Eagle on the Street

  Drexel Chief Executive Fred Joseph had been Shad’s friend for years. While working together at E. F. Hutton they had shared not only a common approach to investment banking but also a personal affinity. “You sure don’t look like an investment banker to me,” Joseph once kidded his overweight mentor. Their relationship was captured by an anecdote friends repeated about a cab ride the pair once had taken to LaGuardia Airport in New York. Impatient and demanding, Shad had told the cabdriver to move first into the right lane, then into the left lane, and then demanded that he take an exit and get back on the highway at the next entrance. The driver slammed on the brakes, got out of the car, and as a mortified Joseph looked on, opened Shad’s door. “If you can drive better than me, sir, you drive,” the cabdriver said. So Shad took the wheel and chauffeured Joseph and the stunned cabbie to the airport. Ever since, Joseph had in some ways followed Shad’s lead. Even when Drexel’s troubles grew while Shad was at the commission, Joseph relied on approaches to management and investment banking he had learned while working for Shad. Joseph thought so highly of Shad that he had framed a 1965 memo from Shad and hung it on his office wall high above Broad Street in the Manhattan financial district—it was still there late in 1986 when the SEC investigators came calling with their subpoenas. It was precisely because Shad knew and trusted Joseph on a personal level that he could not believe any problems at Drexel were pervasive, even after Boesky provided his evidence to the commission. From the arrest of Dennis Levine onward, Joseph maintained a high public profile, immediately issuing bold statements defending the integrity of the firm and its employees. He had learned from Shad years before not to tarry, and to act aggressively; now he was outmaneuvering his teacher on the public relations front. When news leaked that Milken was a focus of the SEC’s investigation, Joseph declared categorically that he knew of no wrongdoing by Drexel or any of its employees. If the public had known that Drexel paid Milken an astounding $550 million in 1987, more than ten times his 1983 compensation of $45.7 million and more than the firm itself earned that year, after paying salaries and bonuses and taxes, Joseph would have been far less convincing. Even among big producers, no one in the history of Wall Street had ever been paid a salary approaching that figure. (At the same time, the firm paid Milken’s brother, Lowell—who spent much of his time overseeing investment partnerships that made hundreds of millions of dollars for the Milkens and select Drexel employees—nearly $50 million. The salaries reflected the enormous clout Michael Milken had at Drexel to act independently, even when it came to setting salaries.) But the public had no clue, and Joseph’s combative attitude gave pause to those in Congress and the press who assumed that Milken and his firm would topple like dominoes as Levine, Boesky, and the others had before. Joseph’s attitude also helped to convince Shad that the increasingly harsh allegations about Drexel bandied about on Wall Street and in Washington did not tell the whole story about the firm or its lucrative junk bond business.

  But the more Shad resisted, the more his assumptions about Wall Street seemed to crumble. During the second week of February 1987, all of the Street was jolted when federal marshals entered the trading floors of two prestigious firms and arrested Robert Freeman, the chief arbitrager at Goldman, Sachs & Company and Richard Wigton, a top trader at Kidder, Peabody, charging them with criminal insider trading. (While the initial charges against both men were dropped, Freeman later entered a guilty plea to one count of insider trading and Wigton was exonerated.)* The highly public arrests quickly moved the Boesky scandal to the heart of old Wall Street, to the world of clubs and handshake deals John Shad inhabited before he left to chair the SEC. The arrests were made because of information provided by Marty Siegel, the Drexel merger specialist who decided to plead guilty to two criminal counts soon after he received subpoenas indicating that Boesky had turned him in. Siegel resigned from Drexel in disgrace, acknowledging that he had accepted suitcases full of hundreds of thousands of dollars in cash from Boesky in exchange for insider tips. Later that same month, Dennis Levine was sentenced to two years in prison. But it was the spectacle of top traders at venerable firms like Goldman and Kidder being hauled away in handcuffs like common criminals that mortified traders and executives across Wall Street. If it could happen to these guys, the feeling was, it could happen to anybody.

  To the public and to his colleagues on the sixth floor, Shad vacillated between boasts about the SEC’s success and assertions that the scandal really wasn’t such a big deal after all. “We came out in 1981 and said we’d come down on insider trading with hobnail boots,” Shad told the Congress in early 1987. “Now you’re seeing the boots hit the sidewalk.”* But it was obvious to those close to him inside the commission that Shad was distraught. Congressional criticism that the SEC’s settlement with Boesky was too lenient upset him terribly, leading some inside the commission to ask whether there were other sanctions the SEC could impose on Boesky. (Lynch resisted such pressure, saying the agency had to live up to its promises to Boesky. Boesky was sentenced to three years in prison in early 1988, a sentence Judge Morris Lasker said would have been more severe had it not been for the arbitrager’s extraordinary cooperation with prosecutors.) Shad also seemed uncomfortable in his role as the chief Wall Street watchdog at a time of great scandal, and he seemed genuinely disappointed in the Street and shocked at the magnitude of the crimes uncovered. Yet even in closed meetings with only his senior staff and fellow commissioners present, Shad repeated his favorite aphorisms about the integrity of the stock market. One difference from the past, though, was that his staff began to challenge him.

  Let’s not forget that by the highest conjecture, the level of securities fraud is a fraction of one percent of overall stock market activity, Shad said during one closed meeting during this period. America has today by far the best securities markets the world has ever known—the broadest, the most active, efficient, and the fairest.

  I don’t buy the one-bad-apple theory, Lynch countered from across the table. I think we have found at least one bad apple in every firm at this point.

  Through his actions more than his words, Shad seemed to acknowledge that Lynch was right. An active alumnus, he was in touch regularly with the Harvard Business School, and that winter he began to talk with school officials about an extraordinary gift—Shad said that he wanted to donate most of his personal fortune, approximately $20 million, to establish a new and unprecedented program to teach business ethics.* Harvard, naturally, was delighted, though some professors at the school were skeptical about teaching ethics. The school announced the donation in March 1987, just a month after Freeman and Wigton were arrested on their Wall Street trading floors. It was the single largest gift in the history of the Harvard Business School. Shad described the gesture—and the time he would devote to developing the ethics program while continuing his government work—as a consummation of his grandmother’s adage that a person should spend one third of his life learning, one third earning, and one third serving. There were those who saw the gift as an attempt by Shad to secure his public legacy and to outdo the other members of the famed Harvard Business School Class of 1949. Others wondered whether it was intended in part to expiate some abstract guilt Shad felt about the corruption his commission had uncovered in the industry where he had labored. There was some questioning around the SEC about throwing money at a problem that money helped to create, and skepticism about whether integrating ethics into the business-school curriculum would make any difference. But most people accepted Shad’s philanthropy at face value and lauded him for his extraordinary generosity. By any measure, he had come a long way from Brigham City, Utah.

  If there was one thing that steeled and encouraged John Shad throughout the trying early months of 1987 as he prepared for his posting in the Netherlands, it was the stock market. The numbers in the financial markets, on which he had always relied for an empirical measurement of success and failure, seemed to him unequivocal. They kept going up. Defying the insider trading sca
ndal, the great Reagan bull stock market raced ahead. The Dow Jones Industrial Average had soared 400 points between 1985 and early 1987, reaching an unprecedented 2,300 points. The Dow had more than doubled since May 6, 1981, the day George Bush had sworn Shad in as the twenty-second chairman of the SEC. Shad’s policies had clearly played a role in the Dow’s rise. Five years of continuous economic growth was a major factor driving prices higher. But at the same time, the wave of corporate takeovers Shad encouraged had removed billions of dollars of stock from the public markets, driving up the price of those stocks and the remaining shares. Even more than the rise in stock prices, the growth in daily trading figures seemed to Shad a testament to his push for liquidity in the marketplace and the economy. Daily trading volume at the New York Stock Exchange had increased nearly fourfold since 1981 to about 175 million shares. While the stock market boomed, Shad developed tables in the SEC’s 1986 annual report showing across-the-board productivity increases at the agency during his tenure. The number of insider trading cases was up, the number of corporate financial filings reviewed by the commission was up, and the fees collected by the agency from new issues of stocks and bonds were up. To Shad, these were hard and satisfying facts. These were the numbers that mattered.

  But Shad found that there were many in Congress and even on Wall Street who were less impressed by the numbers than he was. As had been true on Capitol Hill after the Boesky announcement, those who had been his opponents for the previous six years remained skeptical of his achievements. New York Stock Exchange chairman, John Phelan, broke publicly from Shad and warned in the spring of 1987 of the potential for a “financial meltdown” caused by the buildup of computerized program trading in the stock and futures markets. Phelan found a receptive ear in Congress, where Democrats expressed concerns about the violently volatile short-term moves in stock prices apparently caused by program trading. Though there were many variations, at its core the program trading that raised concerns was an outgrowth of Shad’s SEC-CFTC accord. Whenever stock futures in Chicago were offered for sale at one price, and the underlying stocks were offered in New York for another price, aggressive traders using computers could earn arbitrage profits by simultaneously buying one and selling the other. On the day every three months when stock futures expired and the prices in Chicago and New York converged, massive buying or selling of stocks was necessary to lock in these profits. On one such day, January 23, 1987, the Dow had whipped up and down 115 points in about an hour and stock market volume had zoomed above 300 million shares, a record.

  Program trading was a game played exclusively by and for large institutional investors, who by early 1987 had begun to dominate the action in the stock market. Pension fund assets, insurance company funds, Wall Street brokerage monies, and other institutional assets comprised an estimated half of the $3 trillion of public stocks owned in the United States and more than three-fourths of the daily trading volume. By 1987, the competition among money managers had led many of them to look in every nook and cranny of Wall Street for any short-term edge they could find to beef up their performance numbers. Program trading gave them just what they needed: by pouring millions of dollars into and out of the market with the help of computers, the managers could lock in “sure” profits and bolster their short-term performance. Some corporate executives complained loudly that the trading games drove their own companies’ stock prices up and down without regard for corporate financial performance. Yet these same executives hired money managers for their corporate pension funds who played the very program-trading games that roiled the markets. One reason they did was that the edge in short-term performance delivered by program trading created excess cash in the pension funds, which corporations could then tap for other business purposes. The truth was that everybody wanted an edge—the institutions, the managers who controlled their money, the Wall Street firms that sold program-trading services, and with the exception of Phelan at the NYSE, the financial markets themselves, which profited from the increased trading volume.

  “When people talk about … the possibility of a market meltdown because of this telescoping and that you get everybody coming through the door at the same time.… Is it feasible for that kind of thing to happen, in your view?” John Shad was asked on May 13, 1987, while appearing before a Senate subcommittee to testify about the stock market. The questioner was Senator Donald Riegle, a skeptical Democrat from Michigan.

  “I think there’s an enormous panoply of reasons why something comparable to 1929 is incredibly improbable to occur under the present economic and regulatory environment,” Shad predicted boldly. “Nothing is impossible [but] I think that there are an awful lot of reasons why that is highly, highly improbable. As for the meltdown theory, I just don’t think that’s likely.”

  “Some have argued that given the number of market devices that are now being used … that you could conceivably get a combination of events where, in the name of volatility, you might see the market in a given day not go up or down 150 or 200 points but maybe 500 points. Is that also beyond the realm of realistic possibility in your view?” Riegle asked.

  “In terms of probabilities of a one-day break of 500 points of the Dow Jones average? I would say I think it’s highly remote, very remote,” Shad answered. “But I don’t want to say anything is impossible.”

  It was the last major market prognostication Shad made before Congress, as his six-year tenure as SEC chairman—the longest in commission history—drew to a close.

  They came to the basement on Fifth Street to say good-bye at his official farewell party, even some of those who had fought him and criticized his policies and warned that potential disaster lay ahead: Congressman John Dingell, New York Stock Exchange Chairman John Phelan, and former SEC enforcement chief Stanley Sporkin. In the crowd were Federal Reserve Board Chairman Paul Volcker as well as several former SEC commissioners and advisers to Shad. And there was a large group of current staff and commissioners.

  Standing at the head of the room, mumbling as he spoke, Shad tried to get off a few jokes, pausing rhythmically for them all to laugh. “The first two years were pretty rocky,” he said. “In fact, yesterday wasn’t too great.… At my initial luncheon with John Dingell, there were just the two of us and our food tasters. Partisan politics aside—in the trenches, I want ‘Rambo’ Dingell on my side.”

  Shad had never completely adjusted to Washington—he still lived in a hotel room and heated his bowl of Campbell’s soup for dinner just as he had ever since his wife’s stroke quashed their plans to buy a house—but he clearly had been at home inside the commission for some time. When his first grandchild was born just before he left the SEC, he had received hearty congratulations from his colleagues at the commission; none of his family was in Washington to share his joy. He had pushed the agency away from its focus on the “public good” and toward a concentration on shareholders’ interests. Now there was a new public interest group being formed in Washington—the United Shareholders Association led by T. Boone Pickens—to fight for stockholders, Shad’s favorite cause, even after the chairman had gone, a symbol of how much had changed in Washington during the Reagan years. As he bid them an official farewell, Shad thanked his staff and colleagues on the commission, and then he reeled off a series of points, ranging from the SEC-CFTC accord, creating stock futures, to the insider trading crackdown, which he said reflected the highlights of his tenure.

  “My only regret,” Shad concluded, “is that I will be a distant observer of the exciting events that are unfolding before this great institution.”

  On a sweltering afternoon in early summer, John Shad sat in the conference room of his large corner suite at the SEC and answered questions under oath while movers in the adjoining office gathered up his personal belongings to haul them out of the building. It was Friday, June 12, 1987, the last day of the chairman’s last full week at the helm of the commission.

  He had spent a lot of time in the last six months answering questions—fro
m the press, from Congress, and from his own staff. It had been a long and reflective farewell. But this session was different from all the rest. For one thing, there were no hot television lights bathing him or microphones jabbed toward his face or reporters pressing in around him. Shad, in his last hours of power, was being interrogated aggressively behind closed doors by a former SEC enforcement lawyer.

  Seated across from him was Cathy Broderick, the former Washington Regional Office (WRO) attorney who had filed a lawsuit against the SEC and against Shad as chairman of the commission. In her suit, Broderick alleged sexual harassment by her supervisors at the WRO across the Potomac River in Arlington, Virginia, saying she had been forced to labor for five years in a “hostile work environment” poisoned by open sexual liaisons, afternoon drinking parties, and favoritism toward women employees who slept with their bosses. Broderick had never before met Shad. She had come to the deposition so she could look him in the eye before he departed from the SEC.