Insider Scandals Reveal Cracks in ‘Chinese Wall’
When Staley Continental last week sued the investment firm of Drexel Burnham Lambert, charging that its traders tried to bully the Illinois food company into hiring Drexel as an investment banker, it meant more than some extra controversy for Drexel, already notorious for financing bitter corporate takeovers.
The charges, vigorously denied by Drexel, brought fresh attention to an old, yet unresolved, controversy: whether Wall Street is riddled with conflicts of interest, and whether the safeguards against potential abuses are adequate.
Wall Street firms have long maintained that there is a “Chinese Wall”--a term the industry coined years ago--that separates their various departments. For example, traders in many instances are supposed to operate independently of investment bankers who make merger deals or arrange financing for corporate clients.
Investment bankers are obligated to protect a client’s non-public information, yet brokers or traders seek to make money through well-informed investment decisions. Traders obviously can make easy money if they know in advance of deals being cooked up by their investment banking colleagues. And investment bankers aren’t supposed to line up clients by threatening to have their colleagues in the trading department throw the market for a company’s stock into disarray, as Staley Continental alleges Drexel did.
Trading and investment banking are supposed to coexist on opposite sides of the Chinese Wall, until a deal becomes imminent and trading legally must be halted in the investment banking client’s securities.
Now critics question the strength of those self-erected walls amid the arrest or conviction of nearly a dozen top Wall Street executives on insider trading charges. “They have a wall, but it’s made of Swiss cheese,” says Kenneth McLean, staff director of the Senate Banking Committee, which is investigating potential abuses and weighing legislative reform.
Charges earlier this month against Robert M. Freeman, a top trader at Goldman, Sachs & Co., illustrate what critics say is a breach of the Chinese Wall. The government alleges that Freeman obtained confidential information about one or more of Goldman’s investment banking clients. As a trader, he should not have been privvy to details of the deals.
Freeman was accused of passing the inside information to Martin A. Siegel, the former top mergers specialist at Kidder, Peabody & Co. Siegel, for his part, has already pleaded guilty to accepting a tip from Freeman and passing it to Kidder Peabody’s department specializing in arbitrage--an activity that involves speculating in the stocks of firms involved in takeover attempts. Presumably, Siegel also breached a Chinese Wall to communicate with his firm’s arbitrageurs.
Investment houses have had policies to curb the flow of confidential information ever since the Securities and Exchange Commission narrowly recommended to Congress more than 50 years ago that Wall Street firms be allowed to trade securities and make finance deals under one roof.
The SEC does not dictate what the policies should be. However, in the 1968 settlement of a case against Merrill Lynch, Pierce, Fenner & Smith, the agency made clear that it expects to see a Chinese Wall between various departments. And in 1980, federal securities laws were strengthened to penalize those who communicate insider tips about tender offers.
Despite these efforts, recent maneuvers by some corporate raiders, arbitrageurs and investment bankers have prompted fresh concern in at least three areas. How diligently does a firm instruct its employees about its Chinese Wall policies? Can arbitrageurs be successfully walled off from other units of a Wall Street firm? And finally, should investment bankers or traders accept seats on a client’s board of directors?
Spokesmen at four big Wall Street firms--Drexel; Goldman, Sachs; Merrill Lynch and Bear, Stearns--flatly refused to discuss such issues last week.
Wary of Commenting
“Merrill Lynch’s compliance procedures are believed to be among the finest in the industry and, since we are not involved in the current controversy, we wish to say no more,” said William Clark, vice president of media relations.
Executives at several other firms spoke only on the condition that they not be identified. Some said their firms did not want to invite congressional subpoenas to testify about their practices; others said they wanted to avoid boasting publicly about their precautions, lest one of their own executives be exposed in coming weeks.
Privately, new recruits in two firms’ mergers and acquisitions units said last week that despite the hoopla over insider trading, they’ve never been instructed by their superiors whether they should talk to arbitrageurs. The newcomers added, however, that they’ve never been contacted by such a trader.
At a third firm, a more seasoned mergers specialist said he did not believe that the firm’s arbitrageurs called upon his unit “a lot.” In his personal experience, he said he cannot recall a single query from one of his firm’s arbitrageurs, although “we get outside arbs calling all the time.”
Getting the Facts
Instead, he said, “We would call the arbs,” to ask why a client’s stock was behaving in an unexplained way. The mergers specialist might ask, “ ‘What are you hearing?’ ” he said, adding, “It used to be they heard a lot.”
There is no suggestion of criminal wrongdoing, but those quests for information appear diametrically opposed to his firm’s policy. In a separate interview, the same firm’s in-house lawyer insisted that a mergers specialist “may not communicate with any trader, including an arbitrageur.”
At another major firm, however, a spokesman expressed a more lenient view. “Wouldn’t it be perfectly normal for (a top arbitrageur) to try and get as many facts as possible on any deal?” the spokesman asked, adding that it would not be unusual for an arb to call his own mergers department.
“Who are you going to rely on in this world more than your own people?” the spokesman asked. If the mergers specialist had inside information, he could handle the conflict by replying, “ ‘Sorry, we can’t comment,’ ” the spokesman said.
Only one banking executive contacted by The Times agreed to speak on the record.
Herbert A. Allen, president and chief executive of Allen & Co., spoke skeptically of the Chinese Wall at most large, high-pressure firms. With rare exceptions, he said, “you can’t build” a wall that blocks the swapping of information. Large firms make “bone-crushing” demands of their deal makers and brokers to succeed, he said, “because of the (costly) overhead and the need to compete.”
Allen & Co. is an aberration, he said, because it has only 20 senior people yet handles deals for companies as large as Coca-Cola Co. In addition, the firm’s arbitrageur limits his trading to “announced deals,” Allen said, “so there’s no question about getting inside information.”
At a smaller firm, where dealmakers and traders may share the same room, the conflicts are resolved in just one way. “You make a choice: one or the other,” Allen said.
Complete segregation of traders and dealers was contemplated in the 1930s, after a reform-minded Congress passed the Glass-Steagall Act to separate commercial and investment banking.
In recent years, scholars and prominent securities lawyers have continued to argue that companies and investors are served more efficiently by firms engaged in a variety of investment activities, and that conflicts can be handled by self-regulation and existing laws. Irving Pollack, a Maryland attorney who headed the SEC’s enforcement unit from 1960 to 1972, notes that Great Britain recently ended its segregation of traders and dealers.
Torn in Allegiance
Yet another controversy involves the widespread practice of investment bankers accepting seats on a client’s board. Larry L. Varn, a Boston attorney who addressed Chinese Wall problems in a Nebraska Law Review article three years ago, reserved some of his toughest criticism for the practice.
Varn noted that an investment banker who accepts a director’s seat can be torn in allegiance, particularly if his firm helped the client go public by selling stock to a number of the firm’s older customers, and “the (new) company’s prospects unexpectedly go sour.” Investment firms may feel obligated to alert those who bought the stock so that they don’t lose money. Varn wrote that “the incentives to cheat may not be adequately ameliorated by other considerations.”
Freeman, the Goldman, Sachs trader arrested 10 days ago, served as a director on a company controlled by David H. Murdock, one of the firm’s clients. Government lawyers said Freeman passed inside information to Siegel about Murdock’s plan to bid for Continental Group. Siegel has pleaded guilty to acting on the tip.
The government has not detailed whether it believes Freeman obtained the information about Murdock’s plans from Goldman’s investment banking unit or from his participation on Murdock’s board. Murdock has said the deal was proposed by Geoffrey T. Boisi, a Goldman, Sachs mergers specialist.
