Feds Launch Probe of Stock Loan Abuses

"The firm obtained business, including legitimate business, which it might not have had but for its willingness to participate in these improper transactions," the NYSE said in its complaint against Van der Moolen.

Stock lending can be a profitable business for Wall Street firms, given the daily demand from hedge funds and other big traders for shares to sell short. In a short sale, a bearish trader borrows stock, sells it, then hopes to repay the loan later with stock purchased at a lower price. In the vast majority of cases, the transaction is a simple one for the brokerages, which normally keep an inventory of shares on hand to lend to clients.

A difficulty arises when too many people want to borrow the same shares. In those cases, brokerages trying to service big customers often resort to borrowing shares themselves and re-lending them to the client. In these cases, stock finders can be useful in helping firms track down shares to borrow.

But investigators are targeting those situations in which a finder serves no legitimate business function in tracking down shares to lend, other than simply lining his own pocket.

Stock lending, as critical as it is to keeping Wall Street running smoothly, is something of a backwater operation in the securities industry and is ripe for abuse. There's little transparency in the operation of a stock-lending desk. Wall Street firms have great freedom in setting the terms of loans, and many stock-loan finders are largely unregulated.

Indeed, the current criminal and regulatory investigations are reminiscent of a similar crackdown nearly two decades ago that led to a number of fines and criminal convictions against a group of disreputable stock-loan finders.

In one case, the SEC charged two stock-loan finder firms with collecting $50,000 in improper fees for arranging $127 million in phony stock loans between Merrill Lynch and another brokerage. The SEC charged that the finders had arranged for a small brokerage to lend stock to Merrill Lynch, even though Merrill Lynch had never agreed to borrow the shares.