S.E.C. Is Looking at Stock Trading

The Securities and Exchange Commission has begun a broad examination into whether Wall Street bank employees are leaking information about big trades to favored clients, like hedge funds, in an effort to curry favor with those clients, executives at Wall Street banks said.

The inquiry, these people said, seems aimed at determining how pervasive insider trading, or the illegal use of market-moving nonpublic information, may be on Wall Street. Knowledge about a large trade, like the sale of a big block of stock by the mutual fund giant Fidelity, would tell a trader which way the stock would move.

Trading ahead of client orders, or front-running, has long been an issue on Wall Street. Large mutual fund companies have often complained in the past that Wall Street brokerage firms were front-running their trades, using information about the funds’ plans to buy or sell to make a risk-free bet on a stock’s direction.

But the latest S.E.C. investigation appears to have a new twist: Rather than examine whether a bank is trading ahead of its own client by using knowledge of the customer’s trade, the scope of the investigation will allow regulators to see if banks tip their valued customers who then go trade at another bank, making the paper trail harder to detect.

The commission sent out letters in mid-January to the major Wall Street banks, including Merrill Lynch, Morgan Stanley, UBS and Deutsche Bank. The commission, according to one Wall Street employee, is requesting a wide swath of information: all stock and option trading data, for themselves and their customers, for the last two weeks of September. Those weeks are the close of the third quarter and investigators may be looking to see any pickup in trading activity as money mangers sought to dress up their returns.

Representatives for the Wall Street banks declined to comment on the investigation.

“Mutual fund traders have long complained that their big trades may be being front-run by market participants with inside information about their trades, and they believe the price on those trades suffers as a result,” said Lori Richards, the director of the Office of Compliance Inspections and Examinations at the S.E.C. “We are looking into these allegations in a systemic way. It is fact-finding and too early for any conclusions.”

The S.E.C. confirmed the existence of the investigation but declined to comment further.

Concerns about insider trading have escalated as mergers and buyouts have boomed and the use of complex derivatives has soared. Studies of various markets — including those for stocks and credit default swaps — have pointed to an unusual amount of trading ahead of announcements for deals.

The growing power of hedge funds — and their opaqueness and the wide range of trading strategies they employ — is feeding those concerns. Hedge funds control an estimated 30 percent to 50 percent of trading on most major markets. They are also Wall Street’s best customers. Hedge funds trade, borrow and finance more, on average, than other clients And as more hedge funds enter a crowded field, the premium on information has never been higher.

With data on millions of trades from most major Wall Street banks, the S.E.C. will try to examine whether outside traders like hedge funds or internal traders like those inside the firm who are trading with the bank’s money may be getting tips from the bank handling the mutual fund’s trade and using the information to place a trade elsewhere.

“If an investment bank is tipping a hedge fund on a trade we are doing on Dell, those people all need to go to jail,” said Andrew M. Brooks, vice president and head of equity trading at T. Rowe Price, the mutual fund company. “We are absolutely concerned and worried and paranoid about information leakage, information that would allow someone to know about our trades and run ahead.”

If the commission finds any evidence of possible insider trading, it would then commence a formal investigation. The S.E.C. could ultimately bring civil charges against individuals or firms.

Regulators and law enforcement officials have pursued other cases related to the sharing of information about trades. In what became known as the squawk box case, brokers from institutions, including Merrill Lynch, Citigroup and Lehman Brothers, were accused of allowing traders to listen in on the public outcry system — the squawk box on the trading floors — to glean tips about customer orders coming in.

The S.E.C. sued the A. B. Watley Group and 16 people in the case. Next month, the United States attorney’s office in Brooklyn will bring to trial a case against seven people. Two have pleaded guilty to insider trading. While the accusations in the squawk box case involve an obvious dissemination of insider information, detecting whether traders were illegally tipped in huge, fast-moving markets is much harder.

When Linda Chatman Thomsen, head of enforcement at the S.E.C., testified before Congress in September about insider trading, she outlined some of the problems inherent in such cases.

“Piecing together an insider trading case can be a complex and painstaking process,” she said. “It is rare to find a ‘smoking gun’; virtually all insider trading cases hinge on circumstantial evidence. It is quite common for insider traders to come up with alternative rationales for their trading — rationales that the staff must refute with inferences drawn from the timing of the trades, the movement of the funds and other facts and circumstances.”

There are many gray areas. If Mr. Brooks of T. Rowe Price wants to sell stock in the XYZ Company and he hires a bank to do that, the bank has to call clients to gauge interest in the stock. That is not tipping, but legitimate work for the bank to do.

And detecting any trades will be difficult. If a trader received a tip about a stock whose price was set to rise, that trader could enter into trades that are harder for regulators to detect — like derivatives transactions that are not traded on any exchange and whose value may be linked to a change in a stock price rather than the stock itself or an option on the stock.

Here’s how a questionable trade might take place: If Fidelity asked brokerage firm X to sell a large part of its stake in I.B.M., and traders at that brokerage firm told its favorite clients to expect a drop in I.B.M.’s price as a result, that favorite client could go to another brokerage firm — or group of banks or trading venues — and sell I.B.M. shares short, betting on a decline and making money when Fidelity’s order went through. The trader could pay back the source of the tip by directing more business to his bank.

“The information is going to the bank as an agent, and the bank is only supposed to use the information for the mutual fund’s benefit,” said Larry E. Ribstein, a professor of law at the University of Illinois. “If it uses it for someone else’s benefit, you might have a concern.”

The hedge fund business has long argued that it is unfairly tarnished with suggestions of insider trading. Amid increased scrutiny by regulators into hedge funds’ use of information in the loan market, the Managed Funds Association said in a statement last year, “We reaffirm our collective commitment to promote fair and competitive markets in which inappropriate use of material nonpublic information is not tolerated.”

Some money managers disagree.

“Hedge funds pay a lot in commissions,” said Mr. Brooks of T. Rowe Price. “They are smart and work hard, but they can’t be that smart and work that hard to get some of the advantages they have gotten.”

“There are too many conflicts of interest between those who serve hedge funds and hedge funds themselves