Did huge hedge fund make big profit on Microsoft inside information?

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If you thought the SEC missed a chance to crack down on Bernie Madoff's $65 billion Ponzi scheme, you won't be surprised to learn that it let a much smaller scam go on for years. That's right folks, if the fine reporting at the Boston Globe is to be believed, the now-closing $15 billion Pequot Capital Management -- whose head, Art Samberg, was a member of Barron's round-table of stock pickers -- allegedly made $12 million by trading on insider information it bought from someone at Microsoft (MSFT) a few years ago.

This is not the first Pequot insider trading investigation that the SEC bungled. As I posted, back in July 2006, the SEC fired a lawyer who wanted to depose current Morgan Stanley (MS) CEO John Mack to examine whether he spilled the beans about General Electric's (GE) 2001 acquisition of Heller Financial on which Pequot allegedly made an $18 million profit. The SEC investigator, Gary Aguirre, was fired after receiving a glowing performance review -- allegedly because he didn't back down from his efforts to depose Mack after his SEC bosses told him to.

But back to Pequot's alleged insider trading on Microsoft. In early 2001, Pequot offered a job to David Zilkha, then a mid-level Microsoft executive who in April 2001 allegedly found out from a colleague, Mark Spain, that the company would beat its earnings expectations. Zilkha allegedly told Samberg this news who bulked up on Microsoft stock and call options. Pequot then profited when Microsoft stock rose after the better-than-expected earnings came out -- to the tune of $12 million.

The SEC thought it had rid itself of this case a few years ago. But they did not know about Zilkha's ex-wife Karen who hired a private investigator -- to copy the hard drive on Zilkha's PC, give Karen the original, and return a copy to Zilkha -- to seek evidence of marital infidelity. Karen's PI didn't find that but she did find other useful information on the hard drive.

How so? After their 2003 divorce, Zilkha -- who worked at Pequot for less than a year -- and Karen had a dispute over child support. Zilkha was required to file periodic financial statements with a Stamford, CT court. In 2008, Zilkha reported that Samberg was paying him $2.1 million in three installments, beginning in April 2008. This led Karen and her new husband to re-examine that hard drive where they found emails that raised some big questions about Zilkha's role in the alleged insider trading scheme.

For example, the Globe wrote about an email exchange with Spain that may have proven particularly helpful for Pequot. According to the Globe, "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."

Spain's response, according to the Globe, revealed good news: "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."

When Zilkha allegedly forwarded this information to Samberg, it allegedly helped convince him that he should bulk up on Microsoft stock.

Let's hope that under new leadership, the SEC can get serious about stopping this kind of alleged insider trading by the hedge fund industry. Because I would be surprised if Samberg was the only one who may have engaged in it.

Peter Cohan is a management consultant, Babson professor and author of eight books includingYou Can't Order Change. Follow him on Twitter. He owns GE shares and has no financial interest in the other securities mentioned.

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