Circle of Friends (6 page)

For that, he had a zero-tolerance policy.

Pitt managed to fight back the wave of rumor and innuendo. During his short term as head of the agency, he was actually quite effective at bringing cases against Wall Street firms such as Citigroup, Merrill Lynch, and Morgan Stanley. His knowledge of the securities laws allowed him to start a profitable legal and consulting business after leaving the commission in 2003.

Which brings us to Pitt's curious remark about a stock analyst named Raymond Dirks. In 1977 Dirks caught the attention of the SEC, which had launched an all-out effort to codify insider trading as a market crime. As the commission's general counsel—or its chief lawyer—Pitt reviewed the agency's enforcement actions, including one pending about Dirks. Pitt embraced the post-Cary mandate to test the limits of the securities laws as they apply to trading on nonpublic information. Since there was no insider trading law—just the SEC's evolving definition of what constitutes a dirty trade—commission lawyers were for the most part making it up on a case-by-case basis.

They were making it up big time in their pursuit of Dirks. In effect, the commission's enforcement lawyers were saying that there were no practical limitations to what they considered an illegal trade. In the perfect market world envisioned by the SEC it didn't matter if that trading involved a CEO who sold his stock just before he issued a negative earnings announcement, or if football coach Barry Switzer bought stock after having casually overheard news of a pending merger. (After facing SEC charges, a court said Switzer didn't violate the law.)

That's because the reigning ethos at the commission in the decade that followed Cary's first case was that in order to establish a fair marketplace, the public should know that
all trading
on nonpublic information is illegal.

Pitt would refer to the SEC's enforcement approach regarding insider trading as the “perspiration effect.” The SEC couldn't and wouldn't bring every case that came its way, but it would bring enough cases that even average people, not just Wall Street traders, would think twice, or sweat a decision about trading on confidential information. The SEC clearly wanted to make Dirks sweat—and others who followed his lead. Dirks had discovered a fairly significant fraud at an insurance company named Equity Funding. He went to the SEC with the details, but the commission didn't see the merit in the case.

The case it was looking to pursue involved Dirks's own actions. He had alerted his own clients of the fraud before the broader market and he advised them to start trading on the information he had uncovered. His clients were thankful, but the early warning, according to SEC officials, was tantamount to passing on illegal insider information. At least that was the sentiment of the SEC enforcement division at the time.

P
itt's recollection of his role in the Dirk's case is somewhat hazy. But he does recall being among the few people at the commission who urged caution.

Troubling Pitt was the fact that Dirks didn't exactly hide his findings. Rather he came to the commission with them. To be sure, a profit motive was behind Dirks's attempts to spark an enforcement action that would have crushed shares of Equity Funding that his clients had shorted. But he was far from deceptive, the characteristic securities laws point to as one of the key elements to any fraud charge.

Nevertheless, the prevailing wisdom at the time was pretty clear: There must be one market, not a specialized market for Dirks's customers and another one for everyone else.

In fact, Dirks presented what some SEC staffers thought was the perfect case: He was paid handsomely by his client, a large institutional investor, for exclusive information about a market-moving event, while other investors were left in the dark. The specifics of the case made it even more enticing to the federal agency, who wanted to establish an important precedent to further crack down on insider trading. The information on the fraud came to Dirks from a company insider, so it wasn't already priced into the stock. Dirks either had to make the matter public to
all market participants
or keep his mouth shut.

In the most far-reaching interpretation of insider trading yet, the SEC argued that a man who uncovered a fraud was actually committing fraud simply because he profited from an unlevel playing field.

This was an important development. Insider trading enforcement after Cary left the commission in 1964 revealed just how murky the legal terrain surrounding insider trading cases was. First came a big win for the commission in 1968, when the courts ruled that officials at a company called Texas Gulf Sulphur had illegally traded on information about a major new copper ore find that would boost shares. The upshot of the verdict for the SEC was that it now had a clear definition of just what nonpublic information company insiders can legitimately act upon in the securities markets.

A reasonable standard was established: If a reasonable trader believes the information could move the stock, for example, news of a major find of copper ore or some other corporate event, then company insiders have to keep it private; they can't trade on it until the information is made public.

Keep in mind that the SEC's case brought during the Cary years against Robert Gintel involved a tip that was relayed from a board member to a stockbroker who then traded shares. But in the Texas Gulf Sulphur case, board members didn't relay the information to third parties; they traded on the information themselves. They also issued a press release the commission believed was misleading in trying to downplay the find when rumors began to sweep the market. The victims were the public shareholders of Texas Gulf Sulphur—the people the corporate insiders owed “a duty” to disclose information to if they planned on trading on it.

It was the type of behavior that everyone, from the SEC's insider trading purists to even those who believe there's some broad merit in such dealings, would find particularly repugnant: a group of fat-cat insiders getting rich with no risk while screwing the investing public with bad information.

Next came a setback for the SEC: a case and conviction against a financial printer named Vincent Chiarella, who traded on information he obtained on the job from the companies whose materials he was printing.

It seemed like an open-and-shut case to the SEC, which brought charges in 1977. Chiarella worked at a printing plant that notified all its employees that they were prohibited to trade on any information obtained on the job. One of the biggest lines of business for Chiarella's employer, a New York–based company called Pandick Press, was printing documents used by large investors to make tender offers for other companies. Such tender offers would send shares of the target company soaring, which is why financial printers had often blocked out the names of the target companies in the documents.

Chiarella never went to college nor did he ever come close to a job on Wall Street, but he knew the value of the information he was handling if he could take the next step and try to figure out the names of the target companies whose identities were being concealed.

And he did by observing “the suits,” as one observer would later point out, who hung around the printing plant. Over the next fourteen months, Chiarella made more from trading stocks—around $30,000—than he earned as a printer, by piecing together this confidential information and trading on it. It also came at a cost: He was caught by the SEC, which noticed the suspicious trading activity in the targeted stocks. It wasn't long before he was sanctioned by the SEC, forced to give back his trading profits, and charged by New York prosecutors, among the first criminal prosecutions ever for insider trading.

Chiarella was eventually convicted of securities fraud for trading on inside information, and his conviction was upheld on appeal. But the Supreme Court agreed to hear the case, and in a stunning move, reversed course. The court ruled in favor of Chiarella and nullified the SEC's main arguments for bringing the action in the first place: that by handling confidential information Chiarella was actually a corporate insider. That meant, according to the SEC, he owed a “duty” to the investors of the corporate entities involved not to trade on the shares of the target companies before the news was made public.

The Court's decision, announced in 1980, put the SEC on notice that its use of 10-b wasn't a blank check to bring just any case. In fact, the ruling made Swiss cheese out of one of the key arguments that the SEC had used in its war against insider trading: that anyone with access to nonpublic information that can move a stock is a classic insider, owing a duty to shareholders and “victimizing” them by trading on it.

Chiarella was not a company insider in the same way that board members in Texas Gulf Sulphur had been, the court ruled. The government couldn't even call the people on the other side of his trades real victims. Chiarella bought his stock on the market, where people trade all day for different reasons.

In other words, fairness in the markets had its limits.

It would be limited even more three years after the Chiarella decision, and nearly eleven years after the SEC first charged Ray Dirks with insider trading. Once again the commission was before the nation's high court, looking for a bit of redemption, and of course, a further expansion of what the law considers insider trading, even if the agency did pick a pretty lousy example to make its case.

The echo chamber inside the commission failed to come to grips with what Dirks had really done. He had performed a function that was
good
for the markets and for investors. He had uncovered a fraud, and while his clients benefited first, so eventually did other investors as his information became reflected in the price of Equity Funding's stock.

Here's what Pitt meant by the SEC “dropping the ball” on Dirks: After charging the analyst in a civil proceeding, it expected Dirks to take his punishment and walk away. But Dirks wasn't the “sweating” kind of stock analyst. He built a career taking on managements who ran fraud like Equity Funding, and short sellers he believed were wrong about companies they targeted as frauds.

He was also willing to take on the SEC, and he won. The Supreme Court's ruling established a precedent that would define insider trading for years to come, but not in the way the purists in federal law enforcement had wanted. By stretching for the ultimate enforcement tool, the SEC wound up having the law diminished. Keep in mind that nothing in what the commission found Dirks had done resembled the wild quid pro quos of payments and other compensation that would become the modus operandi of the markets decades later, or even the gross abuses found before. He followed up on a tip from a company insider, a former executive from Equity Funding who told him that the outfit was a fraud. He investigated the claim, interviewing executives at the company, and came to his own conclusion about the stock. It was the ultimate in what traders would later call the “mosaic theory”—piecing together various pieces of data and then making a market call.

Common sense may have been missing from the SEC's pursuit of Dirks, but not at the Supreme Court. Neither Dirks nor his initial tippee had stolen the information that Equity Funding was a fraud, because, the court ruled, it's impossible to actually steal information that a company is a fraud. In other words Dirks wasn't a criminal, just a stock analyst who uncovered criminal activity and made his clients a lot of money from it. Case closed.

Well, not quite. The tortured history of what constitutes insider trading had become even more tortured following Chiarella and Dirks. The SEC continued to push for as wide an interpretation as possible, and based much of its efforts going forward on a dissenting opinion of Chief Justice Warren Burger in the Chiarella case.

Burger pointed out that the Court would have been forced to uphold Chiarella's conviction had the SEC not argued that Chiarella was an insider with an absolute duty to either refrain from trading or alert the world of the information. It would have been on stronger ground if it simply said “the defendant had misappropriated confidential information obtained from his employer and wrongfully used it for personal gain,” or Chiarella had stolen something, in this case confidential information that didn't belong to him.

With that, the misappropriation theory became the SEC's latest, albeit imperfect, weapon to democratize information and criminalize insider trading.

T
he 1980s' boom and burst of stock market scandal would later be declared the Decade of Greed by future president Bill Clinton. (No matter that his wife had allegedly earned big sums of money at the time trading in the futures pits, where insider tips and circles of informed friends have been known to run rampant.) The corporate crime wave of the mid to late 1980s would be defined by the illegal activities of a high-level circle of friends, people like the famed arbitrageur Ivan Boesky, white-shoe lawyer/investment banker Martin Siegel, Dennis Levine, the journeyman deal maker who finally found fortune at Drexel Burnham Lambert, or his boss, Drexel's junk-bond king, Michael Milken—all of whom spent time in jail for their various crimes involving the markets as they related to insider trading.

Milken was never directly convicted of insider trading, although he would spend time in jail for securities fraud involving his role in what prosecutors believed was a string of dubious corporate takeovers at the center of the largest insider trading scandal in recent history. As any judge or mobster will tell you, fraud involving the U.S. postal system or conducted over the telephone, known as “mail and wire fraud,” is far easier to prove than demonstrating that information from a confidential source is illegal, and that proved to be Milken's downfall.

The trading of Boesky, Levine, and Siegel was clearer cut, particularly due to the cooperation of all three when confronted with proof of their various misdeeds. (Boesky and Siegel would wear wires to help the feds make cases against their business partners, including Milken.) They faced civil insider trading charges from the SEC, and various criminal charges from the Justice Department that landed each in jail.