Eagle on the Street

by Coll, Steve; Vise, David A. ;

  But Shad had promoted the agreement not only because it suited his deal-making and deregulatory instincts, but also because it helped to fulfill a specific, almost utopian vision he harbored about how the country’s financial markets should ideally work. Shad saw as potentially beneficial the same speculation that prompted an investor like Warren Buffett to issue a warning about the ill effects of gambling on the health of the public markets. He believed that some speculation enhanced the stock market’s efficiency. One of Shad’s favorite words was liquidity, which he used to conjure up the image of money flowing through the stock market and the economy like water through a fertile delta. Shad thought of faltering economies as dry gulches where the flow of money had been cut off; the solution was to open a spigot and let cash pour again, until it lapped into every parched corner and brought barren land to life. Stock futures and the speculators who might trade them helped promote liquidity by making it easier for companies to find money to pay for growth.

  There were times when Shad’s views about liquidity sounded almost like a religious revelation. “The millennium to which mankind can aspire is that great day when capital will be permitted to flow, with safeguards against fraud and with the ease of water, into every nook and cranny of economic opportunity, first within nations, second throughout the Free World, and ultimately throughout the earth,” he declared.

  It wasn’t just stock futures that Shad wanted to free in the hope that increased trading would help to “liquify” the economy, it was old-fashioned stocks as well—the securities traded at the New York Stock Exchange, the American Stock Exchange, in the National Market System, and at other venues directly under the regulatory control of the SEC. The commission’s division of market regulation was responsible for day-to-day supervision of the stock markets. When he first came to Washington, market reg, as it was called, was the directorate Shad viewed with the most reservation—its very name, with the emphasis on regulation, provoked a visceral dislike in him. Shad’s intuition had been reinforced by Doug Scarff, the director in charge in 1981, a nervous, chain-smoking lawyer whose inexperience with the actual business of trading stocks seemed to irritate the chairman. Shad was always asking why, questioning the assumptions and the fundamental purpose of the division’s work, and his approach had the predictable effect of putting market reg’s staff lawyers on the defensive. He said the same words over and over—liquidity and efficiency, liquidity and efficiency—but Shad’s broad vision of an economy enriched by the unfettered flow of money, and of a government that regulated only when absolutely necessary, did not square with many of the commission staff lawyers who spent their days forcing the big Wall Street firms to comply with the division’s minute rules.

  When it came to resources, Shad favored enforcement over market reg. Shad and the market reg staff had different ideas about how the commission should enforce morality in the stock market, and what sort of morality it should endorse. During the 1970s, the market reg division had shared the enforcement division’s enthusiasm for regulatory expansion and moral righteousness. Shad tried to change some of the market regulation staff’s assumptions about the division’s role in the markets. During 1982, for example, a group of lawyers in the division conducted a big investigation of allegedly abusive trading practices in the stock-option pits of the Philadelphia Stock Exchange and the Chicago Board Options Exchange. The lawyers found, after months of study, that traders in the pits were fixing options trades to generate bogus tax losses for investors, and that the exchanges weren’t doing anything about it. So prevalent was the bogus-tax-loss trading that daily volume figures about the numbers of options traded in the Philadelphia and Chicago pits, which were disclosed to the public so investors could evaluate the general level of interest in specific options, had become distorted and false. The trading was wrong, the market reg staff felt, and they wanted to find a way to stop it.

  That same winter of 1983, when stock futures began trading, the market regulation division sent a confidential memo to the commission recommending that the SEC crack down on the tax trading schemes at the options exchanges. The memo conceded that tax violations were not part of the commission’s jurisdiction, but said the distorted volume figures posted at the exchange were a securities-law violation. But Shad opposed the recommendation—he said he would not permit the commission to wander outside its jurisdiction. If the Internal Revenue Service was concerned about bogus trading in options, then let the IRS attempt to stop it, he said. The market reg memo went nowhere.

  Even some inside the SEC who generally shared Shad’s political ideology could be frustrated by the chairman’s view that the stock market was essentially an honest place, that its principal purpose was to promote capital liquidity for the nation, and that the government ought to let the stock exchanges regulate themselves.

  Shad sided with those aligned with the New York Stock Exchange who wanted to block the construction of a sophisticated computer surveillance system that would allow the commission to track the names of buyers and sellers in every transaction on the exchange floor—information that had always been closely guarded by the Wall Street investment firms. The surveillance system, whose purpose seemed obvious and essential to some in the commission’s enforcement division, had been proposed during the 1970s. The technology for it was already available. As its development progressed, the Wall Street firms who were members of the NYSE became alarmed by the possibility that the government would soon be able to monitor buyers and sellers on the exchange floor—it would be like Orwell’s Big Brother, they said. When Shad arrived at the commission, many of his colleagues on the Street wanted the development of any such government surveillance system stopped. He initiated a market regulation division review of the proposal and decided finally to end the program, assuring those staff lawyers who disagreed with him that he would support alternative private-sector programs through which the SEC could collect names and other data about players in the stock market. Shad thought the alternatives he backed were cost-effective; others inside the commission thought the New York Stock Exchange had taken the SEC’s teeth away.

  Yet it was an irony of Shad’s relationship with many of the senior staff responsible for the commission’s regulation of the stock markets that, despite their sometimes heated internal battles, the staff seemed increasingly to forgive and respect him. John Wheeler, secretary of the SEC for two years under Shad, felt as much as any of the senior staff, and perhaps more so, that the decision to kill the system of computer surveillance of the stock market could turn out to be a grave and even irresponsible mistake. He thought the raw power of the stock exchange’s member firms had succeeded against the commission, and that Shad’s position had been influenced in part by the hysterical, self-interested fears of Wall Street executives who dreaded the prospect of accountability to the SEC. But any anger Wheeler harbored against Shad was less political or ideological than filial, the disappointment of a son in the weaknesses of his father. That was how Wheeler thought of Shad—as a father figure to him and to other senior commission lawyers, especially Fedders. And Shad was no saintly, benevolent patriarch. He liked to bet; he liked to smoke; i.e., he “sinned.” That was part of what attracted Wheeler and the others to him.

  Wheeler was highly visible away from the commission as the leader of a controversial effort to build a memorial to veterans of the Vietnam War. Opponents of Wheeler’s plans continually attacked his credibility and his motives. When he started his crusade, Wheeler asked Shad for permission, knowing that he was going to attract heat and controversy to the commission, and Shad had said it was all right. Then Wheeler’s opponents dug up his private military records, which showed that he had been reprimanded for stealing a jeep in a combat zone. Worried about how Shad would react to the disclosure, Wheeler hurried to the chairman’s expansive office suite and asked for an audience. That was no problem—Shad’s doors were almost always open to the senior staff, who moved in and out in a series of ad hoc, informal meetings. Wheeler d
ecided to go right up to Shad and blurt out his preemptive confession.

  “Boss, in Vietnam I was reprimanded for using a jeep that I got from a motor pool without permission. It was a hot jeep, and my God, I feel so guilty,” Wheeler blubbered.

  Shad looked at him and laughed. “Don’t ask me about the jeep I used in China,” he answered jokingly. That was it. When the news about Wheeler came, Shad didn’t bat an eye.

  All around Shad that year—in the personal problems of his top officials, in the debates over how financial futures and corporate takeovers and junk bonds were changing the markets and the economy, and in the secret enforcement cases being developed against Michael Milken and other powerful financiers suspected of corruption—notions of morality and ethics were becoming increasingly central. And yet, within the commission, nobody, least of all Shad, was able to confront the quandaries head on. It was Shad’s conviction that the SEC had to stop thinking of itself as the Securities and “Ethics” Commission, the Wall Street–thought police, the way he believed it had before his arrival. So the questions unasked and the contradictions unresolved just simmered and bubbled, gathering heat as the months passed. When at last it boiled over, there was nothing John Shad could do.

  8

  High Yield, High Risk

  In August 1983, not long after Jared Kopel settled into his new and larger office in the commission’s recently built, concrete headquarters on Fifth Street, one of his bosses, associate enforcement division director Ted Levine, stopped by to see him.

  Bearded, broad-shouldered, forceful, and excitable, Levine intimidated some of the staff lawyers who worked for him, but Kopel was one of his protégés, and the pair had an exceptionally smooth relationship. Levine recently helped to promote Kopel to branch chief, a mid-level position that brought with it prestige within the enforcement division, a little extra pay, and the chance to supervise the investigative work of a handful of attorneys.

  Levine handed Kopel a confidential memo. We have to decide what to do about HO-1395, he said.

  The memo had been drafted by Jack Hewitt, the staff lawyer and decorated Vietnam combat veteran who had been pursuing for more than a year his theory that Michael Milken and the investment firm Drexel Burnham Lambert fraudulently manipulated the stock and bond markets in connection with a corporate takeover and other transactions. Hewitt was one of the attorneys in the enforcement branch Kopel had just taken over, and HO-1395 was one of the cases Kopel had inherited.

  There may be some questions about this investigation, Levine told Kopel. Read the memo and we’ll talk.

  So Kopel read. He knew that contrasting personalities within the enforcement division had already affected the course of the case, which was officially captioned “Trading in the Securities of Certain Issuers.” (The case was most commonly referred to by its file number, HO-1395. HO stood for Home Office or the SEC headquarters in Washington; 1395 was the sequentially assigned number of the case.) As in any large institution, the enforcement division had its cliques and petty personal rivalries, and inevitably decisions were influenced by who was up, who was down, who was in, or out of, favor. In this case the problems were especially complex. For many months Jack Hewitt had been pouring himself into the Milken investigation, but he hadn’t really had much guidance from his supervisors. Hewitt hadn’t gotten along very well with his former branch chief, Dwayne Cheek, whom Kopel had replaced. Hewitt, who as an ex-military man respected the importance of chain of command, didn’t think this was his fault—Cheek didn’t seem to get along with some of the other attorneys in the branch, either. Hewitt was older than many of his peers at the commission, he lost his temper from time to time, and there were those who thought Cheek was outright intimidated by him. The peace was kept mainly through isolation, leaving Hewitt largely on his own as he chased Milken and Drexel.

  Perhaps that was why Kopel had trouble comprehending Hewitt’s memo as he read it that summer—perhaps the presentation would have been sharper if a senior attorney had been working at Hewitt’s side. As it was, Kopel found much of the memo’s contents hazy and imprecise. In particular, Kopel was mystified by Hewitt’s sweeping allegations that Milken was at the center of some far-flung market-manipulation scheme designed to produce special favors for Drexel clients.

  It wasn’t that Kopel didn’t think such a scheme was conceivable. He understood the complexities of high finance. He had been educated firsthand during the 1970s when, as a reporter, at the New York Post, he had covered New York City’s fiscal crisis. His job then had been to examine large quantities of complex financial information and zero in on the most important elements.

  That’s what Kopel and his superiors said was missing from Hewitt’s memo about Milken and Drexel. They called Hewitt to roundtable meetings in their offices, where they reviewed the investigative testimony he had taken from Milken and others and grilled Hewitt about the conclusions in his memo.

  Kopel, Levine, and the others kept saying the same things to him. What, exactly, is this scheme that Milken has supposedly concocted? Yes, there are trades and deals here that look suspicious. But what’s the motive? What’s going on here?

  Hewitt tried to explain. But they felt that he wasn’t clear enough about the alleged manipulation scheme. It was extremely complicated—the most sophisticated frauds always were, Hewitt thought.

  The weeks passed and Hewitt drafted his final memo on the case, taking care to make his allegations clear. Thick, printed transcripts from his interrogations of Milken and others were stacked around him. Hewitt didn’t think of himself as an exceptionally talented writer—one of the things Kopel criticized was his writing ability—nor did he see himself as a legal scholar. But as he scratched the words that laid out his theory of Milken’s manipulation of the markets, he was satisfied that his superiors would grasp the essential details and accept his thesis.

  To a degree, he was at their mercy. Kopel, Levine, and possibly even Fedders, all would have to accept his recommendation to file charges against Milken and Drexel before any presentation was made to John Shad and the other SEC commissioners. Hewitt knew that if things got that far, and he brought his case to the table, the commissioners would evaluate his proposed lawsuit by an exacting standard: Could the SEC win in court, where it would have to persuade a judge or jury by a preponderance of the evidence that fraud had occurred? Rarely did SEC lawsuits actually go to trial, but the commission had to assume in each case that a trial would result. Though he didn’t know for certain, Hewitt thought Milken would go to trial, fighting rather than settling any charges brought against him by the commission. Most SEC defendants opted for the easy way out, settling their cases without admitting or denying the allegations and agreeing not to commit similar wrongful acts in the future. In some cases a defendant might agree to make certain changes in his business operations. From the SEC’s point of view, the advantage in settlement was that the agency wouldn’t have to devote people and money to a lengthy court battle, where there were no guarantees of success. In a settlement, wrongdoing would be disclosed publicly, albeit in closely negotiated, carefully limited documents. The commission relied on publicity from settlements to deter wrongdoing on Wall Street. While suffering a certain amount of negative publicity on the day a settlement was announced, a defendant also benefited by avoiding the expense, uncertainty, and long-running public exposure of a trial. There was a convenient symbiosis between prosecution and defense that had grown up around SEC settlements, which made Hewitt’s belief that Milken would fight in court all the more exceptional. Still, as he rewrote his memo, Hewitt was confident the commission would prevail if it took his case to court.

  Hewitt had come to believe that Milken and Drexel were at the center of a massive fraud. At the beginning, Hewitt’s investigation had focused on suspicious stock trading late in 1981 by Cincinnati-based American Financial Corporation and its chairman, Carl Lindner. Hewitt didn’t know whether anyone at American Financial had knowledge of any scheme involving Milken. Bu
t, over the months, Hewitt had come to believe that clients of Milken’s were mere appendages, customers for whom favors may have been done and who may have obliged when called upon by Milken, who was the master of a scheme.

  Proving it was another thing. Market manipulation could be a difficult crime to establish in a court of law, Hewitt knew. If someone such as Milken were a big trader of stocks and bonds, and through his massive trading affected, or at times even dictated, prices, that might be a natural and lawful extension of his market prowess rather than illegal manipulation. Defendants in SEC manipulation cases generally didn’t admit to criminal intent—they always had a rationale that ostensibly explained their trading and market activity. Such cases usually rested on circumstantial evidence—trading records, telephone records, and financial statements—rather than on direct testimony by a participant who admitted to fraud. Lacking any inside witnesses, often the commission lawyers had to guess at motive and intent, and the success of their cases depended in part on how plausible their guesses were. In this case Hewitt thought he could articulate a complex but undeniable motive.

  It wasn’t anything as simple as money. Usually in SEC cases that’s all there was to it—greed. Hewitt had known one stockbroker involved in a securities trading scam who rushed out when it was completed and bought a white Rolls-Royce and a yacht. The defendant’s conspicuous consumption weakened his case. With Milken, it was clear that he wanted to accumulate large amounts of wealth, Hewitt thought, but there had been no apparent change in lifestyle, no conspicuous consumption. The money might be a scorecard of sorts to chart Milken’s progress, but Hewitt saw something else, something perhaps more intoxicating than dollars and cents to a man who was working sixteen to eighteen hours each day, building a new bond market that would alter fundamentally the course of American finance—power.