Lawsuits Accuse "Prime Brokers" of Securities Fraud

By Wayne Jett
San Gabriel Valley Tribune
July 19, 2006

Two class-action lawsuits filed in Manhattan federal court in April allege fraud by the world's largest "prime brokers" in securities lending practices.

Goldman Sachs, Bear Stearns, Lehman Brothers, Morgan Stanley, Merrill Lynch, Citigroup, Banc of America Securities, Credit Suisse, Deutsche Bank Securities, UBS Financial and Bank of New York allegedly charge high fees to lend securities for short selling, but fail to deliver the securities sold short by hedge funds.

On June 28, the Senate Judiciary Committee held a hearing in Washington, D.C., on hedge fund relations with independent research firms. That hearing's star witness was Gary Aguirre. Until September 2005, Aguirre was the Securities & Exchange Commission's senior counsel leading its most important investigation of illegal trading by a hedge fund.

Aguirre told the Judiciary Committee that SEC's investigation of Pequot Capital Management (a $7 billion hedge fund) began after 18 reports of suspected insider trading from self regulating organizations (SROs), such as NASD or NYSE. After he interviewed dozens of witnesses, Aguirre says, his SEC superiors allowed him to take the evidence to the U.S. Attorney for criminal prosecution, and to subpoena the central target of insider trading cases - the "tipper."

But Aguirre testified that his attempt to take sworn testimony of the "tipper" was derailed after he revealed the primary suspect to be John Mack. At the time, Mack was being recruited as the CEO of Morgan Stanley.

Aguirre says his SEC superiors told him Mack's political connections were so powerful he should not be subpoenaed. When Aguirre persisted in contacting SEC's higher officials, he was fired. Aguirre's firing occurred within weeks after he received a two-step pay increase and an award for excellent performance.

Upon firing Aguirre, the SEC informed Morgan Stanley the agency had no interest in Mack. Mack was hired as Morgan Stanley's CEO, and was pictured in a June 28 Wall Street Journal feature as an icon of the investment world.

Morgan Stanley is a named defendant in the two class-action suits against prime brokers alleging intentional failure to deliver shares sold short by its clients.

Aguirre says hedge funds tend to flock, or "swarm," to profitable trading tactics, including illegal insider trading and naked short selling.

The SEC warned Aguirre against testifying at the Judiciary Committee hearing and demanded return of all documents relating to his work at the agency, threatening civil suit and criminal prosecution.

Revealing a contest of Senate authority, the Senate Banking Committee delivered a letter to the Judiciary Committee asserting exclusive jurisdiction over the SEC. Charles Schumer, New York's senior senator and a member of the Banking Committee, appeared at the June 28 Judiciary hearing to deliver the same message.

Judiciary chairman Arlen Specter encouraged witnesses at the June 28 hearing to bypass the SEC by filing complaints of illegal trading activities directly with a U.S. Attorney's Office of the Justice Department. Two witnesses said they will do so.

Aguirre told Specter that a high-powered attorney for Morgan Stanley went over his head in seeking SEC clearance of John Mack. That attorney was Mary Jo White, who served as U.S. Attorney in the Southern District of New York during the Clinton administration.

As U.S. Attorney, White was responsible for investigating Clinton's pardons of felons, including tax evader Marc Rich, at the end of his second term as president. White closed those investigations without indictments.

When prime brokers and hedge funds fail to deliver shares sold short, buyers ordinarily are unaware they receive only electronic entry of shares for their money paid. Depositary Trust & Clearing Corporation (DTCC) allows the funds to be cleared to the seller without actual delivery of shares.

The suits filed in federal court by Electronic Trading Group and Quark Fund LLC allege this illegal practice has occurred widely since at least April 2000. The SEC has been ineffective in stopping the unlawful practices, and Aguirre's testimony indicates why that may be the case. At a public hearing July 12, the SEC voted to consider minor changes in its Reg SHO, a regulation adopted in 2004 that has been ineffective in eliminating or punishing failures-to-deliver shares sold short.

The Senate Banking Committee appears reluctant to remedy risks to investors arising from millions of "phantom" shares sold but not delivered. So far, financial press reports of the June 28 Judiciary Committee hearing have downplayed concerns that hedge funds are causing investor risks in the markets.

Wayne Jett is managing principal and chief economist of Classical Capital LLC, a registered investment adviser in Pasadena, California.

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