Federal prosecutors have launched a broad probe into price-gouging in the market for borrowed stock, targeting Wall Street firms that allegedly attach gratuitous finder's fees for arranging stock loans.

Among other things, prosecutors are probing allegations that employees of Wall Street trading desks are receiving kickbacks in return for lending stock, say lawyers familiar with the inquiry.

Stock lending has been a hot-button issue on Wall Street for a year, primarily for its role in an ongoing probe of short-selling abuses. But the finder's fee investigation is separate. It centers on a belief among regulators that some firms effectively impose a tax on small brokerages that are under intense pressure to locate and lend shares to hedge funds looking to make bearish bets.

The criminal investigation by federal prosecutors in New York is occurring in conjunction with regulatory investigations by the

New York Stock Exchange

and the

Securities and Exchange Commission

. The criminal probe is believed to be in its early stages, and no charges are imminent against any individuals, sources say.

A spokesman for Eastern District of New York U.S. Attorney Roslynn Mauskopf declined to comment. Also not commenting were spokesmen for the SEC and the NYSE.

Officials with

Bear Stearns



Goldman Sachs

(GS) - Get Report


Lehman Brothers



Merrill Lynch



Morgan Stanley

(MS) - Get Report

, all of which operate big stock lending desks, either declined to comment or said they were unaware of any criminal investigation.

The alleged improprieties that prosecutors are looking into are similar to ones outlined by the NYSE last week in a regulatory action against

Van der Moolen


, a Big Board specialist trading firm. The NYSE, in fining Van der Moolen $3.5 million, charged it with paying "unjustified finders' fees" to 29 friends and family members of its now-defunct stock-lending department.

Big Board regulators charged that the finders, all whom worked at other firms, did nothing to merit the fees they earned. The extra payments only served to "inappropriately" increase the cost of the transaction to the borrower of stock from Van der Moolen. The payments were often embedded in the fees paid by the borrower to the lender.

"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.

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


(CSCO) - Get Report

, 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


(NFLX) - Get Report

, 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.