Leaking Deals?

The WSJ posted a good article on the possibility that several recent M&A deals have been leaked to certain individuals before they were announced publicly. Insider information, as its often called, can give certain market partcipants an "unfair advantage" and the opportunity to extract returns in excess of the general market.

Check out the article below.

Are Deal Makers
On Wall Street
Leaking Secrets?

Trading Jumps Before Acquisitions
As Low Surveillance, High Payoff
May Be 'Recipe for Bad Behavior'

By SERENA NG and DENNIS K. BERMAN in New York and KARA SCANNELL in Washington
July 28, 2006; Page C1

As the boom in corporate takeovers continues, unusual trading in obscure investments or via offshore accounts is raising concerns about insider trading.

Suspicious trading patterns -- including increased activity and well-timed bets -- have cropped up in several companies' securities in advance of news of their involvement in big transactions, suggesting Wall Street's deal-making machine may be leaking confidential information.

The list includes deals both mammoth and modest: the just-announced $21 billion leveraged buyout of hospital operator HCA Inc.; the $1.7 billion buyout of Petco Animal Supplies Inc.; the $2.6 billion sale of Maverick Tube Corp. to Tenaris SA; and Anadarko Petroleum Corp.'s $21 billion offer for both Kerr-McGee Corp. and Western Gas Resources Inc.

Some of the trading is in a corner of the financial markets that hardly existed during past takeover waves, which featured questionable trades mainly in plain-vanilla stocks, bonds and options. In advance of the HCA deal, there was a notable uptick in trading in financial contracts tied to HCA's bonds -- derivatives known as credit-default swaps.

Credit-default swaps are private contracts intended to be insurance policies against a company going bankrupt, but they also allow investors to bet on the likelihood of a bond default and are especially popular with fast-trading hedge funds that cater to wealthy clients and institutional investors. The more likely a company is to default, the more expensive its credit-default swaps become. When a company is bought in a leveraged buyout, as is happening with HCA, it assumes dramatically more debt, increasing the likelihood of a default.

In the five days before news of a potential HCA deal was disclosed in The Wall Street Journal on July 19, the price of HCA's credit-default swaps rose 11%, according to data from Markit Group. The market was effectively betting that the likelihood of an HCA default was rising at a time when prices more broadly in that market were rising just 4%, as measured by a Dow Jones index for these instruments. Triad Hospitals Inc., whose contracts usually move in tandem with HCA, declined 2% during the same period, Markit data show. The difference was starker in the six weeks leading up to the news. HCA swaps rose 31% in price, while a broad market index rose 10%, and Triad rose 11%.

After HCA reached a deal with its private-equity sponsors, prices of its credit-default swaps rose more than 60% and its bonds dived in value.

A surge of trading in stock options tied to HCA stock in advance of news of the deal has attracted the attention of the Securities and Exchange Commission. On July 14, options traders bought and sold 10,322 options contracts, which gave buyers the right to purchase HCA stock at a fixed price in the future. By comparison, the average daily volume in call options during June was 1,142 contracts, according to data from Options Clearing Corp.

SEC officials say insider-trading enforcement actions have stayed relatively consistent in recent years. Since Oct. 1, 2005, the agency has brought 40 such cases; it had 42 such cases in fiscal 2004 and 52 in fiscal 2002.

But that could change as the takeover boom grows. A March study by England's equivalent of the SEC, the Financial Services Authority, found suspicious stock-price movements prior to 29% of the merger announcements it studied between 2000 and 2004. The study recommended more "visible enforcement action."

"Definitely something is going on. In the last few years, with all these hedge funds, there's probably a lot more leakage," says Narayanan Jayaraman, a Georgia Tech University professor.

To be sure, rumors are the markets' oxygen, and it can be difficult for regulators to prove the distinction between an ill-gotten piece of information and long-churning speculation that just happens to be true.

The merger market is changing in ways that have increased the possibility of leaks and the opportunities for players involved to profit from them before they are public. Deals are taking longer to play out and involve more deal makers. During the 1980s and 1990s, merger deals typically took a few weeks to consummate. In 1996, WorldCom Inc. spent two weeks from its first takeover discussion to seal its $12 billion deal for MFS Communications Inc. But boards have since grown wary of quick deals, demanding more methodical study. Discussions of a takeover of HCA began back in April.

"Clearly, the length and size of the deals seems to require more time, which of course increases potential leakage," says Cam Funkhouser, senior vice president of market regulation at the National Association of Securities Dealers.

The increasing use of lots of borrowed money to acquire companies in leveraged buyouts creates more leak potential. As the deals grow larger, more money, and thus more bankers and lawyers, are coming in "under the tent," in Wall Street parlance. In HCA's $21 billion transaction, announced Monday, six financial firms -- Bank of America Corp., Citigroup Inc., Credit Suisse Group, J.P. Morgan Chase & Co., Merrill Lynch & Co. and Morgan Stanley -- and at least seven law firms were involved.

Banks and law firms typically are required to submit to market regulators the names of people who worked on a given transaction. The HCA list is 40 pages long, a person familiar with the matter says.

Though using offshore accounts for illegal trading is nothing new, technology is making such trading easier. "There appears to have been an increase in illegal insider-trading activity taking place outside the United States in U.S.-traded securities," said Randall Lee, director of the SEC's Pacific Regional Office. "With advances in technology and the increasing globalization we're seeing people engage in insider trading anywhere."

In the case of Tenaris's acquisition of Maverick Tube, the SEC said in a complaint filed in federal court in Chicago that several individuals used accounts in Buenos Aires to make more than $1.1 million in profits from purchases of U.S. shares and call options of the latter company. Tenaris is an oil-and-gas pipeline supplier owned by an Argentinean conglomerate; Maverick Tube is based in Chesterfield, Mo.

In the Petco case, the SEC this month asked a federal judge to freeze $862,000 of profits in offshore funds used to trade Petco options in advance of its sale to a private-equity group -- even though regulators didn't identify the traders.

The SEC used a similar tack last November when it obtained an emergency asset freeze against "unknown purchasers" of call options in Placer Dome Inc. stock, a few days before Barrick Gold Corp. made an offer to buy Placer. At least 5,000 of the options were under water and set to expire at the time of the purchase, the SEC alleged. The SEC estimated the buyers used overseas accounts to make improper gains totaling more than $1.9 million. Petco didn't return a call for comment.

The rise of derivatives markets -- less closely regulated than stock and bond trading -- also creates new opportunities for insider trading. Regulators in the U.S. and the United Kingdom recently have been studying credit-default swap prices, but it isn't clear whether that is a prelude to a formal investigation.

Trading in credit-default swaps takes place away from formal exchanges. Banks, hedge funds, money managers and other institutions enter into contracts directly with each other and trade them in the so-called over-the-counter market.

"You're talking about a very large and unregulated market which makes it hard to identify malfeasance or to ensure that people are abiding by the rules," said Chris Dialynas, a portfolio manager at bond behemoth Pacific Investment Management Co., or Pimco, a unit of Allianz AG. "The surveillance is low and the payoff is high -- that's a recipe for bad behavior."

Mr. Dialynas added that there aren't policing mechanisms or specific penalty systems in place for parties that trade credit derivatives using inside information. However, lawyers say that the SEC can probably find a way to bring cases against people or firms who buy and sell credit protection using inside information if it can be shown that fraud was involved in the transactions.

A few years back, four trade associations associated with debt markets jointly released a set of guidelines for banks with access to inside information about corporate borrowing plans.

"There's still lingering concern out there, but it's obvious to us that the large financial institutions have put in place internal barriers to prevent information from being shared across their divisions," says Kimberly Summe, general counsel for the International Swaps and Derivatives Association, one of the groups behind the guidelines.

--Mohammed Hadi contributed to this article.

Write to Serena Ng at serena.ng@wsj.com¹, Dennis K. Berman at dennis.berman@wsj.com² and Kara Scannell at kara.scannell@wsj.com³