Adviser Eyed in Morgan Stanley Theft Probe

Updated from 7:41 a.m. EDT

S3 Partners, a hedge fund advisory firm, is attracting some unwanted attention following last week's arrest of a New York man on charges of pilfering top-secret computer files about Morgan Stanley's ( MS) clients.

Federal prosecutors on Friday charged Ira Chilowitz, a former Morgan Stanley consultant, with stealing the confidential pricing information from Morgan Stanley's hedge fund prime brokerage group and passing it on to a "co-conspirator'' at a midtown company that provides advisory services to hedge funds.

Prosecutors in Manhattan did not identify either the co-conspirator or the firm. But people familiar with the investigation confirmed that the firm is S3 and that the unidentified co-conspirator is a former director. These same people say the former S3 director, who previously worked in Morgan Stanley's prime brokerage group, was recently fired.

A representative for S3 declined to comment. A spokesman for Michael Garcia, U.S. attorney for the southern district, declined to comment. A lawyer for Chilowitz did not return several phone calls.

A Morgan Stanley spokesman says prosecutors took action after Morgan Stanley notified them about the "misappropriation of proprietary and confidential'' information.

The stolen information is of great value to Morgan Stanley because it reveals that not all its hedge funds pay the same price for various prime brokerage services. In the wrong hands, the information could give hedge funds leverage in negotiating payment schedules with the big Wall Street firm.

S3 was founded by Robert Sloan, the former head of prime brokerage at Credit Suisse, in June 2003. The firm provides a wide array of services ranging from helping hedge funds negotiate prime brokerage fees to managing money to working with small brokerages in arranging stock loans. The 14-employee shop, which has a number of former executives from Morgan Stanley, Lehman Brothers ( LEH), Barclays Capital ( BCS) and Deutsche Bank ( DB), has $618 million in client assets under management.

S3's relationships span Wall Street. The firm is partially owned by Knight Capital Group ( NITE), one of the largest Nasdaq Stock Market trading-execution firms. Knight and S3 established a strategic partnership in January 2005, in which S3 offers some managementservices to Knight's hedge fund clients.

There are no indications that prosecutors suspect any wrongdoing on the part of S3 or Sloan. A person close to Morgan Stanley says the big Wall Street firm still does business with S3.

The former S3 director, who joined the three-year-old firm last July, had worked for eight years as a client-service representative in Morgan Stanley's prime brokerage operation. A press release announcing his arrival at S3 is no longer posted on the advisory firm's Web site.

But a copy of the press release, turned up during a online search, describes the former S3 director as a former Morgan Stanley vice president in prime brokerage, who had a managerial role. A source close to Morgan Stanley says that description is inaccurate.

The former director has not been charged by prosecutors with any wrongdoing. But prosecutors allege Chilowitz and the unidentified co-conspirator planned to use the stolen information to either build a new business or help the co-conspirator in his current job.

The FBI agent investigating the matter says, in a court affidavit, the two men had put together a business plan about helping hedge funds get the best deal on prime brokerage services from Morgan Stanley. The agent says the co-conspirator sent an email to Chilowitz discussing the plan, which concludes: "Here's to a great 2006 for both of us.''

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