Circle of Friends (20 page)

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 overstatement. 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.

M
ost 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

Not so uncomfortable that Slaine wouldn't eventually dabble in it himself. He left Galleon to start his own hedge fund with two traders who had left SAC Capital. The fund dissolved for performance reasons, and then after bouncing around a bit Slaine landed at a hedge fund known as Chelsey Capital, the same Chelsey Capital where Erik Franklin had worked when he was busted for insider trading in 2007.

Slaine was there for only a short stint, less than a year beginning in February 2002, before ultimately setting out on his own, using his connections to both hedge funds and the Wall Street banking business to manage money. And he had largely dropped out of sight except for several honorable mentions in a book about the Wall Street trading culture,
The Other Side of Wall Street
, written by Todd Harrison, a former trader turned financial website entrepreneur. Slaine was described as a tough but fair trader who loved the action of “the desk” as much as he loved working out. Harrison also described Slaine as someone who understood at least some of Wall Street's dark side; it's a place where many of your friends exist as long as you help make them money.

W
ith his muscular physique and blue-collar Boston accent, David Slaine was an intimidating presence even on Wall Street trading floors. People who know him say he came from fairly humble beginnings on the Wall Street scale where many of its highest paid people attend private academies and Ivy League colleges.

Those close to Slaine describe him as a product of a broken home, in middle class Malden, a suburb of Boston (voted in 2009 as the “Best place to raise your kids,” by
Bloomberg Businessweek
). He was a standout high school athlete, and later attended Clark University in Worcester not far from where he grew up. He was known to his many friends as “Slaineo,” for reasons that no one seemed to recall, but it sounded cool and didn't annoy Slaine. In fact, for a legendary hothead, Slaine had many friends. He earned his way to the big investment bank Morgan Stanley because he was a gifted trader; he would eventually run the firm's trading desk that specialized in technology stocks, just in time for the tech bubble of the mid to late 1990s.