In the middle of the day on Thursday, December 17, 1987, about fifty armed men and women burst out of the third-floor elevators to raid our office in Princeton, New Jersey. They were from the IRS, the FBI, and the postal authorities. Our employees were searched before they were free to leave the building. They were not allowed to return. The invaders impounded several hundred boxes of books and records, including Rolodexes. They dug through contents of wastebaskets and crawled through the ceiling spaces. It went on into the early-morning hours of the next day.
This was part of a campaign by Rudolph Giuliani, US Attorney for the Southern District of New York, to prosecute real and alleged Wall Street criminals. As a prosecutor later told a defense attorney, Giuliani’s real objective in attacking individuals in our Princeton office was to get information to further his case against Michael Milken at Drexel Burnham and Robert Freeman at Goldman Sachs. My partner Jay Regan knew them both well and spoke to them often. Freeman had even been a roommate of Regan’s at Dartmouth. Giuliani believed that Regan could help him bring them down. Regan refused to cooperate.
The government used evidence from the raid and testimony from a disgruntled former employee to develop their case. Ironically, when this man was being considered for a job as a trader by the Princeton office, they flew him to Newport Beach to get our opinion. We said emphatically that he was not suitable. However, it was our practice for each office to have the last word in the areas of the business for which it was primarily responsible. The Princeton office hired him. The five top people there were indicted and tried on sixty-four charges of stock manipulation, stock parking, tax fraud, mail fraud, and wire fraud. The defendants, in addition to Jay Regan, were our head trader, head convertible trader, the CFO and his assistant, and a Drexel Burnham convertible trader.
Neither I nor any of the forty or so other partners and employees in the Newport Beach office had any knowledge of the alleged acts in the Princeton office. We were never implicated in, or charged with, any wrongdoing in this or any other matter. Our two offices, more than two thousand miles apart, had very different activities, functions, and corporate cultures.
The key to the government’s case was a few conversations they discovered on three old trading room audiotapes that had been saved years earlier, then misplaced and forgotten. They were originally created because it was the normal business practice in the Princeton office, as it was elsewhere on Wall Street, to temporarily record all telephone conversations in the trading room. A major purpose for this was to quickly resolve disputes with counterparties over trading orders and executions. With our volume of eighteen billion shares a year, mistakes were inevitable. One such trade, part of a gigantic Japanese warrant hedge executed through a firm I’ll call Enco, was based on what they told us about the terms of the warrant. Our traders said Enco repeatedly assured us that the information they gave us was correct. In fact it wasn’t. Our proof was on those tapes.
The resulting mistake in the quantities of securities used for our hedge position cost us $2 million. Ordinarily the tapes ran continuously, keeping the last four days of conversations, writing over the oldest as they recorded the newest. But pending a resolution, our traders saved the tape covering the disputed trade. Later, since Enco refused to admit the error was theirs, our traders prepared for arbitration or litigation by initiating and recording two more conversations in which Enco again told our traders the original information they had given us was correct. This meant two more tapes, including eight more days of conversations, were set aside for evidence. We then showed management at Enco how the facts contradicted what their staff had told us, and asked for compensation. Normally, the erring broker compensates the other party. Enco refused and said that if we litigated, they would no longer do business with us. We knew that all of the big four Japanese brokerage firms, which controlled the market in Japanese warrants and convertible bonds, would follow suit. As this area was a major contributor to our profits, we accepted the $2 million loss. Though the three tapes should then have been reused as was our usual practice, they sat forgotten in a desk for a couple of years until the government seized them in the 1987 raid as part of hundreds of boxes of files and materials.
The government invoked the Racketeer Influenced and Corrupt Organizations Act (RICO), a tool designed to prosecute mobsters, for the first time ever against securities industry defendants. It was a landmark case. The defendants posted cash bonds totaling $20 million.
To pressure them further, the US attorney began contacting our limited partners and making arrangements to subpoena them to come to New York and testify (to what?) before the grand jury. As they were passive participants not involved in the operations of the partnership, these subpoenas had no conceivable value for Giuliani’s case against Regan and the others, other than to disturb and upset them, perhaps enough so they would withdraw from the partnership.
One of our investors had just returned with a carload of groceries to her country home in Northern California. As she described it, it was a sunny August afternoon, with the fragrance of pines in the desert-dry air much like the unforgettable atmosphere of Lake Tahoe in the high summer. As she prepared to carry in the bags, she noticed a sedan parked across the street, dented and with badly oxidized paint. The vehicle clearly did not belong in the neighborhood and she became concerned when two scruffy men got out and approached her. They brought a subpoena from the US Attorney ordering her to come to New York and testify before the grand jury in the Princeton Newport case.
Tall, poised, and elegant, with an artistic background, our partner was part of the Bay Area social establishment. She began by asking the two men to help her carry in the groceries. As they chatted, she said she really didn’t know anything about the Princeton Newport case but she’d love to help. And she always looked forward to a trip to New York. Of course they would put her up at her favorite hotel and arrange theater tickets and restaurant reservations, wouldn’t they? And she would need the information on the current exhibits at the Metropolitan, the Guggenheim, and the Whitney, and could they get her the schedule of programs at Carnegie Hall?
The bemused subpoena servers shuffled off and she heard no more from Mr. Giuliani.
Not all our investors reacted with such aplomb, but every last one of our more than ninety limited partners stood fast. No one asked to withdraw. Giuliani’s ploy was exposed as a bluff when no limited partner was actually called to testify. Even so, we expected him to wreck our business if Regan didn’t help him convict Milken and Freeman.
Limited partners were alarmed by the threat that RICO could be extended to their partnership assets, and by the doubts the investigation raised about some of our leadership in the Princeton office. I was disturbed by this and by the fact that information about the case was not being freely supplied to me by the Princeton office. For instance, when the government made a transcript of the trading room tapes and supplied it to the defendants, I asked to see it. I was put off with promises for weeks. Meanwhile, the lawyers for PNP, the partnership, who were separate from the defense team, also obtained a copy. At my request, they properly sent a set to me. An adviser for one of the defendants, hearing of this, was enraged and asked that PNP’s lawyers be fired. I could understand why I was strung along when I read through the foot-deep stack of documents. There, in black and white, were conversations that had to be extremely embarrassing for those involved.
Legal fees for the defendants were estimated at between $10 million and $20 million. There was no telling how long the case would go on or how it would end. If the defendants were found guilty they would be liable for their own legal bills whereas if they were declared innocent, the partnership would pay. To get closure, I negotiated a flat advance payout to the defendants of $2.5 million, to cover any and all responsibility the partnership had for their legal expenses. In addition to this payout, the partnership was burdened with its own considerable legal expenses.
The return for PNP during this traumatic year was a mediocre 4 percent, reduced not only by the millions in legal costs from the case but also because the team in Princeton, consumed by defending themselves, couldn’t devote their usual time to partnership business. As 1988 drew to a close, I saw no good way forward for PNP. I said I was leaving. Limited partners followed and the partnership then wound down.
Rudolph Giuliani resigned as a US Attorney early in 1989 to run unsuccessfully later that year for mayor of New York, propelled by his fame and notoriety from the several years he spent first prosecuting the mafia and then Wall Street figures. He ran again for mayor four years later, this time successfully, and served two terms.
The defendants were convicted in August 1989 on multiple counts and sentenced to jail terms of three months and fines. The convictions, using RICO, were crucial in breaking the will to resist by Milken and Freeman. Both plea-bargained. But they may have acted too soon. Two months after the PNP convictions, which included racketeering counts under RICO, the US Department of Justice for a second time took “steps to rein in the tactics in racketeering prosecutions that sparked controversy during Wall Street corruption cases brought by former Manhattan U.S. Attorney Rudolph Giuliani.” The PNP defendants appealed and the Second Circuit Court of Appeals threw out the convictions for racketeering and tax fraud. It upheld the charges of conspiracy for all six defendants and securities fraud for two. In January 1992, having achieved their real goal, which was to convict Milken and Freeman, the prosecutors dropped the remaining charges against four of the five PNP defendants and a related charge against the Drexel trader. Princeton’s head trader and the Drexel defendant were still facing fines and three-month prison terms for their remaining counts. In September 1992, a federal judge vacated these sentences as well.
Superficially, the PNP case appears simply to be a federal prosecution of securities violators. To understand why it really happened, you need to go back to the 1970s, when first-tier companies could routinely meet their financing needs from Wall Street and the banking community, whereas less established companies had to scramble. Seizing an opportunity to finance them, a young financial innovator named Michael Milken built a capital-raising machine for these companies from within a stodgy old Wall Street firm, Drexel Burnham Lambert. Milken’s group underwrote issues of low-rated, high-yielding bonds—the so-called junk bonds—some of which were convertible or came with warrants to purchase stock. The higher yield was the extra compensation investors required to offset the perceived risk that the bonds would default. Filling a gaping need and hungry demand in the business community, Milken’s group became the greatest financing engine in Wall Street history.
Such innovation outraged the old line establishment of corporate America, who were initially transfixed like deer in the headlights as a horde of entrepreneurs, funded with seemingly unlimited Drexel-generated cash, began a wave of unfriendly takeovers. Many old firms were vulnerable because the officers and directors had done a poor job of investing the shareholders’ equity. With subpar returns on capital, the stocks were cheap. A takeover group could restructure, raise the rate of return, and make such a company considerably more valuable. Since that company’s potential was so great, the prospective new owners could pay more than the current market price.
The officers and directors of America’s big corporations were happy with the way things had been. They enjoyed their hunting lodges and private jets, made charitable donations for their personal aggrandizement and objectives, and granted themselves generous salaries, retirement plans, bonuses of cash, stock, and stock options, and golden parachutes. All these things were designed by and for themselves and paid for with corporate dollars, the expenses routinely ratified by a scattered and fragmented shareholder base. Economists call this conflict of interest between management, or agents, and the shareholders, who are the real owners, the agency problem. It continues today, one example being the massive continuing grants of stock options by management to itself, already estimated by the year 2000 to have risen to 14 percent of the total value of corporate America. By 2008 the greedy incompetence of the chieftains of corporate America had helped bring on one of the greatest financial crises in history, leading to a massive taxpayer-funded federal bailout to save the US economy from ruin.
The Drexel-funded newcomers were knocking the more vulnerable managers off their horses into the mud. Something would have to be done. Government ought to be sympathetic—the old corporate establishment had most of the money and they were the most politically powerful and influential group in the country. Their Wall Street subdivision might sustain some damage, but one could expect the fall of Drexel to release, as it did, a huge honeypot of business to be taken over by everyone else.
The old establishment financiers were lucky in that prosecutors would find numerous violations of securities laws within the Milken group and among its many allies, associates, and clients. However, it is difficult to judge how relatively bad these were, compared with the incessant violations that have always been, and continue to be, endemic in business and finance, because only a few of the many violators are caught, and when they are prosecuted it may be for only a tiny fraction of their offenses. This contrasts with the case of Drexel, where the searchlight of government was focused to reveal as many violations as possible. It’s like the case of the man who was cited three times in a single year for driving while intoxicated. His neighbor would also drink and drive, but was never pulled over. Who is the greater criminal? Now suppose I tell you that the caught man did it only three times and was apprehended every time, whereas his neighbor did it a hundred times and was never caught. How could this happen? What if I tell you that the two men are bitter business rivals and that the traffic cop’s boss, the police chief, gets large campaign contributions from the man who got no traffic citations. Now who is the greater criminal?
The situation was a dream come true for the government’s ax, Rudolph Giuliani. Politically ambitious, Giuliani was aware of how an earlier US Attorney, Thomas E. Dewey, prosecuted bootleggers in the 1930s and parlayed this into the governorship of New York and almost, the US presidency in 1948. The prosecution of securities violations and insider trading was the perfect ladder.
What could PNP have been worth twenty-five years later, in the year 2015? How could I possibly have any idea? Amazingly enough, a market-neutral hedge fund operation was built on the Princeton Newport model—the Citadel Investment Group. It was started in 1990 in Chicago by former hedge fund manager Frank Meyer when he discovered the young quantitative investment prodigy Ken Griffin, who was then trading options and convertible bonds from his Harvard dorm room. I met with Frank and Ken, outlining the workings and profit centers of PNP, as well as turning over cartons of documents outlining in detail the terms and conditions of older outstanding warrants and convertible bonds. These were valuable, because they were no longer available.
Citadel grew from a humble start in 1990 (when I became its first limited partner) with a few million dollars and one employee, Griffin, to a collection of businesses managing $20 billion in capital and having more than a thousand employees twenty-five years later, annualizing at about 20 percent net to limited partners. Ken’s net worth in 2015 was estimated at $5.6 billion.
As Princeton Newport Partners closed I reflected on the proposition that what matters in life is how you spend your time. When J. Paul Getty was the richest man in the world and manifestly not fulfilled, he said the happiest time of his life was when he was sixteen, riding waves off the beach in Malibu, California. In 2000, Los Angeles Times Magazine, speaking of new multibillionaire Henry T. Nicholas III of Broadcom Corporation, said, “It’s 1:30 a.m. He’s just turned 40—at his desk, in a dimly lit office. He hasn’t seen his wife and children, ‘my reason for living,’ for several days. ‘The last time we talked, [Stacey] told me she missed the old days, when I was at TRW and we lived in a condo. She told me she wants to go back to that life.’ But they can’t go back because he can’t let up.” (They later divorced.)
I initially thought that I might continue on my own with a PNP-style partnership. But if I did that, then, in addition to the fun parts, I would be responsible for things I didn’t enjoy. I changed my mind and gradually wound down our PNP office in Newport Beach, finding good jobs in the securities industry for some of our key people at places like the giant hedge fund D. E. Shaw, the financial engineering firm Barra, and the investment group running the multibillion-dollar pension and profit sharing plan at Weyerhaeuser. Then I called Fischer Black, who was now at Goldman Sachs, after hearing that he wanted to build a computerized analytic system for trading warrants and, especially, convertible bonds. Our proven state-of-the-art system was for sale, so he flew out and spent two days with Steve and me learning how it worked. He took detailed notes but finally said that it would be too costly to convert the code to run on their computers.