Feds Launch Probe of Stock Loan Abuses

A year ago, the NYSE issued an advisory notice cautioning firms on the use of finders, saying in most instances there was no justification for getting a middleman involved in a stock loan. The advisory says there are "only limited instances where a finder is actually providing services that an effective internal stock loan department could not provide.''

It's easy to see why regulators and prosecutors take a dim view of stock-loan finders. The service they claim to provide -- finding shares to borrow -- can be almost always be handled by normal brokerage employees with access to other trading desks around Wall Street.

Another complicating factor is the opacity of the stock loan fee structure. In a typical stock loan, the person borrowing the stock puts up cash collateral in case he can't replace or "cover" the stock when the loan comes due. That money is invested in an interest-bearing account. Interest on that deposit is sometimes pocketed by the lender as his finder's fee.

In some instances, a lender might "rebate" a portion of the interest earned to the borrower, depending on how widely available a stock's shares are in the market. With a widely traded stock such as Cisco(CSCO Quote), a borrower can expect to get back a big chunk of the interest earned on the collateral, since it's relatively easy for the Wall Street firm to dole out those shares.

But with a stock with fewer shares available to lend out, such as Netflix(NFLX Quote), a lender might keep all of the interest earned on the collateral.

In theory, a finder should come into play only when a broker or hedge fund is trying to locate shares for a hard-to-borrow stock. But people familiar with the inquiry say finders have been collecting payments for arranging stock loans for readily available shares of big-cap stocks.

Most finders operate by word of mouth. The stock-loan finders don't readily advertise their services. Sources say that many people who serve as finders are former brokers who have been drummed out of the business for regulatory infractions.