Circle of Friends

by Charles Gasparino

  Gruntal was the perfect place for Cohen; it was a no-frills firm for a no-frills guy known for wearing polo shirts instead of tailored suits. More than that, people who know Cohen say it was a replica of what he wanted to start on his own: a firm dedicated to making money trading, and little else.

  He stayed at Gruntal for nearly a decade, and launched SAC Capital (his initials) in 1992.

  His style of trading was hyperaggressive; the reason for his traders freaking out was that they were on standing orders to make money on small increments of stocks, so-called teenies, which when multiplied with volume could produce big results. He demanded market knowledge that wasn’t available on the Internet; he traded so much, he wanted the Wall Street desks that got his commissions to reciprocate in kind, through more and better market intelligence.

  As evolving legend would have it, he did it through a trading style that resembled that of a day-trader, rapidly buying and selling stocks. Or as Cohen put it in a speech: “We trade a lot, over twenty million shares a day. A broker’s dream come true. We trade fast. . . it’s not growth investing. It’s not value investing. It’s short-term catalyst investing.”

  At SAC Cohen soon doubled and tripled the $25 million initial investment he had to work with (half of it his own cash) in just a couple of years. By the end of the decade, he was a billionaire and his fund one of the most successful in the hedge fund business. At the same time, Funkhouser’s computers and those now running at the SEC and the Justice Department were picking up disturbing patterns that the profitable trades were often made before corporate events.

  How Cohen managed to achieve such consistent, over-the-top success became a matter of fierce debate on Wall Street, in the media, and increasingly among regulators. His friends, mainly at the big banks—those “brokers” he referred to on Wall Street who get paid fees for executing the massive volume of trades from SAC—simply consider him a genius. Larry Fink, the head of the big money management firm BlackRock, described him as an “information junkie,” someone who knows more about stocks than just about anyone else alive.

  With that power comes privilege; even people who admire Cohen and his firm say he and his team will use SAC’s leverage as a major supplier of trading order flow to get first dibs on research, or market intelligence that’s only handed out by Wall Street to its best customers.

  All of which is perfectly legal.

  What isn’t legal—if you believe criticism from competitors and even some former employees—were allegations that SAC used confidential tips as part of their trading strategies. These detractors describe SAC as something close to a sweat shop. Cohen sits in the middle of SAC’s massive trading floor listening to investing ideas from traders and portfolio managers and occasionally barking out orders. Traders and portfolio managers need to hit certain yearly performance benchmarks or else face termination. “If you’re up fifteen percent one month and down two percent the next you can get fired,” one former trader said. At SAC it’s called hitting your “down-and-outs.” Cohen even hired a psychiatrist as a coach for his traders so they can better handle the stress of his daily grind and reach their peak performance.

  Those who hit their marks are rewarded handsomely, and when they leave SAC on their own accord to set up their own hedge fund, they can expect to receive an investment from Cohen himself.

  It’s this pressure to produce, according to people who have worked for Cohen and those who know about his activities, that at the very least creates the environment for traders to push the envelope. As SAC grew through much of the 1990s into the next decade, those whispers began making their way back to investigators, including a growing number of SEC officials, FBI agents, and more than a few prosecutors who began taking a deeper dive into SAC’s trading activity and the secrets to Steve Cohen’s success.

  CHAPTER 3

  DO WHATEVER IT TAKES

  Pathmark was once the largest grocery chain in the New York City area. It was so successful it remained open twenty-four hours a day, seven days a week, featuring football-field-sized stores that stocked just about everything in the world.

  But by the 1990s the chain was falling apart; Forbes magazine called its stores “unkempt, dirty, and outmoded” while continuing “to stock scores of the dreary no-frills offerings customers have shunned for years.” Pathmark filed for bankruptcy reorganization in 2000. It secured bank financing and began to rebuild some of its most dreadful outlets. The company would soon emerge somewhat healthier and regain its listing on the New York Stock Exchange.

  But Pathmark would never return to its glory days. Not even close. Underscoring its downmarket status, a grungy Pathmark in Long Island, New York, was featured in the Michael Moore documentary Sicko, about the healthcare crisis and the poor souls at dead-end jobs with no health insurance coverage.

  As bad as things were, Pathmark still had a brand that was recognizable in Middle America. And that brand caught the attention of a white knight, billionaire grocery store magnate Ron Burkle, who in 2005 took a 40 percent controlling interest in the food chain through his investment company Yucaipa Companies.

  From the moment Burkle announced his investment, the speculation on Wall Street was that he would do his best to unload the stake when the timing was right. But first he needed to repair a company that suffered from years of neglect, by cleaning up the 140 stores now under his control and replacing the old management with a new one.

  It doesn’t appear that Wall Street paid much attention to Pathmark’s transformation. Shares hovered around $11, and Pathmark continued to lose money. But rival chains did, making offers to buy Pathmark to expand their reach. Burkle, wasting little time, agreed to the first serious offer he received, unloading Pathmark to A&P in a deal that was announced in early 2007. According to media reports, Burkle pocketed around $150 million on the Pathmark sale. He celebrated it in style with a “swanky dinner with Bill Clinton, Jay-Z and Bono,” raved the New York Post.

  But Burkle wasn’t the only one making a fast buck on Pathmark; in fact, someone on Wall Street may have made an even faster one.

  How the fuck did Steve Cohen know about the deal?” raged a Pathmark board member to one of the company’s corporate attorneys. “Someone has got to tell the SEC!”

  The news of SAC’s investment in Pathmark slid across the wires on December 21, 2006—a couple of months before the chain’s publicly announced sale to A&P. SAC had bought 2.6 million shares, a 5 percent stake, in a money-losing company. Sure, there had been plenty of talk and at least one trade-publication report speculating about a possible Pathmark sale, given Burkle’s propensity to wheel and deal. In early December 2006, during Pathmark’s third-quarter earnings conference call with Wall Street analysts, Pathmark CEO John Standley was asked by a Wall Street analyst “whether or not you guys may be looking to possibly merge with one of your competitors. . . for instance, A&P. . . . Are you guys looking to possibly do that?”

  “We’re not making any comments about rumors about anything,” Standley shot back. “We’re not going to do that.”

  But based on the filing, Cohen’s hedge fund appeared to be betting big that Pathmark was on the verge of completing something significant. SAC’s timing was possibly too good, one former Pathmark board member recalled in an interview years later.

  That’s because SAC’s December 2006 filing disclosed that it was accumulating shares just as both sides were finally drawing up official merger documents, the board member said. The deal was on schedule to be announced in late February 2007, nearly two months to the day after Cohen’s fund placed its bet. When the deal was announced as planned in February 2007, shares of Pathmark soared, of course, handing a nice profit to those who saw the deal coming.

  “SAC made a fortune,” the board member who worked on the deal said. Initially, this executive reckoned that a leak came from inside Pathmark, given its precise timing and Cohen’s growing reputation for having a circle of friends unmatched in the investment business. “We all thoug
ht it had to be a leak from the board.”

  Or maybe there was no leak and SAC’s trade shows how much of a legitimate edge professional traders have over average investors and just how futile it is for regulators to be obsessed with leveling the market for everyone. Indeed an SAC insider remembers the trade differently. SAC officials had been following the company closely, and weighed the public comments by the analyst community about a Pathmark-A&P deal before buying shares.

  And these insiders say it’s unclear how much money SAC made from the trade. Around the time the Pathmark deal was announced, some SAC traders were shorting shares (a trade where money is made when stock prices fall, or money is lost if shares rise) believing that the stock would fall at some point. It didn’t and as a result, SAC lost some money.

  Either way, the Pathmark official said the firm alerted the SEC to Cohen’s well-timed trades, and that’s where it ended, at least as far as this person knew (the SEC never filed charges on the matter). The Pathmark official would later remark that giving a tip to the SEC was like sending information down a “black hole.”

  To be fair, while the SEC has had its problems (Madoff, the financial crisis, etc.), tracking possible insider trading, with Funkhouser’s computers and its own databases, isn’t one of them. When it came to looking at suspicious trades at SAC Capital or anywhere, the problem had less to do with incompetence, or lack of effort, and more to do with not having the right kind of evidence to make a case.

  In 2003, Cohen’s firm already had escaped a possible fraud charge when the SEC looked into whether one of its traders had placed market bets ahead of research reports published by the trader’s fiancée who worked on Wall Street. The SEC at another point considered fraud charges against SAC for possible front-running, buying or selling stocks ahead of the orders of some of its customers. Again nothing happened.

  And Funkhouser, over at Nasdaq’s market surveillance unit—soon to be relabeled the Financial Industry Regulatory Authority—was amassing a laundry list of suspicious trades from SAC’s headquarters in Stamford and handing them to the SEC for a closer look.

  The closer look, however, led to dead ends. Cohen and his traders always seemed to have the right answers involving the suspicious trading.

  As for the front-running charges, Cohen and SAC traded so much that the trading ahead of other people in the market could be just coincidence. Then take the individual stocks Funkhouser was examining, or even SAC’s Pathmark trade. SAC traders were known to have the best circle of friends in the investment business, so it could have come from anywhere: a banker, a trader, someone on A&P’s board, or one of those “industry” experts that regulators were only beginning to hear about from their contacts in the hedge fund business. Finding any possible leak would be like finding that needle in a haystack, only worse, because Wall Street and the hedge fund business were by now far bigger than any barn.

  Indeed, one of the major enforcement hurdles faced by regulators was the growing complexity of Wall Street’s circle of friends. The expert networks had yet to make it on the government’s radar screen by 2007, but they were making their mark with hedge funds. The biggest of these outfits, including Primary Global Research and Gerson Lehrman Group, were private companies, so the exact size of their operations was largely unknown, but their importance to the hedge fund business can’t be overstated. By the mid-2000s, every major hedge fund looking for a competitive edge (and that meant all of them) had a relationship with the industry expert networks, for the simple reason that the thirst for information—particularly the stuff that could move stocks—was immense.

  “Hedge funds are on the phone with these experts all the time and if they are not giving them the right info, they’re going back to supervisors and asking for more and someone else,” a former industry expert explained as he reflected on the growth of the industry and the pressures faced by experts for “actionable information”—often a code word for information that violates the law.

  Also breaking into the circle of friends (and going largely unnoticed by regulators) was the old “sell-side” analyst, now reinvented as an “independent researcher” for the hedge fund business. Since around 2003, analysts who worked at the big banks were being demoted and downsized as regulatory pressure prevented them from aiding and abetting deal making. They would find a second life in the booming information business that centered on trading, even if many of them would succumb to the same sleazy behavior in their new incarnation as “independent” analysts.

  Wall Street or “sell-side” research began as a tool to gain market intelligence for traders and investors, but that changed in the late 1970s when Congress deregulated commissions on stock trades. Before then, investors would pay analysts for information; analysts who did their homework and recommended winning trades got reimbursed with a hefty share of these trading commissions.

  Now analysts faced extinction unless they joined their firm’s investment banking business and began touting stocks—using their research to promote stocks of companies that were the corporate clients of the big Wall Street firms.

  This conflict would lead to one of the great Wall Street crimes in recent memory, when, during the Internet bubble, investors lost countless billions of dollars buying overvalued and sometimes worthless stocks at least in part based on stock ratings later found to be fraudulent.

  Insider trading may be a fraud on the market, and a deceptive act, as the courts have ruled, but the federal government’s decades-long obsession with stamping it out came at a price: Bigger frauds with more identifiable victims went unaddressed or received far less attention.

  None were bigger and with more identifiable victims than Wall Street’s peddling of advertisements for their investment banking clients under the guise of research. The exposure of this crime—and the crime of the government’s inattention to it—can be traced to the waning days of the Internet bubble, when firms were placing buy recommendations on just about any technology company they could find, though not because they were making money and were good long-term investments. In fact many of these companies were start-ups that barely had revenues, much less profits.

  Nevertheless, Wall Street had convinced enough investors through their incessantly hyped research that these companies would be successful, and they spared no hyperbole to entice investors. The scam lasted through the great technology bubble that began roughly in 1995, with the IPO of a browser technology company called Netscape, through March 2000, when technology stocks began their painful correction, and for years later.

  During this time, of course, the SEC and other regulators made great strides in their pursuit of insider trading even as they ignored complaints about Wall Street fraudulent research. With the boom in technology stocks growing through the 1990s, a “virtuous circle” was created: Analysts wrote glowing reports, companies sent their investment banking business to the firms those analysts were employed at, and then everyone repeated the process all over again. The SEC, meanwhile, sat by and watched.

  That would eventually change, and not because of anything the SEC or other regulators did but thanks to the actions of a pediatrician and part-time investor from Queens, New York. In 1999, Debasis Kanjilal went to his Merrill Lynch broker and asked for some information about how to make some quick money on Internet stocks. He had about $600,000 in the market—a sweet spot for any broker looking for hefty fees and commissions that well-off retail or individual investors often generate for brokerage firms.

  Kanjilal was handed the research of an analyst named Henry Blodget, a former journalist turned Wall Street analyst, who made the transition to Wall Street like a lot of smart Ivy League grads did during the 1990s Internet and technology bubble. And presto, Blodget had become a star.

  His gift, at least superficially, was in understanding the new-economy companies at the heart of the Internet craze and translating their business model in a way that was clear to the non–Wall Street professional. This research was then distributed to clients,
including increasingly wealthy individuals like Kanjilal who watched business television and read the Wall Street Journal.

  As technology exploded in the 1990s, Blodget was in the right place at the right time. He was a good writer so his reports were widely read in the media, and he soon found a home at Merrill Lynch, after a short but hypersuccessful stint at Oppenheimer, where he famously predicted in 1998 that shares of Amazon.com, the online bookseller, would rise to $400. They did shortly thereafter. With that, Blodget’s star was born. Merrill Lynch, the nation’s then-largest brokerage firm, came calling and hired Blodget to run its technology research team. Blodget became one of the most recognizable figures for the millions of small investors who bought stocks through Merrill’s brokerage arm during the great bull market for technology stocks.

  Henry Blodget went from being viewed as a visionary to what many considered a tout—an analyst who seemed to have nothing but nice things to say about the companies he covered. Debasis Kanjilal knew none of this, of course, when his Merrill Lynch broker handed him a Blodget research report and he handed his broker $600,000 to follow Blodget’s advice and begin snapping up shares of tech companies.

  Over the years, Merrill had vehemently denied conflicts of interest whenever the business press occasionally raised the matter of whether it skewed its reports to suit the needs of its investment-banking customers. But after tech stocks began to crater and Kanjilal lost most of the $600,000 he invested using Blodget’s research as his guide, the good doctor went to an attorney for answers.

  That attorney, Jake Zamansky, knew the research game better than the guys in the Manhattan U.S. attorney’s office or the people in Washington at the SEC. He had once defended so-called bucket shops, small brokerage firms that operated on the fringes of Wall Street but used the Wall Street research business model as their guide. At the bucket shops, the only difference was that some analysts were bankers as well; Zamansky thought it was more honest than what he saw at the big firms, where analysts like Blodget posed as independent thinkers when in reality they were trying to win deals.