Chiarella never went to college nor did he ever come close to a job on Wall Street, but he knew the value of the information he was handling if he could take the next step and try to figure out the names of the target companies whose identities were being concealed.
And he did by observing “the suits,” as one observer would later point out, who hung around the printing plant. Over the next fourteen months, Chiarella made more from trading stocks—around $30,000—than he earned as a printer, by piecing together this confidential information and trading on it. It also came at a cost: He was caught by the SEC, which noticed the suspicious trading activity in the targeted stocks. It wasn’t long before he was sanctioned by the SEC, forced to give back his trading profits, and charged by New York prosecutors, among the first criminal prosecutions ever for insider trading.
Chiarella was eventually convicted of securities fraud for trading on inside information, and his conviction was upheld on appeal. But the Supreme Court agreed to hear the case, and in a stunning move, reversed course. The court ruled in favor of Chiarella and nullified the SEC’s main arguments for bringing the action in the first place: that by handling confidential information Chiarella was actually a corporate insider. That meant, according to the SEC, he owed a “duty” to the investors of the corporate entities involved not to trade on the shares of the target companies before the news was made public.
The Court’s decision, announced in 1980, put the SEC on notice that its use of 10-b wasn’t a blank check to bring just any case. In fact, the ruling made Swiss cheese out of one of the key arguments that the SEC had used in its war against insider trading: that anyone with access to nonpublic information that can move a stock is a classic insider, owing a duty to shareholders and “victimizing” them by trading on it.
Chiarella was not a company insider in the same way that board members in Texas Gulf Sulphur had been, the court ruled. The government couldn’t even call the people on the other side of his trades real victims. Chiarella bought his stock on the market, where people trade all day for different reasons.
In other words, fairness in the markets had its limits.
It would be limited even more three years after the Chiarella decision, and nearly eleven years after the SEC first charged Ray Dirks with insider trading. Once again the commission was before the nation’s high court, looking for a bit of redemption, and of course, a further expansion of what the law considers insider trading, even if the agency did pick a pretty lousy example to make its case.
The echo chamber inside the commission failed to come to grips with what Dirks had really done. He had performed a function that was good for the markets and for investors. He had uncovered a fraud, and while his clients benefited first, so eventually did other investors as his information became reflected in the price of Equity Funding’s stock.
Here’s what Pitt meant by the SEC “dropping the ball” on Dirks: After charging the analyst in a civil proceeding, it expected Dirks to take his punishment and walk away. But Dirks wasn’t the “sweating” kind of stock analyst. He built a career taking on managements who ran fraud like Equity Funding, and short sellers he believed were wrong about companies they targeted as frauds.
He was also willing to take on the SEC, and he won. The Supreme Court’s ruling established a precedent that would define insider trading for years to come, but not in the way the purists in federal law enforcement had wanted. By stretching for the ultimate enforcement tool, the SEC wound up having the law diminished. Keep in mind that nothing in what the commission found Dirks had done resembled the wild quid pro quos of payments and other compensation that would become the modus operandi of the markets decades later, or even the gross abuses found before. He followed up on a tip from a company insider, a former executive from Equity Funding who told him that the outfit was a fraud. He investigated the claim, interviewing executives at the company, and came to his own conclusion about the stock. It was the ultimate in what traders would later call the “mosaic theory”—piecing together various pieces of data and then making a market call.
Common sense may have been missing from the SEC’s pursuit of Dirks, but not at the Supreme Court. Neither Dirks nor his initial tippee had stolen the information that Equity Funding was a fraud, because, the court ruled, it’s impossible to actually steal information that a company is a fraud. In other words Dirks wasn’t a criminal, just a stock analyst who uncovered criminal activity and made his clients a lot of money from it. Case closed.
Well, not quite. The tortured history of what constitutes insider trading had become even more tortured following Chiarella and Dirks. The SEC continued to push for as wide an interpretation as possible, and based much of its efforts going forward on a dissenting opinion of Chief Justice Warren Burger in the Chiarella case.
Burger pointed out that the Court would have been forced to uphold Chiarella’s conviction had the SEC not argued that Chiarella was an insider with an absolute duty to either refrain from trading or alert the world of the information. It would have been on stronger ground if it simply said “the defendant had misappropriated confidential information obtained from his employer and wrongfully used it for personal gain,” or Chiarella had stolen something, in this case confidential information that didn’t belong to him.
With that, the misappropriation theory became the SEC’s latest, albeit imperfect, weapon to democratize information and criminalize insider trading.
The 1980s’ boom and burst of stock market scandal would later be declared the Decade of Greed by future president Bill Clinton. (No matter that his wife had allegedly earned big sums of money at the time trading in the futures pits, where insider tips and circles of informed friends have been known to run rampant.) The corporate crime wave of the mid to late 1980s would be defined by the illegal activities of a high-level circle of friends, people like the famed arbitrageur Ivan Boesky, white-shoe lawyer/investment banker Martin Siegel, Dennis Levine, the journeyman deal maker who finally found fortune at Drexel Burnham Lambert, or his boss, Drexel’s junk-bond king, Michael Milken—all of whom spent time in jail for their various crimes involving the markets as they related to insider trading.
Milken was never directly convicted of insider trading, although he would spend time in jail for securities fraud involving his role in what prosecutors believed was a string of dubious corporate takeovers at the center of the largest insider trading scandal in recent history. As any judge or mobster will tell you, fraud involving the U.S. postal system or conducted over the telephone, known as “mail and wire fraud,” is far easier to prove than demonstrating that information from a confidential source is illegal, and that proved to be Milken’s downfall.
The trading of Boesky, Levine, and Siegel was clearer cut, particularly due to the cooperation of all three when confronted with proof of their various misdeeds. (Boesky and Siegel would wear wires to help the feds make cases against their business partners, including Milken.) They faced civil insider trading charges from the SEC, and various criminal charges from the Justice Department that landed each in jail.
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.
Wall 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
The 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.
Circle of Friends Page 5
