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BULLS & BEARS: SEC faces difficult task fighting insider trading

April 23, 2007

In the second episode of the excellent trilogy "Back to the Future," Biff Tannen obtains a magazine that gives the final scores of yet-to-beplayed sporting events. He uses that information to "gamble" his way to wealth. Similarly, haven't we all wistfully wondered what we would do if we only had a copy of tomorrow's Wall Street Journal today?

Well, occasionally some people do obtain that kind of advantage in the securities markets. One former Securities and Exchange Commission attorney noted that, while there are laws preventing the misuse of material nonpublic information, "there are people who, knowing there is a probability to get caught, will still act in a manner to try to make a quick buck."

To be sure, regulators run into extreme difficulty in separating rumors and speculation from outright possession of material nonpublic information. However, the SEC is clearly concerned that leaks are on the rise.

Regulators are looking into the suspicious trading that preceded the announcement that Kohlberg Kravis Roberts & Co. would acquire First Data Corp. for $26 billion. Before the deal, unusual trading took place in First Data's options, credit swaps and common stock. In the week before the acquisition was announced, more than 100,000 of First Data's options traded-well above the 53,572 options that traded for the entire month of February. One trader commented that if a regulator were looking for a pre-deal trading pattern, the April 30 call options would "stand out as a sore thumb."

The SEC already is investigating three insider trading cases stemming from the proposed buyout of TXU Corp., a Texas utility being acquired for $32 billion by KKR and Texas Pacific Group. In one instance, a British couple was charged with trading on insider information and earning $270,000 in illegal profits.

Other unusual events are advancing the concern that suspicious market activity is on the rise. Recently, Dow Chemical fired a board member and another executive for apparently entering into unauthorized discussions to sell the company.

Mutual funds have complained to the SEC that hedge funds are front-running their trades. Front running involves making trades ahead of large institutional buy or sell orders. If true, it could only happen if the hedge fund managers are receiving information from the brokerage firms executing those institutional trades. Because of the allegations, the SEC is undertaking a fact-finding mission on all stock and option trading done by the major Wall Street firms in their business dealings with hedge funds.

And then there is the bizarre confession by the host of CNBC's "Mad Money." The former hedge fund manager went on a rant about how some hedge fund managers, including himself, would try to manipulate the market via deceptive trading and by spreading false information to the press. He noted that while this activity is illegal, it was safe enough because "the Securities and Exchange Commission never understands this."

Considering the scope of its task, the SEC does an admirable job policing the securities markets. Let's hope the recent rise in suspicious trading is quickly contained, for integrity in the financial markets is a critical factor for its participants and capitalism as a whole.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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