Big Brokers Hit By Another Lawsuit
Liz Moyer, 04.20.06, 4:51 PM ET
Prime brokers are the targets of another lawsuit filed in recent days by a hedge fund claiming to have been charged excessive fees for stock loan services not provided.
Quark Fund LLC is seeking class action status in the anti-trust lawsuit, which names as defendants Bank of America (nyse: BAC - news - people ), Bear Stearns (nyse: BSC - news - people ), Citigroup (nyse: C - news - people ), Credit Suisse, Deutsche Bank (nyse: DB - news - people ), Goldman Sachs (nyse: GS - news - people ), Lehman, Merrill Lynch (nyse: MER - news - people ), Morgan Stanley (nyse: MWD - news - people ), UBS (nyse: UBS - news - people ) and unnamed individuals.
The suit is almost identical to one filed in New York federal court last Thursday by Electronic Trading Group, a brokerage firm, which also says the same 11 Wall Street firms earned "illicit" fees by taking advantage of their prime brokerage clients.
Prime brokers cater to hedge funds, providing basic services like stock lending, margin financing and derivatives transactions. Stock lending alone brings in an estimated $10 billion annually in revenues to the industry, according to Vodia Group, and it is a business that is little understood outside the back offices of the firms that provide the services.
The suits, both filed by law firm Entwistle & Cappucci, raise the issue of naked short selling, which happens when a short seller arranges a stock sale but the shares are not in his possession by the time the transaction is done. This creates a "failure to deliver," basically a broken trade. Stock exchanges keep lists of stocks that regularly fail to deliver, and these are the very same hard-to-locate stocks that are often said to be the victims of naked short-selling.
Hedge funds complain that when their trades fail to deliver because they end up paying a high fee to their prime brokers to locate and deliver shares without actually having those services provided. The lawsuit contends naked short selling wouldn't happen without the consent of the prime brokers, and it says prime brokers collude to maintain this system of phantom trading "to their individual and collective enrichment," shutting out the pension funds and other institutions that lent the shares as well as the traders.
More lawsuits against prime brokers are expected, and many observers who are not connected with the pending litigation say regulators are likely investigate prime brokers' roles in contributing to naked short selling.
"What we are seeing today is the beginning of a seismic change in the securities lending business," says Josh Galper, managing principal of Vodia Group, in a research report.
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