Updated from 10:32 a.m. EST

James J. McDermott Jr., former chairman and chief executive of

Keefe, Bruyette & Woods

, has been arrested and charged with two counts of securities fraud for providing insider trading information to Kathryn Gannon, a pornographic film star, the

Securities and Exchange Commission

said Tuesday.

The SEC, which began its investigation of McDermott in April 1999, said Keefe, Bruyette, a privately run Wall Street investment firm, canceled its planned initial public offering as a result of the investigation. Two months later, the firm forced McDermott to resign after 21 years with the company.

Keefe, Bruyette, which specializes in banking and financial services, was expected to raise $85 million in the IPO. At the time, Keefe, Bruyette did not disclose the reasons for the cancellation, but McDermott, who was the fourth-largest shareholder, would have increased his stake by $16 million had the IPO gone through, the SEC said.

McDermott, who lives in Briarcliff Manor, N.Y., surrendered to FBI agents on Tuesday. Anthony Pomponio, a friend of Gannon, who has been charged with two counts of securities fraud as well as perjury, was arrested at his home in North Caldwell, N.J. Gannon has been charged with two counts of securities fraud, the SEC said.

McDermott and Pomponio were arraigned Tuesday afternoon in Manhattan federal court to face the criminal charges brought by

U.S. Attorney for the Southern District of New York

.

U.S. Magistrate Judge Theodore Katz released McDermott on a $1 million personal bond secured by $100,000 in cash. Pomponio was released on a $50,000 personal bond. Both men were required to surrender their passports and travel restrictions were imposed. A preliminary hearing was set for Jan. 20.

The U.S. attorney's office has issued a warrant for Gannon's arrest. Federal authorities believe Gannon, a Canadian who resides in Miami, has fled to Canada.

Thomas F.X. Dunn, a lawyer for Pomponio, said his client looks forward to addressing the charges and plans to plead not guilty. Attorneys for McDermott and Gannon did not return calls for comment.

If convicted of the criminal charges, the defendants each face a maximum prison term of up to five years for conspiracy and up to 10 years for insider trading plus fines of up to $1.25 million. Pomponio also faces up to five years in prison for perjury and an additional fine of up to $250,000.

According to the SEC's civil complaint, Gannon, who goes by the screen name Marylin Star and also works as an escort and an exotic dancer, made more than $88,000 from June 1997 through April 1998 using information McDermott provided her regarding six potential and actual bank mergers and acquisitions.

During that time, the SEC said McDermott, who was serving as chairman and chief executive of Keefe, Bruyette, was having an "intimate relationship" with Gannon.

The SEC said McDermott disclosed inside information to Gannon concerning potential acquisition transactions involving Keefe, Bruyette & Woods' clients, including

Sun Trust

(STI) - Get Report

,

National Australia Bank

( NAB),

Central Fidelity Banks

,

First Commerce

,

First Commercial

and

California State Bank

.

McDermott, 48, also transferred at least $37,000 to Gannon, 30, via certified checks and wire transfers, some of which came from a joint bank account he held with his wife at

Chase Manhattan Bank

in New York, the court papers said.

The SEC's civil complaint alleged that Gannon also tipped off Pomponio, 45, who used the information to trade in advance of the bank mergers. The SEC also said he reaped profits of more than $86,000 using the information.

The SEC investigation centered around a suspicious trading pattern that evolved from June 1997 to February 1998.

According to the court documents, Gannon, who had little prior trading experience, opened a brokerage account at

Charles Schwab

on June 13, 1997, with an initial deposit of $25,800. One month later, Pomponio, a novice investor, also opened an account at the same brokerage.

Over the next eight months, Gannon and Pomponio both bought approximately the same number of shares at roughly the same time in Keefe, Bruyette's client companies, the lesser-known regional banks.

The SEC said McDermott admitted that he had recommended stocks to a friend, including the stocks of Keefe, Bruyette's clients, but denied he had violated any of his firm's policies or confidentiality rules.

In October, Pomponio testified at an SEC hearing, attributing the timing of one of the transactions he was questioned about to "sheer coincidence."

Pomponio said Gannon frequently boasted that her clientele included Wall Street investment bankers and lawyers and claimed to have only inferred that Gannon was trading in bank stocks based on her contacts with her high-flying customers.

Pomponio, who is a majority owner of an industrial diamond wheel manufacturing company called

Pomponio Industries

, first met Gannon at a trade show for the pornographic film industry in Atlantic City, N.J., the SEC said.

In April 1999, Gannon was subpoenaed but she pleaded the fifth and did not testify.

The SEC, which is continuing its investigation, said it is seeking compensation for any ill-gotten gains, prejudgment interest and civil monetary penalties.