Circle of Friends

by Charles Gasparino

  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 sale of these securities while the public is ignorant of the fact which may exist.”

  Both letters were part of an increasing pattern of complaints from average investors about the unlevel playing field of the stock market. The country’s postwar wealth created many benefits, including a burgeoning investor class of people who for the first time weren’t content to sock their money away in an FDIC-insured bank deposit, where it would earn interest at a rate lower than those offered on government bonds. They plowed money into stocks; shares of the Dow Jones Industrial Average were now well above their pre–Great Depression peak, while daily trading volume of shares on the New York Stock Exchange soared to 4 million shares, nearly triple the level immediately following World War II. The markets were booming, contributing to the postwar wealth effect. But many of those new investors who helped push stocks higher believed they were doing so in a vipers’ nest. Unscrupulous brokers were selling them stocks to help drive up the price so corporate “insiders” could sell their inflated shares at a profit. Those insiders—the men running America’s biggest companies—had access to information well before the public did, and they acted on it by selling and buying shares before major corporate announcements without a peep from the SEC.

  William L. Cary, an academic appointed by President John F. Kennedy to run the commission, was somewhat of a renegade among market experts. Yes, people were complaining about an unequal playing field, but the prevailing wisdom among many academics was that insider trading was good—or at the very least produced a societal benefit in the form of more efficient markets (since prices would more quickly reflect all available information, including insider information). If the markets were so rigged, as the complaints suggested, then why were people continuing to snap up stocks more than ever before?

  Such were some of the arguments made by a prominent law professor at the time, Henry Manne, now dean emeritus of George Mason University, in his book Insider Trading and the Stock Market. In it he stated convincingly (or convincingly enough that regulators used it as a rationale for their lack of enforcement for decades) that without insider trading, asset prices would lag behind true investor sentiment, thus distorting the market.

  Cary, however, didn’t see the benefits and in fact took great offense at the notion that corporate insiders were using their positions for personal gain. Even more, he argued insider trading violates the fundamental basis of the markets in the aftermath of the 1933 and 1934 securities acts: that information must be disclosed in an equitable manner to all investors.

  With that Cary took the first giant leap by any federal law enforcement official to make insider trading a crime. He began to expand the SEC, populating its ranks with like-minded legal experts largely from academia who disagreed with Manne’s doctrine about the market efficiency of insider trading. He then began to use existing law more broadly, leaning heavily on one part of the SEC’s founding mandate, known as Section 10-b of the Securities Exchange Act of 1934.

  The securities laws of 1933 and 1934 were revolutionary in their scope in that for the first time the activities of Wall Street were being monitored by a federal agency with the power to sanction fraudsters. As sweeping as the laws were, they stopped short of giving the SEC the authority to put people in jail.

  But the law wasn’t without its teeth, miscreants could be fined, banned from the securities industry or from serving as an officer or director of a public company. Section 10-b of the act was particularly onerous because it covered just about every activity from outright theft to manipulating stocks, and as Cary would argue, insider trading as well. The rule was broad and open to interpretation, he believed. It allowed the commission to regulate just about anything it considered fraud if it involved “deceit or fraud” in connection with the sale of a security.

  Three decades went by before the SEC began using 10-b as a weapon to crack down on insider trading, and Cary thought it was way overdue. In doing so, he made history, becoming the first SEC chairman to state openly what is now the accepted wisdom among securities regulators: Insider trading erodes public confidence in the markets, and it’s something the commission must do everything in its power to eradicate.

  The first case brought by the SEC under Cary’s new mandate involved a board member of a public company who inadvertently tipped off a friend and business partner about a market-moving corporate event. What made the case against the brokerage firm Cady, Roberts & Co. so significant involved the SEC’s rationale in bringing action: insiders with exclusive access to nonpublic information must either “disclose” that information to the broader market, or “abstain” from trading on it.

  The information, in this case, involved a decision by the company, Curtiss-Wright Corp., to cut its dividend, with the likely fallout of lower stock prices in its aftermath. One of the company’s board members, a fellow named J. Cheever Cowdin, also moonlighted at a big brokerage firm—underscoring Cary’s core belief regarding the incestuous world of corporate America. Cowdin in his role as stockbroker told one of his colleagues at the brokerage firm, Robert Gintel, about the dividend move.

  Gintel did what you might expect: He acted on the tip, selling shares before the information became public, and not just his own shares. He also sold shares on behalf of his clients, saving lots of money for investors who benefited from his inside knowledge as prices did eventually fall on the news. Gintel thought he was doing what everyone else was doing, and what the government at least until now had tolerated in t
he markets—that is, obtain information in any and every way possible, and trade on it even if it was to the detriment of the suckers on the other side of the trade.

  Cary, however, saw illegality, based on his interpretation of the securities laws. And his efforts in bringing a securities fraud case would have far-reaching implications for years to come. Gintel had traded on information that was the “property” of the company, Curtiss-Wright, Cary argued. Lowering the dividend was the company’s information to dispense as it pleased, and by trading on that information before the rest of the market, Gintel had effectively used stolen information to make a quick buck.

  Gintel didn’t go to jail and Cowdin wasn’t even charged with a crime. For all Cary’s efforts, insider trading hadn’t risen to criminal status—that would eventually come. Instead, Gintel was charged with a regulatory infraction, a civil charge, and fined $3,000. Nevertheless, an important precedent had been established: The trading of material, nonpublic information was regarded as illegal by the nation’s top markets regulator. And this precedent would be repeated and expanded upon for the next fifty years.

  The SEC completely dropped the ball on Dirks.”

  That was the assessment of the commission’s general counsel some thirty years later about one of the most important Supreme Court cases in the history of insider trading law. Ray Dirks was a little-known analyst who would later gain fame for confronting the government’s ever-widening definition of what is dirty information.

  Just a few years before Ray Dirks appeared before the Supreme Court in 1983, Harvey Pitt had been a thirty-something general counsel of the SEC. In the years that followed, he would go on to have a fairly significant career in white-collar law litigation, representing stock swindler Ivan Boesky during the insider trading scandals later in the decade, and big Wall Street firms for years to come. He built a practice as an attorney who could be tough with regulators and tough with his clients, telling them when and where they stepped over the line and just how far he could push the government in protecting them.

  That ability helped land him the job he coveted throughout his career: SEC chief under President George W. Bush. It was Pitt’s dream job. He was overwhelmingly confirmed by the Senate in 2001 and he promised to put all his years in government and in private practice to use in doing big things at the agency.

  But it was also a short-lived tenure, shorter than most in recent history, as Pitt was pummeled with questions about his ability to crack down on his former clients, the big Wall Street firms, under scrutiny for various misdeeds stemming from the bursting of the Internet bubble and subsequent crash of the Nasdaq index.

  Democrats attacked him as a lapdog for his old corporate clients, even as he launched investigations into major post-bubble frauds involving short-lived high-flyers WorldCom and Enron. A memo leaked by a Democratic political operative laid out a damning scenario: Pitt’s long years in private practice defending Wall Street bad guys would be used to expose how the Bush administration was soft on corporate crime. But reality was different. Pitt’s philosophical stance made him as much of an advocate of tough enforcement as his predecessor Cary had been, particularly in the area of insider trading.

  For that, he had a zero-tolerance policy.

  Pitt managed to fight back the wave of rumor and innuendo. During his short term as head of the agency, he was actually quite effective at bringing cases against Wall Street firms such as Citigroup, Merrill Lynch, and Morgan Stanley. His knowledge of the securities laws allowed him to start a profitable legal and consulting business after leaving the commission in 2003.

  Which brings us to Pitt’s curious remark about a stock analyst named Raymond Dirks. In 1977 Dirks caught the attention of the SEC, which had launched an all-out effort to codify insider trading as a market crime. As the commission’s general counsel—or its chief lawyer—Pitt reviewed the agency’s enforcement actions, including one pending about Dirks. Pitt embraced the post-Cary mandate to test the limits of the securities laws as they apply to trading on nonpublic information. Since there was no insider trading law—just the SEC’s evolving definition of what constitutes a dirty trade—commission lawyers were for the most part making it up on a case-by-case basis.

  They were making it up big time in their pursuit of Dirks. In effect, the commission’s enforcement lawyers were saying that there were no practical limitations to what they considered an illegal trade. In the perfect market world envisioned by the SEC it didn’t matter if that trading involved a CEO who sold his stock just before he issued a negative earnings announcement, or if football coach Barry Switzer bought stock after having casually overheard news of a pending merger. (After facing SEC charges, a court said Switzer didn’t violate the law.)

  That’s because the reigning ethos at the commission in the decade that followed Cary’s first case was that in order to establish a fair marketplace, the public should know that all trading on nonpublic information is illegal.

  Pitt would refer to the SEC’s enforcement approach regarding insider trading as the “perspiration effect.” The SEC couldn’t and wouldn’t bring every case that came its way, but it would bring enough cases that even average people, not just Wall Street traders, would think twice, or sweat a decision about trading on confidential information. The SEC clearly wanted to make Dirks sweat—and others who followed his lead. Dirks had discovered a fairly significant fraud at an insurance company named Equity Funding. He went to the SEC with the details, but the commission didn’t see the merit in the case.

  The case it was looking to pursue involved Dirks’s own actions. He had alerted his own clients of the fraud before the broader market and he advised them to start trading on the information he had uncovered. His clients were thankful, but the early warning, according to SEC officials, was tantamount to passing on illegal insider information. At least that was the sentiment of the SEC enforcement division at the time.

  Pitt’s recollection of his role in the Dirk’s case is somewhat hazy. But he does recall being among the few people at the commission who urged caution.

  Troubling Pitt was the fact that Dirks didn’t exactly hide his findings. Rather he came to the commission with them. To be sure, a profit motive was behind Dirks’s attempts to spark an enforcement action that would have crushed shares of Equity Funding that his clients had shorted. But he was far from deceptive, the characteristic securities laws point to as one of the key elements to any fraud charge.

  Nevertheless, the prevailing wisdom at the time was pretty clear: There must be one market, not a specialized market for Dirks’s customers and another one for everyone else.

  In fact, Dirks presented what some SEC staffers thought was the perfect case: He was paid handsomely by his client, a large institutional investor, for exclusive information about a market-moving event, while other investors were left in the dark. The specifics of the case made it even more enticing to the federal agency, who wanted to establish an important precedent to further crack down on insider trading. The information on the fraud came to Dirks from a company insider, so it wasn’t already priced into the stock. Dirks either had to make the matter public to all market participants or keep his mouth shut.

  In the most far-reaching interpretation of insider trading yet, the SEC argued that a man who uncovered a fraud was actually committing fraud simply because he profited from an unlevel playing field.

  This was an important development. Insider trading enforcement after Cary left the commission in 1964 revealed just how murky the legal terrain surrounding insider trading cases was. First came a big win for the commission in 1968, when the courts ruled that officials at a company called Texas Gulf Sulphur had illegally traded on information about a major new copper ore find that would boost shares. The upshot of the verdict for the SEC was that it now had a clear definition of just what nonpublic information company insiders can legitimately act upon in the securities markets.

  A reasonable standard was established: If a reasonable trader belie
ves the information could move the stock, for example, news of a major find of copper ore or some other corporate event, then company insiders have to keep it private; they can’t trade on it until the information is made public.

  Keep in mind that the SEC’s case brought during the Cary years against Robert Gintel involved a tip that was relayed from a board member to a stockbroker who then traded shares. But in the Texas Gulf Sulphur case, board members didn’t relay the information to third parties; they traded on the information themselves. They also issued a press release the commission believed was misleading in trying to downplay the find when rumors began to sweep the market. The victims were the public shareholders of Texas Gulf Sulphur—the people the corporate insiders owed “a duty” to disclose information to if they planned on trading on it.

  It was the type of behavior that everyone, from the SEC’s insider trading purists to even those who believe there’s some broad merit in such dealings, would find particularly repugnant: a group of fat-cat insiders getting rich with no risk while screwing the investing public with bad information.

  Next came a setback for the SEC: a case and conviction against a financial printer named Vincent Chiarella, who traded on information he obtained on the job from the companies whose materials he was printing.

  It seemed like an open-and-shut case to the SEC, which brought charges in 1977. Chiarella worked at a printing plant that notified all its employees that they were prohibited to trade on any information obtained on the job. One of the biggest lines of business for Chiarella’s employer, a New York–based company called Pandick Press, was printing documents used by large investors to make tender offers for other companies. Such tender offers would send shares of the target company soaring, which is why financial printers had often blocked out the names of the target companies in the documents.