Circle of Friends (11 page)

“SAC made a fortune,” the board member who worked on the deal said. Initially, this executive reckoned that a leak came from inside Pathmark, given its precise timing and Cohen's growing reputation for having a circle of friends unmatched in the investment business. “We all thought it had to be a leak from the board.”

Or maybe there was no leak and SAC's trade shows how much of a legitimate edge professional traders have over average investors and just how futile it is for regulators to be obsessed with leveling the market for everyone. Indeed an SAC insider remembers the trade differently. SAC officials had been following the company closely, and weighed the public comments by the analyst community about a Pathmark-A&P deal before buying shares.

And these insiders say it's unclear how much money SAC made from the trade. Around the time the Pathmark deal was announced, some SAC traders were shorting shares (a trade where money is made when stock prices fall, or money is lost if shares rise) believing that the stock would fall at some point. It didn't and as a result, SAC lost some money.

Either way, the Pathmark official said the firm alerted the SEC to Cohen's well-timed trades, and that's where it ended, at least as far as this person knew (the SEC never filed charges on the matter). The Pathmark official would later remark that giving a tip to the SEC was like sending information down a “black hole.”

To be fair, while the SEC has had its problems (Madoff, the financial crisis, etc.), tracking possible insider trading, with Funkhouser's computers and its own databases, isn't one of them. When it came to looking at suspicious trades at SAC Capital or anywhere, the problem had less to do with incompetence, or lack of effort, and more to do with not having the
right kind of evidence
to make a case.

In 2003, Cohen's firm already had escaped a possible fraud charge when the SEC looked into whether one of its traders had placed market bets ahead of research reports published by the trader's fiancée who worked on Wall Street. The SEC at another point considered fraud charges against SAC for possible front-running, buying or selling stocks ahead of the orders of some of its customers. Again nothing happened.

And Funkhouser, over at Nasdaq's market surveillance unit—soon to be relabeled the Financial Industry Regulatory Authority—was amassing a laundry list of suspicious trades from SAC's headquarters in Stamford and handing them to the SEC for a closer look.

The closer look, however, led to dead ends. Cohen and his traders always seemed to have the right answers involving the suspicious trading.

As for the front-running charges, Cohen and SAC traded so much that the trading ahead of other people in the market could be just coincidence. Then take the individual stocks Funkhouser was examining, or even SAC's Pathmark trade. SAC traders were known to have the best circle of friends in the investment business, so it could have come from anywhere: a banker, a trader, someone on A&P's board, or one of those “industry” experts that regulators were only beginning to hear about from their contacts in the hedge fund business. Finding any possible leak would be like finding that needle in a haystack, only worse, because Wall Street and the hedge fund business were by now far bigger than any barn.

Indeed, one of the major enforcement hurdles faced by regulators was the growing complexity of Wall Street's circle of friends. The expert networks had yet to make it on the government's radar screen by 2007, but they were making their mark with hedge funds. The biggest of these outfits, including Primary Global Research and Gerson Lehrman Group, were private companies, so the exact size of their operations was largely unknown, but their importance to the hedge fund business can't be overstated. By the mid-2000s, every major hedge fund looking for a competitive edge (and that meant all of them) had a relationship with the industry expert networks, for the simple reason that the thirst for information—particularly the stuff that could move stocks—was immense.

“Hedge funds are on the phone with these experts all the time and if they are not giving them the right info, they're going back to supervisors and asking for more and someone else,” a former industry expert explained as he reflected on the growth of the industry and the pressures faced by experts for “actionable information”—often a code word for information that violates the law.

Also breaking into the circle of friends (and going largely unnoticed by regulators) was the old “sell-side” analyst, now reinvented as an “independent researcher” for the hedge fund business. Since around 2003, analysts who worked at the big banks were being demoted and downsized as regulatory pressure prevented them from aiding and abetting deal making. They would find a second life in the booming information business that centered on trading, even if many of them would succumb to the same sleazy behavior in their new incarnation as “independent” analysts.

Wall Street or “sell-side” research began as a tool to gain market intelligence for traders and investors, but that changed in the late 1970s when Congress deregulated commissions on stock trades. Before then, investors would pay analysts for information; analysts who did their homework and recommended winning trades got reimbursed with a hefty share of these trading commissions.

Now analysts faced extinction unless they joined their firm's investment banking business and began touting stocks—using their research to promote stocks of companies that were the corporate clients of the big Wall Street firms.

This conflict would lead to one of the great Wall Street crimes in recent memory, when, during the Internet bubble, investors lost countless billions of dollars buying overvalued and sometimes worthless stocks at least in part based on stock ratings later found to be fraudulent.

Insider trading may be a fraud on the market, and a deceptive act, as the courts have ruled, but the federal government's decades-long obsession with stamping it out came at a price: Bigger frauds with more identifiable victims went unaddressed or received far less attention.

None were bigger and with more identifiable victims than Wall Street's peddling of advertisements for their investment banking clients under the guise of research. The exposure of this crime—and the crime of the government's inattention to it—can be traced to the waning days of the Internet bubble, when firms were placing buy recommendations on just about any technology company they could find, though not because they were making money and were good long-term investments. In fact many of these companies were start-ups that barely had revenues, much less profits.

Nevertheless, Wall Street had convinced enough investors through their incessantly hyped research that these companies would be successful, and they spared no hyperbole to entice investors. The scam lasted through the great technology bubble that began roughly in 1995, with the IPO of a browser technology company called Netscape, through March 2000, when technology stocks began their painful correction, and for years later.

During this time, of course, the SEC and other regulators made great strides in their pursuit of insider trading even as they ignored complaints about Wall Street fraudulent research. With the boom in technology stocks growing through the 1990s, a “virtuous circle” was created: Analysts wrote glowing reports, companies sent their investment banking business to the firms those analysts were employed at, and then everyone repeated the process all over again. The SEC, meanwhile, sat by and watched.

That would eventually change, and not because of anything the SEC or other regulators did but thanks to the actions of a pediatrician and part-time investor from Queens, New York. In 1999, Debasis Kanjilal went to his Merrill Lynch broker and asked for some information about how to make some quick money on Internet stocks. He had about $600,000 in the market—a sweet spot for any broker looking for hefty fees and commissions that well-off retail or individual investors often generate for brokerage firms.

Kanjilal was handed the research of an analyst named Henry Blodget, a former journalist turned Wall Street analyst, who made the transition to Wall Street like a lot of smart Ivy League grads did during the 1990s Internet and technology bubble. And presto, Blodget had become a star.

His gift, at least superficially, was in understanding the new-economy companies at the heart of the Internet craze and translating their business model in a way that was clear to the non–Wall Street professional. This research was then distributed to clients, including increasingly wealthy individuals like Kanjilal who watched business television and read the
Wall Street Journal
.

As technology exploded in the 1990s, Blodget was in the right place at the right time. He was a good writer so his reports were widely read in the media, and he soon found a home at Merrill Lynch, after a short but hypersuccessful stint at Oppenheimer, where he famously predicted in 1998 that shares of Amazon.com, the online bookseller, would rise to $400. They did shortly thereafter. With that, Blodget's star was born. Merrill Lynch, the nation's then-largest brokerage firm, came calling and hired Blodget to run its technology research team. Blodget became one of the most recognizable figures for the millions of small investors who bought stocks through Merrill's brokerage arm during the great bull market for technology stocks.

Henry Blodget went from being viewed as a visionary to what many considered a tout—an analyst who seemed to have nothing but nice things to say about the companies he covered. Debasis Kanjilal knew none of this, of course, when his Merrill Lynch broker handed him a Blodget research report and he handed his broker $600,000 to follow Blodget's advice and begin snapping up shares of tech companies.

Over the years, Merrill had vehemently denied conflicts of interest whenever the business press occasionally raised the matter of whether it skewed its reports to suit the needs of its investment-banking customers. But after tech stocks began to crater and Kanjilal lost most of the $600,000 he invested using Blodget's research as his guide, the good doctor went to an attorney for answers.

That attorney, Jake Zamansky, knew the research game better than the guys in the Manhattan U.S. attorney's office or the people in Washington at the SEC. He had once defended so-called bucket shops, small brokerage firms that operated on the fringes of Wall Street but used the Wall Street research business model as their guide. At the bucket shops, the only difference was that some analysts were bankers as well; Zamansky thought it was more honest than what he saw at the big firms, where analysts like Blodget posed as independent thinkers when in reality they were trying to win deals.

Zamansky would eventually file a lawsuit against Blodget and Merrill—the first of its kind against an analyst, especially one of Blodget's stature—and win a $400,000 settlement on behalf of Kanjilal. Merrill's decision to settle stemmed not just from the controversy surrounding the case—which earned lots of press coverage in the aftermath of the bursting of the Internet bubble—but from what Merrill's management knew about the process of disseminating market information to its small investor clients.

That process largely guaranteed that small investors received what were essentially sales pitches in the form of research reports.

Investors just like Kanjilal were now sitting on huge losses as Internet and telecommunications stocks began to reflect their true value, which in many cases was nothing. Zamansky's lawsuit was largely ignored by the SEC and the Nasdaq's stock market investigators but not by the recently elected attorney general of New York State, Eliot Spitzer, and one of his deputies, Eric Dinallo, who spotted a story in the
Wall Street Journal
about Blodget issuing a rare downgrade of a stock—but only after Merrill was denied an investment banking deal.

Blodget's deposition and Dinallo's investigation in which he subpoenaed Blodget's emails showed that the analyst's glowing stock recommendations to small investors varied markedly from his private emails, where he described those selfsame stocks as “pieces of crap,” “dogs,” or occasionally “POS,” for “piece of shit.”

For some reason, those very candid phrases never made it into Blodget's research read by small inverstors. In the weeks after Blodget gave his deposition to Spitzer's investigators, he resigned from Merrill with several millions of dollars in salary, bonuses, and severance. Merrill, meanwhile, kept the Spitzer investigation quiet while its research machine continued to churn out reports as if nothing were happening.

Across town, the Nasdaq kept falling—from a peak of 5,000 at the top of the bubble in March 2000 to just under 1200 in early 2002. Somewhere close to $5 trillion of investor wealth had disappeared.

Can you blame it
all
on the faulty research of Blodget or his fellow analysts?
No
, but nearly every investor will tell you that they perked up when Blodget's research hit the wires.

In the coming months, the public would see just how well oiled that sales machine had become, all under the noses of the SEC. Jack Grubman, a technology analyst at Citigroup's Salomon Smith Barney unit, had even more latitude than Blodget to promote those companies that rewarded his firm with investment banking business (and indirectly, rewarded him, via a remarkably generous pay package).

Much of Grubman's research wasn't just conflicted—it was conflicted and thoroughly horrible. He called on investors to “back up the truck” and invest all that they had in a company called WorldCom, a telecom outfit he claimed would revolutionize the wireless business. He kept a high rating on the company nearly to the day it declared bankruptcy. An accounting fraud would later send senior management to jail.

It was that insight that helped Grubman earn as much as $25 million in one year and millions more before he was forced to resign. Soon regulators at the SEC and the Nasdaq would finally force him out of the business for good in a settlement that called on the big firms to radically change the way they handled research. Some of those structural changes fell flat. The ratio of buy recommendations remained virtually where it had been before the entire investigation began.