Circle of Friends (4 page)

U
ltimately
Circle of Friends
is less a polemic than a crime story, filled with larger-than-life Wall Street characters and their counterparts in federal law enforcement, and intended to show why each side is motivated to do what they do. This book will also delve into the origins of the crime known as insider trading, which began well before the current hysteria, and should provide some perspective on what actually occurs when someone trades on confidential information, and just how much the markets and society are injured by that act.

But
Circle of Friends
is also about the politics of insider trading—how this sort of Wall Street crimefighting has been used to make headlines and to buff and polish political careers. You may agree that insider trading is as bad as the regulators say it is for market confidence, but the fact remains that countless millions of dollars (the government won't release the exact amount) have been spent to deter crimes that have nothing to do with the cataclysmic events of 2008, which continue to shake the U.S. economy.

CHAPTER 1

PERFECTLY LEGAL

T
he world's oldest profession is said to be prostitution, but if you're looking for the world's oldest economic crime, insider trading has to be at the top of the list. Historians say people have been looking for an information edge through various means almost from the time people began to buy and sell goods for a profit. When the European
bourses
, or stock exchanges, were created in the 1600s, financiers wasted little time before cultivating sources who could give them access to information not available to the general public.

Such gamesmanship wasn't even considered a crime by the businessmen who in 1792 signed the Buttonwood Agreement—agreeing, under that famous buttonwood tree in lower Manhattan, to a set of rules and standards that would govern how they would trade various commodities, which led to the creation of the New York Stock Exchange.

That doesn't mean average people liked it when rich fat cats used their wealth and privilege to game the market, as one such fat cat, William Duer, discovered. Duer was assistant Treasury secretary to Alexander Hamilton, and the same year the Buttonwood Agreement was signed, he thought he could make a boatload of money by speculating on debt issued by the U.S. Treasury—the first such debt issued by the nascent country.

Duer was looking to make a killing, using his connections with Hamilton and his position in the U.S. Treasury to take advantage of the market for newly issued government bonds. Yet in the end he was the one who was almost killed, and using insider information wasn't his only mistake.

News of his gambit and his use of
leverage,
or heavy borrowing, to finance his bets became the talk of Washington and New York. Leverage is like the financial equivalent of an athlete on steroids. Normally, if you bet $1 on a given stock (or Treasury bond) and it rises to $2, you've doubled your investment. But if you borrowed an additional $9, and invested all $10, the resulting doubling in value would give you $20—
twenty
times your initial $1 stake (or ten times once you've paid back the loan). The leverage magnifies your gains enormously.

The problem with leverage (like steroids) is that the opposite occurs when the trader bets wrong—the leverage turns modest losses into astronomical ones—and that's what ultimately happened to Duer. (It's also what happened to the big banks during the 2008 financial crisis.) When prices of his government bonds began to tank, and the nation fell into a recession, Duer lost everything short of his life. At one point, an angry mob chased him through the streets of lower Manhattan, and according to one account, nearly disemboweled him. He died a little while later in debtor's prison.

The bad example set by Duer didn't do much to persuade financiers that insider trading doesn't pay. Insiders made countless millions gaming railroad bonds during the 1800s by using their connections to key politicians, since the nation's railroad system was heavily subsidized by Congress. The same financiers sold stock in railroads
short
(a trading technique whereby you can profit when stock prices fall) when they knew that certain rail companies would go bust. Bribes were common, and even when the miscreants were caught outright manipulating markets, prosecutions were almost nonexistent.

President Ulysses S. Grant even found himself in the middle of an insider trading scheme, which this time involved his assistant Treasury secretary tipping off business associates about the timing of gold sales. As the tips began to filter through the markets, the price of gold began to fall. After the government sale, gold prices fell even more.

At the time, gold was the nation's reserve currency, and thus the value of the U.S. dollar plummeted. The day in September 1869 was known as “Black Friday,” as news spread about how a few fat cats profited while the rest of the country suffered. Even so, it would be decades before the practice was declared a crime.

Indeed, over the next sixty years or so, the courts meandered in and out of the insider trading maze, not really taking a firm stand. The country, of course, had much bigger issues on its hands, including World War I and the growing influence of organized crime, which cornered markets in booze (during Prohibition), broads (prostitution), and buildings (unions). White-collar crime was largely regarded as a fact of life; those who ventured anywhere near a stock exchange, the gold market, or the trading of any security or commodity knew what they were getting into.

Then came the Great Depression.

I
t takes one to catch one,” was what Franklin D. Roosevelt said when he was asked why he would hire a stock speculator to play cop over the stock market.

That stock speculator was, of course, Joseph P. Kennedy—businessman, political insider, rumored bootlegger, and not least, father of a future president—who was tapped by Roosevelt to head his new market watchdog, the Securities and Exchange Commission.

The year was 1933, and the consensus after years of ignoring financial crimes and insider deals was that stock speculation was the root cause of the ongoing economic catastrophe soon to be known as the Great Depression. Stock speculation had been rampant for years leading up to the 1929 market crash among people like Joe Kennedy, a prominent investor who for years earned millions buying and selling on tips that were hoarded among the Wall Street pros.

Not only was insider trading ignored by the courts, but the laws of the day almost
encouraged
it. Companies faced no legal compulsion to provide the public with any information more than advertising that wasn't an outright lie. Financial statements were subject to state laws, which were pretty weak.

In essence there was no legal responsibility on behalf of corporate America to tell the truth to investors, while those who knew better, that is, the corporate insiders, could trade until their hearts were content.

Of course, in such an environment, speculators had a field day, and one of those was Joe Kennedy. He was smart enough to seize on the largely nonexistent regulatory environment, earning a fortune through what we today would consider insider trading and blatant stock manipulation, while keeping his reputation as a “legitimate businessman.” Among his favorite practices was said to be one of the oldest scams in the market: the “pump and dump.”

Kennedy and his business associates would buy the stock of target companies, spread positive news about them through the press, and dump the shares at a profit. Some seventy years later, the SEC and Justice Department announced a massive crackdown on the practice, which was the business model of a slew of brokerage firms operating on the fringe of the markets and often seeded with money from organized crime. The small firms were known as
boiler rooms
and investors who fell for their schemes lost tens of millions of dollars (as they did in the more modern-day versions). Many of the heads of the boiler rooms went to jail, while their foot soldiers were thrown out of the securities business for good. What the SEC didn't say as it began to roll out such cases was that the scheme had been all but perfected by its own very first chairman.

By the late 1920s, Joe Kennedy was both incredibly rich and ready to be a political kingmaker. Being an Irish Catholic upstart who never forgot his working-class roots (his grandparents left Ireland to escape the potato famine), he was a lifelong Democrat and an early supporter of President Franklin Roosevelt.

Roosevelt, the hyperconfident new president, liked what he saw in Kennedy: Here was a Wall Street moneyman who agreed with him philosophically on the need for an expansive government to deal with the ravages of the Great Depression. More than that, Roosevelt used Kennedy's status as a Wall Street insider to support his broader agenda; in other words, the creation of new laws that would forever reform the way the securities business worked.

Kennedy was soon armed with some of the most powerful new laws in the nation's history pertaining to white-collar crime. Investment schemes, outright manipulation of stocks, distribution of false information—all hadn't merely been tolerated by law enforcement authorities; they had been almost expected because Wall Street was regarded by regulators as “buyer beware” territory.

No longer.

Right after Roosevelt's election in 1932, Congress passed and Roosevelt signed into law the Securities Act of 1933, and later the Securities Exchange Act of 1934. These laws armed the new agency, known as the Securities and Exchange Commission, with broad powers. Shady stock market dealings, by now considered a root cause of the stock market crash and the Great Depression, would become a crime:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange. . . [t]o use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

In plain English, this new agency was seeking unprecedented authority to regulate any market activity it considered “deceitful.”

Some crooks were indeed locked up in the post-market-crash era, but not by the SEC under Joe Kennedy. As broad as the laws
sounded
, the commission's powers were actually pretty narrow—it regulated the securities markets but enforced its rules on a civil basis. Companies and individuals could only face fines and censures under the two laws that gave the commission its legal mandate. But the commission had no authority to put people in jail.

Nor did it have much authority to do exactly what today's law enforcers say is the very meaning of the securities laws of 1933 and 1934: to level the playing field for all investors by trying to rid the markets of the scourge known as insider trading. That would have to wait.

Fiduciary obligations of directors ought not to be made so onerous that men of experience and ability will be deterred from accepting such office. Law in its sanctions is not coextensive with morality. It cannot undertake to put all parties to every contract on equality as to knowledge, experience, skill and shrewdness.

—Arthur Prentice Rugg, chief justice,
Massachusetts Supreme Judicial Court

The year was 1933. Stock manipulation and the sharing of inside information—the same stuff that the SEC chairman had profited from in another life—was now regarded as among the chief causes of the 1929 stock market crash and the Great Depression that followed. The U.S. Senate launched hearings aimed at holding those culprits responsible. They were known as the “Pecora Hearings,” named after Ferdinand Pecora, the chief counsel of the Senate's Banking Committee who led the inquisition.

The Pecora hearings were big news at a time when the American people were reeling from the country's financial collapse and wanted blood, namely banker blood, for the wild risk-taking that had led to the country's economic woes. Pecora forced many of the country's top moneymen to appear before his panel; he was considered a crusader in some quarters, and a publicity hound in others.

Either way his tactics would be copied by prosecutors and congressional investigators for years to come. People who worked for New York State attorney general Eliot Spitzer said his crackdown on Wall Street abuses and flamboyant unveiling of charges in front of rooms packed with reporters was inspired by Pecora.

Decades later, after the 2008 financial crisis, senior executives of the big banks would be taken to task for their sins before modern-day congressional investigative committees, in very Pecora-esque fashion. The son of Sicilian immigrants, Pecora was often photographed with a cigar in his mouth and cultivated the image of a working-class hero going up against the corrupt blue bloods of Wall Street. He didn't just uncover schemes; he badgered his banker targets during his hearings with rapid-fire questions about their various misdeeds. The bankers called it a witch hunt, but Pecora had both the president and the public on his side for the simple fact that he showed how Wall Street insiders benefited unfairly from their privileged status and other conflicts of interest that would easily rank up there with the practices that led to the 2008 banking debacle.

Pecora's hearings also had real teeth. He forced the resignation of the head of National City Bank, one of nation's largest financial institutions and a precursor to mega-bank Citigroup, and his work gave impetus to a series of new banking laws, including the Banking Act of 1933, one of the most sweeping banking reforms in U.S. history.

And yet, even as Pecora railed against Wall Street's chummy circle of friends, insider trading still wasn't viewed as much of a crime, as the case of Cliff Mining and Rodolphe Agassiz demonstrates.