Circle of Friends (7 page)

The convictions were big news because they showed that insider trading occurred at the highest levels of the Wall Street food chain. And the details were pretty sordid. Siegel, a white-shoe attorney turned investment banker, admitted to handing bags of money to Levine, a midlevel Drexel banker, in exchange for tips about upcoming mergers and acquisitions that Drexel and Milken were financing.

The convictions made the careers of the federal law enforcement officials at the heart of the case, and provided a road map for other politically astute officials looking for ways to leverage crackdowns on white-collar crime to further their careers. U.S. Attorney Rudy Giuliani would become mayor of New York City several years later. The SEC enforcement chief, Gary Lynch, at this time went into private practice, defending big Wall Street firms. Harvey Pitt, the former SEC general counsel, defended Boesky and negotiated his cooperating agreement. Boesky's cooperation became instrumental in the conviction of Michael Milken, the highest-ranking Wall Street executive to be charged in the crackdown.

And yet, insider trading was hardly a settled matter. Milken didn't go to jail for criminal insider trading. The Justice Department in the final indictments relied on more nebulous criminal violations such as mail and wire fraud involving market manipulation. And with good reason: The misappropriation theory was challenged again and again with some success. Foster Winans, a writer for the
Wall Street Journal
, was charged with handing traders prepublication details of his market-moving “Heard on the Street” column. He spent eighteen months in jail for receiving some $30,000 in payments for giving traders an early read on the column, but his appeal reached the Supreme Court, which produced a mixed verdict.

The Court upheld his conviction but was deadlocked on whether Winans, as a newspaper columnist instead of a true corporate insider, had indeed violated the misappropriation theory. The vexing question the Court left unanswered was how someone who didn't work for any of the companies involved in the mergers he reported on, and who didn't pay someone to steal the information, could meet the legal test of insider trading.

W
all Street survived the 1987 stock market crash, and the junk bond market was only temporarily stymied when it lost brainchild Michael Milken to a prison term, but the lessons of the 1980s were short-lived.

Greed was back.

In the early 1990s, Orange County, California, would gamble with complex financial products known as
derivatives
and lose so much money it would be forced to declare bankruptcy. Its Wall Street adviser, Merrill Lynch, would stand by silently counting the millions it had earned from selling these risky products to public officials who had no clue what they were buying. Brokerage firms merged with white-shoe investment banks, meaning firms like Morgan Stanley could now pump up endless IPOs and other stock deals to mom-and-pop investors in its Dean Witter brokerage unit. The 1990s was the decade of the average investor on Wall Street—even if Wall Street didn't miss its chance to screw its most vulnerable customers. A combination of newfound affluence and a need to find investments for retirement made the stock market the place for average investors to save.

As the SEC fretted over how to keep the pressure on inside traders, it failed to grasp how the vast changes on Wall Street, including the creation of mega-banks such as Citigroup, posed potentially bigger problems for the average investor. Stock market research became more suspect; banks themselves were so big that their corporate clients became their best customers, and thus no analyst or researcher would dare slap a “sell” recommendation on a company that was paying his or her salary.

In these new megabanks, the small investor wasn't viewed as a client, but as a conduit used to pump up the value of the bank's real clients—corporate customers such as Enron and WorldCom and countless overhyped technology companies—even if those clients were frauds, as more than a few turned out to be. The small investor had little reason to suspect that analysts were now reduced to little more than touts; such relationships were barely disclosed outside the fine print of research reports.

This compromised research would play a large role in the destruction of small investor wealth following the collapse of the Nasdaq stock market in 2000. What was the SEC doing at this time? Not much when it came to cracking down on Wall Street's research scam or the growing menace of the big banks. In fact the SEC didn't even consider the various conflicts of interest involved in stock research a
real scam
until 2002, when it was prodded by New York State attorney general Eliot Spitzer to investigate the matter.

Through much of this time, the commission's bigger obsession remained insider trading. It's goal: To get the courts to provide a more concrete working definition. A big break came in 1997, when the Supreme Court ruled in
U.S. vs. O'Hagan.

James Herman O'Hagan was an attorney who in 1988 worked at the firm Dorsey & Whitney in Minneapolis, which was an adviser on a fairly large transaction, Grand Metropolitan PLC's takeover of Pillsbury. O'Hagan didn't work on the deal—he just heard about it inside the firm, which he believed gave him carte blanche (since he wasn't a fiduciary or a classic insider to either company) to buy options and the stock of the target company, Pillsbury, before the takeover was announced. He made millions when, as expected, shares of Pillsbury soared, but he was investigated by the SEC and charged with various levels of fraud, including insider trading. O'Hagan was sentenced to nearly four years in prison.

He appealed the case, and in 1996, an appellate court threw out O'Hagan's conviction, once again calling into question whether the misappropriation theory could be used on nonfiduciaries. In effect, the court ruled that O'Hagan had no duty to the shareholders of Pillsbury to alert them to the sale before he bought the stock.

That would change a year later when the Supreme Court finally codified the definition of misappropriation into modern insider trading law. O'Hagan was being “deceptive,” the Court said in its 1997 ruling, since he knew the information about the deal wasn't his, but in fact property of the companies involved in the transaction. By not alerting the entire market to the deal before he traded on it, he had actually stolen or “misappropriated” the information from people who had a duty to keep it quiet, and he did so purely for personal gain. Alas, misappropriation could be expanded to cover just about anyone.

The ruling was about as far reaching as the government could hope for, though it was hardly a perfect tool. All individuals who seek to profit from nonpublic information gleaned through what the Feds consider a “deceitful act” were, according to the courts, now guilty of insider trading.

But proving that deceit could be difficult, as the government would discover. Even with the O'Hagan victory there is still no insider trading statute, just the opinions of federal judges which regulators were forced to interpret. In a business where information is constantly flowing through rumors, speculation, and a hungry business media, proving that someone had stolen confidential information through deceit was no layup.

But O'Hagan was clearly a victory. Depending on their level of intent, people convicted of insider trading could also face years behind bars as sentencing guidelines for white-collar felonies began calling for more jail time. Moreover, the government wasn't about to let some murky court rulings stand in the way of making insider trading the white-collar-crime equivalent of armed robbery, as its increasingly aggressive investigative techniques would demonstrate.

CHAPTER 2

TEN DIFFERENT CAMERAS ON EVERY TRADER

T
he SEC viewed the O'Hagan victory as a milestone—and it was. Law enforcement had for years relied on the misappropriation theory to combat insider trading despite its gaping hole: It didn't cover the larger universe of potential insider traders, just corporate insiders who traded on nonpublic information about the companies at which they work, or people like Ivan Boesky who pay those insiders to steal company-specific information and then trade on it.

With O'Hagan
anyone
could be successfully targeted for trading on an illegal tip—even strippers who got their stock tips from their Wall Street clientele and a celebrity homemaker who got tipped off to major corporate events before anyone else.

The SEC and the Justice Department wasted little time going after this newly expanded pool of potential criminals and expanding its own ranks. The Justice Department, led by the U.S. attorney for the Southern District of New York, the main criminal agency involved in rooting out white-collar fraud on Wall Street, began hiring attorneys who had a knack for reading balance sheets. The perpetually underfunded SEC, through its politically savvy new chairman, Arthur Levitt, demanded more funds and got them to beef up its own enforcement efforts. The regulatory arms of both major stock markets, the Nasdaq and the New York Stock Exchange, were never much for catching bad guys, but they too were under pressure from Levitt to expand their enforcement staffs, as were the various state attorneys general—epitomized somewhat later by New York's Eliot Spitzer—who were also looking to make a mark in rooting out white-collar crime.

Still, officials knew they needed something more than legal precedent and a few more cops to successfully penetrate the now-criminal and ever-burgeoning circle of friends.

During the seven years that it took the courts to decide what James O'Hagan had done was criminal, the U.S. economy had fallen briefly into recession and then began a long economic expansion. There had been two presidential elections, a bailout of Wall Street over the big firms' investment in the Mexican peso (which collapsed in 1994), and then a roaring stock market that ignited vast changes to the U.S. banking and financial system, in turn making Wall Street bigger and more powerful than ever before.

Wall Street's business model began a substantive shift to more and more risk-taking through trading in far-flung markets to boost profits. Far-flung, that is, both geographically, as the growth of electronic trading united the globe's markets, and in terms of the types of items being traded. No longer were plain-vanilla stocks and corporate and government bonds enough for Wall Street's trading desks, which were under intense pressure to develop new products to sell to investors hungry for outsized returns. Interest rate swaps (where two parties trade their interest flows from loans or bonds), credit default swaps, and even more esoteric financial instruments were being created as rapidly as the market could consume them. Additionally, the firms were turbocharging these profits through the use of leverage, which made their losing trades more catastrophic.

Banks themselves became bigger and more complex. The controversial financier Sandy Weill created the mega-bank Citigroup, which combined investment banking and trading with the traditional commercial banking businesses of consumer lending and deposits.

It didn't matter that Citigroup was technically illegal when Weill merged his firm, the Travelers Group, with banking giant Citicorp in 1998. Even though the Depression-era Glass-Steagall law, which mandated the separation of Wall Street risk-taking from commercial banking, was still in effect, Weill's newly formed Citigroup received a temporary waiver to operate until the law could be changed. For years Glass-Steagall had been a paper tiger. Loopholes allowed banks to slowly encroach on the Wall Street businesses of underwriting and trading.

Weill supplied the final stake through the heart: He hired a slew of lobbyists and persuaded his friends in Washington to kill the law once and for all, and they did without much thought about the future consequences of unbridled risk-taking at commercial banks. Most notably, they failed to consider that consumers' deposits at commercial banks are backstopped by the federal government (meaning, of course, ultimately by taxpayers) via FDIC insurance. And now that these commercial banks were merged with high risk-taking trading operations, taxpayers were essentially insuring the mammoth risk being incurred by the big Wall Street firms. This was all fine and dandy as long as the economy was humming along, but as we all know, matters came to a head with catastrophic consequences in 2008.

With risk being embraced on such a large scale, a powerful new force began to emerge in the financial industry by the mid-1990s. The trader was king on Wall Street. Investment banking deals may have garnered the biggest headlines, but the trading desks at the big firms were the quiet profit centers, and with those profits came a vast expansion of Wall Street's trading culture, including its lust for inside information.

And it was not just at traditional banks and brokerages. Hedge funds—once a little-known investment vehicle for the rich—exploded in size and strength as the market's rapid rise created a new class of people: the superrich, who were not satisfied with steady market returns of mutual funds or dividend-paying stocks.

They turned to a new breed of sophisticated trader, people like Steve Cohen, a former trader at a midsized brokerage firm named Gruntal, who set up his own hedge fund, using the three initials of his full name, S-A-C. Under SEC guidelines, SAC could avoid most disclosure requirements and review while trading with almost no restrictions.

By the end of the 1990s, Steve Cohen's SAC Capital was trading so much that it regularly accounted for 3 percent of the daily volume on the New York Stock Exchange, and about 1 percent of the Nasdaq's daily volume. Cohen amassed enormous wealth during this time—reportedly several billion dollars and growing—but he was far from alone. The hedge fund business soon became the biggest, most active center of trading in the markets, with returns that defied normal market returns, as regulators soon discovered, on a regular basis.

With that, the trader had now replaced the investment banker as the Wall Street superstar, and the hedge funds had replaced the traditional investment bank as the market's power center