Circle of Friends (12 page)

But analysts could no longer pose as investment bankers—and get paid like bankers. A bigger “Chinese wall” was erected to separate research from investment banking so analyst bonuses could no longer be based solely on how many deals they helped the bankers win.

Spitzer and the SEC (finally) made certain that the era of the banking analyst moonlighting as a banker was over. But that gave rise to another type of compromised research: the business of “independent research analysts” catering to the whims and pressures for inside information from the big hedge funds.

One of those analysts was a man named John Kinnucan.

B
eing independent didn't mean John Kinnucan was on the side of the angels—far from it. Yes, information, as opposed to hyping stocks, mattered again to investors, and they were ready to pay for it as an increasingly competitive industry of information seekers (hedge fund traders) demanding an edge from the new and burgeoning business of information providers (analysts and expert networks).

Steve Cohen was clearly one of those edge seekers as his fund grew in size and importance. His marketing brochure even boasted of SAC's “edge” over the competition, which everyone inside the hedge fund business and an increasing number of regulators understood to be its uncanny ability to beat the markets by demanding the best research and information.

With market-busting returns (72 percent in one year) money kept flowing into SAC. In just five years, SAC had more than tripled in size; it was now heading toward $14 billion in assets under management and competing against other funds with a similar thirst for fresh information—much of it, regulators were starting to believe, based on the increasing frequency of suspicious trades from illegal sources.

The researchers and experts were possibly the biggest source of information for the hedge fund business. But these researchers couldn't distinguish themselves from one another simply by passing on earnings projections based on orders for the components that went into building a computer. They needed more. They needed something others didn't know.

Increasingly, the trading community wanted the actual earnings number itself—or something close to it. For that, the independents went out and hired their own experts to cough up any tidbit from inside their companies. As for the experts, no one cared if he or she had attended MIT and understood how a microprocessor worked.

To satisfy the gamblers on Wall Street they would have to do what was necessary—which often meant dishing out company secrets—or they wouldn't be able to count on a paycheck from their hedge fund masters.

“It was all about the money,” a former expert explained about the pressures in the job to step over the line and provide clients with anything that could move the stock, “even if it was illegal.”

Those on the information side of the business quickly understood the new definition of “independent research.” The growth of hedge funds didn't necessarily mean more business for the experts and the analysts or more autonomy for the information providers. With the Dow rising to around 14,000 in late 2007, and the eventual financial crisis yet to take its toll on stocks, just about anyone could make money buying a mutual fund that tracked the broader markets. Hedge funds needed to show results that are better than that to justify those huge fees, the highest being charged by the most successful shops in the business.

So a certain breed of information provider was in demand, one who was ready to push the envelope and at times break the rules.

It didn't begin that way, at least for John Kinnucan. “There was a need for real research; that's why I left Wall Street,” he explained as he looked back on his decision to leave Wall Street. Kinnucan set up his own shop as an independent researcher, out of his home, right around the time Spitzer was making the Wall Street research business nearly untenable.

Real research, however, was exactly what made Kinnucan such a valuable commodity for the hedge fund looking to score big. Kinnucan knew his way around the industry; he was more than familiar with the business models of Apple, Cisco, and a slew of smaller tech companies. But his niche was in knowing where to find the right kind of actionable information that the big hedge funds were looking for.

And it didn't take long for him to hit paydirt, even if his old Wall Street colleagues thought he was taking a big risk by creating a company called Broadband Research and working out of his home producing market research and charging for it.

The thirst and demand for information from hedge funds, and as it turned out, Kinnucan's malleable ethics, had in a short time produced a business that earned about $1 million a year. What's more, he didn't even have to leave his house too often, since his long years covering technology provided him with a network of sources—a separate circle of friends—who were more than willing to dish out insider tips for the right amount of money over the phone or by email.

Kinnucan, of course, had seen the rise of the hedge fund business for years. The best of them, like Steve Cohen's SAC Capital, Ken Griffin's Citadel Investment Group, and the Galleon Group, run by Raj Rajaratnam, offered returns far better than what the market was offering even in those good times.

How did they do it? Conventional wisdom was that since hedge funds were lightly regulated (in contrast, SEC rules curtailed risk at mutual funds sold to “average investors” by preventing certain investment strategies), they had a freer hand to trade using derivatives and other esoteric securities that allowed them to amp up returns relative to more highly regulated entities. The other part of the conventional wisdom was that Cohen and his ilk were simply brilliant. Because people like Cohen and Griffin were such savvy investors, they knew just how much risk to take and not blow up.

Cohen and those of his caliber, so the thinking went, gathered data points from the expert networks and the researchers like Kinnucan along the way, assembling these disparate small bits of data into a “mosaic” that would tell the trader whether to buy or sell a stock. It was all highly scientific—small pieces of information that meant almost nothing on their own but could fit together as part of a mosaic that painted for the trader a compelling picture of whether to buy or sell a stock.

The mosaic theory was all the rage in the hedge fund world through most of the late 1990s and into the next decade. Its beauty: Each piece of information collected might be derived from a nonpublic source but would not in and of itself move the market, so it fell within acceptable standards.

But the highly competitive nature of the hedge fund business would soon make the theory obsolete, as Kinnucan would later explain, recalling the words of one of his clients: “If you can call me tomorrow, and tell me here is what Oracle sales will look like this quarter, and I can buy the stock at the end of the day and it goes up ten percent tomorrow. Then I will buy your research all day long. . . . But if you are going to give me analysis on Oracle, everyone has that.”

Kinnucan understood the dynamic at work. His clients wouldn't actually ask for him to divulge secrets, or get others to do so, but they didn't have to. He knew that an early read on a company's quarterly earnings was much more valuable than some guess on how many semiconductors Apple was using. The trick was getting
inside
companies—gaining exposure to midlevel executives who either knew sales numbers or even the latest earnings report or had a good indication about their direction.

Kinnucan had sources all over the tech industry whom he would schmooze with fancy meals, vacations, and outright payments to get what he needed. Walter Shimoon, then an executive at a company called Flextronics, was one of a handful of technology executives on Kinnucan's payroll, providing not just industry insight but cold, hard nonpublic data about stocks that were passed on to Kinnucan's clients.

Kinnucan's client list grew to include big hedge funds like SAC Capital and Citadel, and major mutual funds as well. It was all so easy if you were someone like Kinnucan, who had the right sources: No more laboring over reports, which had been standard fare on Wall Street, demanded by the analysts' supervisors so company brokers would have something official to peddle to small investors as a reason to buy a stock.

“We didn't write up many reports,” one independent analyst told me. “Instead we were on the telephone all day, sending IMs [instant messages] and talking to our sources to get whatever data we could feed to our clients.”

Did the clients ask
where or how
they were getting this information or whether it was legal?

Rarely, at least according to the researcher's account. “You would go into a trader's office and say ‘You want to buy Google.' The first question he asks is ‘Why?' By listing a bunch of general reasons, you lose that business because he wants to know something he doesn't know, not what is already out there.

“So you call your friend in Google's finance department and get something. It's a culture of justifying trades via information no matter how you get it. The Feds can't prove anything because no one wrote anything down.”

For such circles of friends (and circles of friends-of-friends), the “proving” part of that scenario was about to change.

CHAPTER 4

A REGULAR GUY

I
t's unclear exactly when Steve Cohen and his hedge fund first appeared on regulators' radar screens, but by the time the Pathmark trade went down, Cohen and SAC were under scrutiny by the SEC, FINRA, and increasingly the FBI and Justice Department. His trades were regularly flagged by the increasingly sophisticated computer networks that tracked suspicious market activity. Government officials believed producing returns that beat the market every year is suspicious enough. Doing it year after year by snapping up stocks right before major events was thought to be nearly impossible by the government snoops, unless, of course, you were cheating the system.

Cohen had many defenders—though most of them either worked at the firm or at firms that benefited from its trading order flow, or were investors who benefited from his market-beating returns and kept shoveling money into SAC. Cohen was lauded by the
Wall Street Journal
as the “Hedge Fund King.”
Time
did the
Journal
one better, naming him to its list of most influential people.
Forbes
made his star status official, ranking him as the “Top Billionaire Art Collector” in 2005, based on his love of expensive art and his salary, which hit $1 billion that year.

“The guy's just very good at understanding money flows, the way money flows into and out of the market,” Jonathan Ludwig, a money manager who worked at SAC in the mid-1990s, told the
New York Times
.

Ludwig told
Times
reporters Alex Berenson and Geraldine Fabrikant that it was Cohen's “mind” rather than his connections to an informed circle of friends that accounted for his extraordinary performance—nearly always beating the market averages, and by wide margins.

All of which may have been a great selling point with investors as Cohen's funds soared in value, but not with regulators, who increasingly questioned the SAC narrative put forth by his cultish Wall Street followers and some reporters. What wasn't myth was his success, which he was increasingly willing to flaunt, much to the chagrin of regulators. As Cohen's net worth soared into the many billions, he purchased multiple homes, further expanded his fancy art collection, and found a new wife. He was known to remain extremely private, though friends say the vast security apparatus he set up around his 35,000-square-foot mansion in Greenwich, Connecticut—everything from armed guards to a multitude of cameras surveilling a fourteen-acre estate—is aimed less at protecting him than it is his family. Cohen himself was now making the rounds in Manhattan and Greenwich as an affable dinner partner to a coterie of friends, some of whom worked on Wall Street and a few who didn't.

Even with these indulgences, there was something surprisingly down-to-earth about “Stevie,” as all his friends called him. He continued to dress the way he had when he was a mere multimillionaire, in casual clothes; sweaters, and khakis, almost never in a suit. Cohen's “regular guy” attitude with friends became legendary. No gold watches, no bodyguards, and no arm candy when he's around town.

However, none of this earned him any points with the feds. There were just too many inconsistencies in the story that Cohen was achieving these results through sheer brain power and hard work. First, markets don't really work that way—they never have. Even Buffett has big losing years.

Yet as investigators perused Cohen's investing record, they could barely find a losing one (it finally came in 2008, during the financial meltdown). The too-good-to-be-true market performance on its face might not mean all that much if it weren't for the buzz coming from inside SAC. Insider trading wasn't outwardly encouraged, certainly not by Cohen himself or anyone in management. But the general consensus from former workers and people now cooperating with the feds as they began to ramp up their examination of insider trading—interviewing and deposing various witnesses and turning the occasional cooperator—was that SAC looked past this kind of illegality when it occurred.

Not only was SAC hypercompetitive, but traders described the atmosphere as a hedge fund version of “don't ask, don't tell.” There were lots of lawyers and compliance people, for sure. The firm's compliance manual basically likens insider trading to mortal sin. But as cooperators described the situation, in the ruthlessly competitive environment of working at SAC, such behavior was tolerated as long as it produced results and no one was getting caught.

Investigators noticed something else, too: Sometime around 2002 SAC began decentralizing the information flow among the various specialized groups at the fund, moving Cohen, who would directly manage just a portion of SAC's money, away from the center of the information flow. Still he would be briefed on performance, and seemed to know the performance of his company's big trading positions. Traders and analysts would recommend stocks and strategies, and he would use that information in the trading of the portfolio under his specific care while prodding them on their “conviction” levels, usually on a 1–10 scale, people who worked with him say, with 10 being the highest conviction or 100 percent certitude of a trade's success.