Overall, the realization among all the regulators was that for all their laws and court precedents and expertise, they were up against a foe better financed than they had ever seen. The hedge fund business grew astronomically in size. It attracted more than $100 billion in new cash in 2006 with double digit returns that beat prior the year’s stellar performance. Profits like that buy a lot of loyalty and a nearly impenetrable circle of friends.
The teamwork wasn’t paying dividends just yet, of course; as much as Kang tried, he had no luck bringing a case against Cohen. The same was true for the SEC, and the Justice Department’s Southern District office concluded that nothing they had seen so far would merit a criminal indictment against any major hedge fund player. But it would shortly, and the payoff would be enormous, thanks in large part to a midlevel SEC enforcement attorney toiling long hours in New York.
CHAPTER 5
WHAT FRIENDS ARE FOR
I’d rather kill myself than go to jail,” was how hedge fund trader Erik Franklin described his decision to cooperate with federal officials investigating what the government billed as the largest insider-trading bust since the days of Ivan Boesky.
That was probably an overstatement since the ill-gotten gains from Boesky’s fraud were tremendous (he ended up paying a $100 million fine) and the Franklin scheme netted its participants around $15 million. But untangling Franklin’s circle of friends—a close-knit group of drinking buddies and Wall Street acquaintances—set the stage for what would rank among the largest inside trading busts ever.
Franklin didn’t kill himself and he didn’t go to jail, primarily because he helped the feds uncover the entire five-year scheme, which began in 2001 when he worked at Bear Stearns as a money manager for an internal hedge fund named Lyford Cay. The illegal trading, government investigators discovered, ran almost nonstop through 2006 as an initial circle of friends expanded its ranks to include individuals working at firms such as UBS and Morgan Stanley and the growing hedge fund business.
The Bear Stearns connection was important, investigators discovered. The Lyford Cay fund was named after an exclusive resort in the Bahamas where the fund’s lead broker, Kurt Butenhoff, had vacationed. Butenhoff was a veteran of the firm who made his fortune (he earned as much as $10 million a year) by handling the trades of Bear’s billionaire CEO James “Jimmy” Cayne and some high-net-worth clients, including an ultrarich commodities broker named Joe Lewis.
Lewis, who would eventually become Bear’s largest shareholder just before the firm’s implosion in 2008, lived on Lyford Cay himself, in a mansion outfitted with trading screens in just about every room showing the performance of the markets and his various investments. He was said not to be an investor in the Lyford hedge fund, but Butenhoff’s boss Cayne was, which made its performance a top priority at Bear.
Also making it a top priority was what the Lyford hedge fund meant for Bear itself; the firm’s clients increasingly wanted from their Wall Street financial advisers what they could get from the most successful hedge funds like the Galleon Group: investments that beat the market.
Bear, like most big banks, had responded by creating its own hedge funds. What regulators also found out was that the hedge funds at the Wall Street firms may have been copying the same sleazy trading techniques rampant in the broader industry.
In Franklin’s case, the specific scheme he engaged in found its roots at a meeting in 2001, where he hooked up with a friend named Mitchel Guttenberg at the famous Oyster Bar restaurant in Grand Central Terminal, just blocks from his office at Bear headquarters in midtown Manhattan.
Guttenberg owed Franklin $25,000 from a personal loan. Among the up-and-coming Wall Street thirty-something set, loaning a friend $25,000 is akin to a $25 loan made by one friend to another in Middle America. But this isn’t the Midwest. In midtown, Franklin broached a way for Guttenberg to repay the favor. Guttenberg worked in the research department at the bank UBS and was privy to pre-market information about analyst research and market calls.
The scheme proposed by Franklin went something like this: To pay off his debt Guttenberg would tell Franklin what the UBS analysts were saying about a particular stock before the call was announced to the broader market. Franklin would, in turn, arrange his trades accordingly, shorting before downgrades, for example, and going long or buying shares that would benefit from positive analyst calls.
Guttenberg agreed, on one condition: After he paid off his loan, they would begin sharing the profits. The arrangement lasted for years. As it matured, so did the methods used to pass on information. They initially passed money inside Doritos bags, but later used personal banking accounts. They started using disposable cell phones and codes to signal upgrades and downgrades in order to hide their tracks more effectively.
They traded in what they thought were barely discernible blocks of stock—10,000 here; 7,500 here; and the occasional 70,000 share block over there—on the assumption that the computers like those at the SEC or run out of Funkhouser’s unit were too busy looking elsewhere for big frauds.
Over the years, their circle of friends widened. Franklin left Bear in 2002 for a hedge fund named Chelsey Capital, where he crossed paths with traders like David Slaine. But he kept his personal accounts at the firm, which traded on the same insider tips. His broker Rob Babcock now worked on the Lyford Cay fund and would piggyback Franklin’s personal trades both for the fund and for himself.
A couple of other traders at Bear with access to Franklin’s trading activity joined in, copying his trades with the pre-market knowledge of the UBS analyst recommendations.
Even as Lyford Cay was closed down in 2004 (Lewis remained a trading client of Bear and Butenhoff), much of the scheme continued. A husband-and-wife team of lawyers, Christopher and Randi Collotta, made their way into the circle of friends, by providing confidential tips on upcoming mergers and acquisitions in which Morgan Stanley was an adviser. Randi Collotta worked in Morgan Stanley’s global compliance department, where she was supposed to be safeguarding such secrets at least until they were made public; she and her husband began trading on the confidential merger information, and tipping off others. They included a Wall Street trader, the feds discovered, who turned out to be a high school friend of her husband, who then tipped off Babcock who in turn tipped off Franklin.
But what are friends for?
That’s a truism on Wall Street when it comes to sharing inside information; friends share information mostly because friends trust each other, whether it’s because of shared life experiences or because committing illegality creates bonds of its own. Shared guilt nurtures the shared responsibility to keep quiet.
But that shared responsibility only extends to the point when someone like David Makol or B. J. Kang shows up at your door and offers you a deal, as was the case with Erik Franklin. Now five years into his little network of trading on inside tips, Franklin had been feasting off his illegal gains at yet another hedge fund, this one set up with his own money, called Q Capital.
Franklin’s practice of keeping this circle of friends out of the sights of the feds by trading in barely noticeable amounts had proven to be a very good trick. But by extending the scheme into the arena of mergers and acquisitions, they had opened themselves up to one of the key variables checked by people like Funkhouser and his ever more sophisticated tracking system. The trade in question here involved a stock called Catellus Development. In 2005 it was being taken over by a company called ProLogis in a deal where Morgan was the adviser. That was the whisper that made its way from Randi Collotta to Babcock to Franklin and to the others, all of whom quickly began snapping up shares, even through accounts held by family members. The circle’s big mistake was using Franklin’s father-in-law’s trading account in their activities. That relatively small brokerage account somehow touched off alarm bells inside the commission and connected the dots to the wider circle, much the same way the porn star’s bank trades led to Jim McDermott.
It wasn’t long
before the SEC questioned Franklin on the trade. Flustered, he made up a false account of how it occurred. That was dumb since he had just added perjury charges to his potential criminal resume. But then he did something smart, and reached out to attorney Michael Bachner who told Franklin he was in serious trouble. Based on what the SEC was asking, it wouldn’t be long before the Justice Department and the FBI added criminal insider trading charges to the mix.
If Franklin fought the charges and lost, he faced years in jail. If he turned himself in and cooperated, he probably could work out a deal that would reduce or possibly eliminate jail time.
Franklin decided to cooperate. Makol, who would loom large as the insider trading probe progressed, gave Franklin his standard pitch: If you want to stay out of jail, you have to tell us everything. Franklin has told people the experience was jarring, and he was “near suicidal” at the prospect of jail time. With that, he turned over detailed records of his dirty trades to the government, including the names of people he did them with, and like Ivan Boesky and Marty Siegel, he agreed to wear a wire so investigators could snag the others.
Franklin began by fingering Guttenberg and then his friend Babcock, who made for an especially juicy target because he was still at Bear Stearns. As part of his deal for leniency, Franklin eventually pointed to others involved in insider trading, including David Slaine, then a Wall Street heavyweight who went to work at Chelsey Capital. Slaine wasn’t named in the eventual charging documents; the feds, as we shall see, had bigger plans for him.
Meanwhile, investigators believed the deterrent value of nailing a Wall Street trader was huge. Indeed, Babcock fancied himself as a tough jock, particularly in the macho atmosphere of the Wall Street trading desks where he worked. But rather than go to jail, the former college lacrosse player agreed to cooperate as well, wearing a wire and helping the feds nail down others involved in both the UBS trades and in passing along Morgan Stanley’s pre-merger deal information.
Like Franklin, Babcock was rewarded for his cooperation and pleaded guilty to a felony but no jail time. Guttenberg wasn’t so lucky; he was sentenced to seventy-eight months in a federal prison.
Babcock has told friends that while working as an informant at one point he tried to get his boss Butenhoff to concede to knowledge of the illegal activities, but without any luck. “He kept asking me weird questions,” was how Butenhoff later described Babcock’s efforts. To date, Butenhoff hasn’t been charged, much less questioned by federal authorities about being part of the ring.
Babcock, for his part, has also told friends that he recently touched base with Franklin to patch things up. “Rob basically told Erik that he harbors no hard feelings because Rob helped catch others,” said one mutual acquaintance. “It was kind of like an Alcoholics Anonymous meeting with everyone ’fessing up to their sins.”
“Greed is at work,” Manhattan U.S. attorney Michael Garcia announced as the feds unveiled the case in March 2007, calling it the biggest insider trading bust since the infamous Ivan Boesky case back in the 1980s. To illustrate the sweep of the investigation—including the sheer number of people involved and the number of stocks that were traded illegally—Garcia stood in front of the large board of names and photos with lots of arrows diagramming the various schemes at work by this particular circle of friends. The illegality was breathtaking in its scope; it occurred at major Wall Street firms (Morgan Stanley and Bear Stearns, even though the firms weren’t directly charged) and at hedge funds. Lawyers and traders were involved. Taken together, it appeared that insider trading was rampant across the financial business—not just inside hedge funds, which were only now facing heightened supervision from the SEC through new inspection laws, but also in places that the SEC and a host of regulators had been watching for years: the big investment banks.
As the feds were announcing the breaking of the Franklin-Babcock ring in March 2007, the first rumblings of the financial crisis had begun, and ironically at Bear Stearns, which was holding mountains of debt tied to the increasingly fragile housing market.
Still during the first quarter of 2007, Wall Street firms posted record profits sustained by taking massive risks in the trading of complex securities. Working anywhere in the financial business meant a huge pay day, from the trader to the chief executive. Steve Cohen earned roughly $1 billion in 2006. Jimmy Cayne, who ran the smallest of the big banks, Bear Stearns, earned a salary and bonus of $34 million for 2006, in a check that was delivered and announced in early 2007.
The difference between SAC Capital and Bear was of course in how they each managed risk. Cohen would take the necessary precautions to protect SAC and its investors from the worst that the looming financial crisis would offer. “You’re all idiots!” Cohen screamed one morning to his portfolio managers as he implored them to begin selling out of their positions and start hoarding cash in the face of the coming financial storm.
Cayne, meanwhile, did almost nothing until it was too late. Mortgage bonds on the balance sheet of Bear and the rest of the big banks were falling in value, and their implosion set in motion a chain of events that in about a year’s time would lead to the demise of Bear itself. The rest of the banking industry’s largest players would have also collapsed were it not for a historic bailout financed by the American taxpayer.
Likewise, the first glimmers of the financial crisis had barely made an impression on government regulators as insider trading had now emerged officially as public enemy number one for the white-collar cops. That was the warning made by the prestigious law firm Skadden, Arps, Slate, Meagher & Flom to its clients, many of them Wall Street traders and hedge fund traders, around this time. It didn’t matter that the then SEC chairman, Chris Cox, a former congressman from Orange County, California, and an appointee of President Bush, was known as a libertarian on most matters involving the economy, meaning he favored low taxes and less government regulation, except in the matter of insider trading. According to the firm, Cox adopted the SEC’s long-held position that trading on material nonpublic information was a threat to the “integrity of the markets.” As such he created a “working group” inside the commission dedicated specifically to tracking down insider trading cases, and particularly among hedge funds, where the feds believed for good reason that problems continued to fester.
Still, the length of time it took to crack the Franklin-Babcock-Guttenberg circle of friends only underscored just how difficult breaking the code of insider trading had become. It had taken five years for the most sophisticated surveillance systems in the world—now employed not just by Funkhouser’s crew but also at the SEC and the Justice Department—to snare a bunch of Wall Street frat kids who traded high-level insider information hidden in bags of Doritos.
Hell hath no fury like a women scorned,” agent B. J. Kang must have thought as he listened intently to the story of Patricia Cohen, the ex-wife of Steve Cohen, and the allegations she made about her ex-husband.
Patricia Cohen had many axes to grind against her ex-hubby, including the fact that when they divorced in 1992 and she received her share of Steve Cohen’s wealth, he wasn’t a billionaire—indeed, far from it. He had just launched SAC Capital, a firm devoted, as he would later say, to “information arbitrage,” a fancy way to describe the practice of finding out the best information available, and trading on it all day and every day to extract the maximum amount of profit.
When he started with the chunk of money he made while at Gruntal, no one outside the Wall Street trading community really knew who Steve Cohen was. His claim to fame in the popular culture: a 1992 appearance on a tabloid show called Christina, where he discussed how he was sleeping with his soon-to-be-ex-wife, Patricia, while he was dating his soon-to-be-new-wife, Alexandra.
Cohen, then with a full head of hair (an odd sight to those who’ve only seen him since he made his fortune), described his philandering this way: “A lot of these things occurred in the first year when I still wasn’t committed to Alex and maybe I used the ex as a wedge.
. . . I had gone through a pretty messy divorce and wasn’t ready. . . . It wasn’t a clean separation. . . . We went back and forth for a while,” he said, before adding that he and his first wife had “some financial difficulties.”
Times had changed, obviously. Some fifteen years later, Steve Cohen never appeared on television (unless clandestinely filmed) and gone were the financial difficulties. He had built one of the world’s largest hedge funds and made a lot of money. He lived with wife number two and seven children in a mansion in Greenwich, Connecticut.
And Patricia Cohen merited only a few sentences in the Wikipedia bio of her now famous and famously rich ex-husband. Patricia and Steve Cohen had been married for ten tumultuous years. The couple were married during the stock-market boom of the 1980s and divorced in 1990. They had two children together. Like all married couples, they fought, though at least once, according to Patricia, it was violently. When they divorced, Patricia got custody of the children, their apartment, and $1 million on top of child support, which Cohen believed was more than a fair deal.
Patricia Cohen never thought it was all that fair, particularly after her millionaire ex-husband became a billionaire ex-husband. Cohen, meanwhile, moved on with his new and relatively happy life. Patricia never quite moved on, remaining single, and according to Cohen’s friends, envious of the life Steve had created.
That’s one side of this messy story. The other side, outlined in a New York magazine account, went something like this: Patricia was watching a 60 Minutes profile of Steve Cohen, which alleged, among other things, that he manipulated shares of a company called Biovail. After some digging through old records, she had what she believed was proof that Steve hid assets from her during their divorce. She decided to file a lawsuit to recover $8 million she said was rightfully hers.
Circle of Friends Page 11
