Octopus

by Guy Lawson

  Marino was trying to hide the loss, of course, but it was done with the dexterity of a black belt in jujitsu. He made it look like a boon to investors. It appeared that Marino was bene!ting Bayou’s members at the expense of Sam Israel as owner of the broker-dealer. Marino was displaying a nascent genius to take a perfectly obvious fact (Bayou had performed terribly) and distort the mirror to make the situation look entirely different.

  “I proposed a lump-sum transaction to the auditors,” Marino recalled. “I told them I could’ve rebooked the commissions without telling them and they’d never have known.

  So why not rebate the commissions to the fund and call it a day? I told them that we could be in and out of a stock two, three, four times in a day, which cost Bayou’s investors a lot in commissions. I said that if the investor su#ered a loss because of our trades, why should they have to pay the brokerage commission as well? It was unfair that we earned the commission if we’d accomplished nothing. It would mean the net cost to the hedge fund of doing the trades was nearly zero. It allowed us the "exibility to trade how we wanted—high frequency. It also supported the risk management concept. I told Jimmy and Sam that the idea could be used as part of the sales pitch by showing investors we rebated commissions from the broker-dealer so there was no way we would churn the account. We were being honest with our partners.”

  The commissions totaled $400,000, more than enough to compensate for the losses of the hedge fund. With the commissions rebated, Bayou Funds would look as if it had turned a tidy pro!t. Bayou Securities was another matter. But that was owned by Sam Israel and was not the concern of the hedge fund’s auditors. Or so Marino claimed.

  Grant Thornton’s accountants scratched their heads and pondered the question.

  Meanwhile, the deadline for release of the audited results came and went. Bayou was obliged to provide investors !nal con!rmed results by the end of the !rst !nancial quarter. As the end of March passed, Israel and Marquez were furious with Marino.

  Each day made Bayou look more and more dubious. Investors were getting nervous.

  Casting any suspicion on Bayou’s competence or honesty at such an early point was risky—especially when they were trying to hide real losses.

  After an excruciating delay, Marino was !nally able to convince the auditors to agree to his approach. Once that money was applied to Bayou Funds’ performance, the trading loss of 14 percent was magically transformed into an adjusted gross ROR of 40

  percent. The dollar amounts were tiny. But the impact on Bayou’s prospects was epic.

  Israel and Marquez had been granted a second chance. Even better, Marino had convinced the auditors that no disclosure was required, not even so much as a footnote, so no one was the wiser.

  “Sam and Jimmy congratulated me,” Marino said. “I’d just created a means for them to goose the performance with the commission rebates without disclosing it to investors.

  I thought once they raised more capital and got back on track, it was away-we-go time.

  I was on the verge of making a lot of money, and it was all legal.”

  Marino’s bubble was quickly burst. Marquez and Israel told him they were letting him go. The socially awkward accountant from Staten Island wasn’t giving investors the level of comfort needed, they said. Before Janice Israel had children, she’d been a practicing accountant. She was smart, organized, and inexpensive. With the office in the basement of the house it would be easy for Janice to keep Bayou’s books. Marino was told Janice was going to wait until the summer holidays were over, and the children were in school, before taking over. He would stay for the interim. “I felt betrayed, like they’d stolen my idea about rebating the commissions and now they were throwing me out,” Marino said. “I was going to lose out on a wonderful opportunity.”

  During the !rst half of 1998, the gap between the real numbers and what Sam and Marquez were telling investors continued to grow. Bayou bought Gulf Island and Friede Goldman in the oil sector, Micron and Seagate in tech, Nord in resources. The positions weren’t foolish, but neither were they the huge winners Bayou now needed. Sam’s trading program was pro!table, for the most part. After months of hard work, the pair managed to get Bayou to break even in real dollars. The fund was supposed to be “market neutral,” which meant it made money whether prices went up or down. But being neutral in the sense of making no money was untenable in a bull market.

  The traders might have been able to solve the problem if they’d been modest in the claims they made to investors about pro!ts. But Israel and Marquez were both drawn compulsively to telling extravagant tales about their trading prowess. It was an irony that would haunt Bayou. In terms of actual money, the fund wasn’t doing awfully. It was the imaginary money—the pixie dust—that was impossible to keep up with.

  “In the beginning we had to live low,” Israel recalled. “We were going to !x the problem. The amount of money wasn’t that big. We were in the basement working hard.

  We took small salaries—less than a hundred grand each. We were trying to focus on getting out of the hole. But I was taking steroids for my neck pain and it was a#ecting my mood. I was starting to get more and more angry with Jimmy and Dan. If I’d made the problem on my own that would be one thing. We thought we could trade our way out of it. But that wasn’t happening. It was really becoming a fucking problem.”

  Marquez blamed Bayou’s environment. The basement was noisy, uncomfortable, depressing. He resented having to work in Israel’s house. There was a separate entrance to the basement, but it made Marquez feel intrusive to arrive for work at !ve in the morning while the Israel family was asleep. Marquez wanted the freedom to do his research and make his calls in peace so he could concentrate on the situation that was quickly becoming a crisis. Marquez insisted on a change of scene.

  Sam could see his point about the basement. But Marquez’s solution was absurd.

  There was an o$ce on Long Island Sound he’d been eyeing for years. The four-thousand-square-foot space at 40 Signal Road in Stamford, Connecticut, rented for $18,000 a month. It was the same cost as a suite of o$ces on Park Avenue in Manhattan. The o$ce was only a three-minute drive from Marquez’s home in one of the wealthiest towns in America. Set along a stretch of residential waterfront dotted with mansions, Bayou’s headquarters would be in a tasteful two-story structure that had once been used as a boathouse. To one side there was a large !eld, and in front there was a patio for barbecues. The property came with a large private dock, with a slip to house Marquez’s boat, and sweeping views of Long Island Sound. It was in the heart of an area known as “Hedge Fund Row,” which boasted wildly successful traders like Barton Biggs of Traxis, Steven Cohen of SAC, and Paul Tudor Jones II.

  Israel griped about the expense but did nothing to change the course of events as the lease was signed and movers were hired. On Memorial Day weekend of 1998, Bayou opened in its new prestigious address. Relocating Bayou to the boathouse was upping the stakes in important but unspoken ways. The location staked a claim for Bayou as a fund on the rise. A potential investor visiting Bayou in the basement of Sam’s house would see the fund for what it was: tiny, fragile, dysfunctional. But a money manager or high–net worth individual taking a meeting at the boathouse couldn’t help but be impressed.

  In a strange way, Bayou was in fact succeeding. The broker-dealer business was making money. With Marino’s commission rebate sleight of hand, the hedge fund also looked as if it were making money—at least if it was not inspected too closely.

  Ironically, it turned out that incorporating the broker-dealer into Bayou to avoid the scams of Wall Street had rendered it tailor-made for fraud.

  In the boathouse, Dan Marino—who was doggedly staying with the !rm, hoping for a stay of execution—continued to do the accounting for Bayou, coming to work a couple of days a week to enter data and review the ledgers. But for the most part Israel and Marquez were alone.

  “Jimmy was my friend and we were in this thing together,” Isra
el said. “But he would have these long philosophical conversations. They would last for hours. Jimmy believed that oil and gas were going to go way up. He said they were underpriced. He was very persuasive. He said we were in the darkest hour. Soon people were going to realize that he was right. But who cared about philosophy?”

  In the summer the market became wildly unpredictable. The giant hedge fund Long Term Capital Management had to be saved by the Federal Reserve when it lost more than $4 billion in a matter of days. It was an exceedingly di$cult environment to solve Bayou’s problem. Looking for a windfall trade, Marquez began to hear rumors about the federal government’s annual auction of drilling rights for the outer continental shelf.

  Every year companies bid for lots to drill in the Gulf of Mexico. The auction had not gone well, it was said. If the reports were true, the consequences for oil and oil !eld service companies would be severe. This was the kind of opportunity Bayou could use —a sliver of bad news about an industry that they could trade against.

  “I wanted to check out the rumor,” Israel recalled. “I knew a guy who worked for a company called Tidewater. The company owned boats that took things out to the rigs—pipeline, food, people. So I called him and asked if business was slowing down. I did that kind of thing all the time. I would call companies if I knew someone there—if I had some way into the place. Talking to me was technically not legal. But it was the kind of thing that went on all the time. So I asked my guy what the earning forecasts for the quarter were. I asked if there was a ‘downside surprise’ coming. He said there was a surprise in the earnings. But he said it was an upside surprise. This was great news. I put the phone down and told Jimmy. We loaded up on Tidewater options. We thought, ‘We’re going to make our year.’ A few days later Tidewater announced its quarterly earnings. Guess what? There was a big downside surprise. I was shocked. The guy lied to me. To this day I don’t know why. We got pounded. It was the last time I ever tried to work on our positions at Bayou. There was too much treachery in the market—too many two-faced people. It was impossible to know what to believe.

  “Then Dan found an accounting error. He said we were short one S&P future. By this time, Stanley Patrick had come back from Brazil and he was doing some clerical work for us part time. He’d made an error in closing out our overnight position in S&Ps.

  Stanley said it was me who’d fucked up. We went back and forth but it really didn’t matter. It wasn’t worth arguing about. Who the fuck knew? What mattered was the loss.

  We were down another sixty grand.

  “For the year that meant we were down 18 percent. The market was up nearly 30

  percent. So now we were behind the market by !fty points. I said we had to buckle down and make the money back before the end of the year. But there wasn’t enough time left. That was when the hole really started. The amount of money we were down was small—we’d laugh at that kind of money later on. We only had a million and a half in the fund. We were so tiny. I mean, you got to understand, it was not a large amount of money to me. In dollar terms, we were down two hundred grand. That was a drop in the bucket. That was the kind of money that used to be in my error account when I worked at Omega. But it could ruin us.”

  CHAPTER FIVE

  The Problem

  Accounts di!er on where and when the decision to falsify Bayou’s audit for 1998 was made. The stories of Israel, Marino, and Marquez also vary on who had the idea in the "rst place. When it comes to admitting to hatching the plot to begin a massive fraud, the three coconspirators shift blame, self-justify, and avoid responsibility to varying degrees. No subject was more sensitive or contentious.

  Sam said the conversation took place in the basement of his house on Buckout Road, as he recovered from back surgery. Marino said it happened in the boardroom at the boathouse. Marquez angrily refused to comment. Israel claimed Marquez and Marino came to him with the idea of falsifying the fund’s results. Marino said that the plan came from Israel and Marquez.

  But there was no dispute about what happened—or why. All three of the men had bet their careers—their dreams—on Bayou. Israel could not face the specter of failure. He’d promised himself that he would never go down again—never ever. For his part, Marino was desperately clinging to the hope of a high-#ying career running the business side of a huge hedge fund. He was terri"ed of a life as an obscure accountant doing taxes in a strip mall on Staten Island. Likewise, Marquez still imagined himself to be a big-time trader in the manner of George Soros. Financially strapped after a bitter divorce, Marquez was in his late forties, and spent as a trader.

  As the end of the year neared and the losses mounted, Marino received the reprieve he’d been hoping for. Israel and Marquez told him they’d be keeping him after all. No reason was given. Marino had long been treated as a glori"ed bookkeeper. Now it appeared the two traders needed him.

  “I could never put my "nger on why they changed their minds about keeping me on,”

  Marino said. “They just said they forgave me. I chalked it up to them coming to their senses about the situation with the audit for the year prior and rebating the commissions from Bayou Securities. Their worries about investors redeeming had been overblown. They were letting bygones be bygones. But who knows the evil that lurks in the hearts of men? Maybe they became friendly to me because they decided a fake audit was the only way out long. That’s very plausible. Sam and Jimmy weren’t stupid people. I would prefer to think it wasn’t premeditated. I would feel less of a fool.”

  IN 1998 New York City had its "rst white Christmas in twenty years as three inches of snow fell on the tristate area. But the atmosphere in the Israel house was glum. The pain from Sam’s shoulder injury had migrated to his back. There had always been a psychosomatic relationship between Sam’s state of mind and his pain. Now it seemed as if there were a synaptic connection between the unfolding disaster of his hedge fund and the torment of his body. The postop painkillers he’d been prescribed weren’t working. Nor was the alcohol he was downing in increasingly prodigious amounts.

  A!ecting devil-may-care bravado, Sam sometimes convinced himself he could trade Bayou out of trouble. But other times he wasn’t so sure. In quiet moments, questions about the fund’s survival turned into existential questions. He needed someone to talk to. He needed to share the burden. His wife Janice had no idea of the stress her husband was under. If he confessed to her, Sam knew she’d demand he tell his investors and close Bayou—and perhaps go to prison.

  “I hid everything from Janice,” Israel said. “I’d been hiding things from her since we were kids. It was part of the way our relationship functioned. She was the responsible worker. I was the fuckup. I smoked weed and snorted coke. It was our pattern. I couldn’t talk to her about what was really going on because I couldn’t con"de in her.

  We got together when we were so young, we never had the chance to "nd an adult way to talk to each other. As far as she knew, everything was going well for Bayou. Inside I was dying.”

  Over the holidays, Sam replayed events in his head. Marquez’s trading positions had been dreadful. Moving to the boathouse had created a facade of success, but that had made closing the fund even harder. If only Sam hadn’t invested all his savings in the house on Buckout Road, he could have covered Bayou’s loss with his own money. The big-shot gesture of paying cash for the house had locked all his wealth into an illiquid asset. He couldn’t ask his father for a loan, as a matter of pride but also because it would inevitably lead to uncomfortable questions. With only days left in the year, the options facing Bayou had hardened into a single stark possibility.

  Wherever the meeting took place—Sam’s basement or the boathouse—on the last trading day of the year, Israel, Marquez, and Marino convened to discuss the looming audit. The mood was somber. If Bayou was going to survive, this was the moment of truth—or, rather, the moment to lie.

  “We’re fucked,” Marquez told Sam. “These are the real numbers.”

  Marino han
ded Israel a document showing the results for Bayou. Israel sat in a leather reclining seat. Now that the subject of Bayou’s failure had been broached, the men rapidly discovered they were in agreement. As Sam reviewed the depressing document, Marquez said they needed to buy more time. Not long. A couple of months, maybe a year, maybe two—long enough to get back in the game. The solution was to fake the audit. With a bit of luck, maybe they could make up the shortfall by the time the audit was sent out to investors at the end of March. No one would ever know they’d massaged the numbers.

  Obviously Grant Thornton couldn’t perform the audit. The accounting "rm had been hugely expensive in any event, charging more than $50,000 to audit the tiny fund.

  There was a solution, however. The plan was the soul of simplicity. Dan Marino would do the audit. Not in public, of course. Secretly. Marino was adept with numbers, so he’d know how to create a convincing audit. The deceit would be temporary, harmless, a white lie. If Bayou made it to the three-year mark with good performance numbers, major investors would start to consider putting money into the fund. Three years was the magic number. They were only one year away. All of their hard work was about to pay o!. There was only a small shortfall in real money. Sam and Jimmy just needed to focus, trade with discipline, get lucky—and all would be fine.

  “The truth is that I didn’t need much convincing,” Israel said, insisting that it wasn’t his idea in the "rst place. “I really had no hesitation. Bayou was everything I’d worked for. I was going to do anything and everything that I possibly could to make it succeed —cheating or not cheating. I didn’t have a problem with fudging the numbers. I was con"dent. Everything was going to be okay. Every time I’d gone broke in the past, I’d gone on a huge tear and made the money back in short order. I knew I could do it again. I figured we had a problem, but I didn’t think it was a big problem.”