Circle of Friends

by Charles Gasparino

  It didn’t hurt that Khan had the intellectual aptitude to game the system as long as she had. She was well educated, having graduated with a degree in physics and a master’s degree in engineering from Columbia University. Combining that with her contacts in the hedge fund world, she was able to move effortlessly between the high-tech world of Silicon Valley and the trading desks of Wall Street, where knowledge of companies and their inner workings often translates into big money.

  Put it all together and Kang, along with the rest of the federal investigators assigned to the Galleon case, believed that Kahn had, like Gravano, returned to a life of crime. One key difference, of course, was that Roomy Khan didn’t commit murder or sell drugs. So giving her another chance to set things right seemed appropriate.

  Not that Kang emphasized just how palatable the government found the prospect of letting her go once again. In fact, he did just the opposite, reiterating to Khan in no uncertain terms how ready he, the FBI, and the U.S. Justice Department were prepared to put her in jail for a long time.

  To emphasize his point, as the meeting continued, he showed Khan what he considered one of the more incriminating IMs, dated January 9, 2006, where she appears to have told Rajaratnam that she needed to get back to her sources inside the company for guidance about when he should trade Polycom, a technology company that manufactures videoconferencing equipment and trades under the symbol PLCM.

  “donot buy plcm till i (get) guidance; want to make sure guidance OK,” the IM stated.

  Of course, the notion of “guidance” could mean a lot. For example, she could be doing her “channel checks,” a key component of the mosaic theory where analysts check with various sources of legal information—other analysts and market participants, not necessarily those with insider information—to confirm their mosaic investment thesis.

  Or she could be utilizing her network of friends inside the Silicon Valley tech community to find out confidential information about the company, as Kang and the Justice Department believed. Khan said that wasn’t the case. She told Kang she was no longer speaking to corporate insiders “because of the trouble she got into with the FBI several years ago.”

  Kang wasn’t buying it and kept pressing. He asked about the IMs regarding her trading of shares of Hilton before its purchase by Blackstone. She responded that she bought the shares of Hilton not because of any insider tip but because the publicity surrounding Paris Hilton going to jail for violating the terms of her probation was somehow good for the stock. It had nothing to do with advance knowledge of Blackstone’s purchase.

  As the interview entered its second hour, Kang’s relentless questioning was taking a toll. Khan was growing increasingly nervous and agitated with each and every question that Kang just kept hammering away with, sprinkled with more than an occasional reminder about how much time she could be spending in prison if he were forced to charge her.

  He later recounted to associates that the interview was a “roller-coaster ride” that lasted two hours and that Khan must have lied to him “a thousand and one times” during the meeting, before the wear and tear of having stern-faced FBI agents in her living room calling her a crook finally hit her in full.

  That was when Roomy Khan began to cry.

  “I know, I know, I’m going to jail if I don’t cooperate,” she said in a state of panic.

  “So what will it be?” Kang asked. “Jail or cooperation?”

  “I have to cooperate,” she said, sobbing at the prospect of going to jail and giving up her lifestyle and all the accoutrements that her circle of friends had provided.

  “She’s in the right place,” was the word Kang relayed to Wadhwa just minutes after he had finished with the first of what would turn out to be many interviews with Roomy Khan during the next six months, as a precursor to her full cooperation against the government’s primary target: Raj Rajaratnam.

  Wadhwa deserved the first of many calls since the case was his as much as anyone’s on the government’s payroll. The former tax attorney had now earned a coveted status among the top investigators at the SEC. He was the guy the FBI called to describe the progress of high-level cases, not the other way around. Khan’s initial lies during the interview were, as far as Kang was concerned, enough to put her away. (Remember, Martha Stewart went to jail for lying to investigators looking into suspicious trading, not because she was caught in the act.) But that would have to wait. Kang needed to touch base with his supervisors and come up with an official cooperation agreement to exchange evidence and testimony for leniency that Khan’s attorneys would sign off on, thus leading to the final step: a wiretap that would snare Raj Rajaratnam once and for all.

  The late fall of 2007 was a momentous month on Wall Street, though it had nothing to do with Kang’s progress in making Raj Rajaratnam the white-collar version of public enemy number one. That’s when three of the biggest chief executives on Wall Street, Stan O’Neal of the big brokerage firm Merrill Lynch, Chuck Prince of mega-bank Citigroup, and Martin Sullivan of insurance giant American International Group (AIG), resigned from their posts as it was revealed that they were part of a very different frenzy from the one that had transfixed the regulatory community at this time.

  Each had played a role in the mania of risk-taking that in less than a year would upend the financial system, causing Wall Street firms Lehman Brothers and Bear Stearns to go broke. Those that remained managed to survive thanks to government bailouts.

  The ousting of the big three CEOs were the initial shock waves of that cataclysmic event known as the Great Financial Crisis of 2008. Merrill and Citigroup were once supercharged companies that had feasted on risk for years, basically by underwriting and holding countless billions in faulty real estate investments that were worth just pennies on the dollar as the economy sank and the valuation of formerly overpriced housing began to reflect the economic climate. AIG’s sin was that it had insured all that risk (primarily through writing financial instruments known as credit default swaps) despite not having enough money to cover these pending bills.

  All firms would require some degree of government assistance to survive the eventual tumult along with the rest of the big banks, transforming what was initially a mild recession into a financial cataclysm that in many respects hasn’t fully ended. Indeed, as I write this, the Treasury Department is finishing up its sale of the AIG stock it took in return for the bailout (at an eventual profit to the government), the Federal Reserve is debating whether to continue propping up the economy through what economists term quantitative easing, and the newly reelected President Obama and Republicans in Congress debate what to do about the government’s sad fiscal state, which is due in large part to the enormous amount of spending undertaken in attempts to ameliorate the economic pain of the recession.

  But more than the countless billions of dollars of taxpayer money used to bail out the banks (plus the billions more in higher taxes to come) is the human cost of their recklessness. Millions of people out of work; banks not extending credit to small businesses or to home buyers; new and costly regulations put in place to prevent another banking collapse; regulations that have sapped the industry of much of its growth and job creation. If you think Wall Street bankers in five-thousand-dollar suits are the only ones squeezed by these new rules, consider the impact outsourcing and layoffs have had on back-office personnel and other jobs held by average, hardworking people at the big banks.

  The great risk-taking of Wall Street and the banks went unnoticed for years. In fact, it went unnoticed largely even after the system was showing its first signs of a collapse in November 2007. One of the great truisms of regulation is that the regulators rarely catch the scams and the overindulgence until it is too late to do anything about it. The reasons for this ineptitude vary, though many Wall Street experts pin it on the experience of the typical SEC enforcement agent, who is long on legal theory (most have gone to law school) but short on financial knowledge.

  But that rationale is an overs
tatement. Sanjay Wadhwa and his team of investigators were well-schooled in the ways of Wall Street and could read a balance sheet as well as many a Wall Street analyst. There was just one problem: While the excessive risk-taking that led to the 2008 financial crisis was taking place, Wadhwa and his team were busy cracking down on insider trading, as were their counterparts in the various white-collar crime units at the FBI and the Justice Department.

  It’s ironic that Kang himself made only a slight detour as one of the arresting officers of Ponzi schemer Bernard Madoff, though it was hardly a highlight of his career. The person who should be credited is Madoff himself. He had called the feds in December 2008 (just about a year after Kang made his initial introduction to Roomy Khan) to turn himself in as his scheme fell apart. That’s because big investors began pulling money out of his fund while Madoff was unable to find new investors amid the unfolding financial crisis.

  Madoff, of course, operated illegally for twenty years while government investigators, concluded on several occasions that he ran a clean operation—this despite numerous clues and complaints that he was running a scam. One of the ironies of the government’s Madoff fumble is that investigators failed to use their own logic when confronted with insider trading. Steady returns that beat the market over extended stretches of time are strong signals that cheating is taking place.

  In retrospect, some people in the Justice Department and the Securities and Exchange Commission say it was a manpower problem—they didn’t have enough people to look at everything and catch Madoff. Yet, through 2007 and 2008, there was no vast shifting of manpower and resources from the Rajaratnam case either at the SEC or the FBI to crack down on any of the major financial crisis frauds.

  The reason? “The insider trading case just looked way too sexy for us to change course,” was how one regulatory official put it.

  Yes, it was “sexy” (to regulators, at least) but was trying to catch Raj Rajaratnam trading a stock with insider tips worth ignoring some of the biggest financial catastrophes in a generation?

  Neither the FBI nor the SEC seemed to care as they began assigning additional resources to what they considered the crime of the century.

  Most people think of the FBI as a well-oiled machine, run with an iron fist by an all-knowing director in the tradition of the agency’s founder, the legendary J. Edgar Hoover. The reality is that the FBI is like any other government bureaucracy. Activities aren’t always coordinated; fiefdoms develop and interoffice rivalries over resources and credit for cracking the big cases are common.

  By late 2007, two of the most senior supervisors in the FBI’s white-collar division were engaged in just such a rivalry inside the FBI’s New York headquarters, at Foley Square.

  One of the teams was run by a supervising agent named Richard Jacobs, an aggressive man with a Marine crew cut who talked with the rapid-fire cadence of a drill sergeant. Jacobs was familiar with the workings of Wall Street. He had been a banker for six years before joining the FBI in 1999. According to a profile by Reuters, in his role as a special agent, Jacobs had even posed undercover as a stockbroker to break up an investment scam.

  The Jacobs team, known as C-1 inside the FBI’s office, included B. J. Kang. Its main objective starting in mid-2007 was nailing Galleon chief Raj Rajaratnam by completing a deal with Roomy Khan.

  The other was led by David Chaves, who ran a team known as C-35. Chaves’s experience was more diverse than Jacobs’s. Chaves began his FBI career busting drug cartels and learning the fine points about wiretapping targets. Wiretaps are commonly used in drug and mob-related investigations, which prepared him for the next step in his career as he focused on criminal rings in the white-collar world.

  His group broke up the Babcock-Guttenberg-Franklin circle—the insider trading ring that will go down in history for passing along payoffs in Doritos bags, and exposing just how entrenched the practice had become at major Wall Street firms as well as in the blossoming hedge fund business.

  Its counterweight to B. J. Kang was special agent David Makol, also a specialist in the art of getting bad guys in the white-collar world to flip and provide evidence against bigger bad guys.

  Any rivalry between the two teams was tempered by a shared vision that Wall Street had become a cesspool of illegality where the passing of insider tips was commonplace. They also shared something else, even as they worked on different cases: a desire to nail the biggest case out there.

  Both Chaves and Jacobs developed their approach to insider trading from long years in the trenches of white-collar crime. In addition to bringing down the Doritos gang, Chaves had led the team that worked on the Martha Stewart case and understood how inside information eventually makes its way from within the corporation to a trading desk and quick profits.

  Wall Street had certainly come a long way since the days of Martha Stewart. In just five short years, investigators discovered, the number of hedge funds had exploded, as did their trading profits. Chaves researched the returns of some of the biggest. Both SAC and Galleon were on his list and he saw something that defied common sense: They both made money nearly each and every year and had been doing that for years. The 2007 Babcock-Franklin-Guttenberg circle of friends—Chaves liked to call them clusters—confirmed his worst fears about Wall Street and the hedge fund business and their use of illegal information for profits. The clusters were more like a hydra-headed monster with its tentacles spread from Wall Street to hedge funds to law firms, any place where nonpublic information can be found and illegally acted upon.

  Yet when these players were caught and the fear of long jail sentences hit home, they fell like dominoes, or to be more precise, they reminded him of the famous scene at the end of Quentin Tarantino’s movie Reservoir Dogs, when all the bad guys pull guns on each other and shoot one another dead. His goal was to get more dominoes.

  Indeed, to break up the bigger rings that he knew existed, Chaves needed someone else, someone higher up the Wall Street food chain who would give him access to the bigger world of Wall Street’s version of organized crime—the insider trading conspiracy that he was convinced was much larger than anything law enforcement had seen in a very long time.

  Chaves is known inside the FBI as the “velvet fist,” for his ability to squeeze a lot of information from witnesses in the nicest possible way. He was fond of saying that “if people want to change their life, we’re here to help.”

  He was also known for his devotion to the broad ideological approach of the federal law enforcement bureaucracy toward investigating the white-collar crime of insider trading. To Chaves insider trading was a pox on the free market system, and if not prosecuted and held in check, it will destroy the public’s confidence in the markets.

  For most investigators looking into the activity, the pure evil of insider trading is a given. There isn’t much debate assessing how much time should be devoted to ridding the world of the practice or whether the agency’s resources could be deployed to fight more dangerous crimes, where the victims are more tangible than the “market” or “market confidence.”

  All of which might be heartening news for the Ponzi schemers like Bernie Madoff, who ripped off investors and charities for nearly two decades, but bad for those who appeared on the FBI insider-trading watch list.

  Chaves and Makol applied one of the FBI’s best good cop, bad cop acts in the business, converting hardened insider traders into true believers in their cause—none more devout and successful at breaking up illegal trading clusters than a veteran Wall Street trader named David Slaine.

  By 2007 David Slaine was one of those Wall Street legends who barely made it into the press. He was quoted every so often about market gyrations, particularly when he ran the Nasdaq trading desk for Morgan Stanley during the mid to late 1990s.

  He made a short item on the news wires when in 1998 he left Morgan and joined Galleon Group as a founding partner. Similarly he made wire service news when he was suspended for ninety days from the securities industry
along with a handful of other traders for manipulating stocks in the Nasdaq index through the trading of options while he was still at Morgan, which in the world of Wall Street is like getting a traffic ticket for speeding through a red light. It wasn’t acceptable behavior, but it wasn’t career killing, either.

  As with many traders on Wall Street, to Slaine the burgeoning and lightly regulated hedge fund business represented the endless potential to make money. While at Morgan, Slaine had told friends he wanted to get on the “buy side,” Wall Street slang for working at a hedge fund (the term applies to the primary objective of funds to “buy” securities and invest. Conversely, working at the big Wall Street banks is known as the “sell side” since their primary function is to sell those securities).

  The reason was quite obvious to anyone who knew him: He wanted to make the really big bucks that hedge funds were shelling out, particularly to people like himself who had the connections to make the right trades.

  The big Wall Street banks, with their large compliance staffs, made risk-taking more difficult, while hedge funds were all about taking risk and keeping lots of the profits on successful trades. Hedge funds also rewarded traders with friends who could provide expert guidance on the next merger opportunity or earnings call. The traders and the firm they worked at regarded these confidential tips as nothing more than business as usual.

  Slaine’s connection to Galleon wasn’t its charismatic founder, Raj Rajaratnam, but Gary Rosenbach, Rajaratnam’s right-hand man, and who, like Slaine, was a veteran trader. Slaine left Galleon in 2001 after what was later described as a somewhat tumultuous three-year stint. At the time no reason was given, and considering the amount of movement around the hedge fund business it was totally acceptable for traders to leave one shop, including an established place like Galleon, to venture out to an even smaller place where they could keep a bigger percentage of their earnings. People who know Slaine said he and Rajaratnam had remained friendly even after he left the firm. His real falling out was with Rosenbach, his friend and immediate boss. Some of the details are in dispute, but later Slaine would say he was uncomfortable with the firm’s business practices, including its use of inside information