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A shift in banks' business model raises questions about conflicts.
Alix Stuart, CFO Magazine
October 1, 2006
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."
This certainly isn't the first time banks have been accused of letting interests collide in ways large and small. Conflicts can be as basic as sharing one customer's information with another customer. Reports by Reuters and Dow Jones suggest that Goldman Sachs resigned from its role as mergers-and-acquisitions adviser to Mirant Corp. in its takeover bid for NRG Corp. after being accused of leaking secrets from a previous engagement with NRG (although both companies ended up denying it). More-complex conflicts stem from the Graham-Leach-Bliley Act of 1999, which erased what legal boundaries remained against engaging in both investment and commercial banking, allowing the potential for information to flow within bank divisions. Even when banks are acting well within the law, there is always the likelihood that traders might take positions against former and future clients.
"Most of our firms are conflict-making machines," remarked then–vice chair of The Bond Market Association and Goldman Sachs chief administrative officer Ed Forst at TBMA's last annual meeting. "The question is how we manage those conflicts."
Most, of course, would say that market forces give banks plenty of incentive to manage those conflicts well. "In 99 percent of cases, banks want to do the right thing, because companies are much more likely to do business with them if they feel the banks are carefully enforcing these lines," says Mitchell Petersen, finance professor at Northwestern's Kellogg School of Management. "There's a trust factor with underwriters, and you have to rely on that," says Greg Heinlein, treasurer of Austin, Texas-based Freescale Semiconductor. Certainly most banks have strict policies against leaking client information, and the metaphorical "Chinese wall" often has a physical manifestation, as when banks keep proprietary traders on limited-access floors and investment bankers on others.
Compliance departments also monitor proprietary stock trades for companies involved in M&A or underwriting for excessive trading ahead of a deal's announcement, according to one industry source, and then freeze their banks' trading rights immediately after the deal. (Banks contacted by CFO, including Goldman Sachs, Morgan Stanley, and JPMorgan Chase, declined to comment on any specific measures they take to keep divisions separate.) But, as the blurred lines between underwriters and research analysts revealed, keeping boundaries within a firm "isn't a simple thing to set up," says Petersen.
As the Pequot case highlights, one of the problems with hedge funds being large clients of banks is that the funds may pressure banks to give them nonpublic information about underwriting deals. Or, they may illegally use information that was obtained legally, as British regulators concluded last summer. The Financial Services Authority (FSA) fined London-based hedge fund GLG Partners and one of its top traders a combined $2.8 million (its largest fine ever) for trading on embargoed information from Goldman Sachs regarding a forthcoming equity offering in 2003. According to the FSA, the trader shorted shares of Sumitomo Mitsui Financial Group ahead of a preferred-stock offering and made a "substantial profit" when the shares dropped after the stock's debut. "We have become increasingly concerned about the risks generated by institutions exploiting legitimately received information for illegitimate purposes," said Hector Sants, FSA managing director for wholesale and institutional markets, in a June speech.
In other cases, the issue is not whether a bank acted as an improper conduit of information, but whether it acted on that information for its own benefit. That risk is at the root of the Australian Securities and Investment Commission's (ASIC) current investigation into a unit of Citigroup. As the bank was advising Toll Holdings Ltd. on its $4.6 billion Australian ($3.3 billion U.S.) bid for Patrick Corp., its own trading desk (ostensibly behind the Chinese wall) bought up shares of Patrick on the trading day ahead of the bid's public announcement. Citigroup dumped the shares at the end of the day, creating a profit for the bank of between $50,000 and $100,000 U.S. and contributing to a higher acquisition price for Toll, ASIC charges.
While Citigroup does not dispute the facts of its trading and profit, the bank says it did nothing wrong and "intends to vigorously defend itself," according to a statement from Stephen Roberts, CEO of Citigroup Corporate and Investment Banking.
Regardless of the merits of that case, it's clear that secrets are hard to keep on Wall Street. A recent study by Canadian firm Measuredmarkets Inc. suggests that leaks may have occurred in 40 percent of big companies that were acquired in the past year. The study, which looked at 90 $1 billion–plus deals, found that, in 37 cases, abnormal trading during the deal-making process did not coincide with any publicly announced news. The New York Times reported that anomalous trading coincided with bankers' private meetings in at least 5 cases. However, it is not as obvious that advisers are double-crossing clients. "The study doesn't tell us where the leaks are coming from," says Measuredmarkets founder Christopher Thomas, adding that bankers he knows privately express frustration with the trend as well.
Further opportunities for leaks come on the lending side, via credit derivatives, or contracts that insure one party against another's default. The credit-default-swap market grew from $632 billion in the beginning of 2001 to more than $17 trillion by the end of 2005, and banks are increasingly using the hedges — often with hedge funds as their counterparties — to help offset their risks from lending. That not only means banks are less invested in helping rehabilitate troubled companies, it also means they may be pressured to share confidential, nonpublic information about their lending customers with counterparties.
"The first thing a hedge fund or bank that buys one of these [credit-default swaps] will want to do is hedge it, and in today's market, there's so much pressure on banks to try to sell these things, there's a lot of leakage," says Christopher Whalen, managing director at Institutional Risk Analytics.
Homing In on Hedge Funds
It's still unclear how pervasive any of these potential conflicts are. "This looks a lot like the 1920s, when a couple of great stories led to the Glass-Steagall Act, but you can always find great stories," says Northwestern's Petersen. "The question is, is this a 5 in 100 problem or a 50 in 100 problem?" For the most part, U.S. regulators seem inclined to believe the best about the banks, even as their international counterparts are concerned about the links between a regulated business — banks — and unregulated hedge funds.
The most direct way to regulate hedge funds would be to require them to register with the SEC, as other asset managers must do. The SEC, of course, tried that tack, but was recently stymied by a federal appeals-court decision that held that it was invalid. Chairman Christopher Cox is still formulating a countermeasure. The SEC is the default authority when insider trading is alleged by securities dealers, but concerns about insider trading among hedge-fund advisers don't seem to be pressing.
An indirect way of preventing hedge fund managers from hurting a bank's clients is for the Federal Reserve to require at least commercial banks to track and disclose more about their relationships to hedge funds. That type of oversight also makes sense from a macroeconomic perspective, say some, since hedge funds bear so much of banks' risk and could create a widespread meltdown if they failed along with the banks. "It behooves the lender of last resort to have firsthand knowledge of what's going on at the institutions that would be at the heart of a crisis," says Tom Schlesinger, executive director of the Financial Markets Center, a Fed watchdog group.
But the Fed, so far, has shown little interest in getting involved with hedge funds. "Broadly speaking, the best way to make sure hedge funds are not taking excessive risks or excessive leverage is through market discipline," such as having banks police them and limiting who can invest in them, Federal Reserve Board chairman Benjamin Bernanke told a House committee in late July.
Most other Fed governors agree. One, Randall S. Kroszner, believes commercial banks "are much more aware" of the counterparty risk and that hedge funds are less leveraged after the infamous 1998 meltdown of Long-Term Capital Management.
What You Can Do
Given the resistance at top levels, it's unlikely that fast action from the government will help keep deals fully under wraps. But there are some approaches CFOs can take now to limit exposure. "At the end of the day, it's the company's responsibility to monitor what happens as they bring someone under the tent," says Freescale treasurer Heinlein.
Number one, experts say, is to build relationships with a few select banks and to be loyal to them. "If you can minimize the number of banks you're working with and the number of accounts you have, there's less potential for leakage to happen," says Dan Carmody of treasury consulting firm TreaSolution Inc. Others suggest finance executives find out how much revenue the bank derives from non-investment-banking activity, and consider using boutique investment banks that focus more narrowly on deals. Heinlein also recommends using commercial banks whenever possible "to help keep the investment banks honest," since their clients typically do not include hedge funds.
The second key ingredient in keeping secrets secret is to closely track movements in stock, bond, and credit-derivative prices. "Private-equity and hedge funds can always trade in an offsetting product, so that is always a risk," says Heinlein. "On the other hand, the company always has a right and even an obligation to sniff that out." He tracks Freescale's credit-default swaps in part to look for suspicious activity and in part to see how efficiently the company's bonds are trading.
Finally, Heinlein recommends that, when the situation permits, companies should structure deals with fast turnarounds, such as overnight bond deals, to minimize the likelihood of leaks. Above all, remember Benjamin Franklin's wise words the next time you set up a deal with your bankers: "Three can keep a secret if two are dead."
Alix Nyberg Stuart is senior writer at CFO.
Who's on First?
Banks routinely bundle corporate loans and sell them off, often to other banks or hedge funds, as a way to manage risk. The problem with those derivatives, though, is that slow transaction-clearing processes and the resulting backlog make it unclear who is legally responsible for paying up in the event of a credit default. Should banks be left holding the bag for multiple bankruptcies, their reserves would quickly be depleted, raising fears of a systemwide meltdown.
Such fears spurred the New York Federal Reserve Bank to call a meeting of 14 large banks last fall, asking them to standardize and computerize the process, rather than rely on an outmoded system based on scraps of paper and ad hoc negotiations. By the end of June, the number of uncleared transactions more than 30 days old had been reduced on average by 80 percent, and backlogs at large firms showed a marked decline. Some 60 percent of all swaps now go through the Depository Trust and Clearing Corp., the main clearinghouse for the derivatives, up from 15 percent two years ago.
But don't breathe easy just yet. "Taking care of the backlog [via automation] certainly won't be a panacea," warns Dimitri Papadimitriou, head of the Levy Economics Institute at Bard College. "When we get caught up, we might find that banks' exposure is much larger than we thought." — A.N.S.