Circle of Friends (28 page)

The conventional wisdom was that the banks wouldn't, that is, until 2008, when they almost did.

Between the mega-banks that created bonds based on loans that couldn't be repaid, and the insurance companies that created a hedge against the possibility that the financial system would implode, Wall Street became a tinderbox of risk. It was a bipartisan failure on the part of policy makers to understand the notion of risk and why and how it can spread.

However, many in the hedge fund business saw the house of cards for what it was, and they had the tools to make an easy killing. In 2007 and 2008, the best way to make a quick buck in the markets wasn't just by being part of Rajaratnam's circle of friends; there was a separate circle that involved calling a couple of your buddies and simultaneously shorting shares of bank stocks, and then buying the banks' CDSs.

With the financial system on edge, simply buying the CDS would drive shares of bank stocks dramatically lower as investors saw it as a sign of imminent doom. The run on Bear Stearns, the first bank to fail during the financial crisis, began with a sharp increase in the price of its CDS contracts.

Top executives at Bear complained publicly that the company stock was being manipulated to death—literally—through rapid-fire purchases of CDSs and the simultaneous shorting of its stock that crushed shares. A vicious cycle ensued. Lenders pulled lines of credit, and shares fell further, and CDSs would rise. In just one week in March 2008, that process would lead to the demise of the firm (what was left was sold to J. P. Morgan). A similar cycle would play out in Lehman Brothers' demise, and the rest of the big banks were threatened, too, before the bailouts saved the system.

The manipulation of the credit default swap became a brief and fleeting controversy during the financial crisis. It also exposed a form of insider trading that had a profound impact on the markets but went unaddressed by regulators. Bank executives like John Mack of Morgan Stanley complained to securities regulators during those dark days. To deal with it, SEC chairman Chris Cox banned short-selling of bank shares until the crisis had subsided. But the manipulation never emerged as an enforcement issue.

Of course, many factors led to the near demise of the big banks, but the fact remains that traders could make a quick and easy buck simply buying a credit default swap not for its intended purpose of hedging against a company's debt but in fact to drive shares lower and profit off a short sale.

Bob Khuzami, the general counsel for Deutsche Bank's U.S. subsidiary, knew as much about the practice as anyone in law enforcement even before he received the call from Schapiro to run the SEC's enforcement division. While an assistant U.S. attorney in the Southern District of New York, he was chief of the securities fraud unit and focused on high-profile white-collar crimes, including an investigation of improper trading on the floor of the New York Stock Exchange.

His reputation for diligence got him a key assignment as part of the team that prosecuted the so-called Blind Sheikh, Omar Abdel-Rahman, for the 1993 bombing of the World Trade Center. Beginning in 2002, Khuzami decided to cash in on his government experience, taking a job as general counsel for the U.S. unit of the German mega-bank. He did so at a time of great excess on Wall Street in terms of risk-taking that spread even among foreign firms and their U.S. units. Deutsche Bank was one of the top packagers and sellers of toxic mortgage-backed securities to other firms—instruments that were a primary cause of the 2008 banking collapse.

Khuzami was hardly on the ground floor of the bank's mortgage business, and as general counsel, he wasn't in charge of the bank's risk taking. But those untidy little facts were barely mentioned when Schapiro announced that Khuzami would now head the SEC's enforcement division, the agency's primary investigatory weapon against white-collar crime.

How well Khuzami fared is a matter of debate. Khuzami “moved heaven and earth” to bring cases involving mortgage fraud and the broader financial collapse, according to one senior SEC official. His record, according to the raw data, was impressive: During the Khuzami era, the SEC brought cases against 150 individuals for financial-crisis related activities and set new records for overall enforcement activity.

But the cases of CDS manipulation largely evaporated, as did major cases against executives from Lehman Brothers, Bear Stearns, and other big U.S. banks for broader abuses that led to the banking crisis. Brad Hintz, an analyst for Sanford C. Bernstein who covers brokerage stocks, had been called by government investigators just weeks after the September 2008 bankruptcy of Lehman Brothers about crisis-related fraud, but he never heard from them again.

In private moments with his staff and with reporters, Khuzami would explain the difficulties of bringing cases involving the financial crisis. The accounting gimmicks employed by Lehman during its final months were used elsewhere and received approval by major accounting firms. So, Lehman was simply listening to its auditors, who were interpreting accounting rules. No intent to break the law here.

A 2010 report by an auditor looking at Lehman's bankruptcy said there were “colorable claims” against the firm's senior executives for their crisis-related risk disclosures, but by early 2011, the SEC had all but concluded that it couldn't charge any of them for fraud; not even a parking violation.

Maybe the bank chiefs
really believed
their firms would survive when they made all those statements projecting confidence in the face of mounting evidence that they wouldn't survive, Khuzami explained at one point when questioned about the lack of cases. It's hard to press a fraud case of misleading the investing public unless there is clear evidence of intent to mislead.

Or maybe Khuzami knew that the political clock was ticking, with President Obama gearing up for a second term and declaring war on fat cats, even if those fat-cat cases were taking longer than desired. Thanks to the work of Wadhwa and the people at the FBI, they had instant gratification in the form of insider trading.

O
kay, you got me,” is how regulators describe the initial phases of Richard Choo-Beng Lee's confession to FBI agents after a week of tense negotiations with his attorneys, ending with his agreeing to be the latest rat to cooperate. Lee was a prize catch for investigators; he was a technology geek with degrees in science and business and even chip making. He knew Rajaratnam well, having worked with the Galleon chief while they were both analysts at Needham & Co.

More than that, Lee had worked at SAC Capital and he knew Steve Cohen.

Lee had been on the government's wish list for some time. Investigators simply referred to him as “CB.” He ran a midsized hedge fund named Spherix Advisers, and as the SEC discovered through its maze of records and wiretaps, Lee had traded the same stocks that the Galleon chief had traded, and he had used some of the same illegal sources of information, including the same investor relations consultant who had alerted Khan to the Google earnings announcement.

But in the end, it was a Danielle Chiesi wiretap that finally did him in.

Lee and his business partner at Spherix, a trader named Ali Far, had as many connections as Chiesi in the Silicon Valley tech world, which is why she had kept them in her loop, and they kept her in theirs. Insider trading, the government had discovered, was like any other business in that information as much as cash was the currency that both parties relied upon. It was the quid pro quo that often mattered. With the government listening to various calls, the Lee-Far connection to the broader scheme became evident; both had access to the same Google investor relations executive from Market Street Advisors that Roomy Khan used. Meanwhile Chiesi shared with them tips she got from Moffat.

Kang made his first visit to Lee's Silicon Valley home and offered Lee a chance to cooperate and avoid jail time. As the Galleon probe progressed, its list of targets and possible cooperators had unraveled in bizarre ways. Far was actually approached first by the FBI, and alerted Lee that the government was starting to ask questions about their trading.

Lee listened intently as Kang explained the situation, providing Lee with a little taste of what the government had as evidence by playing some of the wiretaps. Lee seemed interested but let his attorney work the details before fully committing. When the attorney heard the tapes he gave Lee the following assessment: Cooperate or face jail time.

Lee was considered a great “get” by the government because of his obvious connections to the Rajaratnam circle of friends, as well as to Steve Cohen, for whom he had worked early in his career. Rajaratnam and Cohen might have been competitors in the markets, but they were fellow travelers in the hedge fund business. Far, for example, was a former Galleon executive who remained in regular contact with Rajaratnam. The wiretaps were making the case against Rajaratnam rock solid, even as the case against Cohen had stalled. But Kang considered Lee a possible game changer.

Once Lee began to fully cooperate, he explained in various sessions with the FBI and the SEC how he believed the famous SAC “edge” worked. “At SAC you are expected to develop an edge with information that no one else had,” is how one government investigator present at the meetings described Lee's remarks. The takeaway from the government's discussions with Lee: SAC's trading environment was a breeding ground for insider trading.

Based on the Justice Department's review of the Cohen wiretap it was clear that the SAC chief didn't engage in Rajaratnam-like banter, at least on the telephone. So Kang settled on the next best thing. He planned to have Lee approach Cohen for a job, so the feds could plant someone inside the firm.

But first he needed a cover story. Because Lee and his partner, Far, were now government cooperators, they had to shut down Spherix. Kang knew the move would raise suspicions because insider trading actually works: The fund was doing well, posting returns of around 10 percent.

Even worse, the wiretaps were starting to show that the various people under scrutiny were growing suspicious about a possible rat in the circle. Chiesi for one opined that she might end up in jail just like “Martha fucking Stewart.” Indeed, as soon as Lee and Far announced the closing of Spherix, the finance message boards began to speculate that they were in fact the rats.

Kang suggested a cover story to Lee and Far that went something like this: Tell clients and associates you had a falling-out over money, a move that might not raise suspicions in a world where people fight over money all the time. But it did, almost immediately. Rajaratnam, in particular, called Far first and asked if he was working with the government. Great traders have a gut feel for the markets and people, and Rajaratnam's gut was that Lee and Far were now government spies.

Far dodged the question with the cover story, but investigators were on high alert that their cover might have been blown and the authorities might have to move forward with arrests.

D
o you guys know about the expert networks?” Lee asked Kang one afternoon in the late summer of 2009. Up until now, the FBI and even the SEC thought the contingent of traders and analysts sharing and trading on illegal tips was doing so without buffers. But if Lee was to be believed, an entire shadow world existed where so-called experts in specialized fields, mostly in the tech field, sell to the highest bidder information about the companies they work at.

The arrangements were done through various firms, including one outfit known as Primary Global Research, which served as a broker for the information. On its face, the networks and the information-gathering system they said they employed appeared completely legal. What's wrong with an outside company employing executives from Apple or experts in the medical profession, including doctors, to provide insight into trends in technology or new drugs so a trader can better put together his mosaic?

But as Lee pointed out, hedge fund managers rarely wanted trend watching: They were actually looking for actionable material, such as early calls on mergers, earnings announcements, FDA rulings on new drugs—anything that would move a stock.

The experts were employed by just about every big hedge fund. SAC Capital often relied on a company named the Gerson Lehrman Group, which specialized in getting scientists and doctors with knowledge of drug companies to provide analysis of drug stocks, and at times relied on Primary Global. In late 2008, SAC's compliance department believed Primary Global lacked the proper controls on its consultants, and it was rejecting requests by fund managers to hire the firm's experts. The exact reason for the SAC move is unclear. Sometimes the information from the expert networks was like a view from thirty thousand feet—summarizing, for example, industry trends. But often the experts were handing their hedge fund clients confidential information as well. Still, SAC, like other hedge funds, thought experts were an integral part of the research side of their trading business. One such researcher was Dr. Sidney Gilman, a professor at the University of Michigan Medical School and an expert on drugs to combat Alzheimer's disease. Gilman, a Gerson expert, earned $100,000 from Gerson for his SAC work because the people there believed he was well worth it.

When these revelations made it back to the SEC, they shocked Wadhwa, who thought he had a pretty good handle on what was happening on Wall Street. Naturally he had heard about the expert networks but didn't realize just how big a business it had become—and exactly what type of “advice” it was peddling to the big hedge funds. Many of the experts never revealed to their companies that they had cut these side deals, earning tens of thousands of dollars on top of their regular take-home pay, and it was clear, based on Lee's roadmap, that part of their function as part of these networks was to pass on insider tips.

The Galleon investigation was now three years old, and to Kang and Wadhwa it was still in its formative stages. Hearing about the expert networks was revelatory because it deepened their understanding of how illegal information flowed through the markets. In addition to the experts, countless other middlemen roamed through the hedge fund world, offering illegal inside tips disguised as good old-fashioned stock research.