'80s Redux: Insider Trading on the Rise

March 2, 2007 — -- It's back!

Just as '80s trends like miniskirts and electro music have made a comeback, so has insider trading.

Thursday's arrest of nine individuals and the guilty pleas of four others who were accused of taking part in a massive, five-year scheme that netted more than $15 million in profits were just the beginning.

The number of insider trading cases pursued by federal authorities has increased dramatically in recent years. The New York Stock Exchange's referrals of insider trading to the Securities and Exchange Commission are expected to rise by 105 percent over the past two years, according to NYSE market surveillance vice president Robert Marchman.

And the SEC has punished perpetrators with bigger penalties. In 2005, penalties totaled more than $3.9 million. For the first half of 2006, penalties exceeded $3.2 million.

Certainly, trading has spiked in advance of some of the biggest recent takeovers, including TXU Corp. and Hyperion Solutions Corp. And a study last August by Measuredmarkets Inc. demonstrated that insiders may have traded illegally just days before 41 percent of the previous year's' largest acquisitions.

But this time around, there's a new wrinkle. It's not pinstripe-suited traders like Ivan Boesky and Michael Milken, who used nonpublic information to make trades and reap huge profits during the '80s.

Today, much of the insider trading is fueled by the activity of hedge funds, the loosely regulated investment groups that have proliferated like mushrooms after the rain, according to Marchman. "There's a suspicion that hedge funds are engaged in this type of behavior," says John Coffee Jr., professor of law at Columbia University.

The latest case, notable for the fact that it involved senior officers at some of Wall Street's biggest firms, also involved hedge-fund traders. During a meeting at New York's Oyster Bar in 2001, a few friends allegedly came up with a scheme to help one of them settle a $25,000 debt. The executive director of UBS's equity research department, Mitchel Guttenberg, offered to give analyst ratings in advance to Erik Franklin, a hedge-fund trader at Bear Stearns, sending coded messages over disposable cell phones, the SEC claims.

Though there have been several headline-making cases in recent years, most of those involved junior officers trading on inside info through relatives or friends. "This is the biggest case in years," says Coffee. "And it also apparently involved the compliance attorney at Morgan Stanley -- that's like the head of the CIA turning over secret info to Osama bin Laden."

The size of this case may prompt a renewed push to regulate hedge funds. Sens. Arlen Specter (R-Pa.), Charles E. Grassley (R-Iowa) and House Financial Services Committee Chairman Barney Frank (D-Mass.) have all reportedly talked about holding hearings on the industry after complaints indicated that investors might need safeguards against their sometimes-erratic trading activity.

But there is widespread resistance to regulation. Just last week, a group led by Treasury Secretary Henry Paulson said there was no immediate need to regulate hedge funds.

But the SEC, which is conducting a wide-ranging inquiry into hedge-fund activity, vows to keep clamping down on illegal activity, with Chairman Christopher Cox declaring that the targeting of hedge-fund insider trading is a "top priority."

His enforcement director, Linda Chatman Thomsen, was just as resolute, issuing a statement that said, "No matter how clever you are, no matter how hard you try to avoid detection, you underestimate us at your peril."