when a deal was announced. Often, the hint is only slightly subtler, in the form of a news release that a company has hired bankers “to explore strategic alternatives.”

Indeed, a common defense for insider-trading suspects is to show they were acting on published information, says Eugene Goldman, a partner at McDermott Will & Emery's Washington, D.C., office. But a scan of the news flow ahead of much of the suspicious trading so far this year shows this innocent explanation doesn't apply.

But even without such blatant hints like press releases or public filings, it can be easy to figure out something is up -- even if you're not a top company officer. “If you are working in accounting and someone you’ve never seen before walks in and you need to open up books for them, it gets the rumor mill going,” says Sven Monberg, editor of SuperStock Investor, a newsletter that tries to identify takeover targets. “It is really next to impossible to keep a lid on a lot of these deals.”

Unfortunately, if you do suspect you sold shares in a price spike driven by traders using illegal insider tips, you’re not likely to stand much of a chance of getting your money back in court.

“It would be difficult to find the person who bought your shares and connect the dots,” says Randall Steinmeyer, a partner at Milberg, Weiss, Bershad, Hynes & Lerach, a law firm that represents investors who believe they were misled by management. “And even if you could, it would have to be a substantial amount of money. It would be a difficult case to settle or try.”

Bottom line: Despite ongoing market reform, you’ll continue to be at the mercy of privileged insiders who know more than you ahead of takeover news -- and it’s not solely because the SEC is outgunned.

“What happens in takeovers is you are providing people with a once-in-a-lifetime opportunity to make a million dollars,” says Columbia University’s Coffee. “They have never been faced with this kind of situation before, and they flunk the moral challenge. This is something that no amount of regulation is going to cure.”

What's an investor to do? Think twice about selling short-term rallies on no apparent news, if you consider your holding a long-term position. A price increase on no news suggests there may be an event just around the corner that drives it even higher.