Regulators Subpoena Hedge Funds, Others over Actions Ahead of S&P Downgrade
Securities regulators have sent subpoenas to hedge funds, specialized trading shops and other firms as they probe possible insider trading before the U.S. government's long-term credit rating was cut last month, people familiar with the matter said.
Securities and Exchange Commission officials demanded more information about specific trades made shortly before Standard & Poor's Corp. downgraded the U.S. to double-A-plus from triple-A on Aug. 5, these people said. SEC officials are zeroing in on firms that bet the stock market would tumble.
Those trades could have reaped huge profits when the Dow Jones Industrial Average sank 5.5% on Aug. 8, a 634.76-point decline in the first day of trading after S&P announced it yanked the government's top-tier credit rating.
It isn't clear which investment firms have received subpoenas, and an SEC spokesman declined to comment Monday. But the subpoenas are unusually broad, seeking information about why certain trades were made, according to a person familiar with the matter.
Some of the recipients also were asked which person at their investment firm first heard about the S&P downgrade, when they were told about it and by whom, this person said. SEC officials are working closely with the Financial Industry Regulatory Authority, or Finra, a self-regulator of Wall Street that uses sophisticated computer programs to trawl through mountains of reports of trades every day on major stock exchanges.
Rumors that a downgrade was imminent cascaded through trading desks for most of Friday, Aug. 5, whipsawing stock markets for several hours before S&P announced its historic decision at about 8:15 p.m. On Monday, Aug. 8, the first day of U.S. trading after the downgrade, the Dow had its sharpest one-day decline since the financial crisis in 2008. Stock markets have remained volatile since then.
The SEC could face an uphill battle proving that anyone profited from the downgrade by using inside information. While the SEC has asked Finra officials to scrutinize trading in securities that track major indexes like the S&P 500 and Russell 2000, there are lots of other reasons why investors have bet against the stock market recently, including Europe 's woes and the struggling economy.
Another challenge: Traders and investors who knew a downgrade was coming could bet against the market in a slew of different ways, including options and exchange-traded funds.
People familiar with the matter said SEC officials have asked Finra's specialized surveillance unit to look hard for bearish trades that seem unusually large or were made by investment firms that wouldn't normally make such trades.
It isn't clear if securities regulators also are looking at trading of U.S. Treasurys. Inside information might not have been a blessing with these securities. Investors who bet against U.S. government debt suffered losses immediately after S&P's downgrade because rattled stock investors retreated into Treasurys as a safe haven. Such losses wouldn't be a defense against accusations of insider trading, lawyers said.
The Finra surveillance unit monitors most U.S. stock markets, covering more than 10,000 publicly traded securities. Officials are constantly eyeing trading records and patterns for suspicious trading, such as purchases of stock in companies just before acquisition announcements or disappointing earnings. A Finra spokeswoman declined to comment Monday.
SEC officials began reviewing the downgrade shortly after it occurred, starting with inquiries by the agency's examination staff. Since then, the matter has broadened into a full-blown investigation by the agency's enforcement division. As part of the probe, the SEC has asked S&P, a unit of McGraw-Hill Cos., to disclose which employees knew in advance that the firm would downgrade the U.S. , according to people familiar with the matter. Rival rating firms Moody's Corp. and Fimalac SA's Fitch Ratings still rate the U.S. triple-A.
In a statement, a spokesman for S&P said that the firm has "robust policies that prohibit analysts or rating committee members from trading and holding securities or options of the companies or governments they rate." The spokesman added that the firm has "longstanding policies and procedures regarding the appropriate handling, use and protection of confidential information." The spokesman declined to comment about whether the firm had received a subpoena from the SEC, saying, "We are in regular communication and cooperate with inquiries made by our regulators."
Weeks before the downgrade, S&P officials held private meetings with large bond investors, causing some to conclude that the chance of a credit-rating cut was higher than they had previously thought, as The Wall Street Journal reported earlier this month.
The bond investors included Allianz SE's Pacific Investment Management Co., Los Angeles-based TCW Group Inc., Legg Mason Inc.'s Western Asset Management and New York asset-management giant BlackRock Inc., according to people familiar with the matter.
It couldn't be determined Monday if any of those firms was subpoenaed by the SEC. A spokesman for TCW Group said Monday the firm hasn't received a subpoena. Western Asset Management hasn't received a subpoena, wrote Stephen Walsh, the firm's chief investment officer, in an email. A BlackRock spokesman declined to comment. A spokesman for Pacific Investment Management didn't respond to a request for comment.
In another challenge for the SEC, there is no specific regulatory rule barring rating firms from discussing their ratings and analysis with selected groups, though rating firms must have written policies to prevent the misuse of material, nonpublic information.
The SEC's decision to ratchet up its investigation doesn't mean the agency has amassed any evidence of wrongdoing or that it will decide to file any charges, according to lawyers who aren't involved in the probe.
Some of the lawyers said the SEC has a duty as the nation's top securities regulator to determine if an enforcement action is needed, especially because of the downgrade's impact on financial markets.
"It was such an important event [that] the SEC would be remiss not to look at whatever evidence is available," said Jacob Frenkel, a former SEC enforcement lawyer who now is a partner at law firm Shulman, Rogers, Gandal, Pordy & Ecker in Potomac, Md. "That civil investigation doesn't mean there was fraud. And even if there was insider trading, it could prove nearly impossible to bring a successful case."
To win an insider-trading case related to the downgrade, SEC officials likely would need to show that an investor made trades as a direct result of a leak from officials at S&P or the Treasury Department who knew about the downgrade before it was announced, he said.
—Matt Phillips and Jeannette Neumann contributed to this article.