Renewed case peers at hedge fund

SEC dropped early review, but new revelations force agency’s hand

In May, Arthur Samberg said he was shutting down Pequot Capital Management. In May, Arthur Samberg said he was shutting down Pequot Capital Management.
By Scot J. Paltrow
Globe Correspondent / September 6, 2009

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In 2005, just as the peril to his business and reputation looked most dire, legendary hedge fund pioneer Arthur Samberg got a surprise reprieve.

The Securities and Exchange Commission was zeroing in on evidence investigators believed showed that the vaunted high returns to investors in his Pequot Capital Management had been boosted by illegal tips of inside information. The suspected leaks involved several of the biggest US companies, including Microsoft Corp. and General Electric Co., and leading Wall Street figures such as John Mack, now Morgan Stanley’s chairman and chief executive.

As the investigation reached a fever pitch, though, the SEC abruptly backed off. Soon it dropped the case without filing charges.

But beginning late last year, new evidence came from an unlikely source: a Connecticut divorce case. The evidence forced the SEC to reopen its investigation - and led to a criminal inquiry by federal prosecutors in New York.

Samberg has denied any wrongdoing. But in a surprise move in May, Samberg said he was shutting down Pequot, citing adverse effects of the investigation. And last month, he disclosed that the SEC had issued a “Wells notice,’’ an official notification that charges are likely to be filed.

Through a spokesman, Jonathan Gasthalte, Samberg declined to comment for this article. But in an Aug. 10 letter to investors, Samberg said: “We believe the Wells Notices and any resulting enforcement action are without merit and intend to defend the matter vigorously.’’

It now looks as though the original abandoned inquiry was another instance in which the SEC walked away from promising inquiries involving titans of the investment world, as it did in the high-profile case of Bernard Madoff, who is now serving a 150-year sentence for running the largest Ponzi scheme in history. The investor protection agency had investigated Madoff’s investment fund several times, but the inquiries were dropped after it found no signs of any serious problems. Last week, the agency’s inspector general faulted it for bungling investigations that could have uncovered the Madoff scheme earlier.

Samberg, now 68, had been a founder of the hedge fund industry, in 1986 launching with a partner one of the first such firms. At its peak in the late 1990s, the firm had over $15 billion under management. Westport, Conn.-based Pequot, formed in 1998 after Samberg split with the partner, had a wide-ranging coterie of investors, including New England institutions and wealthy individuals, and it had a satellite office in Wellesley. In a May letter to investors announcing Pequot’s closing, Samberg noted that one of his longest-running funds had paid an average annual return to investors, after fees, of 16.8 percent, compared with 8.5 percent growth for the S&P 500.

Several former SEC enforcement division lawyers say the initial closing of the Samberg investigation, which also involved other prominent Wall Street figures, was in keeping with the SEC’s longtime hands-off treatment of hedge funds - investment pools for wealthy individuals that use sophisticated, often risky strategies to produce high returns. By early this decade, hedge funds had become so big and numerous that they became major influences on the markets for stocks, options, derivatives, commodities, and currency.

For years, unusual trading by hedge funds, particularly such trading that takes place in advance of major corporate announcements, triggered alarms in computers for the New York Stock Exchange and Nasdaq that are set to detect signs of illegal trading. When exchange officials consider the evidence strong, they forward the information to the SEC for investigation. Although the exchanges pass these alerts to the SEC, the agency to date has taken action in only a handful of cases, nearly all of them small.

Hilton Foster, a retired veteran SEC enforcement lawyer, faults the agency for not having devoted more resources to investigate hedge funds. He said the hedge funds’ personnel mainly come from investment banks and have close ties to knowledgeable insiders all over Wall Street, so they have access to nonpublic information and strong temptation to trade on it to boost their funds’ returns. “So you’d have to be naive to think it wasn’t happening,’’ he said.

Testimony and other records released with a Senate report show the SEC had been receiving warnings for years of possible insider trading by Pequot, but didn’t act. From 1999 through 2004, exchanges sent the SEC at least 17 alerts to possible insider trading and market manipulation by Pequot. A 2007 report by the Senate finance and judiciary committees, which jointly investigated the SEC’s handling of the inquiry, found that for years the agency had logged alerts but took no action to investigate.

In September 2004, the enforcement division decided to look at Pequot. It handed the case to the enforcement division’s newest, least experienced investigator, Gary Aguirre. While new to the SEC, Aguirre had spent decades as a private lawyer in San Diego, where he had won more than $200 million in a long chain of local environmental and real estate lawsuits. At age 64, he decided to devote the last part of his career to public service, ending up at the SEC.

He focused on two bursts of trading by Pequot that occurred just before announcements of major corporate news. One involved a pending 2001 earnings announcement by Microsoft that would significantly surpass analysts’ expectations. Loading up on Microsoft stock and options before the announcements, Samberg made an estimated profit of $12 million once Microsoft announced its earnings and its stock price shot up, SEC records show.

Aguirre found 2001 e-mail records, which have been made public, in which Samberg asked for Microsoft performance information from David Zilkha, a midlevel Microsoft executive who had been offered a job by Samberg. The e-mails show Samberg asked Zilkha for “tidbits’’ about Microsoft, and after hearing back from him he began rapidly amassing stock in the company.

The original SEC investigation didn’t turn up replies from Zilkha, although it did find an e-mail message Zilkha sent to Samberg months later in an attempt to dissuade Samberg from firing him. In it Zilkha noted that he had given Samberg profitable Microsoft information on April 9, 2001, which was when Samberg had begun buying large amounts of stock in advance of the company’s earnings announcement.

The day Samberg cashed in to take his profits, SEC records show, he e-mailed Zilkha: “I shouldn’t say this, but you probably have paid for yourself already.’’ Through a lawyer, Zilkha denies any wrongdoing.

As spelled out in the Senate report, the other main thrust of the inquiry related to Mack, who is now heading up Morgan Stanley and also a close friend and former business associate of Samberg’s.

Trading records obtained by the SEC showed unusual stock and options purchases that made Aguirre suspect, according to his later testimony, Samberg had been tipped to a planned GE acquisition in 2001 of Heller Financial. The deal at the time was set to be GE’s second-largest acquisition ever. In the days before the deal became public, Samberg bought more than a million Heller shares. He also short-sold GE stock. When the deal was announced, Samberg made a profit of about $18 million, SEC records show.

After sorting through potential leakers, the Senate report recounted, Aguirre began to focus on Mack, who in 2001 was leaving as president of Morgan Stanley to become co-CEO of Credit Suisse. Both investment firms had major roles in the GE deal. Mack, through a spokesman, denies any wrongdoing.

In testimony before the Senate committees, Aguirre said he asked his supervisors’ permission to summon Mack for a deposition. Aguirre later told Senate investigators that to his surprise, the request was turned down. And when he pressed the matter and stated, in now-public e-mails to his supervisor, that he suspected political motives by SEC officials were involved for backing off, the SEC fired him. The firing came just weeks after he had received a glowing employee performance review, the Senate committees’ report noted. In the review, Aguirre’s supervisor lauded his handling of the Pequot inquiry, and wrote: “He has consistently gone the extra mile, and then some.’’

The case received significant attention when The Wall Street Journal on June 24, 2006, disclosed that the SEC had fired Aguirre after he pressed for permission to question Mack under oath. The Senate finance and judiciary committees launched a joint investigation. In a 2007 report, they blasted the SEC, concluding it had “squandered’’ the case when plentiful hard evidence showed “that a thorough and wide-ranging investigation was needed.’’

The report, and a subsequent one by the SEC’s own inspector general, faulted senior SEC officials for having improper private conversations with lawyers for Morgan Stanley and Pequot, in which they disclosed confidential information about the pending investigation. The Senate report also faulted Aguirre’s supervisors for yielding to a belief that Mack was too prominent a figure on Wall Street to take on. The SEC’s inspector general also harshly criticized its handling of the case. Despite the criticism, and pressure from the Senate committees to reopen the case, then-SEC chairman Christopher Cox took no action to revive it.

The SEC investigation of Pequot, officially terminated in 2006, seemed destined to remain defunct. Then, new evidence materialized in late 2008, in a long-running divorce case involving Zilkha, the former Microsoft employee whom Aguirre had suspected of leaking information to Samberg.

Because of a dispute over child support, Zilkha was required to file periodic financial statements with a Stamford, Conn., court. In 2008, he disclosed Samberg was paying him $2.1 million in three installments, beginning in April 2008. The payments seemed mysterious: Zilkha had worked for Samberg for only a few months, in 2001, before Samberg ended his employment, Samberg testified in a now-public SEC deposition.

After the payments were disclosed, investigators said they knew of no business relationship between Zilkha and Samberg since then. Alerted to the divorce case development, the Senate committees demanded that Samberg provide an explanation of the payments, and began pressing the SEC to reopen its case. Senate committee members said in letters to the SEC and in interviews, that the payments raised suspicion Samberg was paying off Zilkha for his silence during the original SEC investigation, and the subsequent inquiries by the Senate committees and the SEC’s inspector general. (In a written response to the committees, Samberg’s lawyers contended the payments were meant to settle a dispute over Zilkha’s termination.)

Then came another bombshell: Documents filed in the divorce and information turned over to federal investigators revealed that around the time the couple filed for divorce in 2003, David Zilkha’s wife, Karen, hired a private investigator.

According to details provided by people directly involved in the case, the investigator removed the hard drive from David Zilkha’s personal computer, copied it, and put the copy back into the computer. He gave the original to Karen. They searched the drive in vain for material, such as signs of infidelity, that could be useful in the divorce case.

After details of Samberg’s payments to Zilkha emerged, though, Karen and her new husband took another look at the disk, these individuals said. They discovered e-mails that seemed to show that Zilkha in 2001 had solicited and received inside information about pending Microsoft earnings announcements from a friend, Mark Spain, then director of Microsoft’s mobile devices unit.

For example, on April 7, 2001 (when Zilkha was still working for Microsoft but had accepted a job with Pequot), Zilkha sent Spain an e-mail, captioned “Any visibility on the recent quarter?’’, asking if Microsoft was about to announce quarterly earnings that were worse than analysts were predicting. The next day, Spain responded that results would be better than predicted, in part because of strong sales of a new Windows operating system. “March was the best March on record,’’ Spain wrote.

The messages coincided exactly with the timing of Zilkha’s communications with Samberg and Samberg’s trading, evidence that already had been pinned down in the original SEC investigation. In a recent interview, Aguirre said the e-mail messages “fit like the last piece of a picture puzzle.’’

Spain left Microsoft earlier this year. Patricia Eakes, a lawyer representing him, said Spain isn’t expected to face SEC charges, and said his departure from Microsoft was “totally unrelated’’ to the investigation.

Meanwhile, people involved with the SEC case now say Zilkha is likely to face SEC action. Zilkha declined to comment, instead referring questions to his lawyer, Henry Putzel. Putzel wouldn’t say if Zilkha, like Samberg, had received an SEC warning of likely civil charges. But the lawyer said Zilkha “asserts he did nothing wrong and I continue to assert that he has engaged in no misconduct.’’

The Mack part of the investigation remains closed. Through spokesmen, Mack has denied any wrongdoing.

An SEC spokesman cited the agency’s policy not to comment on pending investigations. But the SEC disclosed recently, in information given to a Senate committee, that since 2005 it has received more than 40 additional alerts about Pequot from stock exchanges, based on signs of insider trading and market manipulation. SEC chairwoman Mary Schapiro in a letter told the committee that all of these had been forwarded to the SEC enforcement division, although the agency hasn’t disclosed the extent to which the alerts have been investigated.

Earlier this year, the Federal Bureau of Investigation and the US attorney’s office in Manhattan began investigating the case, and obtained the original drive from Zilkha’s computer. People involved in the case said they haven’t seen any recent sign of activity by the US attorney’s office, though. A spokesman for the office said it doesn’t confirm or deny the existence of investigations.