Discussion in 'Wall St. News' started by zdreg, Apr 13, 2006.
Liz Moyer, 04.13.06, 3:35 PM ET
New York -
Wall Street is circling the wagons after the first of what could be multiple lawsuits against several big firms over collusion in the prime brokerage business.
Late Wednesday, Electronic Trading Group filed suit against 11 firms and unnamed individuals in Manhattan federal court, accusing them of "anti-competitive" conduct and "conspiracy" in setting excessive fees and controlling the securities-lending market.
ETG, an institutional trading firm, was acquired in October by Schonfeld Group, a proprietary and retail trading operation. But by Thursday, Schonfeld representatives were already trying to distance themselves from the suit.
"We want nothing to do with this," says Schonfeld President Andrew Fishman.
Howard Jahre, who used to be one of ETG's biggest investors, is believed to be the individual behind Wednesday's lawsuit, which targets Bank of America, Bank of New York, Bear Stearns Cos., Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, Lehman Brothers, Merrill Lynch, Morgan Stanley and UBS. Jahre now runs an entity called Hedge Fund Capital Partners, though a call to his New York office went unreturned.
The suit, filed on behalf of ETG by Entwistle & Cappucci, comes as another plaintiff's firm, Milberg Weiss Bershad & Schulman, is investigating pricing in the prime brokerage business. Milberg is also preparing to bring its own class-action suit against the prime brokers on behalf of hedge funds, which also believe they are being overcharged or charged for services not provided. Earlier this week, a partner at the firm would not comment on the timing of any lawsuit.
Prime brokerage is the business of catering to hedge funds, particularly lending securities to funds so they can execute their trading strategies. Securities lending generates about $10 billion in fees annually for Wall Street, according to research from Vodia Group, yet its pricing structure is a complete mystery to most observers.
But institutional firms like Schonfeld depend heavily on the services of Wall Street and are unlikely to want to risk damaging those ties by flinging around accusations of price collusion.
Nevertheless, lawyers not connected with either the Entwistle or Milberg firms say the issue of pricing and the mechanics of the securities-lending business are ripe for investigation.
One of the thorniest issues, and one which is addressed in the suit filed Wednesday, is the phenomenon known as naked short-selling and the prime brokers' hands in it.
In regular short-selling, the trader borrows shares for a fee from his prime broker and sells them, hoping to buy them back later at a lower price and reap the profit on the difference. But the prime broker has to locate the shares, which then have to "deliver" or be given to the trader before the sale is executed.
Sometimes, especially with illiquid or highly shorted stocks, there is an imbalance, and the shares "fail to deliver." If the trader executes the short sale without possession of the shares, that is known as naked short-selling.
Hedge funds have grumbled for years about paying high fees for hard-to-locate stocks only to find that they were never delivered, even after the trade was executed. The crux of Wednesday's lawsuit isn't that naked short-selling is bad, it is that traders are being taken advantage of by a vast conspiracy among the prime brokers to keep up this faÃ§ade of phantom trading while charging high fees for no service.
"Defendants effectively operated in a tag-team fashion--rotating in the roles of prime broker, clearing agent or counterparty that enabled the short sale transaction to go forward without the expectation of delivery," the complaint says.
Representatives of the banks named as plaintiffs in the suit either had no comment or did not return calls seeking comment. A Citi spokeswoman said, "We believe the suit is without merit."
The complaint does not name money damages for ETG, but it does put the time period from April 2000 to the present. The complaint also doesn't mention specific short sales for which ETG was charged a fee but the shares were not delivered.
The U.S. Securities and Exchange Commission has been studying the issue of naked short-selling and even instituted new regulations in January 2005 that require the stock exchanges to report stocks that routinely fail-to-deliver. Companies like Martha Stewart Living Omnimedia and Overstock.com have been on the so-called SHO list practically since the beginning. Overstock.com Chief Executive Patrick Byrne has tried to put a spotlight on naked short-selling.
Attorneys not connected with the Entwistle or Milberg firms say the suits could potentially hit Wall Street for billions of dollars if the accusations of collusion and unfair pricing can convince a jury that damages are warranted.
And the issue could attract the attention of state and federal regulators, as hedge funds increasingly manage money for pensions and other institutions who manage money for ordinary investors.
Hedge Funds: Got Kleenex?
Liz Moyer, 04.12.06, 6:00 AM ET
By This Author
New York -
Get your hankies ready: Hedge funds feel they're the newest victims.
A long-simmering issue may soon come to a boil, potentially putting Wall Street's largest firms on the hook for billions more in liabilities years after the research scandal that extracted $1.4 billion in legal fines from ten of the most influential investment banks.
This time, prime brokers face scrutiny for the fees they charge hedge fund clients, with securities lending being a particular focus.
Attorneys at plaintiffs' firm Milberg, Weiss, Bershad & Schulmanare investigating securities lending fees and other practices by the biggest prime brokers and are considering bringing a class-action lawsuit on behalf of hedge funds.
Steven Schulman, a partner at the firm, said Tuesday that it's still investigating the issues and declined to discuss details of any lawsuit. But he did say, "We're thinking about what we need to do."
Prime brokerage is the business of catering to hedge funds, everything from loaning securities so funds can sell them short to providing office space for startup funds. The business has consolidated among the biggest three: Goldman Sachs Group (nyse: GS - news - people ), Morgan Stanley (nyse: MS - news - people ) and Bear Stearns Cos. (nyse: BSC - news - people ) in recent years, though several other banks have tried to get bigger in it, including Bank of America (nyse: BAC - news - people ), Credit Suisse (nyse: CSR - news - people ) and Merrill Lynch (nyse: MER - news - people ).
Securities lending is among the most lucrative of prime brokerage services to the banks, reaping some $10 billion in annual fees, and the business just keeps growing as more hedge funds pop up. But it is also among the most opaque of businesses, with plenty of opportunity for abuse, lawyers unconnected with the Milberg firm say.
Hedge funds have alleged privately for years that they are being overcharged for prime brokerage services or charged wrongly for services that haven't been performed. Most of the griping has to do with securities loaned but never delivered, the allegation being that the prime brokers are lending securities at high fees without actually having possession of the securities to lend in the first place.
Playing by the rules, a trader can't sell short a security without having possession of it by the settlement date, or the trade would be what's called a naked short. A trade is often made while the settlement process continues, and most trades wind up with the security being delivered in ten days. Prime brokers lending securities to clients presumably assure their client that the borrowed securities will be delivered.
The hedge fund pays a fee to borrow the shares, presumably with the knowledge that the delivery will occur. The allegation of fraud comes in when the prime broker takes the fee and never delivers the shares and doesn't intend to.
The New York Stock Exchange and the Nasdaq keep lists of stocks that routinely fail to deliver, and some of the companies that have been on those lists since a new rule was enacted in January 2005 say they are the victims of naked short-selling. The most famous of these is Overstock.com (nasdaq: OSTK - news - people ), whose chairman, Patrick Byrne, has been on a mission to bring the issue to the attention of regulators and lawmakers.
Bringing prime brokers into the loop would put the biggest firms at the center of yet another potentially explosive scandal. Lawyers not connected with the Milberg firm say a lawsuit could attract the attention of state attorneys general, who were instrumental in assessing the fines in the conflicts-of-interest scandal and in the mutual fund trading-abuse cases of recent years. Why? Hedge funds increasingly manage investments from pensions and endowments, meaning regular investors could be bearing the brunt of abusive fee schemes in the form of lower returns on their investments.
A spokesman for New York State Attorney General Eliot Spitzer, who led the conflicts and mutual fund trading-abuse cases, had no immediate comment.
"Some hedge funds feel they have been taken advantage of by their prime broker," says Josh Galper, principal at Vodia Group, a New York consulting firm. "Naked short-selling is an example of how pricing abuses can enter the market."
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