Is Insider Trading Part of the Fabric?

Even before the news was official, it filtered out — unofficially — to Wall Street.

Wall Street sign
Wall Street sign

On a trading floor in Midtown Manhattan, the squawk boxes were set to relay a market-moving bulletin at 10 a.m. This was the news: An analyst at the investment house was raising his assessment of Amkor Technology, a big name in computer chips.

But it was only 9:30, and Amkor’s share price was already rising. By the time the announcement came, it was up 4 percent. “It was clear that my research had been leaked,” the analyst, Ted Parmigiani, recalls.

But leaked how, and by whom? To Mr. Parmigiani, there was only one explanation: someone inside his own research department had tipped off the firm’s traders, as well as some fast-money hedge funds.

Nearly seven years later, the events of that June day — and countless others like it, up and down Wall Street — still rankle him. The fallout effectively ended his career. The firm he worked for, Lehman Brothers, was eventually undone by greed and hubris, its spectacular collapse in September 2008 a symbol of an age of financial excess.

Against the sweeping morality tale of Lehman, the story of one analyst may seem trivial. But it’s a story central to post-crisis Wall Street, and to the regulators watching over it. Federal authorities today are trumpeting efforts to root out insider trading, and they’ve caught some big fish. Yet many on Wall Street suspect that the sort of chicanery that Mr. Parmigiani says he witnessed at Lehman may be as common as ever.

More worrying, from his perspective, is that he provided the Securities and Exchange Commission with evidence pointing to frequent insider trading involving analyst research at Lehman, but the S.E.C. ultimately did not bring a case. Mr. Parmigiani spent two and a half years giving information to the S.E.C. He produced materials indicating that Lehman sales representatives were tipped off to upcoming research changes; data showing suspicious trades in dozens of stocks; organizational charts and floor plans showing that some Lehman executives who were part of the research department were located near sales and trading desks. These departments are supposed to be separated.

With that ammunition, the S.E.C. opened an investigation, case HO-10864. Officials told him that his evidence was credible.

Then the case died. And after Lehman’s collapse its employees have scattered across Wall Street.

Since the financial crisis, the S.E.C. has spent a lot of time and money trying to plug leaks. In a case worthy of “Law & Order,” prosecutors used wiretaps to ensnare Raj Rajaratnam, the billionaire Galleon hedge fund manager whose web of tipsters stretched from Wall Street to some of the mightiest corporations in the land. For his crimes, Mr. Rajaratnam, whom prosecutors called “the modern face of illegal insider trading,” was sentenced last Octoberto 11 years in prison.

Mr. Rajaratnam’s conviction, in the largest insider-trading scandal in a generation, handed a much-needed win to the beleaguered S.E.C. Only two years earlier, the commission had been lambasted for missing glaring evidence of Bernard L. Madoff’s vast Ponzi scheme.

But Mr. Parmigiani and others suspect that the P.R. of the Galleon case glosses over risks that insider trading can and does occur regularly at many Wall Street firms. In their view, it has become institutionalized. The flow of information between a firm’s analysts, its traders and its clients — a lucrative heads-up on stock upgrades and downgrades, for instance — can bolster trading profits, brokerage commissions and, ultimately, Wall Street paydays. Those in the know can get rich before the rest of us know what happened.

“Prosecutors say insider trading won’t be tolerated, that this is justice,” Mr. Parmigiani says of the Galleon case. “But they refuse to acknowledge that their widespread net has a very big hole in it.”

What exactly happened at Lehman? Mr. Parmigiani says traders there were routinely advised of changes in analysts’ company ratings before those changes were made public. That way, Lehman could profit on subsequent market moves. Here is how he describes it: First, research officials tipped off the traders; then Lehman’s proprietary trading desk, which cast bets with the firm’s own money, positioned itself accordingly. Lehman salespeople also alerted favored hedge funds. Only later, he says, were ratings changes made public.

Blowing the whistle on any big corporation, as Mr. Parmigiani tried to do in the case of Lehman, is almost always perilous. Shortly after noting the suspicious trading in Amkor, Mr. Parmigiani says, he was fired for not being a team player. He has since been unable to find work on Wall Street.

John Nester, a spokesman for the S.E.C., said it conducted a careful, thorough investigation of Mr. Parmigiani’s allegations.

100,000 EMAILS

“Not only did we investigate the circumstances surrounding each of the research reports specifically identified by Mr. Parmigiani, we conducted a broader examination into the trading by Lehman clients in all companies in which there was a material change in the stock price following the issuance of a Lehman research report,” Mr. Nester said. “We also investigated the communications between 46 Lehman employees and 56 Lehman clients, including nearly 100,000 e-mails.”

The S.E.C. also analyzed voluminous trading data and interviewed numerous Lehman employees, he said. “After all that, there simply was not any evidence in this case to support the conclusion that Lehman, its employees or its clients had committed insider trading.”

Publicly, the S.E.C. is taking a strong stance against insider trading. Officials say the commission is not only going after insider traders but also taking action against firms. A recent case against Goldman Sachs suggests that the S.E.C. recognizes the potential for improprieties that can occur if traders receive special access to research analysts’ work.

In the case, the S.E.C. alleged that Goldman analysts had shared trading ideas and other information with select clients. Although the S.E.C. did not charge any individuals with insider trading or tipping, Goldman’s activities “created a serious and substantial risk that analysts would share material, nonpublic information concerning their published research,” the S.E.C. said. Goldman paid $22 million to settle the matter. As is common in such cases, it neither admitted nor denied wrongdoing.

In an interview with Reutersin late April, Robert S. Khuzami, the S.E.C. director of enforcement, said: “We have charged firms for having compliance failures even where there were no underlying violations. We want to send a message that businesses have to have controls in place in order to prevent fraud.”

Indeed, the S.E.C. filed roughly 60 insider-trading cases in its 2011 fiscal year alone. But aside from a few that sprang from the Rajaratnam case and a handful of other sizable cases, many involved minor players and small sums. Of the 93 people charged during that period, 37 had pocketed less than $100,000 on their inside trades, according to the S.E.C.; 19 made $50,000 or less; and one netted just $8,391.

Lewis D. Lowenfels, an expert in securities laws in New York, says the S.E.C. is wasting time and money by going after small fish.

“This raises questions about the allocation of resources at a time when there is a real hue and cry that the S.E.C. is not getting sufficient funds from Congress,” Mr. Lowenfels says. “When you see that such a disproportionate amount goes to this kind of insider trading, you really have to wonder if the S.E.C. is using this as a means to resuscitate their stature, post-Madoff.”

The real potential targets are much, much bigger. Many people, inside and outside financial circles, have long suspected that Wall Street firms alert favored clients to analyst research before the investing public.

Senator Charles E. Grassley, the Iowa Republican who works closely with whistle-blowers, examined the material that Mr. Parmigiani brought to the S.E.C. Expressing disappointment in its handling of the allegations, Mr. Grassley said: “This case emphasizes serious questions about the S.E.C.’s culture of deference to Wall Street and big players going back a long time. The S.E.C. obtained what appears to be clear evidence of, at a minimum, disregard for regulations designed to ensure that Wall Street firms can’t leak inside information to preferred clients prior to public announcements. Yet there appears to have been no consequences.”

A Rare Kind of Case

When most people think of insider trading, they probably think of Gordon Gekko, the corrupt financier played by Michael Douglas in the 1987 film “Wall Street.” In the movie, the hot tips were about corporate takeovers.

Mergers and acquisitions are big, market-moving news, but so are corporate earnings announcements. These statements are ripe for insider trading, particularly when results take analysts and investors by surprise.

But while insider trading commonly involves nonpublic corporate information, advance warning on research changes can also yield quick, illicit gains. The S.E.C. said as much in a rare research case it filed in 2007 involving an executive at the Swiss banking giant UBS . In that case, eight individuals and three hedge funds were charged with profiting on tips about coming analyst ratings changes — “valuable and material, nonpublic information,” the S.E.C. said. One executive went to jail, and others settled with the S.E.C.

Mr. Parmigiani says his experience at Lehman made him suspect that the firm was trying to profit by trading ahead of changes in analyst recommendations.

“ ‘We’re trying to monetize the research,’ is what they would tell me when they asked for advance warning of rating changes,” Mr. Parmigiani says. “They would say: ‘Just let me know. We’ve got to relay a heads-up to trading. We’ve got to protect the house.’ ”


Clash With Superiors

Ted Parmigiani didn’t take the usual road to Wall Street. In 1986, at the age of 17, he dropped out of high school to join the Navy. He served on the U.S.S. Midway and gained expertise in accounting and supply-chain aspects of technology.

Paul Dublino, who lives near Orlando, Fla., enlisted at the same time and considers Mr. Parmigiani a friend. Mr. Dublino says his old Navy buddy impressed him with his intelligence and honesty. “No matter what he ever did, he excelled at it,” Mr. Dublino says. “I don’t think he has any type of fabrication of any sort in him. He tells it how it is.”

Mr. Parmigiani resigned from active duty in 1990, went to college on the G.I. Bill and then collected a master’s degree in finance. He joined Lehman in 2002.

At that time, Wall Street research was under a microscope. Eliot Spitzer, then the New York attorney general, had exposed how analysts routinely slanted research to win lucrative investment banking business. In 2003, Lehman was among 10 firms that reached a $1.4 billion settlement. They all promised to wall off research operations from other parts of their business.

But Mr. Parmigiani says he was asked to break those new rules. Lehman bosses, he contends, told him to write research that would support investment banking business — a violation of the Spitzer settlement. He says he was warned not to make negative comments about companies, even when he thought they were merited, lest he antagonize corporate executives. In 2003, he says, he was chastised for downgrading a company that was a corporate finance client of Lehman’s.

Most alarming, Mr. Parmigiani says, was that Lehman had created a system that gave its stock trading desks access to its analysts’ research recommendations before those recommendations were made public. The Product Management Group, as this business unit was known, scheduled analysts’ calls on the firm-wide squawk box system and was part of the research department.

Mr. Parmigiani says the Product Management Group often delayed the announcements of recommendation changes for no apparent reason. He says he began to suspect that the delays were meant to allow Lehman’s traders to put on positions ahead of the news and to give the firm’s top sales representatives time to alert favored clients.

On March 30, 2005, Mr. Parmigiani had been scheduled to meet with a series of hedge fund clients, including Moore Capital, to discuss his research. At the last minute, Jared Demark, a vice president in Lehman’s institutional equity sales who covered the hedge funds and had planned to accompany him, bowed out. In an e-mail to Mr. Parmigiani, Mr. Demark wrote: “Go to the Moore meeting without me, we have big ratings change looming ... ”

While Mr. Parmigiani did not learn precisely what Mr. Demark meant by that e-mail, it fueled Mr. Parmigiani’s concern that Lehman was alerting hedge funds to analysts’ pending changes.

Chris Boehning, a lawyer at Paul Weiss, said his client, Mr. Demark, would not comment.

he S.E.C. staff “conducted a careful investigation beginning in the fall of 2008 and concluded that there was no basis to recommend an enforcement action,” Mr. Boehning said. “We were very pleased with the thorough way the S.E.C. went about its work.”

That same day of the e-mail, Mr. Parmigiani said, another salesman told him that he had received a message about an imminent industrywide downgrade and had to start alerting clients.

Even though the Product Management Group was part of the research department, it was on the second floor, next to the stock trading desks and close to the firm’s top institutional sales representatives covering hedge funds.

Before long, Mr. Parmigiani and his superiors butted heads. In 2004, he says, he was asked to vet a company he had properly referred to Lehman’s investment bankers for a securities offering. He recalled Stuart Linde, then director of United States equity research, prodding him to be positive in his analysis, to help ensure that the deal got done. When he questioned whether this followed the rules handed down in the Spitzer settlement, Mr. Linde took offense, he said. But he says he stood his ground.

“One of the things I took out of the military is the one rule and duty you have is a duty to disobey an unlawful order,” Mr. Parmigiani says.

Mr. Linde, now director of United States equity research at Barclays Capital , declined to comment. A Barclays spokesman said Mr. Linde had never received a subpoena from the S.E.C. about the matter.

For Mr. Parmigiani, the final straw came on June 1, 2005, when he decided to change his rating on Amkor from “sell” to “neutral.” He had submitted his change to the Product Management Group that day, but then was told the switch wouldn’t be announced until the following day.

The next morning, he sent his upgrade to the research committee, which agreed that he should discuss Amkor on the squawk box at 10 a.m. But before he could speak, Amkor stock jumped in unusually heavy trading. He accused firm officials of distributing his upgrade ahead of time.

About two weeks later, Lehman fired him, with two weeks’ salary and no severance. On his permanent employee record filed with regulators, Lehman said he had been dismissed because he had “failed to meet performance expectations.” Those words effectively ended his Wall Street career, he says.

He filed a wrongful-termination case in May 2006, which was eventually settled for an undisclosed sum. The check was signed by Richard S. Fuld Jr., who, as chief executive, would later preside over Lehman’s collapse.

Waning Interest at the S.E.C.

Unable to find work on Wall Street, Mr. Parmigiani took his story to the S.E.C. On a Friday in late April 2008, he left a message for Linda Chatman Thomsen, then the commission’s director of enforcement. The next Monday, an enforcement attorney called back and invited him to conduct a conference call with S.E.C. officials. A two-hour conversation ensued, during which he described his experiences at Lehman.

Then, that April, S.E.C. officials asked him to come to Washington from his home in the San Francisco Bay Area. He spent a day with four enforcement lawyers. “They copied all my stuff and we sat there for six hours,” Mr. Parmigiani says. “They asked me questions, they took notes. They were shocked.”

He says the S.E.C. lawyers told him they would get back to him.

But then, as the financial crisis flared that summer, the S.E.C.’s interest waned. After Lehman failed, Mr. Parmigiani got a call from two of the lawyers, signaling that the S.E.C. was probably not going to pursue the matter. The S.E.C. spokesman said the lawyers would not comment.

Mr. Parmigiani took his brief to Senator Grassley’s office. Officials there sent a letter to the S.E.C., inquiring about the status of the investigation. By then, however, Ms. Thomsen, the enforcement director, had left the agency for private practice. Messages left for Ms. Thomsen were not returned.

Eventually, Mr. Parmigiani had another meeting with the S.E.C., in September 2010, and presented an analysis by Steven P. Feinstein, an associate professor of finance at Babson College. Relying on public information, Mr. Feinstein had analyzed the price movements of stocks in 361 downgrades by Lehman analysts between 2004 and 2008. The sample excluded any stocks that had been the subject of market-moving news — like earnings reports or other announcements — as well as shares that had been downgraded recently by other Wall Street firms.

Mr. Feinstein concluded that the stocks “exhibited significantly different price behavior on the two trading days preceding a rating downgrade by Lehman Brothers than they did on other days.” The results, Mr. Feinstein said, indicated that Lehman Brothers “apparently engaged in tipping,” and that stock prices were affected and that investors suffered damages as a result.

Mr. Parmigiani says the S.E.C. seemed impressed with the study. One lawyer, he says, told him that the commission “really liked the case” but that they did not have enough to go forward.

But Mr. Nester of the S.E.C. said a report connecting analyst actions with stock moves does not make an insider-trading case. “Fortunately, our staff can and does interrogate witnesses, review contemporaneous documents, including e-mails, and scrutinize trading records,” he said. “That is evidence, and that is what determines whether insider trading has occurred.”Frustrated, Mr. Parmigiani called investigators for Preet Bharara, United States attorney for the Southern District of New York. These were the prosecutors bringing the Galleon cases.

“I told them that Galleon was one of the spokes of the wheel but that it was not the wheel itself,” Mr. Parmigiani says, but his discussions led nowhere as well. Mr. Bharara’s office declined to comment.

At his last meeting with the S.E.C., Mr. Parmigiani recalled, one of the officials said, “We never doubted your credibility.”

Today, Mr. Parmigiani spends much more time with his two young children; his wife has become the family’s breadwinner. He has paid a price for trying to blow the whistle on Lehman, but says he has no regrets. Still, he says, his experience suggests that the authorities are reluctant to go after high-level executives on Wall Street.

As he puts it: “Law-abiding citizens should not have to beg civil servants charged with law enforcement to do their jobs.”