Are Your Secrets Safe?

A shift in banks' business model raises questions about conflicts.

If you’re like most finance executives, you don’t lie awake at night worrying about the nefarious things your bankers might be doing with your company’s private information. But some recent developments suggest that corporate clients should not rest easy.

Profound changes in banks’ business mixes may create more incentives for conflicts to occur, leaving companies’ secrets — along with their securities — more vulnerable to abuse. First, unregulated hedge funds drive about 30 percent of revenues for brokers and perhaps more than 50 percent of the revenues for prime brokers, which are usually part of big banks, according to a report by Greenwich Associates. That buying power may give them more clout over banks’ other activities. Second, the trading that hedge funds help stoke now accounts on average for 33 percent of revenues at major banks and brokerages, up from 26 percent in 2003, according to a report by Prudential Securities analyst Michael Mayo. Meanwhile, traditional investment banking — underwriting and advising — is now a small piece of the pie: between 11 and 16 percent of revenues for many big firms.

While the impact of these shifts is not clear-cut, they have caught the eye of more than one securities regulator. And in a recent CFO poll, although a minuscule 1 percent say that their companies have actually been harmed by such practices, more than 40 percent of respondents expressed concern about potential conflicts of interest, such as banks owning hedge funds or using credit derivatives.

The ongoing Securities and Exchange Commission insider-trading investigation into Pequot Capital Management, a large hedge fund, provides a window into potential conflicts of interest on the part of investment banks. After being abruptly fired, former SEC lawyer Gary Aguirre went public with allegations that “a former CEO of a large investment bank” (broadly acknowledged to be Morgan Stanley head John Mack) had tipped off Pequot about General Electric’s impending acquisition of Heller Financial in 2001, a deal in which Morgan Stanley advised GE, allowing the hedge fund to capture an $18 million gain through manipulating the stock ahead of the public announcement.

Aguirre maintains that such leakage is not isolated. With hedge funds among their largest clients, big investment banks are almost expected to offer up tips with trading services, Aguirre told a Senate committee in June. And the SEC’s system “breaks down when it comes to referrals [from stock exchanges] involving insider trading by hedge funds,” with 13 referrals on Pequot alone “gathering dust.”

While Aguirre’s claims remain unproven, Sen. Charles Grassley (R-Iowa), head of the Senate Finance Committee, and Sen. Arlen Specter (R-Pa.) are leading a congressional inquiry into the SEC’s handling of his investigation. Meanwhile, in June Rep. Barney Frank (D-Mass.) sponsored a bill that would give the SEC control over hedge-fund regulation, and is now working with Rep. Richard Baker (R-La.) on a bill that would give the Federal Reserve Board such authority. Frank, who is eager to hold hearings on the subject, said, “It would be a mistake if people think this will be the Wild, Wild West.”


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