Securities Fraud Attorney Blog

Fraud in the privately traded markets? Aline van Duyn of the FT wrote a fascinating piece over the weekend about the lessons of the Galleon case going much wider than stocks. We agree. Next wave of large and complex fraud will be in non-exchange traded products. Here is the piece.

Lessons of Galleon case go wider than stocks

By Aline van Duyn in New York

Published: May 13 2011 20:10 | Last updated: May 13 2011 20:10

The seizure of 105 tonnes of marijuana in a Mexican warehouse last year made for dramatic pictures. The 10,000 packages, colour-coded and labelled with symbols, covered a huge car park. The images brought home the sheer scale of the drug industry, not least because, as every cop knows, the amount found is only ever a fraction of the total trafficked.

Wall Street is this week dealing with its equivalent of a drug bust: the conviction of Raj Rajaratnam on insider trading charges. And the drama of his trial raises a similar question as the Mexican haul did. How much of the profit made by hedge funds from equity trading comes from insider trading rings such as the one operated by Mr Rajaratnam at Galleon?

It is, of course, impossible to know. Already, as my colleague Kara Scannell has reported, business practices across corporate America and Wall Street could change following the breakdowns in compliance revealed in the trial.

Questions about whether some investors are breaking the rules or unfairly manipulating prices should not just be asked about stocks.

Share trading was once the bread, butter, meat and potatoes of the financial industry. It has long stopped being the biggest game in town, as the sale of hundreds of billions of dollars of debt and derivatives linked to US housing markets around the globe in the run-up to the financial crisis illustrated.

Just to give a rough sense of scale, a McKinsey report in 2009 estimated that global equity securities were worth $34,000bn. The value of private debt was estimated at $51,000bn and government debt was believed to be worth $32,000bn. Bank deposits were worth $61,000bn. These figures do not include derivatives or real estate.

Many of the non-equity markets are unregulated, or at least not subject to the same strict rules as stock markets are.

“The presence of millions of small investors had politicised the stock market,” writes Michael Lewis in The Big Short, his account of the build-up of the housing and credit bubble that burst in 2007. “It had been legislated and regulated to at least seem fair. The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure. Even as it came to dwarf the stock market, the bond market eluded serious regulation. Bond salesmen could say and do anything without fear that they would be reported to some authority.”

Plenty of bond experts would disagree with this characterisation. However, as the top legal official at one large hedge fund explained to me, it is much harder to pick up warning signs of potential market abuse in privately traded markets such as bonds or derivatives. In many cases, for example, trades do not have reliable time stamps. Without a time stamp, it is almost impossible to build an insider trading case.

The senior hedge fund executive also admitted that the fact that few outsiders can understand what is happening in a private market can affect the way traders behave. “I may think insider trading is as wrong in credit derivatives as it is in stocks, but the attitude of the traders may be different.”

The Dodd-Frank financial reforms are trying to tackle this and swaps will be subject to specific market abuse regulations. As more swaps move on to exchange-like trading venues, prices will be reported, and time stamped. It will be possible for someone – whether it is internal compliance departments or external regulators – to at least look out for odd behaviour.

Narcotics cops would never expect to stamp out all illegal trading, not least because drug traffickers have far more resources at their fingertips. Regulators face similar challenges. But until there is more information about who trades, and when, it is hard to even build a case to tackle problems in markets that now dominate finance. More information about trading is also needed for Wall Street to shake off the persistent allegations from Main Street that the markets are stacked in favour of the professionals, and against the “little guy”.

Over-the-counter (OTC) derivatives can be scary. Derivatives may pose an unsuitably high amount of risk for non-institutional investors yet are being sold by dealers around the world to investors who do not clearly understand the products.

According to Reuters yesterday, U.S. Representative Stephen Lynch said that “taking a ‘soft approach" to regulating OTC derivatives would be a mistake, but that appears to be the direction lawmakers are leaning.” Representative Lynch further said "by allowing a significant part of the derivatives market to just go off unregulated ... we're setting ourselves up to fail."

After the meltdown of 2008 and 2009, now is the opportunity to address the concerns related to OTC derivatives. Hopefully, Representative Lynch’s perspective will prevail and public investors will be further protected.

Over-the-counter (OTC) derivatives are very complicated investments. OTC derivatives are sometimes defined as contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. They include swaps (such as credit default swaps (CDS)) and interest rate, currency and commodities contracts. The OTC market is supposedly made up of banks and other highly sophisticated parties such as hedge funds. Then why have OTC derivatives been sold to less sophisticated investors? Good question.

The U.S. Secretary of the Treasury, Tim Geithner, announced last week the Obama Administration’s broad plan on regulatory reform of OTC derivatives. Much of the news coverage focused on the systemic risk portions of Mr. Geithner’s memo. However, the last section of the memo stated that Treasury’s objective is also “ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.” This is a very important mandate.

Our firm represents investors who were improperly sold various over-the-counter derivatives without the requisite risk disclosure made by the parties selling them. OTC derivatives fraud cases have become more and more prevalent as the OTC market mushroomed to greater than $600 trillion in notional amount in 2008. There is no room for fraudulent misrepresentations in this extremely complex market. Investors should be wary. Let’s hope the government follows through on its objectives and protects investors from the risks posed by OTC derivatives.