Circle of Friends

The Massive Federal Crackdown on Insider Trading--and Why the Markets Always Work Against the Little Guy

Charles Gasparino

• Publisher: Harper Business
• Year: 2013
• Print ISBN: 9780062096067
• eBook ISBN: 9780062096081
• Topic: Business
• Subtopic: Stocks
• Index: Business

The bestselling author of The Sellout tells the explosive story of the government's crackdown on insider-trading networks—an investigation that has already racked up more than 60 convictions.

In Circle of Friends, award-winning journalist Charles Gasparino—one of Wall Street's most knowledgeable observers—follows government investigators and prosecutors as they pursue one of the most aggressive and broad-reaching series of insider-trading cases in the nation's history. A richly textured page-turner of investigative journalism based on extensive reporting, Circle of Friends chronicles the massive federal crackdown that has already put some of the biggest names on Wall Street behind bars, including Raj Rajaratnam, founder of the Galleon Group, and Rajat Gupta, a former CEO of consulting giant McKinsey & Co. Other similarly sized targets are still waiting nervously, including the biggest one of them all—financial impresario Steve Cohen of SAC Capital, the giant hedge fund that has confounded regulators for years by cranking out a steady stream of market-busting returns.

Gasparino goes behind the headlines to reveal how the government makes its case, using every tool at its disposal—and at great expense to taxpayers—to supposedly make the investing world safer for average Americans. Gasparino asks why federal officials are so eager to prosecute these cases: What is the real damage to individuals? Do average investors really care? He explores why insider trading is all the rage these days when the U.S. government has failed to bring a single criminal case against the culprits who caused the 2008 financial crisis.

Circle of Friends is not a defense of insider trading, but it does offer an account of the politics of Wall Street crime fighting, revealing the behind-the-scenes ambitions that motivate headlines and burnish political careers.

A riveting work of narrative nonfiction, as engrossing and explosive as fictional thrillers of the finest magnitude, Circle of Friends is a wakeup call to the investing public.

CHAPTER 1

PERFECTLY LEGAL

The world’s oldest profession is said to be prostitution, but if you’re looking for the world’s oldest economic crime, insider trading has to be at the top of the list. Historians say people have been looking for an information edge through various means almost from the time people began to buy and sell goods for a profit. When the European bourses, or stock exchanges, were created in the 1600s, financiers wasted little time before cultivating sources who could give them access to information not available to the general public.

Such gamesmanship wasn’t even considered a crime by the businessmen who in 1792 signed the Buttonwood Agreement—agreeing, under that famous buttonwood tree in lower Manhattan, to a set of rules and standards that would govern how they would trade various commodities, which led to the creation of the New York Stock Exchange.

That doesn’t mean average people liked it when rich fat cats used their wealth and privilege to game the market, as one such fat cat, William Duer, discovered. Duer was assistant Treasury secretary to Alexander Hamilton, and the same year the Buttonwood Agreement was signed, he thought he could make a boatload of money by speculating on debt issued by the U.S. Treasury—the first such debt issued by the nascent country.

Duer was looking to make a killing, using his connections with Hamilton and his position in the U.S. Treasury to take advantage of the market for newly issued government bonds. Yet in the end he was the one who was almost killed, and using insider information wasn’t his only mistake.

News of his gambit and his use of leverage, or heavy borrowing, to finance his bets became the talk of Washington and New York. Leverage is like the financial equivalent of an athlete on steroids. Normally, if you bet $1 on a given stock (or Treasury bond) and it rises to $2, you’ve doubled your investment. But if you borrowed an additional $9, and invested all $10, the resulting doubling in value would give you $20—twenty times your initial $1 stake (or ten times once you’ve paid back the loan). The leverage magnifies your gains enormously.

The problem with leverage (like steroids) is that the opposite occurs when the trader bets wrong—the leverage turns modest losses into astronomical ones—and that’s what ultimately happened to Duer. (It’s also what happened to the big banks during the 2008 financial crisis.) When prices of his government bonds began to tank, and the nation fell into a recession, Duer lost everything short of his life. At one point, an angry mob chased him through the streets of lower Manhattan, and according to one account, nearly disemboweled him. He died a little while later in debtor’s prison.

The bad example set by Duer didn’t do much to persuade financiers that insider trading doesn’t pay. Insiders made countless millions gaming railroad bonds during the 1800s by using their connections to key politicians, since the nation’s railroad system was heavily subsidized by Congress. The same financiers sold stock in railroads short (a trading technique whereby you can profit when stock prices fall) when they knew that certain rail companies would go bust. Bribes were common, and even when the miscreants were caught outright manipulating markets, prosecutions were almost nonexistent.

President Ulysses S. Grant even found himself in the middle of an insider trading scheme, which this time involved his assistant Treasury secretary tipping off business associates about the timing of gold sales. As the tips began to filter through the markets, the price of gold began to fall. After the government sale, gold prices fell even more.

At the time, gold was the nation’s reserve currency, and thus the value of the U.S. dollar plummeted. The day in September 1869 was known as “Black Friday,” as news spread about how a few fat cats profited while the rest of the country suffered. Even so, it would be decades before the practice was declared a crime.

Indeed, over the next sixty years or so, the courts meandered in and out of the insider trading maze, not really taking a firm stand. The country, of course, had much bigger issues on its hands, including World War I and the growing influence of organized crime, which cornered markets in booze (during Prohibition), broads (prostitution), and buildings (unions). White-collar crime was largely regarded as a fact of life; those who ventured anywhere near a stock exchange, the gold market, or the trading of any security or commodity knew what they were getting into.

Then came the Great Depression.

It takes one to catch one,” was what Franklin D. Roosevelt said when he was asked why he would hire a stock speculator to play cop over the stock market.

That stock speculator was, of course, Joseph P. Kennedy—businessman, political insider, rumored bootlegger, and not least, father of a future president—who was tapped by Roosevelt to head his new market watchdog, the Securities and Exchange Commission.

The year was 1933, and the consensus after years of ignoring financial crimes and insider deals was that stock speculation was the root cause of the ongoing economic catastrophe soon to be known as the Great Depression. Stock speculation had been rampant for years leading up to the 1929 market crash among people like Joe Kennedy, a prominent investor who for years earned millions buying and selling on tips that were hoarded among the Wall Street pros.

Not only was insider trading ignored by the courts, but the laws of the day almost encouraged it. Companies faced no legal compulsion to provide the public with any information more than advertising that wasn’t an outright lie. Financial statements were subject to state laws, which were pretty weak.

In essence there was no legal responsibility on behalf of corporate America to tell the truth to investors, while those who knew better, that is, the corporate insiders, could trade until their hearts were content.

Of course, in such an environment, speculators had a field day, and one of those was Joe Kennedy. He was smart enough to seize on the largely nonexistent regulatory environment, earning a fortune through what we today would consider insider trading and blatant stock manipulation, while keeping his reputation as a “legitimate businessman.” Among his favorite practices was said to be one of the oldest scams in the market: the “pump and dump.”

Kennedy and his business associates would buy the stock of target companies, spread positive news about them through the press, and dump the shares at a profit. Some seventy years later, the SEC and Justice Department announced a massive crackdown on the practice, which was the business model of a slew of brokerage firms operating on the fringe of the markets and often seeded with money from organized crime. The small firms were known as boiler rooms and investors who fell for their schemes lost tens of millions of dollars (as they did in the more modern-day versions). Many of the heads of the boiler rooms went to jail, while their foot soldiers were thrown out of the securities business for good. What the SEC didn’t say as it began to roll out such cases was that the scheme had been all but perfected by its own very first chairman.

By the late 1920s, Joe Kennedy was both incredibly rich and ready to be a political kingmaker. Being an Irish Catholic upstart who never forgot his working-class roots (his grandparents left Ireland to escape the potato famine), he was a lifelong Democrat and an early supporter of President Franklin Roosevelt.

Roosevelt, the hyperconfident new president, liked what he saw in Kennedy: Here was a Wall Street moneyman who agreed with him philosophically on the need for an expansive government to deal with the ravages of the Great Depression. More than that, Roosevelt used Kennedy’s status as a Wall Street insider to support his broader agenda; in other words, the creation of new laws that would forever reform the way the securities business worked.

Kennedy was soon armed with some of the most powerful new laws in the nation’s history pertaining to white-collar crime. Investment schemes, outright manipulation of stocks, distribution of false information—all hadn’t merely been tolerated by law enforcement authorities; they had been almost expected because Wall Street was regarded by regulators as “buyer beware” territory.

No longer.

Right after Roosevelt’s election in 1932, Congress passed and Roosevelt signed into law the Securities Act of 1933, and later the Securities Exchange Act of 1934. These laws armed the new agency, known as the Securities and Exchange Commission, with broad powers. Shady stock market dealings, by now considered a root cause of the stock market crash and the Great Depression, would become a crime:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange. . . [t]o use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

In plain English, this new agency was seeking unprecedented authority to regulate any market activity it considered “deceitful.”

Some crooks were indeed locked up in the post-market-crash era, but not by the SEC under Joe Kennedy. As broad as the laws sounded, the commission’s powers were actually pretty narrow—it regulated the securities markets but enforced its rules on a civil basis. Companies and individuals could only face fines and censures under the two laws that gave the commission its legal mandate. But the commission had no authority to put people in jail.

Nor did it have much authority to do exactly what today’s law enforcers say is the very meaning of the securities laws of 1933 and 1934: to level the playing field for all investors by trying to rid the markets of the scourge known as insider trading. That would have to wait.

Fiduciary obligations of directors ought not to be made so onerous that men of experience and ability will be deterred from accepting such office. Law in its sanctions is not coextensive with morality. It cannot undertake to put all parties to every contract on equality as to knowledge, experience, skill and shrewdness.

—Arthur Prentice Rugg, chief justice,
Massachusetts Supreme Judicial Court

The year was 1933. Stock manipulation and the sharing of inside information—the same stuff that the SEC chairman had profited from in another life—was now regarded as among the chief causes of the 1929 stock market crash and the Great Depression that followed. The U.S. Senate launched hearings aimed at holding those culprits responsible. They were known as the “Pecora Hearings,” named after Ferdinand Pecora, the chief counsel of the Senate’s Banking Committee who led the inquisition.

The Pecora hearings were big news at a time when the American people were reeling from the country’s financial collapse and wanted blood, namely banker blood, for the wild risk-taking that had led to the country’s economic woes. Pecora forced many of the country’s top moneymen to appear before his panel; he was considered a crusader in some quarters, and a publicity hound in others.

Either way his tactics would be copied by prosecutors and congressional investigators for years to come. People who worked for New York State attorney general Eliot Spitzer said his crackdown on Wall Street abuses and flamboyant unveiling of charges in front of rooms packed with reporters was inspired by Pecora.

Decades later, after the 2008 financial crisis, senior executives of the big banks would be taken to task for their sins before modern-day congressional investigative committees, in very Pecora-esque fashion. The son of Sicilian immigrants, Pecora was often photographed with a cigar in his mouth and cultivated the image of a working-class hero going up against the corrupt blue bloods of Wall Street. He didn’t just uncover schemes; he badgered his banker targets during his hearings with rapid-fire questions about their various misdeeds. The bankers called it a witch hunt, but Pecora had both the president and the public on his side for the simple fact that he showed how Wall Street insiders benefited unfairly from their privileged status and other conflicts of interest that would easily rank up there with the practices that led to the 2008 banking debacle.

Pecora’s hearings also had real teeth. He forced the resignation of the head of National City Bank, one of nation’s largest financial institutions and a precursor to mega-bank Citigroup, and his work gave impetus to a series of new banking laws, including the Banking Act of 1933, one of the most sweeping banking reforms in U.S. history.

And yet, even as Pecora railed against Wall Street’s chummy circle of friends, insider trading still wasn’t viewed as much of a crime, as the case of Cliff Mining and Rodolphe Agassiz demonstrates.

Agassiz, the president of Cliff Mining, had access to what the SEC would label today as “material nonpublic information” that his company was sitting on a potentially huge find of copper. Knowing that this would boost shares of his company, Agassiz then did what today would lead to SEC charges, fines, and possibly time served behind bars—he secretly bought shares of his company on the Boston Stock Exchange.

Shares of Cliff Mining would later soar when news of the copper mine was publicly released. That means someone had to lose money from not knowing the same information.

Enter a businessman named Homer Goodwin, who sold the stock just as Agassiz was buying, and while he probably didn’t know it at the time, Goodwin was soon to become an important footnote in the long and convoluted history of insider trading. When he discovered that he had sold his shares before the announcement (and thus missed out on the stock’s huge upswing), and that Agassiz had bought shares almost simultaneously, Goodwin sued Agassiz on the basis that the information about the mine was “material” and should have been made public to investors before they sold their shares.

Goodwin’s complaints as a company shareholder against Agassiz’s actions sound reasonable by today’s standards. But not according to the Massachusetts Supreme Judicial Court, or the SEC, Justice Department, or just about any securities regulator back then. Insider trading may have been one of the outrages the Pecora Commission used to generate headlines and class warfare in order to spur implementation of Roosevelt’s New Deal legislation, but in 1933 it wasn’t even a misdemeanor.

As Judge Prentice Rugg put it, the law “cannot undertake to put all parties to every contract on equality as to knowledge, experience, skill and shrewdness.” Agassiz, Rugg opined, didn’t put a gun to Goodwin’s head. There were no face-to-face meetings and misrepresentations. Both conducted their business on a public stock market. So the trade was perfectly legal.

The logic behind Judge Rugg’s defense of the unlevel playing field goes something like this: It is impossible and impractical for laws to guarantee that business transactions provide equal benefits to all parties—particularly in the securities markets, which are by their nature Darwinian, and where you know that your decisions to buy or sell stocks are based on imperfect information.

These days, it’s hard to imagine a time when leveling the economic playing field was actually frowned upon by the courts, but even during the New Deal, when the government was redistributing wealth at a pace greater than any other period in U.S. history, the securities markets were considered the last bastion of unfettered capitalism. To be sure, there are vast differences in the markets of then and now. In 1933 individual investors were a tiny sliver of the market participants; these days even blue-collar workers are forced to save and invest for retirement given the erosion of guaranteed retirement plans that corporate America has replaced with 401(k) plans and other investments.

The investor class for much of the sixty years after the 1929 stock market crash was pretty elite: Wall Street executives and wealthy individuals, lawyers, doctors, businessmen. Today average investors open online accounts at E*Trade when they want to buy stocks, and they aren’t bashful about looking for quick bucks through frequent trades. The game for the little guy back then was supposed to be long term: Buy stock in a company and watch it grow as the company grows. The overriding philosophy among regulators reflected this perspective—that markets become more perfect in the long run, when all the information, even those trades based on insider tips, get digested by participants and price discovery is created.

And that would be how the SEC under Joe Kennedy and other chairmen would approach insider trading for the next three decades.

In fact, it wasn’t until Joe Kennedy’s son became president in 1961 that the SEC and white-collar prosecutors began to view insider trading as something that must be eradicated.

When are you gentlemen going to investigate the rigged markets in new issues of over-the-counter stocks?” read a letter addressed to the SEC’s New York branch office in May 1961. “There is a lot of funny baloney going on in these issues, with conspiracies up and down the street, one selling to another at higher and phony prices, thereby creating phony markets in new issues, thereby hooking the general public who will eventually hold the bag. Then when the whole thing crashes over the ears of the little guy holding the bag, then you will wonder what happened, when all the time it is going on under your noses.”

Another letter delivered just one month later to the SEC headquarters in Washington, D.C., explained how current laws and the SEC’s enforcement of them were “wholly ineffective when it comes to preventing insiders, with special knowledge unknown to the public, before the issuance of corporate reports from taking unfair advantage of the public by their purchase or...

Table of contents

• Dedication
• Acknowledgments
• Contents
• Introduction
• 1 Perfectly Legal
• 2 Ten Different Cameras on Every Trader
• 3 Do Whatever It Takes
• 4 A Regular Guy
• 5 What Friends Are For
• 6 Bigger Fish
• 7 The Flip
• 8 The Feds Might Be Listening
• 9 Odd Couples
• 10 Something Good Is Going to Happen
• 11 Pounce Hard
• 12 Never Let a Good Scandal Go to Waste
• 13 The Luckiest Men in Law Enforcement
• 14 Stevie Is Worried
• 15 Harpooning the Whale
• Cast of Characters
• Notes
• Index
• About the Author
• Also by Charles Gasparino
• Credits
• Copyright
• About the Publisher