DealBook: Exchange Sale Reflects New Realities of Trading

Spencer Platt/Getty ImagesThe floor of the New York Stock Exchange on Thursday.

On a warm day in Boca Raton, Fla., the host of a reception for an annual financial conference was not a big bank or a powerful exchange as in years past, but a young firm based in Atlanta.

Guests who gathered at the oceanfront resort were surprised. They were greeted with bottled ice water that carried the company’s logo, and as they left, were invited to grab iPod Shuffles.

That event, some four years ago, was the Wall Street equivalent of a coming-out party for the firm, IntercontinentalExchange, or ICE, an electronic operator of markets for derivatives and commodities. Now, the markets upstart is announcing itself to a much larger world with an $8.2 billion deal to buy the symbolic cradle of American capitalism, the New York Stock Exchange.

The takeover illustrates starkly how trading in commodities and derivatives has become much more lucrative than trading in the shares of companies. Warren E. Buffett warned in 2003 that the “derivatives genie is now well out of the bottle,” and that the genie, even after a global financial crisis, was not going back. Currently, derivatives — financial bets tied to underlying assets like oil prices or interest rates, among other things — are a $600 trillion market. Even the parent of the N.Y.S.E. attracted its suitor largely because of its ownership of Liffe, a major derivatives exchange in London.

For many, the Beaux-Arts New York Stock Exchange, and images of traders looking despondent or exuberant on its floor, represent what making money is all about. Yet Wall Street itself has found it more profitable to bet on fluctuations in natural gas or corn or on interest rates. The financial industry often does so electronically and through platforms in cities as scattered as London, Chicago and Atlanta. The biggest bonuses each year are typically for traders who reaped rich gains on these often complex financial products.

That change, decades in the making, has left the New York exchange, with roots going back 220 years, in an increasing difficult position as trading volumes slump and profit margins stay razor thin. While its acquirer has pledged to keep a dual headquarters in the exchange building in Lower Manhattan, as well as in Atlanta, the center of power in finance long ago migrated elsewhere.

The success of the newly combined companies hinges on the derivatives business. ICE is hoping that a greater share of derivatives trading will go through its clearinghouse operations, which act as backstops in case one party defaults. It is being aided by the Dodd-Frank financial regulatory overhaul, which is forcing Wall Street banks to push their derivatives trades into clearinghouses and regulated exchanges.

“For the past decade, our solutions made our markets increasingly electronic and increasingly clear,” Jeffrey C. Sprecher, chief executive of ICE, said this month. “Today, financial reform is imposing that vision on many markets through a rule-making process.”

While Dodd-Frank compliance is still in its early days, and the volume of derivatives trading remains depressed amid broader economic uncertainty, the law is ultimately expected to cement ICE’s business model into the regulatory code.

“Despite the complaints, there’s no question that at the end of the day, Dodd-Frank will be a financial boon to exchanges,” said Bart Chilton, a Democratic member of the Commodity Futures Trading Commission, which regulates derivatives.

Still, such a development will not do much for the traditional business of the New York Stock Exchange. Mr. Sprecher said on Thursday that he was committed to keeping the floor of the exchange open. But according to people briefed on his plans, he intends to use the stock trading operation and its steady cash-generating abilities to finance future deals and expansion efforts.

Nowhere have the changing fortunes of ICE and the parent of the New York exchange, NYSE Euronext, been more apparent than in their value on the stock market. In April 2011, when ICE first tried to acquire NYSE Euronext in league with Nasdaq OMX, it was worth about $1.5 billion less than the New York company. Just over a year later, ICE was worth nearly $4 billion more than NYSE Euronext, even with less than a third of its revenue.

ICE was founded in 2000 by Mr. Sprecher, who began his career developing power plants. In the 1990s, he saw that many power companies and financial firms wanted to hedge their investments in energy with financial contracts, but the market for these contracts was disorganized and opaque.

Mr. Sprecher bought an obscure exchange for buying and selling electricity in Atlanta and turned it into ICE with financing from BP and Wall Street firms, including Goldman Sachs and Morgan Stanley.

Banks were drawn to the idea of a standardized place to buy and sell derivatives tied to the value of oil and other commodities. But they also hoped to create a competitor to the virtual monopoly position being built up by the Chicago Mercantile Exchange in futures trading.

“You talk to people in Chicago, they basically think that ICE is just a front for the banks,” said Craig Pirrong, an expert in futures trading and director of the Global Energy Management Institute at the University of Houston.

As the company grew through a quick series of acquisitions, Mr. Sprecher won a reputation for being the “enfant terrible” of the energy industry, with a “sharp eye for identifying opportunities and seizing on them in a very aggressive way,” Dr. Pirrong said.

Early on, ICE sought to move all trading onto computers, allowing firms to buy and sell contracts 24 hours a day. Soon after buying the International Petroleum Exchange in London, ICE shut down its trading floor.

“They were a technology company from Day 1,” said Brad Hintz, an analyst with Sanford C. Bernstein.

ICE also decided to fashion its own clearinghouse, rather than tap an outsize firm. It expanded through acquisitions, planting the seeds for growth in 2008, when it took over the Clearing Corporation, home to a popular derivative known as a credit-default swap.

The Dodd-Frank overhaul may provide additional benefits for ICE. Under the law, exchanges must turn over public and private information to outside data warehouses, which will, in turn, share the information with regulators. Sensing an opportunity, ICE created its own warehouse, named ICE Trade Vault.

ICE and its Chicago rival, CME Group, have also moved in recent months to convert swaps trades, which are facing more scrutiny under Dodd-Frank, into old-fashioned futures contracts. Futures trading is lucrative territory for the exchanges in part because they can shut out competitors.

“The reality is that there are incentives to convert swaps into futures, where there’s less competition,” said Richard M. McVey, chief executive of MarketAxess, an independent trading platform that is expanding into the swaps business. “There’s no requirement for CME and ICE to open their futures clearinghouses to other exchanges.”

Despite its growing prominence, ICE has a small footprint in Washington. With only two full-time lobbyists, the company relies on Mr. Sprecher to communicate with regulators.

“Jeff is the company,” one official said, though others said he had loosened his grip over the last year or so.

He is well received, officials say, in part because he has embraced some reforms. Unlike executives of other exchanges and financial firms, Mr. Sprecher did not resist an effort in 2009 by the Commodity Futures Trading Commission to close certain loopholes.

Officials recall him saying, “Tell me what the rules are, and I’ll make money with them.”

Michael J. de la Merced contributed reporting.
Spencer Platt/Getty ImagesTraders on the floor of the New York Stock Exchange.

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DealBook: Cerberus to Sell Manufacturer of Rifle Used in School Shooting

Gretchen Ertl for The New York TimesRemington rifle cartridges at Cabela’s sporting good store in Scarborough, Maine.

The private equity firm Cerberus Capital Management said on Tuesday that it would sell its investment in the gunmaker Freedom Group in response to the school shootings last week in Connecticut.

Cerberus acquired Bushmaster — the manufacturer of the rifle used by the gunman in the Newtown attacks that killed 27 people, including 20 schoolchildren — in 2006.

The private equity giant later merged it with other gun companies to create Freedom Group, which reported net sales of $677.3 million for the nine months that ended in September 2012, a 20 percent increase compared with the same period last year.

“It is apparent that the Sandy Hook tragedy was a watershed event that has raised the national debate on gun control to an unprecedented level,” Cerberus said in a news release.

The private equity firm said it had made the investments in gun manufacturers on behalf of its clients, which include pension funds and other institutional investors. Cerberus added that it was the role of legislators to shape the country’s gun policy.

“We believe that this decision allows us to meet our obligations to the investors whose interests we are entrusted to protect without being drawn into the national debate that is more properly pursued by those with the formal charter and public responsibility to do so,” Cerberus said.

The private equity firm said it would retain a financial adviser to sell its interests in Freedom Group, and would return the proceeds to investors. Cerberus, based in New York, was founded in 1992 by William Richter and Stephen Feinberg, and has more than $20 billion of assets under management.

Cerberus is one of several private equity firms that have holdings in gun manufacturers. Colt Defense, which was spun out of the maker of the .44-40 Colt revolver, is jointly owned by Sciens Capital Management, a fund advised by the Blackstone Group and another fund operated by Credit Suisse.

Tuesday’s announcement follows a statement from the California State Teachers’ Retirement System, a large pension fund, that it was reviewing its investment in Cerberus in light of the firm’s holding in Freedom Group.

“At this point, our investment branch is examining the Cerberus investment to determine how best to move forward given the tragic events of last Friday in Newtown, Connecticut,” a spokesman for the Californian public pension fund told Reuters on Monday.

Neil Gough contributed reporting from Hong Kong.

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DealBook: Massachusetts Fines Morgan Stanley Over Facebook I.P.O.

Noah Berger for The New York TimesA Massachusetts regulator alleged that Michael Grimes, a banker at Morgan Stanley, coached Facebook on how to share information with analysts.

Morgan Stanley is paying for its role in the troubled stock market debut of Facebook.

On Monday, Massachusetts’s top financial authority fined the bank $5 million for violating securities laws, the first major regulatory action tied to Facebook’s initial public stock offering.

William F. Galvin, the secretary of the commonwealth of Massachusetts, accused the bank of improperly influencing the stock offering process. The regulator’s consent order asserts that a senior Morgan Stanley banker coached Facebook on how to share information with stock analysts who cover the social media company, a potential violation of a landmark legal settlement with Wall Street. While the banker never contacted the analysts directly, his actions, Mr. Galvin said, put ordinary investors at a disadvantage because they lacked access to the same research.

“The broader message here is we are going to use any means possible to enforce the strict code in place about giving out information,” Mr. Galvin said in an interview. “We want to get the message across that if Wall Street wants to get confidence back, they can’t disadvantage Main Street.”

The consent order did not name the Morgan Stanley banker, referring to him as a “senior investment banker.” But information in the regulator’s order indicated that it was Michael Grimes, one of the nation’s most influential technology bankers.

“Morgan Stanley is committed to robust compliance with both the letter and the spirit of all applicable regulations and laws,” a Morgan Stanley spokeswoman, Mary Claire Delaney, said. Morgan Stanley, in settling the case, neither admitted nor denied guilt.

Mr. Grimes, through Ms. Delaney, declined to comment. Although the banker was referred to in the order, Mr. Grimes has not been personally accused of any wrongdoing.

The Facebook public offering was one of the most highly anticipated debuts of the last decade. In the run-up to the offering, investor interest was robust, prompting the company to increase the size of the offering and raise the share price to $38.

But the I.P.O. quickly turned into a debacle. The first day of trading was plagued with problems. The shares quickly fell below their offering price. The stock closed on Monday at $26.75.

Shannon Stapleton/ReutersFacebook’s initial public offering in May was broadcast in Time Square.

Since the offering, Mr. Galvin and other regulators have opened wide-ranging investigations into Facebook and the banks that handled its debut. The continuing inquiries by the Securities and Exchange Commission and the Financial Industry Regulatory Authority are examining how the banks disseminated nonpublic information to big investors — and whether it conflicted with Facebook’s public disclosures.

Regulators are also looking into Nasdaq, the exchange where Facebook trades. They are questioning whether the exchange failed to properly test its trading systems, which faltered during the stock offering.

The Massachusetts regulator is focused on Morgan Stanley’s communications with analysts.

Shortly before the Facebook offering, analysts at several banks lowered their growth estimates for the social network. The move came after Facebook issued an amended prospectus, detailing a potential slowdown in revenue.

A Facebook executive, whose name was not given in the order but who was referred to as the treasurer, also reached out to analysts. Mr. Galvin’s order asserted that the executive, in private conversations with analysts, had provided additional information on the revenue. The order indicated that Mr. Grimes was personally involved in the decision to file the new prospectus and to have Facebook communicate with analysts.

“Morgan Stanley’s senior investment banker did everything but make the phone calls himself,” the Massachusetts regulator said in a statement, referring to Mr. Grimes. “He not only rehearsed with Facebook’s treasurer who placed the calls to the research analysts, but he also drafted the majority of the script Facebook’s treasurer utilized.”

Just 12 minutes after filing the amended prospectus with regulators on May 9, the Facebook treasurer phoned Wall Street research analysts from her hotel, according to the order. She had a 15-minute conversation with Morgan Stanley analysts, and then spoke with JPMorgan Chase and other banks.

The calls provided the analysts with additional information that did not appear in the amended prospectus, the order said. The conversations, for example, included “quantitative information regarding Facebook’s” second-quarter 2012 projections.

This behavior, Mr. Galvin said, crossed the line, violating the regulatory settlement on stock research that Morgan Stanley and other companies signed in 2003. The agreement limits the communication between bankers and research analysts and bans companies from influencing stock reports to try to bolster banking operations.

The Morgan Stanley case falls into a curious gray area.

Bankers spend months preparing companies to go public, a role that includes providing guidance on research analysts. In this instance, Mr. Grimes did not personally place the calls, which would have been a clear violation of securities laws.

In his testimony before the Massachusetts regulator’s staff, Mr. Grimes indicated that the bank had pushed for Facebook to file publicly an amended prospectus to avoid “the appearance” that the company was sharing information with a select group of clients rather than broadly with investors. Mr. Grimes, the order noted, consulted with Morgan Stanley and Facebook lawyers. Ultimately, Facebook’s chief financial officer, David A. Ebersman, e-mailed the company’s board to say that the new filing would “help us to continue to deliver accurate” information without “someone claiming we are providing any selective disclosure.”

Mr. Grimes, in testimony with the regulator, further defended his role. While the Facebook treasurer was making the calls, he noted that “I was far down the hall so I wouldn’t hear anything.”

Even so, Mr. Grimes, according to the consent order, e-mailed Mr. Ebersman to say that the Facebook treasurer “was a champ in the hotel tonight,” after the treasurer wrapped up the calls.

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