Eagle on the Street

  That same June day, from a sawmill in the small Midwestern town of Neopit, Wisconsin, a thirty-five-year-old accountant named Wayne Knauf telephoned his stockbroker at Smith Barney, the giant Wall Street brokerage house that had branch offices all across the country.

  “What looks good for the next series?” Knauf asked his broker. Knauf had a copy of the Wall Street Journal. He had scanned the tables in the back of the newspaper that listed the prices of stock options.

  “Can’t find anything good,” said his broker, R. Dennis Herrmann, known to his customers as Denny.

  “I can’t find anything good,” Knauf agreed.

  “Well, you know, gees, this Cities Service is at an eighth and that’s three days,” Herrmann said. “You put on forty of those at an eighth, that’s five hundred bucks for three days.”

  The Smith Barney broker was talking about the riskiest type of stock options trading: naked option writing. They called it naked because if you did it, you were exposed theoretically for everything you had, down to the shirt on your back. Herrmann was pointing out to Knauf that the options were priced in such a way that he could earn $500 in just three days if he “wrote,” or sold, 40 options on Cities Service stock. (Each option would obligate Knauf to sell 100 shares of Cities Service stock at current prices, though it seemed unlikely that anyone would demand such a sale of 4,000 shares—40 options contracts times 100 shares per contract—unless the price moved sharply. For each option contract he sold at the prevailing price of one-eighth, Knauf expected to receive about twelve cents. The $500 he hoped to make was the product of multiplying twelve cents per share times 4,000 shares.) Knauf’s trade was a gamble on Boone Pickens’s takeover fight with Cities Service, similar in many ways to a bet on a horse race. Afterward, it wasn’t clear whether Knauf understood it that way or not.

  “Five hundred for three days—that doesn’t sound too bad,” Knauf answered.

  He had made that sort of decision countless times in the last several years, and it came easily now. A whole group wrote naked options up at the Rhinelander, Wisconsin, office of Smith Barney, which was located above the drug store and just down from the coffee shop along the town’s main thoroughfare. There was Larry Graf, the unemployed heir to a modest Milwaukee soda pop fortune, Larry’s unemployed girlfriend Judith Bergquist, “Doctor Tom” the dentist, and David Kuenzli, an expressive, theatrical man who was unemployed, divorced, and living with his mother. Helping to bind this odd lot together were Denny Herrmann, the broker, and Wayne Knauf, the accountant, whose offices were across the hall from one another and who rendered professional services to the entire group. Over the years, Knauf had referred about twenty of his accounting clients to Herrmann, and Herrmann had referred a similar number of his brokerage customers to Knauf.

  Rhinelander—which had a population of about 8,000—and surrounding towns like Neopit were isolated in northern Wisconsin’s lake wilderness, nearly two hours’ drive from Green Bay and twice that from Milwaukee. There were a few prosperous lake resorts nearby, but mainly the area’s economy depended on the fortunes of a local paper company, which was in sharp decline. The nascent Reagan years had been rough for many in Rhinelander; unemployment was up, hopes were dampened. But the downtrodden did not include Denny Herrmann, Wayne Knauf, or the dozen or so others who had discovered the wonders of naked options. Larry Graf, the unemployed soda pop heir, earned $66,500 in 1980 and $81,000 in 1981 writing naked options. Herrmann didn’t write naked options for his own account, but he brought in handsome brokerage fees for assisting and encouraging the others. Herrmann earned about $120,000 in each of 1981 and 1982, a fortune by the standards of a small town like Rhinelander. And as Herrmann prospered, so did Smith Barney, which took in hundreds of thousands of dollars in commission revenue from the Rhinelander group.

  Smith Barney advertised on television that it made money “the old-fashioned way,” by earning it. But the group that gathered most mornings above the drugstore had discovered that writing naked options did not require perspicacity, patience, or experience. It was a way to try to get rich quick. Herrmann’s success was evident most days in the odd scene around his desk at Smith Barney. There, his customers clustered in twos and threes, punching up options prices on the office computer and chatting about the market or the Green Bay Packers or the latest gossip from the coffee shop. Larry Graf had a learning disability and gave the appearance of a mild mental retardation, and yet he was perhaps the most active trader of them all.* Knauf would come over most mornings, carrying his Wall Street Journal and scribbling the results of his carefully planned “system” for naked options writing. Knauf directed some trading for his accounting clients, as did Denny Herrmann on behalf of Larry Graf. The group had grown with dizzying speed. “Doctor Tom” Butler’s decision to join was typical. As Knauf recalled later, “I had some dental work done, and I told Doctor Tom what I had been doing in my own particular account, basically writing naked options and just been doing super … And [Doctor Tom] said, ‘Maybe I’ll do that.’ I don’t know if he really understood anything.”

  He understood this much: Stock options were dirt cheap. As with the new stock futures whose trading in Chicago Jack Shad had helped to unleash, an investor in stock options could get a big bang for his buck. (Like stock futures, stock options required only a small down payment; one of the only important differences between a stock option and a stock future was that most options were linked to stocks of individual companies, such as IBM or AT&T or Exxon, while futures were linked to broad measures of the stock market such as the S&P 500 average. Also, because of Shad’s deal at the Monocle, options were regulated by the SEC, while futures were regulated by the Commodity Futures Trading Commission.) Some stock options cost less than twenty-five cents a share. Without putting up much cash, a buyer or seller of options could speculate in a big way on the future price of individual stocks.

  For example, on the day Boone Pickens appeared on the dais in Houston with President Reagan—the same day Wayne Knauf called Denny Herrmann from a sawmill in Neopit, Wisconsin—the price of oil giant Cities Service stock closed at $36.50 a share on the New York Stock Exchange. But the options Wayne Knauf “wrote,” or sold, by telephone—called Cities-Service-45 options—were priced at only about twelve cents per share. They were cheap partly because the options were due to expire in three days, at which point they could become totally worthless. The other reason had to do with the number “45” in the option’s title. A Cities Service—45 option provided the owner with the right to buy a hundred shares of Cities Service stock at $45 per share anytime before its expiration date, in this case three days away. Since Cities Service was trading at just $36.50, that meant its price had to rise by more than $10 in a very short time or the options would expire worthless. The options cost just twelve cents that June day because people in the options market figured that the likelihood of Cities Service stock rising from $36.50 to more than $45 per share in just three days was remote.

  Wayne Knauf and the others in Rhinelander figured the same thing, and that’s why they were willing to sell Cities Service options. The twelve cents per share Knauf would receive as the seller seemed, on the surface, virtually a sure thing. He and the others had been doing this for years. If they sold cheap options just before they were set to expire, the chance of a sudden explosion in the stock’s underlying price was very small. That might have been true for the group’s trades in the past, but selling naked options on a stock that was a takeover target was incredibly risky due to the possibility that a takeover bid could send the stock price shooting up at any moment. While Knauf was only at risk if the price of Cities Service stock skyrocketed above $45 within three days, if that happened Knauf’s exposure was theoretically unlimited. If the stock rose to $95 per share, for example, he would be liable for the $50 difference between the $45 option price and the $95 market price—in his case, $50 per share times 4,000 shares, or $200,000. If the stock price went higher, so would Knauf’s liability.

/>   Such a catastrophe had never befallen Knauf, Graf, Kuenzli, or the others who met in the Rhinelander office of Smith Barney. Never, that is, until Boone Pickens came along.

  Two days after his appearance with President Reagan in Houston, Boone Pickens sat with a band of his advisers in the dimly lit recesses of the famous 21 Club in midtown Manhattan. Empty bottles of wine cluttered the table. The restaurant was popular with the pretentious Wall Street investment bankers and corporate executives whom Pickens claimed to deplore, yet it was one of the Texas raider’s favorite New York watering holes. In contrast to the bonhomie Pickens usually displayed to the restaurant’s maitre d’ and black-tied waiters, the mood at his table that evening was subdued. The battle for Cities Service was over, and all the alcohol was meant to soothe what for Pickens had been a disappointing, though far from unprofitable, outcome.

  A white knight had arrived that afternoon at 1:00 P.M. to rescue Cities Service from Pickens’s clutches. From its Tulsa, Oklahoma, headquarters, Cities Service had announced that following two days of intense and secret negotiations, it had agreed to a friendly merger with Gulf Oil Corporation for $63 a share. In trading at the New York Stock Exchange, the price of Cities Service stock skyrocketed above $60. Pickens had been defeated, but he wouldn’t go back to Texas empty-handed. Partnerships he controlled owned about four million Cities Service shares, bought for an average of about $45 per share. Even after his expenses, Pickens would pocket a sizable profit from his failed takeover bid.

  Still, in the burgeoning culture of takeovers on Wall Street, winning sometimes mattered as much as money, and the competitive Pickens hadn’t gotten what he said he wanted. As they drank that night Pickens and his advisers comforted themselves by noting that while they hadn’t won control of Cities Service, they had at least altered the company’s destiny by forcing it into Gulf Oil’s arms. And they had come out of nowhere, using very little of their own cash to do it.

  “We put a $5 billion deal in play with no money,” said Robert Stillwell, one of Pickens’s lawyers.

  Surely they could be proud of that.

  That same Thursday afternoon, a Western Union telegram from Smith Barney was delivered deep in the peninsula wilderness to soda pop heir Larry Graf’s home in Ironwood, Michigan, about forty miles from Rhinelander.

  DUE TO THE PROPOSED TENDER OFFER BY GULF OIL TO PURCHASE SHARES OF CITIES SERVICE AT $63 PER SHARE.… IT IS NECESSARY THAT YOU REMIT A CHECK IN THE AMOUNT OF $1,233,500.00 BY 12 P.M. NEW YORK TIME … OR WE WILL BE COMPELLED TO LIQUIDATE SUFFICIENT SECURITIES FOR YOUR ACCOUNT.

  David Kuenzli burst into the Smith Barney office above the Rhinelander drugstore.

  Something is very wrong here, Kuenzli angrily said.

  That much was obvious to the rest of the group. They had lost more than a million dollars among them in just two days, far more than their combined net worth. All of their trading accounts had been liquidated by Smith Barney to cover the losses, and still, they were hundreds of thousands of dollars in debt.

  This smells like a conspiracy, Kuenzli continued. The timing of Gulf Oil’s takeover bid for Cities Service looks suspicious. Was it merely a coincidence that the merger was announced two days before the June options they sold were due to expire?

  Kuenzli thought not. There had been considerable trading in Cities Service stock and options on Wednesday, the day before Gulf’s announcement. Kuenzli thought he detected insider trading. And his theory went further. Somebody, maybe Gulf, maybe Cities Service, maybe some big stock traders on Wall Street, deliberately timed the merger announcement to wreak havoc on the options markets and allow some crooked traders to escape with huge profits—profits made at the Rhinelander group’s expense. The logic of his theory was difficult to accept, but the argument was strongly felt.

  Who could stop this conspiracy? Kuenzli demanded of Denny Herrmann, the Smith Barney broker who had helped to get them into this mess. But he didn’t wait for an answer—he already knew. He went to a typewriter and began to peck out a letter.

  He typed the address: The Securities and Exchange Commission, Washington, D.C.

  “We are writing … in the direst hope that you will be able to intercede to straighten out this terrible affair,” Kuenzli began. He recounted the publicly reported news events of the last several days, ascribing to them a variety of sinister meanings. “The final manipulation was to keep you out of this affair, and it was done via the adjustment of the entire timing to conclude coincident with the expiration of the June options, and hence via that the simple fact that the whole affair would be completed on a Friday afternoon. You would be supposed to, at best, belatedly realize that there was not time to act on the same day, and by Monday the natural psychological buffer of the weekend would place this event beyond reclamation.… The lives of trusting, decent men are being ruined by this. Please, if you can, would you straighten this matter out.”

  There is no time to waste, Kuenzli declared when he was finished.

  He urged Denny Herrmann to join him in signing the letter. Herrmann was reluctant, but he was in a difficult spot. Others besides Kuenzli in the naked-option-writing group were angry, but they were focusing their anger not on an imagined Wall Street conspiracy, but on Herrmann and Smith Barney for failing to anticipate and stop the fiasco. Kuenzli’s theories, however bizarre they might seem to Herrmann, were in some ways preferable to having the blame focused on him. In any event, Herrmann signed the letter.

  The SEC had to act immediately, Kuenzli continued, once Herrmann had agreed to sign. The mails were not fast enough. Kuenzli announced that he was going to fly to Washington that weekend and deliver his letter by hand at the commission’s headquarters. While he was in the capital, he would see his congressman as well. Herrmann was a little incredulous at this proposal—he wasn’t sure where it would lead—but he couldn’t talk Kuenzli out of it.

  On Monday, David Kuenzli arrived at the new SEC building on Fifth Street in northwest Washington, just down from the city’s imposing courthouse on Indiana Avenue. The lobby was cool and spacious and formal, with a buffed stone floor and walls of poured concrete. Walk-in complainers at the SEC were not unheard of, and they ordinarily received courteous but perfunctory treatment. Kuenzli made an impression. One SEC official recalled that after demanding an audience with a commission attorney, Kuenzli trembled and began to cry. In any event, he was granted a personal audience with an enforcement division lawyer upstairs. He told the lawyer all about his conspiracy theory. And he described, too, the group of investors who had been gathering for several years in the Rhinelander office of Smith Barney to write naked stock options.

  Few inside the SEC thought of it this way, but the story David Kuenzli outlined that day was in some respects a disaster of the commission’s own creation. Stock options, like stock futures, had for years been a source of controversy and debate inside the SEC. But in contrast to the debate over futures, in which policy makers tended to focus on sweeping economic issues like liquidity and speculation, the disagreements over stock options centered in large part on whether they were good or bad for ordinary investors like the group in Rhinelander, Wisconsin. And in the end, the SEC had decided that the benefits of options for individual investors outweighed their risks.

  The “individual investor” had always been a kind of abstract icon inside the SEC, akin in the pantheon of political mythology to the “mom and pop” small businessperson, or the “man on the street” in every congressional district. On Capitol Hill and in speeches across the country, SEC officials routinely paid lip service to protecting the individual investor from fraud and from unfair trading practices on Wall Street. The commission’s public concern about individual investors dated back to the 1920s, when millions of naïve and newly rich middle-class investors had poured their money into stocks, only to be burned by the outlandish manipulations of Wall Street insiders and by the 1929 crash. When the SEC was founded, it was seen not only as an institution that would root out crooks from the corner
of Broad and Wall streets, in lower Manhattan, but also as one that would ensure that ordinary, middle-class investors would never again face such abuse. It was the middle class’s hard-earned money, after all, that fueled the country’s economic growth, and thus it was essential that the “individual investors” have faith in the integrity of the financial markets. The federal paternalism inherent in the SEC’s charter irked some conservatives, but during the great rush of the New Deal, when the commission was created, there was a broad consensus in Washington that extensive regulation was necessary to restore fairness to the markets and to protect the quality of life for the middle class and, to a lesser degree, the working class as well.

  By the time Jack Shad arrived in Washington in 1981, the commission’s public devotion to protecting individual investors had congealed into a cliché, a piece of conventional wisdom so soft and malleable that it was used to justify sharply divergent positions on economic issues. Partly the problem was that the economic world of the 1920s no longer existed. The country’s middle class still invested as individuals in stocks and bonds, but their role in the financial markets was overshadowed by the huge institutional investors that had come to prominence during the 1960s. The money controlled by these big institutions—pension funds, university endowments, insurance companies, and bank trust departments—dwarfed the money controlled by individuals. Institutional money usually belonged in one form or another to the middle and working classes, as was the case with pension funds and stock mutual funds, but it was no longer managed by individuals. Instead it was controlled by big money managers on Wall Street who had the expertise and economic clout to profit from stock and bond trading. Thus it could be argued that protecting individual investors now required defending the interests of the large institutions that managed their money. Inside the SEC, though, the image persisted of the individual investor as a hardworking, middle-class homeowner who lived somewhere on the great plains of the Midwest with 2.4 children and a garage for his car. The image wasn’t entirely false: millions of such investors did exist. David Kuenzli and the group of naked options writers in Rhinelander, Wisconsin, were evidence of that.