Do You Sincerely Want To Be Rich? (22 page)

    The Clapps built a magnificent house on Paradise Island, whose psychodelic decorations and cathedral-like main hall have become part of folk lore - which values the house at $1.3 million. After the sec episode, the Clapps' group of companies drew even closer to IOS. Their offices were on the same floor of the same building in Nassau. On January 2, 1966 Ed Cowett was elected a director of Fiduciary Trust. One of the Fiduciary companies changed its name to IOS Acceptances. And about the same time that the Overseas Development Bank started up in the Bahamas, Fiduciary Trust started running down its operations, and was eventually wound up. William Sayad, an associate lawyer of Sam Clapp's who had been general manager of Fiduciary, turned into the general manager of odb in Nassau, and the IOS bank bought up Fiduciary Trust's furniture.

    IOS and Fiduciary cooperated in other little ways. For example one company listed on the board outside IOS’s offices in Nassau was called Lancaster Ltd. This company owned one share -there were only five issued - of the suitably named Palm Trees Ltd, which was registered at Fiduciary Trust's offices and of which William Sayad was a director. Such 'shell' companies were occasionally needed as intermediaries in one deal or another. As Ed Cowett once remarked, 'You never know when you may need a corporation.'

    There are all sorts of ways in which stockbrokers can effectively 'repay' commissions to their big customers, from causing bank loans to be made at favourable interest rates to outright defraying of their expenses. Where such actions become an infringement of the rules is harder to determine. Arthur Lipper, who became IOS’s main broker in 1967, paid for the apartment at NewYork's Hotel Carlyle where Cornfeld often stayed. That was accepted. But his payment of commissions directly to Investors Planning Corporation during the months it was controlled by IOS was later challenged by the sec. Like Cornfeld however Lipper has also been open about his position; he recently told the sec flatly that he thought the level of brokers' commissions on institutional business was 'unconscionably' high.

    The IOS position on rebated commissions was simple and clearly stated by Cornfeld and Cowett in private interviews. If brokers were prepared to give up their 'unconscionably' high brokerage commission wherever IOS wanted to direct it, even if that was back to IOS itself, then they saw no obligation to pass the benefit onto the funds they managed. After all, they argued with some justification, mutual funds under sec control were not allowed to benefit from such give-ups. It is an argument with which the customers, whose money was creating the commissions in the first place, might not always have agreed.

    Tracking down commission statements may have been the most exciting part of the sec investigators' work but it was not the simplest. The most trenchant part of the sec charges against IOS was derived from simple scrutiny of Fund of Funds prospectuses and reports.

    Whether US securities laws were actually broken because the prospectuses and reports of the Fund of Funds failed to make the disclosures that the sec required was a question which turned on the larger question of whether the sec could enforce the jurisdiction that it claimed over IOS. The sec had, however, grasped the important point: the documents were so inadequate that they were misleading by any standards.

    We described earlier how the Fund of Funds has only a small number of voting shares, all owned by IOS. Most of the inadequacies of the FOF prospectuses stemmed from the fact that IOS did not state in these prospectuses, nor indeed in the annual reports, that IOS itself controlled all these voting shares. As a result, no buyer of FOF shares who relied on the prospectus could be aware that IOS could change the whole structure and investment policy of FOF whenever it cared to do so. Investors could, and did, end up owning something almost unrecognizable compared to what they thought they were buying.

    The crucial change came in 1965 when the FOF stopped putting all its money in independently managed public mutual funds in the us and started the proprietary system in which FOF invested also in funds IOS controlled. This was a fundamental change both in structure and investment policy, which could well have affected many people's decision to invest. Even after the transition it was virtually impossible for anyone relying on the prospectus to discover what had happened as the slight, unexplained changes in the wording gave precious little clue, especially to anyone not versed in the intricacies of us securities laws.

    The sec spelled out these changes. The most important was in the section dealing with what FOF could invest in. The FOF prospectus dated April 1, 1964 - and earlier ones - stated that the FOF could invest in 'shares issued by any open-end investment company
(mutual fund)
registered with the United States

    Securities and Exchange Commission which primarily invests in us securities'.

    This section had been altered in the prospectus issued on May 3, 1965. The FOF could now invest in 'shares issued by any open-end or closed-end investment company registered with the United States Securities and Exchange Commission under the
Investment Company Act 0f 1940'.

    The effect of the alteration was dramatic. It meant that FOF need no longer invest in publicly sold mutual funds registered under the all-important Securities Act of 1933. While the Investment Company Act of 1940 gave important new powers to the sec, privately-controlled companies registered under this Act were still left free to do more or less what they liked in many areas.

    No explanation was offered for the change of wording. Yet IOS was then about to invest $10 million of the FOF money in a new fund, called the York Fund, registered under the Investment Company Act, whose controlling management company was half owned by IOS itself, which would have no other clients than FOF, which was going to levy a performance fee and which was specifically designed to sell securities short. Yet the same prospectus still blithely told investors that the FOF was not allowed to sell shares short. Later in 1965 FOF poured money into four more funds which IOS controlled itself.

    The sec also objected to the fact that the prospectuses did not make clear just how IOS itself was benefitting from buying shares in us mutual funds for the FOF portfolio. The same May 1965 prospectus for instance contained this account of the costs that the FOF incurred when investing: 'The cost to the Fund with respect to each transaction will generally go at the minimum rate established by most mutual funds…,
and may not exceed an aggregate total of 1% during any calendar year.
If the total cost of all transactions involves costs to the Fund in excess of 1% (including transfer taxes), Investors Overseas Services, exclusive distributor of the Fund, has agreed to pay such excess.'

    That sounded pretty generous. Yet if you ploughed on through the next ten pages of the prospectus you finally found the following words: 'The purchase and sale of securities for the

    Fund's portfolio will normally be placed through Investors Overseas Services as the investment dealer of record, and IOS will share in the customary charges, if any, relevant to such transactions.' In other words, if any mutual fund was prepared to share its charges with IOS on the FOF investment, IOS would be quite happy to keep some for itself. Because of the enormous blocks that FOF invested there was plenty of room for a us mutual fund to split its sales charge with IOS and for the FOF cost of aquisition still to come out less than 1%. To give one example, in 1964 and 1965 FOF put a total of nearly $6 million into the Value Line Special Situations Fund, on which a sales charge of 1 % - over $59,000 - was levied. The distributors of the Value Line fund gave 80% of that-over $47,000-back to IOS.

    After dealing with all these failures to meet its disclosure standards the sec came to the section of the prospectus dealing with redemption of FOF shares. One condition in which sales or redemptions of FOF shares could be temporarily deferred was, it stated, if 'the Securities and Exchange Commission of the United States government has by order permitted any such suspension.' The implication that the FOF was, after all, under sec regulation must have been the last straw for the sec.

    Misleading investors was one thing. But what really 'scared the hell out of the sec' - as one IOS lawyer put it - was a deal which was put together around a firm called Ramer Industries, and in which Cowett and Cornfeld became involved. It was not a large deal in itself, but to the Commission staff, it seemed to symbolize a whole set of IOS attitudes.

    Ramer Industries was, and is, a Brooklyn firm making sneakers, cheap slippers and shoes in competition with Japanese manufacturers. Early in 1964, the family controlling Ramer Industries decided that they wanted to sell a block of Ramer shares. They began negotiations with a group of prospective purchasers, all of whom were members of a New York law firm called Ross, Stamer, Wolf and Haft. (Robert Haft was the lawyer who had worked for Ed Cowett in 1962, and the firm had acted as counsel to IOS on a number of occasions.)

    Haft, Howard Stamer, and two other members of the firm -all acting as individuals - made agreements to purchase a block of 447,000 Ramer Industries shares, for just over $2 each. The agreements having been made, with the price fixed, the question arose of raising money to pay for the shares. In the summer of 1964, Ed Cowett was brought into the negotiations.

    By this time, the American stock markets had more than recovered from the sickening losses of 1962. The steady rise of the market was beginning to accelerate, and the promoters were once again coming out into the sun. In Geneva, IOS acquired the Overseas Development Bank in 1964. It formed two more banks to specialize in investment banking, and in the underwriting of stock notations. These were the Investors Overseas Bank, in the Bahamas, and the Investors Bank, in Luxembourg. And, after its sad early experiences with glamour stocks, 'IIT, an International Investment Trust' was beginning to recover, although still overshadowed by its vigorous young sibling, the Fund of Funds. Cowett took the view that it would be a good idea for IIT to take part in the Ramer operation.

    The first plan was that IIT, and the Investors Overseas Bank, should put up loans to finance the deal in return for options to buy shares. But for some reason, this plan was dropped, and it was decided instead that IIT itself would take up some Ramer shares.

    The actual mechanism here was that the four lawyers, in return for suitable 'considerations', would assign to IIT the purchase rights which they themselves had acquired earlier in the year.

    IIT agreed to take up 60,000 of the Ramer shares at just over $3 each. But this was not, in itself, enough to put the deal together, because Haft and his colleagues wished to assign more than 60,000 shares. Other purchasers were required, and approaches were made to the Banque Privee, a small bank in Geneva, to one of the partners in Jesup and Lamont, and to a number of us mutual funds.

    The approaches to the mutual funds were made by Bernard Cornfeld, acting in his capacity as chairman of the Fund of Funds. And this was the aspect of the deal which alarmed the sec: because the Fund of Funds was a substantial shareholder in several of the mutual funds to which Cornfeld went bearing Ramer shares.

    In one case, the Fund of Funds was actually in control, legally speaking, of a mutual fund which was persuaded to accept Ramer shares. This was the Value Line Special Situations Fund, in which IOS held more than 25% of the capital.

    Under the Investment Company Act, a holding of 25% in an investment company is regarded as the controlling interest if there is no larger holding. The realism of this is obvious enough if one looks at the case of a normal mutual fund, whose shares will as a rule be held in many small parcels. If anyone holds 25% of such a fund, which he can withdraw at will, he is in a position to inflict something not far short of disaster on the people who manage the fund.

    Value Line Special Situations Fund agreed, on Cornfeld's approach, to buy a parcel of Ramer shares at $3.25 each. It was a reasonable enough purchase, even though Value Line had sold out of Ramer earlier in the year, because Ramer's price then stood at about $4.50 per share. And the Value Line management maintained formally that they acted entirely independently when approached by Cornfeld.

    Nevertheless, the sober fact was that IOS was floating off shares, in which some of its own legal advisers were interested, through publicly issued mutual funds, one of which, in terms of American law, was under IOS control.

    In the end, Haft, Stamer and the other two lawyers assigned to IIT, Banque Privee, Value Line, and the other mutual funds approached by Cornfeld, the rights over 230,000 Ramer shares. As the market price had risen since those rights were obtained, the lawyers, who had got in at $2 a share, were letting the end purchasers have the shares cheap, at a little over $3 each, and for this they got considerations of $218,000, of which $45,000 came from IIT.

    IIT paid $188,000 for the 60,000 shares which it took, and at the end of 1965 Henry Buhl III was able to report an increase of $89,000 in the value of this investment. But the increase didn't last. At the end of 1966 the Ramer holding, although it had been increased by another 1,800 shares, had fallen in value to $146,800: by June 1967, when Ramer made its last appearance in the IIT portfolio, it had recovered to $301,300.

    No matter what Cornfeld and Cowett might say about the essential honesty and independence of all concerned in the Ramer deal, it was unrealistic to think that the sec could tolerate such operations. The fact was that IOS was moving towards a position where it would be able to control the leverage of vast sums of money, put up by American investors, by virtue of the tactical concentration of the Fund of Funds' holdings in us mutual funds. If IOS was going to start floating off promotions of its own on the leverage of such money, the possibilities were hair-raising.