Circle of Friends (14 page)

“I told Cohen to stop his managers from approaching my traders with their offer to give commission in exchange for information if we execute SAC trades,” said then hedge fund manager and future convicted swindler Bernie Madoff about SAC's business practices.

Madoff, of course, isn't a reliable witness (Cohen through a spokesman, denies the conversation took place), but some of what he said did corroborate what federal investigators had received from other more reliable sources. By 2007, Funkhouser's team had sent nearly two dozen referrals to the SEC to look into suspicious trading at SAC, but even more scary, at least according to Funkhouser's data, is that SAC wasn't the only possible bad guy in the business. Far from it. The technology developed by people like Funkhouser, as well as the commission's own surveillance systems, underscored the severity of the problem: Insider trading had become a crime wave. And it was done in the open as shares of companies “secretly” involved in mergers would inexplicably begin to rise.

The worst part for the regulators was that the Wall Street bad guys didn't seem to think twice about breaking the law. The
Financial Times
examined the suspicious patterns in an article titled “Boom Times for Suspicious Trades.” The mergers-and-acquisitions business was booming through 2006 and into early 2007, showering billions of dollars of profits on investment banks. But the M&A boom also touched off a rash of what appeared to be illegal insider trading in the form of profitable trading just before the corporate event was publicly announced, with a spike in trading volume before deals became public.

Nearly two-thirds of all deals over the past year fell into this category, the
Financial Times
concluded, including one of the year's most high-profile buyouts: News Corporation's $5.6 billion purchase of Dow Jones & Co. (owner of the prestigious
Wall Street Journal
).

The Dow Jones deal would eventually lead to SEC civil charges against a Dow Jones director for allegedly tipping off a prominent Hong Kong couple about the transaction. The director, David Li, paid $8 million fine, roughly the amount of profit the couple made by trading on his illegal tip. Under terms of the settlement, Li didn't admit or deny wrongdoing.

The Li case was hardly the deterrent that the feds were looking for, however. The chatter inside the hedge fund business was that the top cops weren't up to the job of catching the really bad guys, who were smart and well protected by amounts of money the hedge funds were doling out for the best inside tip. Informants like John Kinnucan were paid as much as $1 million a year for their work, and $1 million is a lot of hush money.

Meanwhile, the big traders had their handy excuse for knowing what was happening before it happened: the mosaic theory. “We would bring someone in suspected of insider trading and they would give us a million ways they traded legally, by creating a mosaic of information—not from hearing from any one source,” said one former prosecutor. “It was pretty effective because just showing that someone traded before an event is never really enough. You need more because most people on Wall Street will fight before they settle.”

F
or all the obstacles faced by regulators and prosecutors, the groundwork was being laid for the most successful assault on insider trading in modern history. The SEC was now regularly sharing this detailed information about suspicious trading activity at SAC and elsewhere with its counterparts in the Justice Department and the FBI—a change from the previous practice of each agency working on its own and sharing information just before a case was made and competing for the biggest headlines. A regulatory circle of friends was developing to combat the one on Wall Street. The new law enforcement triumvirate passed on tips, briefed each other on depositions, and took the first tentative steps to jointly investigate cases that would pay huge dividends in the not-so-distant future.

Why the change of heart? At the SEC, enforcement agents realized that the threat of the same relatively small fine it levied against Martha Stewart meant almost nothing to a hedge fund trader, who could make that in a single transaction. What they needed was the threat of jail time that only criminal cases could bring. Meanwhile, the Justice Department finally came to the conclusion that though the SEC might have missed some big frauds, its agents were fairly good at unearthing insider trading cases from mountains of trading data.

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.