Circle of Friends

by Charles Gasparino

  But not even the great Gary Lynch could save McDermott with that argument now that the O’Hagan case had widened the pool of people who could be guilty of insider trading by either trading or passing on material nonpublic information. In the end, McDermott pled guilty to misappropriating insider information and spent five months in jail. (Gannon eventually served eight months in a women’s prison after initially fleeing to her native Canada.) Perhaps the biggest indignity of all for McDermott wasn’t the jail sentence or even being permanently barred from the securities business. It was what he learned from prosecutors as his case became a cause célèbre on Wall Street: He wasn’t Gannon’s only lover.

  As it turns out, he may have been naïve about what motivated Gannon’s affections, but he wasn’t so naïve when it comes to the ways of Wall Street—and its use of insider information. Members of his family contend he told them that insider trading occurs all the time—he just got caught. (McDermott said in an interview he made no such statement.)

  Isn’t it nice to have brokers who tell you those things,” Martha Stewart muttered to her friend Mariana Pasternak as they sat in Stewart’s private jet one afternoon, waiting to depart for a planned vacation that would eventually take them to Mexico.

  The year was 2001, and Stewart was, of course, the billionaire entrepreneur of homemaking stuff. Pasternak was just a friend. They were going to meet another friend, Sam Waksal, for a little fun and sun south of the border.

  That’s when Stewart’s cell phone rang.

  It was her broker’s office at Merrill Lynch in midtown Manhattan. Stewart, like most Americans with a few bucks to their names in the 1990s, was caught up in the hoopla of playing the markets. She had a broker at Merrill, Peter Bacanovic, who specialized in celebrity clients, like Stewart, and semi-celebrities like Waksal, a scientist who loved the Manhattan party scene and had long since befriended Stewart; at one point he dated Stewart’s daughter.

  Waksal was also the CEO of a company named ImClone, which was developing a promising cancer drug named Erbitux. Promising, but not yet approved by the FDA for use. In fact, the company had just received a still-confidential and unfavorable ruling from the Food and Drug Administration on Erbitux. The drug, as it turns out, wasn’t the miracle cure for cancer that ImClone and Waksal had marketed it as, at least according to the FDA.

  “Sam’s trying to sell his shares,” was the urgent message that a Merrill Lynch brokerage assistant, Doug Faneuil, said Bacanovic had instructed him to deliver to Stewart as she sat on the runway.

  Stewart’s reply: “I want to sell all my shares.”

  Shares tanked the next day when the FDA publicly released its negative findings about the drug’s prospect, but not before Stewart, Waksal, and a slew of Waksal’s family members, including his elderly father, had sold their stakes and avoided significant losses.

  The exact reasons for Stewart’s soon-to-be controversial stock sale would be debated during a highly publicized courtroom drama. There was no evidence Stewart knew of the FDA ruling—just that she had an advantage over the general public by receiving early warning that he was selling shares of the company. In fact, Stewart’s lawyers argued with some success that she had been looking to sell her shares for months following the advice of her broker, and even had an agreement to sell if they fell below $60, as was the case at the time of her sale.

  But in the end, it didn’t matter. The trial would last five weeks and eventually land the happy homemaker in jail for a few months not for insider trading but for lying to federal officials who investigated her suspicious stock sale.

  Through it all, Stewart would maintain her innocence. Fans said she was made a scapegoat for the public anger that followed the crash of the Nasdaq stock market that would hit average investors particularly hard. Prosecutors at the Manhattan US Attorney’s office said the case underscored that no one—not even a rich celebrity—is above the law.

  But one thing is certain: the case underscored how the Wall Street caste system works against the small investor. Corporate insiders, of course, sell their stock for many reasons including to pay their taxes. But they also get the first look at all company information—good or bad—before it’s released to all market participants.

  If Waksal, Imclone’s top corporate insider, was selling his stock, he might also know something the rest of the market doesn’t. That’s why brokerage firms keep such information confidential before it’s released to all market participants at some later date. According to Pasternak’s somewhat hazy recollection later, Stewart said she liked having a broker who tells you “those things” referring to the early warning she received about Waksal’s stock sale.

  The Jim McDermott–Marylin Star insider trading imbroglio had been notable for what it said about the times—during the 1990s’ bull market, absolutely everyone was making money. The mood of the time was less outrage and more guilty pleasure in watching a Wall Street hotshot implode over his lust for a porn star. And of course, there was a clear violation of the insider trading laws.

  The Martha Stewart case had more to do with outrage. Most average people (those with less than $100,000 in investable assets) never get such tips about inside sales. They’re often relegated to call centers and websites to get the latest news about their portfolios, and they took some of the biggest hits when the stocks hyped by Wall Street began to crater in the spring of 2000.

  They can barely get their broker on the telephone much less a warning that something big was happening to their investment as Bacanovic had given Stewart through his assistant. Stewart held a $228,000 position in Imclone—pretty puny given that her net worth at the time was more than $1 billion. Bacanovic was on standing orders to keep her abreast of any developments he had heard about stock; though there was no evidence that Bacanovic knew about the FDA ruling either, given his relationship as Waksal’s broker, he was certainly in the position to know when the company’s top corporate insider was unloading his stake.

  With that Martha Stewart, the famed homemaker, became a symbol of a market that favored the rich and connected over the average Joe or Jane.

  The case also showed something else: Insider trading remained among the most difficult cases to make.

  Prosecutors in the New York office of the U.S. attorney’s office wanted to bring the toughest charge against Stewart, namely criminal insider trading over selling stock after receiving the confidential information about Waksal’s sale.

  But they labored mightily over exactly what Stewart had done wrong. “There were problems with the case,” one former prosecutor told me. “The money was small compared to her net worth. When it came down to it, she saved so little money (around $50,000) on the trade.”

  And all they really had as evidence that Stewart committed criminal insider trading was Faneuil’s warning that she should dump shares because the Waksals were selling. (Again there was never any evidence that she knew about the FDA ruling.)

  Prosecutors would have to prove that Stewart misappropriated or knowingly traded on confidential information that wasn’t hers, namely Waksal’s own sale, all of which didn’t meet the threshold for bringing a criminal case. In fact, she could have just as easily sold her shares only because her broker had advised her to sell, and nothing more.

  Again, the only evidence to support an insider trading charge came from the testimony of lowly clerk Faneuil telling her that the family was selling—not why they were selling.

  Ultimately, the decision rested with the top prosecutor on the case, assistant U.S. Attorney for the Southern District James Comey. Based on the facts at hand, Comey concluded that charging Stewart with criminal insider trading would have been outside even the expanded definition established in O’Hagan.

  But there was other evidence that showed Stewart had violated the law—just not the criminal insider trading rules. Stewart, for example, denied having spoken with Faneuil during the day of the sale when she was initially interviewed by prosecutors from Comey’s office and SEC offi
cials about the trade. Instead she said she spoke to Bacanovic about the sale and said it was a result of a long-standing stop-loss order hastily exercised by her broker that day. (Ironically, the jury acquitted her of lying about having that stop-loss order.)

  With Faneuil’s testimony that he was the conduit for the information, Comey decided to pursue a criminal charge of obstruction of justice for lying to investigators.

  “What Sam Waksal did was insane. . . if you notice my client isn’t even charged with insider trading,” Martha Stewart’s very able lawyer, the late Bob Morvillo, explained to a skeptical jury in the spring of 2003.

  Waksal had just pleaded guilty to insider trading on shares of Imclone—and for passing that illegal insider information about the FDA decision on Erbitux to many of his family members. Shares of the company did in fact tank as Waksal suspected they would, and he saved a bundle selling his stake, but at a huge cost.

  Since he was a company insider, he clearly violated the “classic” definition of insider trading as opposed to the expanded version established under the misappropriation theory in O’Hagan. He would spend the next seven years in a federal prison for trading and profiting on insider information, a length of time reflecting his refusal to cooperate and name others who had direct knowledge of the FDA’s ruling.

  Stewart may have been accused of lying and obstruction of justice, but the government didn’t have the goods to hit her with insider trading charges, not even close, Morvillo repeated time and again to the jury. Morvillo’s point was obvious: How could Stewart lie about a crime the government says she didn’t commit.

  The federal insider trading police and ultimately the jury saw the matter differently, particularly with the public’s disgust with Wall Street fat cats in the post dot-com era running high. Even more, any case could ultimately advance the government’s broader, zero-tolerance policy when it comes to people who trade and profit off of confidential information, even if that information doesn’t fit the court’s interpretation of criminal insider trading.

  During her trial, Stewart’s celebrity friends such as actors Brian Dennehy and Bill Cosby made guest appearances as her attorney Morvillo hammered away at what he believed were holes in the government’s case and the recollections of the various government witnesses arrayed against her, including Pasternak.

  Neither Morvillo’s arguments nor the celebrity cameos seemed to sit well with a jury of average working-class New Yorkers. They seemed especially incensed by the notion that anyone, much less a billionaire who baked cookies, should receive preferential treatment, while most average suckers lost big bucks in the stock market.

  The evidence that she had an earlier agreement to sell the stock when its price hit a certain level didn’t matter much to the jury as prosecutors picked apart the rest of her account on why she sold her shares of Imclone. In the end it took just about a day for the jury to return a guilty verdict.

  But Morvillo’s arguments did underscore the difficulties investigators faced in pursuing criminal insider trading cases even in the post-O’Hagan environment. The SEC with its lower threshold for culpability would eventually file civil insider trading charges against Stewart, alleging that she should have known that Faneuil was misappropriating confidential information about the stock sales of Merrill clients. But Stewart later settled the civil case without admitting or denying wrongdoing. Her fine: A mere $195,000.

  Prosecutors took their usual victory lap during a lengthy press conference on the steps of the federal courthouse alerting Wall Street to “beware” because conduct such as Stewart’s wouldn’t be tolerated. In retrospect, however, they were less sanguine.

  They believed the case proved just how difficult insider trading was to prosecute and root out of the markets. Despite all their additional manpower, expanded legal precedent, and computer searches, the best they could do was charge that Martha Stewart lied about something that wasn’t a crime.

  Proving the crime of insider trading, the government was beginning to realize, would take something else. In fact, FBI agents and prosecutors were now coming to the conclusion that cracking Wall Street’s vast inside trading rings was not unlike cracking the mob since they both operated on the pursuit of profit and an ingrained code of silence.

  In both cases, there are very few incentives to cooperate with the government.

  What eventually made so many mob cases, besides good detective work, were informants who had incentive to flip because of incontrovertible evidence that their own misdeeds would put them in jail for far longer than seven years (or for the five months that Martha Stewart served at a federal women’s prison known as “Camp Cupcake”).

  That evidence was usually found on a wiretap.

  It would be several years after Martha Stewart was convicted that wiretaps would gain prominence as an effective tool in combating white-collar crime, particularly insider trading. Federal judges at the time were loath to grant such an invasion of privacy for any other potential crime outside of organized crime and terrorism. They established a pretty high barrier to boot: Investigators would have to prove that they couldn’t get incriminating evidence any other way.

  Meanwhile, Funkhouser continued to scan his computer database for potential miscreants. By the early years of the millennium, an increasing proportion of stock trading was done by sophisticated computerized programs, though old-fashioned stock picking was still very much in vogue by the ever-swelling ranks of hedge funds looking for a performance edge to justify the high fees they charged to investors.

  As regulators examined the data, they began to see certain patterns they didn’t see in the past, namely performance that didn’t just beat the market over the long haul based on long-term bets on companies’ performance—which was the mark of great but honest value investors like Warren Buffett. Instead, they were starting to see traders who consistently beat the market and had an uncanny ability to buy or sell stocks at precisely the right times.

  Another difference from Buffett: This new group of market geniuses comprised people who were far from familiar names on Main Street, even though they were well-known at the big banks for being great customers because they traded so much and demanded banking services. They were hedge fund traders and they also had a knack for buying or selling stocks right before corporate events—mergers, surprise earnings announcements, you name it—at a profit. They had to know something the public didn’t know, and given their size and scope they weren’t just making a few bucks à la Martha Stewart (Stewart avoided a loss of around $50,000), but millions of dollars on each trade.

  If they were trading illegally, that would mean insider trading had now spread like a cancer through the markets. It was no longer confined to a few dumb-ass players like Sam Waksal, Martha Stewart, or Kathryn Gannon, but had now reached large, established players mainly in the hedge fund business.

  High on this list of traders whose records seemed too good to be legal was a guy named Raj Rajaratnam, a Sri Lankan–born trader who ran a hedge firm called the Galleon Group. And another trader drew the fed’s attention: a man from Stamford, Connecticut, who ran a firm called SAC Capital and was known simply as “Stevie.”

  Walking through the SAC parking lot in Stamford is a lot like walking through a Ferrari, Lamborghini, or Bentley dealership.

  Inside the firm’s headquarters, some traders toil for thirteen-hour shifts each day. The most successful earn millions; those who aren’t successful are almost immediately shown the door. But those who make it can be set for life after just one good year, earning millions for a single profitable idea.

  So aggressive are the traders at SAC that they monitor every change in a stock’s performance, however infinitesimal to most investors. “I deal with big funds and they call you when shares move a buck or two away from their trade,” said one analyst who regularly deals with big fund accounts, including the traders at SAC. “But at SAC if a stock goes three cents in the opposite direction of his trade the trader is immediately on t
he telephone freaking out.”

  The reason for the freak-out is the man whose name was on the door, Steve “Stevie” Cohen. Funkhouser barely knew who Stevie Cohen was when trades from his firm, SAC Capital, a massively successful hedge fund, began to appear on his surveillance screens. Cohen rarely appeared in the media, and he kept a low social profile. And yet, right around the time that Martha Stewart was going to jail over lying about her suspicious trades, this little-known trader from Stamford was starting to make investigators jumpy.

  Cohen was basically invisible to the public but on Wall Street he was considered a rising rock star. “He’s everyone’s first call,” then Bear Stearns chief executive Jimmy Cayne would say when Cohen’s name came up. Word spread that he was charging his customers almost double the fees of most hedge funds. Whereas the vast majority of hedge funds charge investors 2 percent of their assets under management, and another 20 percent of their returns, SAC charges 3 percent of assets and 50 percent of its returns, and even after subtracting expenses, Cohen had been handing his clients an average of 30 percent in profits since he opened shop.

  It was pretty obvious that Cohen’s customers were more than happy to pay all those fees and expenses because Cohen and his traders reciprocated with returns far exceeding anything else on Wall Street.

  Steve Cohen is known on Wall Street as “a trader’s trader” because he might be—at least on paper—the best that ever lived. He began reading the Wall Street Journal when he was eleven, trading stocks in high school, hanging out at a local brokerage office in his hometown of Great Neck, New York, and further perfecting his market skills while in college.

  He had already made a name—and a small fortune—for himself at the age of thirty at the Wall Street firm Gruntal & Co., albeit quietly. At Gruntal, he was a star trader without a name, known for “reading the tape,” a Wall Street term for traders who look at stocks and their trading patterns, factor in the market chatter, and make money by guessing the stock’s next move up or down.