Suspicious Trading

Whispers of Mergers Set Off Suspicious Trading
By GRETCHEN MORGENSON
The boom in corporate mergers is creating concern that illicit trading ahead of deal announcements is becoming a systemic problem.

It is against the law to trade on inside information about an imminent merger, of course.

But an analysis of the nation’s biggest mergers over the last 12 months indicates that the securities of 41 percent of the companies receiving buyout bids exhibited abnormal and suspicious trading in the days and weeks before those deals became public. For those who bought shares during these periods of unusual trading, quick gains of as much as 40 percent were possible.

The study, conducted for The New York Times by Measuredmarkets Inc., an analytical research firm in Toronto, scrutinized mergers with a value of $1 billion or more that were announced in the 12-month period that ended in early July. The firm analyzed the price, the total number of shares traded and the number of individual trades in each stock during the weeks leading up to the announcement and looked for large deviations from trading patterns going back as far as four years.

Although any number of factors can lead to spikes in trading, deviations of the kind observed by Measuredmarkets are among the data used by regulators to spot insider trading. Of the 90 big mergers in the period, shares of 37 target companies exhibited abnormal trading in the days and weeks before the deals were disclosed.

Christopher K. Thomas, a former analyst and stockbroker who founded Measuredmarkets in 1997, said that his company’s analysis led to the conclusion that the aberrant activities most likely involved insider trading. Measuredmarkets provides examples of unusual trading to institutions, individuals and a regulatory organization in Canada.

It is always possible that a company’s stock moves because of developments in a particular industry or business sector, or because a prominent newsletter, columnist or blogger has written something that could prompt investors to take action. But in the companies that were analyzed, no such influences seemed to be at work. The companies were not the subject of widely dispersed merger commentary during the periods of abnormal trading, nor did they make any announcements that would seem to explain the moves.

The analysis by The New York Times found that, in a handful of the mergers, significant progress toward a deal was being made on the days unusual trading occurred. For example, the day that four bidders were putting together buyout offers for Amegy Bancorp, a Houston bank company, trading in its stock quadrupled.

Attempts to quantify the amount of potential insider activity in deals have come up short in the past, in part because the regulators with access to detailed information do not release it. The Securities and Exchange Commission does not disclose, for example, the percentage of referrals it receives from exchanges that wind up as cases.

The S.E.C. would not comment on the study but said that it had looked at Measuredmarkets’ system and concluded that surveillance techniques of self-regulatory organizations like the New York Stock Exchange were more sophisticated.

Securities regulators, traders and academics agree that merger waves lead to more illicit trading on nonpublic information. In Britain, regulators have made insider trading a primary focus and have shifted their scrutiny to brokerage firms and institutional investors, rather than individuals, involved in mergers.

Like Measuredmarkets, the Financial Services Authority in British has found a pattern of stock trading ahead of mergers. In 2004, 29 percent of companies involved in mergers experienced abnormal trading before public announcements, according to a March 2006 study of large British companies subject to takeovers. In 2001, the comparable figure was 21 percent.

The British study compared the stocks’ price movements with previous returns, adjusted for overall market moves. The comparison period was 240 trading days, ending 10 days before the merger announcement.

In this country, the S.E.C. has focused more on individuals than on institutions in its investigations. And even though merger activity has rocketed in recent years, the number of its cases involving insider trading has held in a range of 40 to 59 annually since 2000, the S.E.C. said.

Some economists and academics assert that insider trading is essentially a victimless crime and therefore not worth deploying regulatory armies to battle. But there are losers, including small investors who miss out on gains, when such trading moves markets.

Moreover, many investors are troubled by what they now see as rampant insider trading, saying it fosters the perception that insiders can profit in the markets at the expense of outsiders.

“Martha Stewart got hurt very badly for something that happens every single day on Wall Street,” said Herbert A. Denton, president of Providence Capital, a money manager and an adviser to minority shareholders. “It’s a falseness and a hollowness to the capitalist system when you are pretending that things are pristine and they are not. Either the S.E.C. should get very, very serious and prosecute a lot of people or forget about it.”

Although Ms. Stewart was investigated for insider trading, she was found guilty of other related charges.

The S.E.C.’s handling of one insider-trading investigation is the subject of scrutiny by Congress after the firing last September of Gary J. Aguirre, a former staff attorney at the agency. Mr. Aguirre contends that his investigation into possible insider trading by Pequot Capital Management, a prominent hedge fund, was thwarted for political reasons by his superiors. He was fired after complaining, even though he had just received a merit pay increase.

Mergers and acquisitions present particularly rich opportunities for profiting on insider information, a violation of the securities laws written to keep all investors on a level playing field. That is why all those involved in corporate unions, from law firms to investment banks to those in between like printers, are supposed to keep quiet during the process.

Officials from the nation’s top securities regulators met on Aug. 18 to discuss emerging trends in insider trading, said Joseph J. Cella, chief of the office of market surveillance at the S.E.C. “We are certainly cognizant of the uptick in merger-and-acquisition activity,” he said.

The companies identified by Measuredmarkets represented many industries and received bids not only from corporate rivals, but also from private investor groups and management-led buyout teams. They included Amegy Bancorp, the subject of a $1.7 billion takeover announced last September by Zions Bancorp, the large Utah bank; CarrAmerica Realty, a real estate investment trust acquired for $5.6 billion by the private investment company Blackstone Group after a March announcement; Dex Media, a directory publisher whose $9.5 billion purchase by the R. H. Donnelley Corporation was disclosed in October; the IDX Systems Corporation, a health care systems company whose $1.2 billion acquisition by General Electric was announced in September; and Texas Regional Bancshares, which the Argentinian bank BBVA said it would acquire in June for nearly $2.2 billion.

In each of the five cases, the abnormal trading occurred during periods of significant behind-the-scenes progress in the mergers, as outlined by the companies themselves in regulatory filings long after the deals were struck.

In the Amegy bank deal, the volume of shares traded more than quadrupled on a day when four of the bank’s bidders were analyzing its financial records and preparing offers. Volume jumped in CarrAmerica’s shares on Feb. 17, the day the real estate investment trust struck a confidentiality agreement with a potential bidder and Goldman Sachs began providing the bidder with an analysis of CarrAmerica’s books.

Trading in Dex Media increased sharply last Sept. 14, the day that management, legal teams and financial advisers representing the company and Donnelley met. And the price and the number of shares traded in IDX jumped on Sept. 7, when its chief executive and a G.E. executive talked and G.E. agreed to increase its bid by 5 percent.

Officials at the companies said that they were unaware of unusual trading in advance of the deals and declined to speculate on reasons for the action.

Measuredmarkets has no way to identify who might have been behind the anomalous trading. But a few of the deals that it flagged are already under scrutiny by regulators.

In June, for example, the S.E.C. froze $1 million in trading gains of South American investors who profited on the June 12 buyout announcement of the Maverick Tube Corporation, an oil equipment maker, by Tenaris SA, a steel company with headquarters in Luxembourg. Anadarko Petroleum’s June bid for the Kerr-McGee Corporation, a smaller rival, is also being investigated, according to a July 13 report in The Houston Chronicle; the transaction closed in August. The S.E.C., following its usual practice, declined to comment on the report.

The takeover crowd includes corporations, management-led buyout teams as well as private equity firms, which represent wealthy private investors. Companies’ directors are reaching out to many potential bidders these days to ensure shareholders get the best price. In the process, they are expanding the number of people with knowledge of the deals.

Still, it is undeniable that brokerage firms, with their varied businesses all under one roof, remain particularly well-positioned to capitalize on inside information. Not only do these firms advise buyers and sellers in mergers, giving them immense access, they also have proprietary trading desks that invest the firm’s money in stocks and other securities, money management units that invest for clients and trading desks that profit mightily by executing trades for hedge funds.

Brokerage firms contend that barriers within their operations keep deal information from seeping out. But regulators at the Financial Services Authority in Britain are challenging these assertions.

In a July 7 speech, Hector Sants, managing director of wholesale and institutional markets at the F.S.A., described why his focus was shifting to institutions. “Our spotlight will shine in particular on relationships between investment banks and their clients,” he said, “because we believe the risk of market abuse is highest where a client can be made an insider on a forthcoming deal.”

The fast and furious pace of deals this year is increasing the opportunities for mischief. In each of the last three months, according to Thomson Financial, the value of announced mergers has exceeded $100 billion — the longest stretch of such volume since 2000.

Although the number of deals in the first seven months of this year slipped to 685 from 763 in the same period in 2005, the dollar amount of transactions rose 31 percent in that time, Thomson Financial said.

Regulators on the front lines also seem to be spotting more irregularities. Officials in the market surveillance unit of New York Stock Exchange Regulation Inc. have made more referrals to the S.E.C. this year than they did in the comparable period last year. As of last month, those regulators had referred 76 cases for possible investigation, up from 60 a year earlier. In 2005, the surveillance unit referred 111 cases, 63 percent more than the previous year.

The number of insider-trading cases filed by the S.E.C., though, has been relatively static. Walter G. Ricciardi, deputy director of enforcement at the S.E.C., said that 9 percent of the cases filed by the commission since Feb. 1 have been based on insider trading, which can encompass merger or any other news that would affect a company’s market price. On a percentage basis, the cases have ranged from 7 percent to 12 percent of the agency’s total since 2000.

“The yield is less probably than in comparable areas,” Mr. Ricciardi explained of insider-trading inquiries. “A lot of times the trading may look like something crazy, but you’ve got to have evidence.”

Recent cases have centered on some relatively small players. In late December, for example, the S.E.C. sued Gary D. Herwitz, an accountant, and Tracey A. Stanyer, an executive vice president at Sirius Satellite Radio, for trading ahead of news in late 2004 that Sirius was going to award a $500 million contract to Howard Stern, a radio show host.

Each settled with the S.E.C., without admitting or denying wrongdoing. Mr. Herwitz paid $52,000. Mr. Stanyer paid $35,000 and was barred from serving as officer or director of a public company. Mr. Herwitz pleaded guilty to insider trading in federal court in Brooklyn and was sentenced to two years’ probation and a $20,000 fine earlier this year.

In May, the S.E.C. sued Jason Smith, a letter carrier in New Jersey, contending he leaked grand jury information to a 14-person ring that included low-level employees of Merrill Lynch and Goldman Sachs, a worker for a printing company and a retired seamstress in Croatia. Regulators say that scheme generated $6.7 million in profits.

What about cases involving larger or more sophisticated investors? “We certainly see institutional-type accounts that have come into the market with extraordinarily good timing on a repeat basis; we have investigated those,” said Mr. Cella of the S.E.C. “But to get the evidence to prove a violation of the statute under which we allege insider trading is difficult.”

And that is true whether the case involves individuals or institutions.

The British securities regulator, for its part, has cited the possibility of hedge funds profiting on insider information as a foremost concern. David Cliffe, a press officer at the F.S.A., said that hedge funds must be keenly watched because they have extensive and close relationships with investment banks that are in a position to provide nonpublic information in exchange for lucrative trading commissions.

Spotting abnormal trading is far simpler than bringing a successful insider-trading prosecution, as Mr. Cella of the S.E.C. noted. Still, the trading anomalies identified by Measuredmarkets are intriguing.

Consider Koch Industries’ bid for Georgia-Pacific on Nov. 13. Senior officials of the companies first met to discuss a merger on Oct. 5. Koch Industries proposed to limit its purchase to certain Georgia-Pacific assets after the company, which makes forest products, had spun off other businesses to the public. Subsequent company filings noted that Danny W. Huff, Georgia-Pacific’s chief financial officer, told Koch officials on Oct. 7 that such a deal would “probably not” be acceptable to his company’s board.

Merger talks continued through October and into November. Both sides conducted corporate analyses — known as due diligence — from Nov. 8-11. Koch Industries’ board voted to approve a bid on Nov. 10.

That day, volume in Georgia-Pacific shares jumped 37 percent above its 2005 average and the number of trades in the stock rose significantly as well, Measuredmarkets found. On Friday, Nov. 11, volume increased yet 66 percent more from the previous day’s high level. Georgia-Pacific shares rose 5.5 percent over the period. The company made no announcements either day, and the overall market rose 1.3 percent over the two days.

On Sunday, Nov. 13, Koch Industries announced that it would pay $21 billion for Georgia-Pacific, or $48 a share, a 39 percent premium to the closing price the previous Friday. Anyone who bought Georgia-Pacific shares on either Nov. 10 or Nov. 11 stood to gain 40 percent in just a few days.

A spokeswoman for Koch Industries did not return phone calls seeking comment.

Another case in point is the surprise merger, announced May 7, between the Wachovia Corporation, a bank holding company based in North Carolina, and Golden West Financial, a West Coast savings and loan. This time the unusual trading showed up both in the stock of Golden West Financial and in its call options.

Traders buy call options, giving them the right to purchase shares of the underlying company at a set price within a specified period, when they expect the stock to rise. Options provide the potential for a sharp profit because each option represents 100 shares.

On May 3, the number of Golden West’s call options that changed hands was triple the daily average. Subsequent filings show that was the day Wachovia’s board met to review a possible acquisition of Golden West and the day after Golden West’s board met to weigh the bid.

Officials at Wachovia and Golden West said they did not know why the volume rose.

The probability of detection appears small, based on the number of cases brought in the United States, and the penalty for insider trading is often a negotiated settlement that may not involve much more than giving up the gains.

An example is the S.E.C.’s conclusion of a case in 2004 with an employee of Fleet Boston. The employee, the S.E.C. said, made $473,000 by trading on knowledge of the bank’s buyout by Bank of America. The commission exacted $525,000 in a settlement, which included his profits, prejudgment interest of $1,576.67 and a civil penalty of $51,842.36.

The penalty portion of such settlements, Mr. Ricciardi said, typically equals the illegal profits. The Insider Trading Sanctions Act of 1984 allows for a penalty of up to three times those profits.

The S.E.C. dispenses a reward, up to 10 percent of the penalties, Mr. Ricciardi said, to tipsters whose information leads to a successful case.

When stocks gyrate because nonpublic information about deals has leaked out, many people are harmed. The most affected are those who sell shares in the company before it is taken over at a significant premium. An investor who sold Georgia-Pacific shares on Nov. 9, just before the unusual trading, missed a 46 percent gain. Those who sold the Andrx Corporation, just before unusual trading began last February missed, a 36 percent gain.

Others also lose. The company that makes the acquisition, for example, may wind up paying more. Investment advisers typically include a company’s target share price and total market capitalization in the analysis of what an acquirer should be willing to pay. If a stock rises in the days or weeks during negotiations, the purchase price could be driven higher. A rising price could even scuttle a merger if the deal becomes too costly to the prospective buyer.

Jenny Anderson contributed reporting for this article, and Donna Anderson contributed research.