Circle of Friends (40 page)

Given some of John Kinnucan's interactions with agents and prosecutors in the year since they first met, you would think that agents would have opted for the shock-and-awe approach. But they didn't. In between his increasingly menacing and insane emails, John Kinnucan had sanely alerted the feds that his wife had a rare heart condition, and the last thing she needed was a 3 a.m. raid on his house.

“I can picture that headline,” Catherine Kinnucan said as it became increasingly clear that her husband was being added to the feds' expanding list of insider trading arrests: “Oops! Killed the wife. . . but they got their man!”

Catherine Kinnucan watched from the bedroom window as her husband was hauled off to jail. She was relieved that her children were still in their bedrooms and had been spared the indignity of seeing their father officially branded a criminal by the federal government. It also helped that the sordid spectacle of her husband's response to the investigation, from the drinking to the incessant emails, was now over.

But she soon came to terms with the reality of the situation: In little more than a year, John Kinnucan had gone from earning around $1 million a year to being broke. When his business dried up he tried money management, which meant he began trading stocks on his own. And he had lost money at that, just about everything the family had except for the house. Now he didn't even have enough to pay for an attorney or make bail.

And the government was going to make an example out of him. Only one cooperator had served time, Roomy Khan, who was sentenced to a year in prison, even after testifying at the trial of Doug Whitman, who received a four-year sentence as part of her circle of friends.

But that was because Khan was a two-time loser. Given Kinnucan's clean record and potential as a witness, he could have avoided jail time altogether, but rather than cooperate he had gone on the attack—the one thing every white-collar attorney says you should never do when dealing with the federal government. Because of those emails, the FBI no longer wanted Kinnucan as a cooperator; they wanted him in jail for a long time.

Catherine Kinnucan may have thought she knew about her husband's business; “I heard his conversations,” she said a few hours after John's arrest. “I've been in the room when he was talking to clients,” she said. “Cheating wouldn't have been fun.” The man she knew loved to research stocks, not game the system.

The feds didn't care whether Kinnucan was having fun. They believed they had a pretty airtight case against him for dealing in insider information. At times Kinnucan believed they were bluffing, or at least that's what he said in recent months.

What he didn't realize is that the FBI rarely bluffs, and agents like Makol and Kang have been doing investigative work a long time. In other words, no guy working out of his house in Portland is going to outsmart them.

They also had Kinnucan on tape, in true Rajaratnam fashion, both lying to his clients about where he had gotten his “research” and talking to his sources at various tech outfits about paying them off for the confidential information that the FBI believed was the lifeblood of his dirty business.

The tapes showed, for example, that Kinnucan had made a $25,000 “investment” in a business owned by an executive at computer memory manufacturer Sandisk after that executive passed on Sandisk's earnings before they were made public. It was, in Kinnucan's words, the “very least I can do.”

Those were better days, both financially and emotionally for Kinnucan, who had descended into a booze-induced state of constant agitation at the government, particularly when he was in front of the computer with a drink in his hand. Catherine Kinnucan says she knew little about her husband's email rants, but she thought he was doing the right thing in refusing to cooperate.

“Those dumb-ass lawyers would have had him plead to something and he would have been in jail already,” she said even as the judge set bail at $5 million—a sum she couldn't and wouldn't meet. “John's a fighter and he'll defend himself any way he needs to.”

That's what she was saying then; but over the next twelve months, she would barely speak to her husband and would file for divorce, she said to protect her children. She would also make a new friend in Craig Drimal's wife, Arlene. The wives of the men targeted in the investigation had experienced their own more private trauma in seeing their husbands going to jail, or in the case of Elyse Slaine, witnessing her husband's excruciating experience of going under cover to set up a friend. Like Catherine and John Kinnucan, Elyse and David Slaine were now divorced. Arlene and Craig Drimal remained married, and Craig would call her almost daily to speak with the children. Money was tight (even when Drimal was trading successfully, Arlene had complained it was like “Monopoly money,” that would come and go depending on the market). But Craig Drimal had come from a wealthy family, and Arlene was planning to go back to work after many years as a stay-at-home mom. At one point, Arlene Drimal reached out to Catherine Kinnucan, primarily because she had read about John Kinnucan's deteriorating mental state, and his family's deteriorating finances, to offer some moral support. The two, I am told, remain friends, often sharing experiences of what it's like raising a family when the breadwinner is in jail.

Even after pleading guilty, fessing up to his crimes, and telling a judge “I'm sorry,” John Kinnucan received more than four years in a federal prison—one of the longer sentences given during Operation Perfect Hedge.

T
he government based its case against John Kinnucan not only on the facts found in the wiretaps, but also on the extremely low odds of someone betting right with such astounding frequency as Kinnucan appeared to have done. The government believes such odds are low unless you're cheating, or, as David Makol told Kinnucan when they first met, “You know something is happening before it happens.”

Government investigators shared a similar disbelief over the legitimacy of some of the trading at SAC even as the fund's legal team maintained it was all in a hard day's work. The debate about where SAC got its famous “edge” was a daily one—between federal investigators and Cohen's legal team, and among rival traders.

And it occurred even over practices that had nothing to do with insider trading, or any illegality for that matter, but underscored the firm's ability to get an advantage over the competition. Such was the case in June 2010, when a drug company named Vivus went before an FDA panel that was ready to approve its new treatment for obesity, known as Qnexa.

Investment bankers packed into a room at the Hilton in Gaithersburg, Maryland, where the FDA advisory committee on endocrinologic and metabolic drugs met for an eight-hour session to decide whether to recommend approval of the weight-loss pill for public consumption. The market sentiment among traders was positive. In the days going into the event, shares of Vivus rose 32 percent to nearly $13 in anticipation that the panel would give the drug its blessing. During the day of the hearing, shares rose as well on what traders perceived to be positive comments from the panel.

SAC, however, was betting that the panel would reject the drug—and that it could profit handsomely. The firm had built up what people close to SAC say was a short position in shares of Vivus, meaning if the panel rejected the move and share price declined—as SAC believed it would—the fund would earn millions of dollars.

Did traders at SAC know something the market didn't? Part of the reason for the broader Wall Street optimism was the favorable research on Qnexa. The FDA had compiled a packet of studies and data about the drug and distributed it to the advisory board members just before the vote. The research was for the most part positive, according to Wall Street executives, showing side effects in the normal range of what the FDA often allows for drugs it eventually approves. In the words of one investment banker who attended the meeting, the panel's approval “seemed like a slam dunk.”

It didn't turn out that way. Wall Street, of course, hates surprises, so when the panel issued a 10–6 vote against approving Qnexa, Vivus's shares tanked 64 percent, to under $4 in the coming days. SAC, meanwhile, was counting its winnings—reportedly in the millions of dollars. The decision was widely covered in the media since anti-obesity drugs were becoming increasingly popular. The market impact alone made it a compelling story, with so much wealth being wiped out of the stock in a matter of days.

Cited among the reasons for the panel's decision were lingering concerns among certain members of the panel that the combination of drugs used to create Qnexa showed incidences of heart disease, depression, and cleft lip, a form of birth defect. But that only tells part of the story, at least according to some bankers who followed the trading.

Norbert Gottesman had been a healthcare analyst at SAC for four years. He was an analyst for SAC's CR Intrinsic unit specializing in pharmaceutical stocks, and in the past year he landed a position with broader responsibilities at the giant hedge fund. Gottesman was part of a new breed of SAC professional who had been making a mark inside the firm; analysts who, instead of reading the tape, spent their time crunching numbers and analyzing data. As Wall Street began to bet that Vivus would get approval to bring Qnexa to market, Gottesman saw other stuff in the data concerning the drug's side effects. He hired an “expert” statistician from Gerson Lehrman Group, the network firm that specializes in healthcare-related issues, to help with his research. Based on some data he and his expert had discovered in the weeks leading up to the vote, Gottesman recommended to a portfolio manager in SAC's healthcare group to begin shorting shares of Vivus.

It was a risky strategy—a “scary” one, was how one former SAC analyst with knowledge of the matter described the trade. But Gottesman appeared determined and confident. His numbers showed that the research the market was relying on understated the possible connection between Qnexa and birth defects. Based on
his
numbers, the incidence of cleft lip was significantly higher than most people realized. In fact, a recent updated study from the North American Antiepileptic Drug Pregnancy Registry shadowed his own analysis.

But it was unclear if the panel was up to speed on the new data. The packet of research distributed to the panel, for example, relied on a study conducted in winter 2009, which showed the occurrence of birth defects to be lower.

That was about to change. Early in the meeting, panelist Dr. Mary Roberts brought up the registry findings as part of her comments. Then, just before the committee's final vote, Dr. Eric Coleman, the FDA's deputy director of endocrine products, reminded the panel of Dr. Roberts's comments about the registry study for “isolated cleft” and added that the information shows that the incidence of the birth defect was actually greater than it might appear.

“It's just limited data,” Coleman said, “but there's an odds ratio that you don't generally ignore.”

And it wasn't ignored, at least according to bankers who attended the hearing and saw firsthand the surprise results as the panel voted against the drug's approval, and watched shares of Vivus get crushed with it. Such advisory votes are also nonbinding, meaning the FDA can ignore their outcomes, though that is rare. Moreover, there were several reasons cited by panelists for their no vote. Indeed, FDA panels rejected at least two other similar drugs around the same time.

But Coleman's comments certainly stood out to bankers in the room. “They came out of left field,” said one banker who worked with the company. “And why was he alerting people to what he described as ‘limited data'? It made no sense.”

For the company's financiers on Wall Street, and many small investors who owned the stock, the 2010 outcome was heartbreaking. But it was a cause of celebration at SAC. Speculation swirled that SAC had contacted the FDA before the vote—a perfectly legal action—on its way to victory.

An FDA spokeswoman says there was no communication with the firm and that both Coleman and Roberts brought up publicly available information. Meanwhile, the SAC edge had worked again, earning by one estimate tens of millions of dollars on the trade (the exact amount couldn't be determined; an SAC spokesman wouldn't comment on the matter). It would take two more years for the Vivus drug to receive final approval based on further data that showed the risk of birth defects to be less worrisome.

Investigators looking into the activities of SAC had come to believe that the fund's “edge” came in several forms. For one, there was its ability to legally root out information overlooked by the market, as it did in the Vivus trade. There was also its organization of around one thousand employees (300 of them market professionals), who operated day in and day out like a machine, cranking out massive trades as well as investment ideas that were passed on to the man at the top of the pyramid, primarily through a series of buffers, that also shielded him from any impropriety below.

SAC's vaunted “hub and spoke” trading model, where Cohen sat at the center of the information flow, was billed by SAC as the most creative way to maximize returns, with the world's best trader weeding out bad ideas and trading off the good ones. To get a meeting with Cohen was a big event in any trader's career. It meant the likelihood of a huge payday because, when Cohen used a strategy and it made money, he always shared the wealth. That's why some traders would do almost anything—including possibly breaking the law—to get in front of the big boss.

It also meant that Cohen had gained a certain level of comfort with that trader, which he didn't necessarily have with most of the people on staff. That's why flipping someone who was directly involved in insider trading and actually had direct dealings with Cohen became a key objective of government investigators as the investigations moved forward. So far most of the best witnesses were too removed: Jon Horvath and at times Noah Freeman, for example, dealt with Michael Steinberg, who was close to Cohen but not close enough for them to make a case against their ultimate target. Jonathan Hollander never spoke to Cohen directly at least about business. So the government's strategy was to pick off someone with direct ties to Cohen—and pray he would flip.