Eagle on the Street

  But what was the commission supposed to do about David Kuenzli and his friends? Risky options trading of the kind carried on in Rhinelander was sanctioned by the SEC, with certain restrictions concerning the “suitability” of individual investors to participate. Because of their leverage—the bang-for-the-buck they offered—stock options had become popular during the 1970s. Regulation was lax, however, and a widespread scandal in the options markets led the SEC to impose a moratorium on some options trading during Jimmy Carter’s presidency. After a lengthy study, and over the objection of those who thought options were too speculative, the SEC decided finally that the “liquidity and efficiency” options promoted were fundamentally good for the nation’s financial markets, and that public trading and the introduction of new stock options should be allowed. But to prevent repetition of scandal and to protect individual investors from risks they didn’t understand, the commission adopted strict standards whereby Wall Street brokerage firms were required to supervise closely the riskiest trading strategies of their customers. In its 1978 options study, the SEC said that customers should be made aware “on an ongoing basis of the risks of any and all options transactions undertaken.… A brokerage firm should not be permitted to recommend any options transaction to a customer unless the firm reasonably believes the customer is capable of both evaluating the risks and bearing the financial burden of those risks.”

  With ambiguous, legalistic phrases such as “reasonably believes,” the SEC left plenty of room for debate about what exactly a stockbroker was supposed to do when his customers, inspired by illness or misjudgment or merely the speculative fever of the times, wished to take enormous risks by writing naked options. By authorizing the growth of public options markets, the SEC had tacitly blessed the sort of trading carried out by the Rhinelander group. Yet the commission insisted that brokerage firms be sure that their customers knew what they were doing, even though the firms’ reason for being was to make money by encouraging, rather than discouraging, trading. It was in some ways like asking a casino to judge whether one old man at a slot machine, as opposed to another, was fully apprised of the risks of gambling and could afford to lose a bucketful of quarters. Without strict government supervision, could a Wall Street brokerage really be expected to fulfill such a paternalistic responsibility?

  The story David Kuenzli told that day at SEC headquarters was a case in point. Had Kuenzli known what he was doing when he sold naked Cities Service stock options? What about Larry Graf, the unemployed soda-pop heir with a learning disability? Whoever was responsible for the idea, selling naked options on the stock of a company involved in a public takeover fight was foolish almost beyond comprehension. The basic risk in writing naked options was that some unexpected event would cause the stock of the company in question to rise dramatically and suddenly in price. The event most likely to have such an effect was a takeover. While writing naked options, it was impossible to completely eliminate the risk of an unexpected takeover announcement that might send the price of a target company’s stock soaring. Yet the risk could be reduced substantially by avoiding companies that were being stalked publicly by Boone Pickens, or whose managements were being referred to as “clowns” to the amusement of the president of the United States. When the Rhinelander group wrote options on Cities Service stock, the company was already in receipt of a $50-per-share takeover offer and was fighting for its life against Pickens. It wasn’t clear to investigators from the commission who in the Rhinelander group had been aware that Cities Service was in the midst of a takeover fight. Details of the battle were chronicled almost daily in the Wall Street Journal, which several of the group professed to read. It was plausible, although hard to believe, that none of them understood what might happen.

  Denny Herrmann sat bundled in his overcoat. The lawyers were all around him. They had been crawling all over him for months now, or so it felt to Herrmann. He had never been through anything like it in his life. And now, the week before Christmas, 1983, the SEC attorneys had summoned him to an interrogation in this ugly federal building in downtown Milwaukee, where the heat didn’t work, where the walls seemed gray and forbidding. The deposition was supposed to last for days, and Herrmann wasn’t sure that he could make it.

  “All these accounts had a strategy in common,” he wanted them to understand. “They felt they’d really found the golden goose.… I felt I had warned these people time and time again.”

  During a preliminary interrogation in August, SEC attorney Susan Pecaro had asked him how he knew when it was all right for a particular customer to write naked options. Herrmann replied: “Well, to answer that question without trying to make this sound silly, it would be like how does a father know the first time his daughter can stay out to midnight?”

  This was Herrmann’s defense: His clients were old enough and mature enough to gamble with their life’s savings.

  Now Susan Pecaro bore in at him from across the conference table. Herrmann understood that she was not impressed. Young and relentless, Pecaro was the enforcement division attorney who had been running the SEC’s confidential investigation of Herrmann and Smith Barney, captioned in the commission’s files as HO-1480, “Trading in the Securities of Cities Service Co.” The probe had begun the day David Kuenzli presented himself in the lobby of the SEC’s Washington headquarters. Pecaro had interviewed most of the members of Denny Herrmann’s options trading group, subpoenaed records, and interrogated his superiors at Smith Barney headquarters in New York. Herrmann felt pressure from all sides. Wisconsin state-securities regulators had initiated proceedings against him, saying that Herrmann had failed to supervise properly the naked options writing of the Rhinelander group, that he had doctored options-trading application forms, and that he had failed to follow Smith Barney’s internal rules. And Smith Barney wasn’t happy with Herrmann, either. After initially expressing support at a breakfast meeting in Rhinelander just after the Cities Service takeover was announced, Smith Barney executives had begun to keep their distance from him, it seemed to Herrmann. For one thing, they were furious about his decision to sign Kuenzli’s protest letter to the SEC. It had only prompted the commission to initiate an investigation of Smith Barney.

  Pecaro and her superiors in the enforcement division thought it was clear that Herrmann and Smith Barney had violated the securities laws. The SEC rules about options trading admittedly were vague, especially the standard that required a brokerage firm to refrain from recommending options trades “unless the firm reasonably believes that the customer is capable of both evaluating the risks and bearing the financial burden of those risks.” Such a rule could only be enforced on a case-by-case basis, with the discretion of a prosecutor. But in the months since Kuenzli’s flight to Washington, Pecaro and her colleagues had ferreted out evidence that Smith Barney and its employees had grossly ignored the SEC rules. Documents subpoenaed from Smith Barney showed, for example, that the brokerage’s executives in New York had been warned repeatedly about the impending calamity in Rhinelander, yet had failed to respond.

  Denny Herrmann’s boss, Robert Heck, who was the Rhinelander-branch supervisor, was required each month to report to Smith Barney’s lawyers at its Wall Street headquarters on the state of his office. Pecaro discovered that in the six months leading up to the Cities Service takeover announcement, Heck had reported clearly and repeatedly that the naked-options-writing group assembled under the eye of Denny Herrmann was headed for serious trouble.

  “Compliance Department has been advised repeatedly re: the tremendous option activity in various clients accounts,” Heck had written six months before the Cities Service calamity. “New York should also continue to assist in monitoring option activity,” he wrote again three months later. He wrote the same thing in his next report. The following month, in a final act of prophecy, Heck warned: “Continue to be concerned about large naked positions re: option activity.”

  The Smith Barney lawyer responsible for the firm’s compliance with the
SEC rules never saw Heck’s reports, Pecaro learned. The clerk at Smith Barney’s Wall Street headquarters who received the monthly reports filed them away in a drawer; they were never circulated to either the compliance or general counsel’s offices, as the brokerage’s procedures required. Pecaro and some of her colleagues in the enforcement division regarded this as an egregious failure—and clear evidence that Smith Barney, as well as Herrmann and Heck, should be publicly charged with securities-law violations. They were preparing, that December of 1983, to mount a securities-fraud case against all of them.

  Denny Herrmann told Susan Pecaro that day in the frigid Milwaukee conference room that she was wrong. Herrmann was a savvy, articulate, sometimes defiant, man, and for a while during the interrogation he was able to project an air of confidence. He was a gambler who spent Thursday nights playing poker at Rhinelander’s country club, a weekly game where the loser might drop two or three hundred dollars. He had grown up in Des Moines, Iowa, and spent most of his life in Wisconsin, so he had become accustomed to the leisurely pace of the rural Midwest, but Herrmann also fancied himself a tough man, a realist, especially about money.

  He considered the SEC’s investigation of him essentially unjustified. Sure, Herrmann conceded, he might have broken a few rules, but his customers all knew what they were doing—they talked together about their gambling in options nearly every day of the week. The way Herrmann figured it, there was nothing wrong with making a bet, whether on a poker hand or the stock market or the outcome of a corporate takeover, so long as you were prepared to pay up if you lost. Herrmann claimed he always paid his bets out at the country club and didn’t grumble about it. In the time since Kuenzli had started the whole affair, some of those who had been writing naked options in the Rhinelander office had settled their accounts without much complaint. The accountant Wayne Knauf, for example, readily acknowledged that he knew the risks he was taking by selling Cities Service options, and though he didn’t have enough money to pay the huge debt he owed Smith Barney, he had agreed to pay off his losses on an installment plan. The others—including Graf and Kuenzli—had merely been dealt a bad hand in the options market, and now they were trying to make a federal case out of it, Herrmann said.

  Susan Pecaro showed him a document. It was the application Larry Graf had filled out at the Rhinelander office when he first began to trade stock options. As part of its compliance with SEC “customer suitability” rules, Smith Barney required an investor who wanted to trade options to disclose detailed information about his finances and sources of income. Graf was described on the form as “self-employed,” with a net worth of $350,000 and an income of $75,000 annually—both numbers were exaggerations. Other application forms from Herrmann’s customers contained similar misstatements, and some of the forms had been filled out in Herrmann’s handwriting.

  Herrmann said he had tried to check the information provided by his customers, that he hadn’t deliberately invented or exaggerated any information about them.

  Pecaro opened a fat legal book and began to read aloud from sections of the U.S. criminal code concerning forgery.

  Herrmann’s head began to whirl. Every question seemed to challenge him. He had a lawyer with him from a big Milwaukee firm retained by Smith Barney, but Herrmann thought the attorney might be more interested in protecting the brokerage firm that paid his bills than in defending one of its stockbrokers.

  At one point, while explaining the long history of his own trading in stock options, Herrmann said that he had mostly “sold options short” in the months before his customers lost their life savings in the Cities Service takeover. By selling short, Herrmann was betting that stock prices would go down. One of the SEC lawyers pounced on him.

  “You mean, you were shorting options prior to the bull market?” the lawyer asked incredulously.

  “That’s ridiculous,” he practically shouted in reply. “What—am I supposed to be able to predict a bull market?”

  Afterward, Herrmann recalled the exchange vividly—he regarded it as one of his few triumphs during the days of interrogation. Increasingly, he felt the pressure mount on him. On the last day, at about three-thirty or four in the afternoon, he felt that he had reached his breaking point. He was agitated, exhausted. All of what Herrmann had built for himself in Rhinelander—the six-figure income, his second marriage and children, the Thursday poker game at the golf club—appeared to be in jeopardy. He seriously believed that he was about to have a breakdown. And it seemed to Herrmann, finally, that Susan Pecaro saw how he felt, and that she relented.

  “I guess we’ve done enough,” Pecaro told him, and she began to gather her papers.

  That evening the SEC lawyers returned to Washington for the holidays. It was nine months before Herrmann heard from them again. There was no answer, no resolution—everything was left hanging.

  So Herrmann went about his business in Rhinelander, reporting to the office each day, advising his customers on stock and bond and option trades.

  Back in the capital, Jack Shad would soon embark on a surprising mission that would put him at odds with the White House on the most pressing financial issue of the day.

  * In a subsequent court proceeding, Graf was questioned about his education, and he acknowledged that he had sought special assistance for his learning disability. This exchange occurred during the examination:

  Q.You do know how to read?

  A.Very slowly.

  Q.Do you ever read books?

  A.No.

  Q.Do you ever read magazines?

  A.Not really.

  Q.Do you ever read the newspaper?

  A.Occasionally.

  Q.What newspaper do you read occasionally?

  A.Occasionally I look at the Wall Street Journal.

  10

  The Leveraging of America

  John Shad called the commission meeting to order a few minutes late, just after he and commissioners Charles Cox and Jim Treadway settled into their swivel chairs on the raised platform illuminated by the hot television lights. Before them the public citizenry was assembled, or at least its salaried representatives, in the form of lawyers and Wall Street consultants and journalists. They had come to the SEC’s basement conference room, in the cool deep of its headquarters on Fifth Street, drawn by the rare chance to watch the commissioners wrestle openly with the most divisive and pressing economic issue of that spring of 1984, the unprecedented boom in corporate takeovers.

  Shad seemed in a hurry, oblivious to the political opportunity presented by such a well-attended public forum.

  “We’ll be able to do it, I hope, in a rather abbreviated form,” he mumbled in the direction of his microphone. He was referring to the commission’s agenda, which included a final vote on what new rules the SEC planned to adopt or recommend to Congress to curb corporate mergers.

  The room was tense, not least because the commission had opened its deliberations under the Sunshine Act, the ironically titled law that permitted the SEC to hold nearly all of its important debates in the sanctified privacy of the closed-meeting room six floors above. The meeting took place amid fiery political debate about takeovers. That Tuesday morning, March 13, 1984, the newspapers were filled with startling reports that two prominent Democratic senators hoped to enact a six-month moratorium on mergers in the oil industry. The immediate causes of the senators’ distress were the continuing takeover raids of T. Boone Pickens, Jr., and a recently announced $5.7-billion takeover bid for Superior Oil by Mobil Oil, a deal so big it would have been almost unimaginable months before. The White House was under pressure. Informed of the proposed congressional ban, spokesman Larry Speakes publicly waffled, saying that Reagan hadn’t expressed any “concern or opposition” to takeovers, but he wasn’t ready to express approval, either.

  “I find there definitely is some sentiment for us to act,” an emboldened Senator Howard Metzenbaum, a liberal Democrat from Ohio, had told reporters on Monday. “Reagan would be very hard put, in view of the p
olitical picture, to veto” any congressional ban on takeovers.

  This was exactly what Shad had tried to avoid—a political frenzy about the takeover issue—and now he was right in the center of it, stationed before the cameras on a raised platform at the head of the commission’s basement meeting room. That morning, voters across the South were flocking to the polls in a chaotic electoral event dubbed Super Tuesday, a host of simultaneous Democratic and Republican primaries in the 1984 presidential campaign. Reagan’s position within his own party was secure, but Democrats felt the vigor of an electric battle between two senators, Gary Hart and Walter Mondale, with Hart claiming that his youth, charisma, and “new ideas” held the only hope for defeating Reagan in the fall. Shad’s colleagues in the Republican party and at the White House were concerned—a private poll completed the day before showed Reagan ahead of Hart by only four points, while the president held a sixteen-point lead over Mondale. Hart’s economic advisers, drawn principally from Harvard University, offered a sharp rebuttal to the laissez-faire approach to takeovers advocated by the right-wing Chicago School economists. On the campaign trail across the South, Hart and Mondale each attacked the Reagan economic program as fundamentally unfair, and the boom in big takeovers provided an easy target for their populist rhetoric.

  Shad and his fellow commissioners found themselves uncomfortably in the center of this political storm. For the first time since the surge in wild and hostile corporate takeovers began in the summer of 1982, the SEC was poised to act. Shad’s takeover advisory committee, dominated by his friends and former Wall Street colleagues, had submitted its muddled report the summer before, and only now, after months of private tinkering and review, was the commission prepared to accept or reject or alter its recommendations. In the interim, more and more mergers had been announced each month for greater and greater sums of money, each one greeted by the assessment that such an audacious takeover “would have been unthinkable” weeks earlier. Stock prices surged and gyrated daily on the floor of the New York Stock Exchange amid speculation about which previously untouched corporate giant was to be the next target. The good news for Shad and Reagan was that usually at the end of the week stock prices were higher, buoyed by the continuing economic recovery and teased upward by rumors of new and bigger deals.