When Ivan F. Boesky’s book, “Merger Mania,” came out in 1985, it was thick with fancy arithmetic that purported to explain how Wall Street’s most powerful arbitrager, or speculator in takeover stocks, had made his millions. People who read it thought Boesky was a pretty smart guy.
They had second thoughts the following year, however, when Boesky pleaded guilty to a list of insider trading violations and gave up $100 million in fines and illegal profits. People began to wonder whether the arbitragers were so smart after all, or whether they had been making piles of money by simply gathering secret information on upcoming takeover deals.
Such suspicions have given the business an image problem that continues to dog it. And suspicions may mount after Wednesday’s announcement that a federal grand jury in Manhattan indicted three arbitragers and two firms for insider trading violations.
“There’s been a feeling out there that a lot of their success has been due not to informed investing, but to getting information from a lot of illicit sources,” says Alan Bromberg, professor of securities law at Southern Methodist University. Since the insider trading scandal began to unfold in 1986, “it has looked like some of the most successful of them have had lots of that information.”
Risk arbitragers are people who make a sophisticated bet on the outcome of a possible takeover. They buy huge blocks of stock in anticipation that a merger will be completed and can make millions if the acquirer ultimately buys up a company’s shares at a higher price than they paid.
The arbs, as they are called, can also lose millions if the deal falls apart and the stock sinks.
To make sure they bet correctly, arbitragers spend their day gathering information on the prospective takeover from myriad sources. They pore over public documents. They talk to Wall Street traders, company officials, investment bankers, takeover lawyers, other arbitragers--or anyone else who may know anything about a deal.
Some, such as Boesky, have hired squads of detectives to trail executives or stake out corporate headquarters to watch for the comings and goings of deal makers.
But it has become apparent in the past 2 1/2 years that they also turn to illicit sources of information. Boesky, who commanded a $3-billion pool of speculation capital before his fall, had a worldwide network of informants.
Among them was Dennis B. Levine, the former investment banker who made $12.6 million trading 54 takeover stocks and whose fall in May, 1986, began Wall Street’s biggest scandal. Levine, in turn, gathered information from his own network and passed on some of it to arbitragers such as Boesky.
Another insider trading ring, the young Wall Street professionals called the “Yuppie Five,” included a member of the arbitrage department of Marcus Schloss & Co., one of the companies indicted Wednesday. Their information came from one member, lawyer Michael David, who illegally gathered it from his employer, the prominent law firm of Paul, Weiss, Rifkind, Wharton & Garrison.
The cases “have put a real taint on us, and it’s still there,” says Sharon J. Kalin, president of an arbitrage firm called Athene-Coronado Management. “People always wonder whether your information is clean. And frankly, with some people (in this business), it isn’t.”
Sen. William Proxmire (D-Wis.), the retiring chairman of the Senate Banking Committee, has warned of the conflicts of interest he says exist in the Wall Street firms that arrange mergers but also have arbitrage desks that speculate on their outcome.
‘Chinese Walls’ Fall
The companies are supposed to have “Chinese walls” that prohibit the mergers and arbitrage departments from communicating with each other. The purpose of these restrictions is to prevent merger secrets from flowing from one department to the other. But Proxmire and others have questioned whether such “walls” have been effective.
Martin A. Siegel, the Wall Street takeover star who pleaded guilty to insider trading charges in February, 1987, headed the mergers department of Kidder, Peabody & Co. at the same time that he was setting up the firm’s risk arbitrage unit. Kidder agreed to close down the arbitrage department in June, 1987, as part of its settlement of securities violation charges with the Securities and Exchange Commission.
A study prepared for Proxmire by the SEC found last year that 25 of 31 arbitrage firms surveyed acknowledged that they had invested in potential takeover targets before there had been any public disclosure of takeover bids. The finding suggests that there may have been leaks of inside information.
The study also found that the 31 firms had made $1.11 billion between 1984 and 1986.
Last year, a Proxmire-sponsored bill called for the registering of arbitragers. The bill went nowhere, and other securities experts wonder whether that step, or other regulation of arbs, could be effective.
“It’s hard to define the takeover situation where you think they shouldn’t be making money,” said Helen Scott, securities law professor at New York University.
And, as the arbs point out, they do serve the beneficial function of buying up stock after takeover bids have been announced. By doing so, they are shouldering the risk that the deal will fall through.
And their buying allows other stockholders to sell out. Many institutional investors like to sell their stock as soon as a takeover deal has been announced so they can claim their profits and move on to other investments, said Kalin, whose firm invests $75 million.
The amount of money controlled by risk arbitragers grew rapidly during the late 1970s and 1980s as the takeover boom accelerated. Many firms pulled back, however, after the twin shocks of the corruption scandal and the devastating crash of October, 1987.
By the end of last year, some arbitragers believed that half of arbitragers’ assets had evaporated from crash losses and the withdrawal of funds by frightened investors. A number of arbitrage operations were closed down, including those of the Smith Barney investment firm and of Comdisco, a big Miwestern leasing outfit.
But some in the business say money has been gushing back this year due to the continuing stream of mergers. There are now, they note, some $60 billion in pending takeover deals. “As long as there is money to be made, there will be arbs there,” says NYU’s Scott.
HOW ARBITRAGERS OPERATE: A HYPOTHETICAL CASE XYZ Corp., whose stock has been languishing at $40 a share, receives a $60-a-share takeover bid from corporate raider Acme Widgets. XYZ shares jump $17 as longtime stockholders sell and speculators buy. Arbitrage firm Arbs & Co., believing the bid will succeed, buys 100,000 shares of XYZ at $57. XYZ quickly agrees to the takeover at $60. Arbs & Co. sells its shares at $60, realizing a quick $300,000 profit. XYZ fights the takeover for months, forcing Acme to raise its bid to $80 a share, which is accepted. Arbs & Co. sells at $80, realizing a $2.3-million profit. XYZ fights the takeover for months, and Acme eventually drops its bid. XYZ shares immediately fall to $40. Arbs & Co. sells at $40, taking a $1.7-million loss.