Earlier this year, someone was confident that Hydril Co.’s stock was due to take flight—and very soon. During the two days ended on Friday, February 9, investors purchased options conveying the right, through February 16, to buy more than 160,000 Hydril shares for $90 apiece.

It was the first time anyone had invested in that particular option. On its face, the wager looked like a long shot: The Houston-based oil-drilling-equipment maker’s stock fell 2.3 percent that Friday to $83.04 and had never topped $90. The shares would have to rise almost 9 percent in a week before anyone could make money by exercising the options.

The bet paid off almost instantly. Before the sun was up on Monday, February 12, Luxembourg-based Tenaris SA announced it was buying Hydril for $97 a share. By day’s end, Hydril stock jumped to $95.24. The $90 options that traded at 50 cents on Friday soared to $5.30, for a one-day gain of 960 percent.

During this year’s record-setting rush of corporate takeovers, a surge of well-timed investments in Hydril and other acquisition targets has triggered insider trading alarms at the US Securities and Exchange Commission and stock exchanges around the world.

As regulators follow the money from suspicious trades, they’re discovering a number of trails are leading straight to Wall Street investment banks.

“One of the things that is particularly disturbing to me is the number of Wall Street professionals that are engaged in insider trading,” says Linda Thomsen, director of the SEC’s enforcement division. “It is frankly outrageous.”

Since April 2006, the SEC has filed insider trading-related lawsuits against more than a dozen investment bankers, analysts and executives whose jobs require them to safeguard clients’ secrets. That’s a higher number of cases than during the entire decade of the 1990s.

At least another dozen recent complaints involved brokers and traders. The defendants come from Credit Suisse Group, Goldman Sachs Group Inc., Merrill Lynch & Co. and Morgan Stanley.

Sworn to secrecy

TWENTY years after the 1987 film Wall Street popularized the catchphrase “Greed is good,” the new wave of insider trading cases suggests that the ends-justify-the-means ethos that gripped Wall Street in the 1980s has returned.

“For a lot of these people, if you look at what they’re making in terms of salary and bonus, there’s no other way to view it except as being greedy and a view that you’re above the law,” says Robert Marchman, NYSE Regulation Inc.’s executive vice president for market surveillance.

Premerger trading that appears too timely to be dumb luck has tainted dozens of takeovers, according to securities trading data and SEC filings. After buyouts are announced, US companies typically submit documents to regulators that pinpoint key dates during their confidential negotiations.

In many recent cases, prices for stocks, options or credit default swaps jumped conspicuously at those turning points, when all participants were supposedly sworn to secrecy.

Since the buyout boom of the 1980s, investment alternatives have flourished, offering unprecedented outlets for insider trading in the 21st century. A sprawling, secretive market for credit default swaps, which are wagers on the likelihood a company will default on its debt, has more than doubled in size during each of the past three years.

At the end of 2006, almost $35 trillion worth of the swaps were outstanding, up from $3.8 trillion in 2003, according to the International Swaps and Derivatives Association.

Trading in equity options—which let investors buy or sell stock at predetermined prices for fixed periods—has quintupled on the Chicago Board Options Exchange in the past 25 years.

Because options are much cheaper than actual shares, suspiciously well-timed investments before buyouts, such as Hydril’s, can turn big profits from small outlays of cash.

SEC files suits

CASES filed this year by the SEC and US Justice Department show how brazen these alleged insider traders have become. Credit Suisse Group investment banker Hafiz Naseem was arrested on May 3 in New York on federal criminal charges that he tipped off a friend ahead of time to nine imminent takeovers involving Credit Suisse clients.

Among them was Hydril’s $2-billion acquisition by Tenaris. Naseem, 37, denied wrongdoing and is free on a $1-million bond.

Ajaz Rahim, an investment banker at Faysal Bank Ltd. in Karachi, Pakistan, was charged by US prosecutors on May 29 with making a $5-million profit in one trading day from options and stock purchased with advance word about the $45-billion offer for Dallas-based utility owner TXU Corp. from Kohlberg Kravis Roberts & Co. and TPG Inc.

Rahim was given the tip by Naseem, prosecutors allege. Rahim’s lawyer, Spencer Barasch, a partner at Andrews Kurth Llp in Dallas, says the banker plans to contest the charges.

On May 8, the SEC froze brokerage accounts owned by a Hong Kong couple it accused of turning an $8-million profit on Dow Jones & Co. shares after getting wind of News Corp.’s $5-billion offer for the publisher of the Wall Street Journal.

The SEC says in a civil suit that Kan King Wong and Charlotte Ka On Wong Leung spent $15 million—as much as $12 million of it borrowed—in an 18-day buying binge that accounted for more than 3 percent of all Dow Jones trading during that time. A lawyer for Wong and Leung, Michele Hirshman of Paul, Weiss, Rifkind, Wharton & Garrison Llp in New York, declined to comment.                               

Opportunities go up

LIKE the scandal that brought down merger speculator Ivan Boesky two decades ago, the alleged misuse of market-moving secrets has developed alongside a frenzy of big-money mergers. That’s not an accident, says Stephen Luparello, NASD’s senior executive vice president for regulatory operations.

“Whenever the market picks up for buyouts and mergers and acquisitions, you see the opportunities for insider trading go up,” he says. Boesky was among the most-prominent Wall Street arbitrageurs, known colloquially as “arbs,” who tried to invest in likely takeover targets to reap the run-up in share prices when acquisitions were announced.

Global acquisitions announced this year totaled $2.8 trillion through June 13, on pace to top 2006’s all-time high of $3.5 trillion. Much of the merger mania is fueled by cash-flush private equity firms, which accounted for nine of this year’s 15 biggest acquisitions of US companies through June 11.

Many leveraged buyouts are mounted by partnerships made up of two or more firms, multiplying the roster of bidders, investment bankers, lenders and lawyers privy to hush-hush negotiations.

“With a friendly acquisition, it greatly expands the universe of people who have access to material nonpublic information, and as the pool of people expands, the possibilities for inappropriate use of the information increase,” Marchman says.

The TXU bid, for example, involved seven investment banks and 12 law firms, according to data compiled by Bloomberg. The purchase by KKR and TPG, formerly known as Texas Pacific Group, is expected to close by the end of this year.

What’s more, when public companies attract interest from would-be acquirers, they often sound out other potential buyers or conduct confidential auctions in search of better prices, further swelling the circle of those in the know.

“How many people can you have knowing a secret and keep it a secret?” asks John Coffee, a securities law expert at Columbia University in New York. “Under about 10 people, I think Wall Street can keep a secret. But much beyond that, I don’t know.”

The stain of possible insider trading is tarnishing acquisitions big and small, from the TXU bid, which would be history’s biggest leveraged buyout, to the $30-million purchase of First Federal Bancshares Inc., a bank with $340 million in assets based in Colchester, a town of 1,500 in west-central Illinois.

Suspicious trading in TXU options started three business days before the February 26 announcement that KKR and TPG planned to buy TXU for $69.25 a share. On February 21, when TXU stock fell almost 2 percent to $56.07, investors began flocking to an option to buy TXU shares for $60 apiece.

The trading volume for the options soared to almost 25 times the average amount since it first traded, and on February 23, it exceeded 100 times the average. Those options, which cost as little as 20 cents on February 21, closed at $8 on the day of the takeover news—as much as a 3,900-percent gain.

“That pretty much screamed that something was up, that somebody knew something,” says Michael McCarty, an options trader who tracks unexplained moves in the options market at Meridian Equity Partners in New York. “That was pretty egregious.”

Almost overnight, profits on some TXU options were so eye-popping that within four days of the takeover announcement, SEC lawyers won a federal court order freezing accounts holding $5.3 million of alleged ill-gotten gains from trades originating in Frankfurt, London and Zurich.                                                  

Stock trading also showed signs of suspicious timing before recent mergers. In the weeks after First Federal’s board met on September 20 to consider offers from two potential buyers, the bank holding company’s shares vaulted as much as 33 percent to an 18-month high of $24.

The jump complicated the directors’ decision about selling the company: The highest bid was $23 a share, which had seemed like a handsome premium when the stock traded for $18.

“It was the board of directors’ belief that the increase in the price of the stock most likely reflected speculation of a merger and not an actual increase in the intrinsic value of FFBI,” the company’s January 12 merger proxy said.

On November 6, First Federal accepted the $23 offer by Heartland Bancorp. Shares fell on the news to $22.60 from $22.75.

Dramatic consequences

AS regulators search for the sources of inside information, they say any whiff of Wall Street culpability prompts priority scrutiny. “Where you’ve got somebody in the industry that’s involved, those always get raised right to the top of the pile,” Luparello says.

Bankers who go bad and are caught likely face prison terms, on top of fines and forfeiture of ill-gotten gains from SEC civil lawsuits, says Thomsen, 53, a 12-year veteran of the SEC’s enforcement division who led the agency’s probe of Enron Corp.

Dennis Levine, a Drexel Burnham Lambert Inc. mergers specialist charged in 1986 with tipping Boesky to confidential information, was jailed for almost a year and a half. James McDermott, former chief executive of Keefe, Bruyette & Woods Inc., spent five months behind bars in 2000 and 2001 for passing takeover secrets to a Canadian adult film actress.

Earlier this year, former Merrill Lynch analyst Stanislav Shpigelman was sentenced to 37 months in prison after pleading guilty to leaking advance word of mergers involving the firm’s clients.

“Criminal prosecutors will not hesitate to pursue insider trading when it’s done by professionals,” Thomsen says. “People need to be reminded that there are dramatic consequences for this.”

Former Morgan Stanley compliance officer Randi Collotta cried in a Manhattan federal courtroom on May 10 as she and her husband pleaded guilty to securities fraud and conspiracy. Prosecutors charged that Collotta, 30, alerted a stockbroker friend about secret merger talks by Morgan Stanley investment banking clients.

As a compliance officer, Collotta was supposed to make sure other Morgan Stanley employees obeyed rules safeguarding confidential information.

Later the same day, in the same New York courthouse, US attorney Michael Garcia brought charges against former Morgan Stanley vice president Jennifer Wang and her husband, former ING Investment Management analyst Ruben Chen. Wang, 31, and Chen, 34, face four felony charges alleging they traded on information Wang learned about merger negotiations.

They plan to plead innocent, says their lawyer David Spears of Spears & Imes Llp in New York.

Global trading                                       

SIGNS that insiders are profiting from confidential information are visible around the globe.

The UK Financial Services Authority said in a March report that insider trading may have sullied one-quarter of Britain’s announced takeovers in 2005. Last year, unusual trading preceded 33 of 52 Canadian takeovers valued at more than $188 million, according to Toronto-based research firm Measuredmarkets Inc.

Timely premerger investments don’t always turn out to be illicit. Through research into company financial statements and takeover trends, savvy investors may identify likely buyout targets without access to nonpublic information, Thomsen says.

“There could be rumor or speculation that is not borne of material nonpublic information,” she says. Sometimes, innocent investors get lucky.

Still, SEC merger filings show that unusual trading in many transactions has been so closely tied to closed-door developments that it defies coincidence.

On December 7, after Redback Networks Inc. got a $25-a-share takeover offer from Ericsson AB, Redback’s bankers at UBS AG told Ericsson that the Internet router manufacturer wanted talks to proceed as quickly as possible to cut the risk of leaks, according to a December 22 regulatory filing. Redback’s shares soon showed signs the secret was out.

On December 14, one day after Ericsson’s lawyers delivered a draft merger agreement, Redback’s stock jumped 12.3 percent on almost four times its average trading volume for the previous three months. From Ericsson’s initial bid on December 1 to the disclosure of the deal on December 19, Redback shares skyrocketed almost 46 percent to $21.17 from $14.52. The 184-member Nasdaq Telecommunications Index rose 3 percent.

While Redback’s board saw the stock price rise, company directors couldn’t do anything, says Paul Giordano, who was Redback’s nonexecutive chairman before the takeover.

“We noticed it,” says Giordano, CEO of Tamalpais Asset Management Lp in Sausalito, California. “The markets are going to do what the markets are going to do. All you can do is act in the best interests of your shareholders.”

New generation

THE recent rush of suspicious trading comes 21 years after Wall Street was rocked by the SEC’s May 1986 suit against Drexel Burnham’s Levine, then a 33-year-old investment banker. Levine led authorities to Boesky, who agreed to pay $100 million to settle the SEC’s case.

By the time it was all over, Drexel Burnham was defunct and Levine, Boesky and Drexel Burnham junk bond head Michael Milken were behind bars.

Those cases seemed to suppress the allure of insider trading for brokers and bankers. During the first half of the 1990s, the SEC’s enforcement division filed no cases against Wall Street professionals.

From 1995 to 1999, the SEC’s enforcement watchdogs sued 10 investment bankers, analysts and compliance officers for trading on nonpublic information.

The cluster of SEC insider trading cases on Wall Street since last year may mean a new generation of bankers and brokers is too young to remember Boesky and Milken, says Harvey Pitt, who was SEC chairman from 2001 to 2003.

“The investment banking business is a young man’s and young woman’s business, and some of these people weren’t around in the 1980s,” says Pitt, who now runs Kalorama Partners Llc, a Washington consulting firm.

Former Morgan Stanley compliance officer Collotta, who was nine years old in 1986, was among 11 people sued by the SEC in March, including five employees of Bear Stearns Cos. and UBS who were 31 to 41 years old. The group made more than $15 million over at least five years from tips about mergers and analyst rating changes, the government alleged.

In fighting insider trading, the first line of defense includes surveillance units at the SEC, NYSE, NASD and US options markets. They use computers to sift through millions of daily trades, looking for statistical oddities, such as abrupt changes in price or volume.

Investigators can later crosscheck trades with other databases, such as chronologies of merger negotiations and lists of people who knew about the talks. Current probes are focusing on traders, not companies.

To impose sanctions, regulators must find out who made the trades and prove the traders had access to company secrets. “The hard part is drilling down to find particular individuals who have particular bits of information that is both material and nonpublic and not gotten from some other source,” Thomsen says.

Suspicious gains may be obvious when made by stock market neophytes. Illicit trading can be less conspicuous when done by hedge funds and other big investors who routinely buy and sell stocks in dozens of companies. “The hedge fund is sophisticated; it doesn’t stand out,” Columbia’s Coffee says.

Under the radar

INSIDER trading by professionals is a cat-and-mouse game, Pitt says. “People who plan these trades are many things: They’re evil, they’re cheaters, but they’re not usually stupid,” he says. “So they figure out how they’re going to try to mask what they’re doing.”

Burgeoning swaps and options markets can help wily scofflaws avoid detection, Luparello says. “More sophisticated players have more tools,” he says. “When it comes to catching insider trading, it makes it harder and harder because they can be working in the option, they can be working in the equity, they can be doing a swap over the counter.”

Increasingly, prices for credit default swaps are soaring in tandem with supposedly secret merger talks, according to Bloomberg data.

Swaps prices represent the annual cost of contracts that guarantee repayment of the principal on corporate bonds if a company defaults. In day-to-day trading, that cost rises if investors think a company has a greater risk of missing payments.

When multibillion-dollar takeovers are financed with new debt, the jump in credit default swap prices may far outstrip gains in the target company’s stock.

Suspicious trades of credit default swaps aren’t as easily spotted as stock or option investments. Most swaps are bought and sold in privately negotiated deals. Trading isn’t tracked by market surveillance systems, and there’s no central database of transactions.

Former swaps trader Frank Partnoy, now a law professor at the University of San Diego, says the unregulated swaps are a magnet for illegal insider trading. “Only a moron would engage in plain-vanilla insider trading,” he says. “If you’re smart, you do it under the radar.”

When speculators with illegal inside information drive up prices, the victims are investors who sell without knowing that a bigger potential windfall is just over the horizon, says James Cox, a securities fraud expert at Duke University Law School in Durham, North Carolina.

“Retail investors, and maybe even some sophisticated investors, when there’s an anticipated run-up in the price, may be selling, thinking it’s good news,” he says.

Regulators are pursuing cases against investment bankers at a time when sanctions for insider trading are tougher than ever. The 2002 Sarbanes-Oxley law boosted maximum penalties to 20 years behind bars and a $5-million fine from 10 years and $1 million.

Still, some Wall Street professionals are convinced they’re too clever to be captured, says David Steiner, NYSE Regulation’s vice president of market surveillance division.

“The main deterrent for this type of activity, and this type of individual, is the possibility of getting caught, with the loss of standing in their job and in their community,” Steiner says.

With round-the-clock international markets and new kinds of investments to exploit for illicit insider gains, cunning profiteers are looking for ways to stay one step ahead of the law. “While the government has proved it can catch some of those people, I’m not sure they’re catching most,” Coffee says.

Until the risk of getting caught exceeds the certainty of getting rich, the new flow of merger-linked insider trading is likely to keep bubbling along.

GREED IS BACK

Earlier this year, someone was confident that Hydril Co.’s stock was due to take flight—and very soon. During the two days ended on Friday, February 9, investors purchased options conveying the right, through February 16, to buy more than 160,000 Hydril shares for $90 apiece.

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