Investment: A History

THIS CHAPTER IS ABOUT INVESTMENT’S unscrupulous: those who have committed fraud, engaged in market manipulation, or traded on insider information. While these three offenses do not encompass every form of securities violation, they most endanger fair markets and are highly covered in the media. Furthermore, these violations come with a clear intent to profit from malfeasance and unethical behavior. Indeed, the crafty and crooked operators who engage in this behavior inspire a sense of profound injustice, visceral indignation, and a desire to right the wrong. These strong emotions can drive a search for meaning: What can we learn from the deceitful? What are the general typologies of these bad actors? How has society adapted over time? Is any progress being made?

This chapter turns to the historical record to examine each type of behavior in turn—first fraud, then market manipulation, and last, trading on insider information—and looks at some of the pivotal cases in each category. In doing so, it enables us to reach a remarkable conclusion—namely, that as a society we have gotten much better at creating the legal framework to prosecute this behavior. The legal landscape has changed on several fronts, and we have substantially bolstered our ability to catch and punish offenders. Yes, the fraudster has always been around and always will be. If there is a dime to be made through deceit, there will be someone chasing it. But fortunately, those collecting the dimes of duplicity are now doing it in front of an ever-larger and ever-faster steamroller. Deception has become a dangerous business.

Before diving into the realm of bad actors in the investment world, it is important to recognize that the vast majority of investment managers are, in fact, quite ethical. The malicious characters, while they do a disproportionate amount of damage for their numbers, are truly relatively few and far between. We must keep in mind that these agents of malice are certainly not good for the ethical managers who have their profession tarnished as a result of the immoral behavior. We examine the nefarious as such, fully cognizant that they are not representative of the industry at large but must nonetheless be understood, given how much devastation and disruption they produce.

It was in this Upper East Side penthouse apartment that the conversation catalyzing his end took place the day before his arrest. Madoff explained to his wife and sons, Andrew and Mark, that his firm was completely insolvent and that the entire operation was a fraud. Andrew later quoted his father as having said, “It’s all been one big lie. It’s a giant Ponzi scheme and it’s been going on for years, and there have been all these redemptions, and I can’t keep it going anymore. I can’t do it.”²

The story goes that Andrew and Mark then brought their father to the authorities. However, this narrative of no culpability on the part of Andrew and Mark has been difficult to accept by some. In fact, the court-appointed trustee in the bankruptcy, Irving Picard, brought suit against the brothers. It is true, however, that the fraudulent investment advisory business operated on a different floor than the market-making side of the companies, which the brothers operated.³

There are scores of questions one could ask along these lines: Were they so incurious about what was happening on the other floor not to find out? Did they not hear from investors that their father was a supposed legend, and would they not want to learn how to emulate his prowess? Why were they not alarmed that they did not hear conversations about new strategies or novel investment theses on the advisory side? Or, even if curiosity did not motivate them, why did the simple realities of key man risk not spur them—for was it wise to continue having a man of seventy running a portion of this ostensibly very lucrative business no one else in the firm understood?

Shedding light on this question are Bernie Madoff’s own contentions that it should have been abundantly obvious to the SEC that he was running a Ponzi scheme. Madoff said, “I was astonished. They never even looked at my stock records.” He also noted that investigators did not check with the Depository Trust Company. “If you’re looking at a Ponzi scheme, it’s the first thing you do,” said Madoff.4 If Madoff believed that the commission, charged with overseeing thousands of firms, should have had no difficulty in ascertaining that a fraud was underway at his company, then surely his two sons, who spent their entire workweeks directing a part of the firm, had to have figured it out. It is also unconvincing to argue that Mark and Andrew were just too dimwitted to have asked such questions or made these observations. Andrew’s educational pedigree, for example, suggests otherwise: he graduated from the Wharton School at the University of Pennsylvania.⁵

The investors who had put their money with Madoff for decades were perhaps less interested in speculation on the involvement of Mark and Andrew and more interested in what drove Madoff to do it in the first place. When pleading guilty to the charges brought against him, Madoff claimed that it was not until the 1990s that the fraud began. He stated that market conditions were such that it was too difficult to deliver the returns his investors had come to expect. In this account, Madoff seems to describe himself as a victim of his own success.⁶ However, this story too seems to be just another drop in the deep stream of fabrication. The recent prosecution of David Kugel, a trader whose employment began at the firm in 1970, has indicated that there was, in fact, fraud going on in the 1970s.⁷ Further, an expert investigator on the subject believes it could have gone on even before that, beginning around 1964 or 1965.⁸

Given both the number of people involved and the fact that the fraud was being perpetrated for decades, how was he not discovered earlier? First, Madoff’s ostensible legitimacy was enhanced by his time serving as chairman of the board of the NASDAQ, a fact he placed right on the fund’s website.9 As evident in other cases, many fraudsters have benefited from affiliations with trusted individuals and institutions. Madoff was also well connected within the Jewish community, and many wealthy individuals as well as charities looked to Madoff to manage some of their funds. This religious and ethnic commonality may have given some investors a greater sense of trust than may be typical in a manager-client relationship. As Rabbi Yitzhok Breitowitz said, “I do think that psychologically in the Jewish community we often feel that our fellow Jew would never do that,” and “I think that created an atmosphere of trust.”¹⁰ Surely, while many investors were not Jewish, having a close association with the community did help Madoff grow his asset base.

Further, Madoff largely stayed out of the major headlines talking about brilliant returns, lest some perspicacious soul would try (and most likely fail) to reconstruct how he achieved them. In a world where many investment advisers try to shadow the techniques and methods of other, successful firms, Bernie wanted to keep a low profile.

But even so, how is it possible that this fraud went on so long with nobody noticing? One seldom discussed but exceedingly strange angle on the Bernie Madoff fraud was the role of the auditor. The auditor, after all, is the last line of defense in such an investment structure with few regulations. The auditor is tasked with determining whether the assets claimed on the books are in fact present. Who was responsible? Surely a firm managing tens of billions of dollars in assets would have a well-known, highly reputable auditor with many capable employees. After all, it is no small task to examine the books of such a large firm with an array of different investments. And yet, defying all logic, Madoff’s auditor occupied no such exalted status but instead was completely obscure. The entire firm, Friehling and Horowitz, had an office about 550 square feet in size.11 Jerome Horowitz, Friehling’s father-in-law, retired in 1998 and died in 2009, leaving Friehling as the firm’s only active accountant. Someone working in the vicinity of the office in New York City suggested that Friehling would stop by the office for perhaps fifteen minutes at a time and leave again. For this, Friehling received payments of $12,000 to $14,500 per month. Friehling told the American Institute of Certified Public Accountants (AICPA), which oversees private auditors’ compliance with standards, that the firm was not actually conducting audits. Firms that conduct audits are generally subject to a peer review process whereby external auditors look at the practices of an auditing company to see if they are up to par. As such, by Friehling and Horowitz’s misstating that it was not conducting audits to AICPA when, in fact, it had been conducting the audit for the Madoff funds, the firm avoided the peer review process. Furthermore, at the time, New York was one of six states that did not even require these peer reviews to take place.¹²

The sad reality is that it seems Friehling had no idea Madoff was running a Ponzi scheme. After all, Friehling’s family had money with Madoff. It seems that it was not complicity but incompetence that created a situation where the auditor merely rubber-stamped the financial statements. Friehling was quick to admit that he took these statements at “face value,” not quite the standards one would expect of an auditor.¹³ The takeaway is simple: if there are to remain relatively unregulated investment vehicles, it is absolutely essential that the function of proper oversight is at least supported by strong auditing and accounting standards. Someone somewhere must have an eye on the books, and if it is not a government agency, then there must be robust protocols for proper audits and very stiff penalties for noncompliance.

Curiously, many people did notice, and one man in particular was persistent in trying to get the Madoff operation shut down: Harry Markopolos. In fact, it was precisely in trying to emulate what Madoff was doing that Markopolos made his discovery. Markopolos came upon Bernie Madoff as part of an assignment from his employer, Rampart Investment Management, to deconstruct Madoff’s returns.14 The very essence of Bernie Madoff’s fraud was that he contended he used a “split-strike conversion” strategy when in fact he was simply running a Ponzi scheme. Split-strike conversion is a trade where one buys an index (or some subset of it), sells call options, and buys put options. Put options increase in value when the index declines in price, so that serves to protect the portfolio against falling asset values. The sale of call options means that Madoff’s firm would exchange some of the upside (if stock prices increased) for a fixed amount of money. This strategy, of course, should involve reasonably low volatility (as it is buffered on both sides by the options trades). The problem? Such an approach could not possibly generate the risk-adjusted returns (that is, the return per given unit of volatility) Bernie Madoff had claimed.¹⁵ Analyzing Madoff’s returns through one of the feeder funds that gave Madoff money to manage (Fairfield Sentry) reveals that Madoff claimed average annual returns of 10.59 percent with a volatility of just 2.45 percent (and a worst month of just—.64 percent) from December 1990 to October 2008. It is interesting to note that the average returns themselves were not outrageous—a split-strike conversion strategy over this period could have produced between 7 and 11 percent annually, but at four times the standard deviation of the returns (a measure of the volatility).¹⁶ In other words, it was the consistency of the strategy that should have been seen as clearly fraudulent, a strategy different from the unbelievably high absolute returns claimed by Carlo Ponzi, examined later in this chapter.

Markopolos realized this and came to the conclusion that there were effectively two possibilities: either Madoff was unethically front-running his clients—meaning that because he was also their broker, he could see what his clients intended to buy and then simply buy some of those securities for his own book before executing the trade for the clients—or he was simply running a Ponzi scheme.¹⁷ Markopolos wrote a detailed nineteen-page report with a succinct and explicit title: “The World’s Largest Hedge Fund Is a Fraud.” This report, too, was just one correspondence among many with the SEC that went back as far as May 1999.¹⁸

Markopolos, though, was far from the only person to figure this out. In that report, Markopolos also states that he spoke with many heads of equity derivatives trading desks (options are derivatives) at different firms and states that “every single one of the senior managers I spoke with told me that Bernie Madoff was a fraud.” However, people did not want to jeopardize their careers by making public statements attempting to expose him earlier, suggested Markopolos.¹⁹

In the wake of the internal investigation to discover why the SEC failed to properly conduct an adequate review of the firm, it was revealed that other sources had submitted notes of concern and additional evidence pointing to the conclusion that Madoff was a fraud. The SEC had received a note from a hedge fund manager stating that Madoff’s returns over the previous decade had no correlation at all with the equities markets and that it seemed unlikely he was transacting as many options contracts as would have been necessary to maintain a split-strike conversion strategy of that size. Another note received in October 2005 was from an investor in the fund who noted how suspiciously secretive the firm was and that he quickly decided to withdraw his own money.20 There were ample warnings, but little was done. The SEC failed to properly conduct regulatory oversight, a fact to which we will return at the end of the chapter.

The Bernie Madoff fraud shook the foundations of the investment management industry so profoundly because of just how vast it was. It struck so many experienced professionals as shocking that a fraud of the order of magnitude of tens of billions of dollars could ever be pulled off.

There have been changes in the wake of Madoff’s crimes. One has been implemented because Bernie Madoff failed to use an independent custodian, who is in charge of overseeing asset protection. After all, if Madoff had used an independent custodian, the only way he could have perpetrated this fraud for so long was if the custodian were either complicit or completely incompetent. In the post-Madoff world, registered investment advisers who do not use an independent custodian are subject to surprise exams where an accountant can show up to determine if the total asset pool is consistent with reported figures. Furthermore, the registered investment advisers who fail to use an independent custodian must have their protocols for managing asset flows reviewed by an independent third party.²¹

There were also reforms within the SEC, including enhancing the talent in units responsible for fraud detection, creating a single repository for all tips relating to potential fraud, and establishing responsibility for agency resources to triage and pursue these tips accordingly.²² This was especially important after the clear failure to heed the work of Markopolos, who presented compelling evidence that something was awry as early as 1999. Of course, only time will tell how effective these reforms prove to be, and so much depends upon the quality and tenacity of the personnel at the SEC.

Stanford seems not to have been keen on legitimate business. Perhaps the fact that he failed early in his career pushed him toward making a business out of fraud. Indeed, he failed in a rather simple business, a health club known as Total Fitness Center in Waco, Texas. He grew the business by establishing other clubs in Galveston and Austin and attempting to establish a club in Houston. The business went bankrupt in 1982, however, precipitated in great part by the effect of a souring oil market on Houston. Stanford filed for personal bankruptcy in 1984, showing assets of less than a quarter of a million dollars and liabilities over $10 million.24

And yet, Stanford was undeterred. In 1986, just two years after filing for bankruptcy, Stanford established the Guardian International Bank, domiciled on the island of Montserrat. It was seeded by Stanford’s father, who took the money he earned from some real estate investments and put it into the bank, becoming its chairman. The bank looked for customers in Latin America, running advertisements depicting large yields for certificates of deposit.²⁵ In 1992, Stanford founded the Stanford Financial Group in Houston, again selling certificates of deposit, and quickly the organization gained $3 billion in assets.²⁶

Where did this money go? Not to liquid securities with low risk, as he told investors. Some of the money went into real estate and business investments instead. Much of it went straight to Stanford. During his high-flying days, Stanford funneled the money into purchases of enormous mansions, extravagant yachts, gifts for girlfriends, and patronage of cricket matches.²⁷ Some of his purchases seemed excessive, including spending over $100 million on private jets and helicopters within a three-year period and $12 million to add six feet of length to one of his yachts.²⁸

Stanford’s deception did not end with the funds he took from investors. Stanford also told tall tales about the origins of the Stanford financial institutions. He claimed that Stanford International was a family business dating back to his grandfather, who started it in 1932. He would insist as time went on that a picture of his grandfather be put in all of the firm’s offices. Sadly, this was another notable misrepresentation. While Stanford’s grandfather did indeed have a firm called Stanford Financial, it was a little insurance brokerage with no connection to the bank. Stanford would tell other lies, too, even when they were for no apparent gain except for some odd self-aggrandizement. For instance, he claimed he was descended from Leland Stanford, founder of Stanford University, even though there appears to be no connection at all.29

The prosecution of Stanford’s case depended in large part upon the testimony of James Davis, the CFO, who described at length the bribes given to Antiguan officials, the false documentation provided to clients, and the circumvention of US government scrutiny.³⁰ Davis’s job was, in effect, to fabricate numbers, which he did for over 20 years from 1987 or 1988 until 2009.³¹

Even at the end, Stanford insisted that he was not insolvent and that instead the federal government was at fault for ruining his business, saying, “They [government officials] destroyed it and turned it to nothing.”³² He showed not even a tinge of remorse. When one victim asked all the other victims to show their pained faces to Stanford in the courtroom and the judge advised Stanford that he was not obligated to meet their stares, Stanford still did so without showing the slightest sign of contrition.³³

It was in this environment of little regulation in the Caribbean that a man with no banking experience had an organization with billions in deposits. Stanford’s episode is just another in a long string of individuals who seemed ill equipped to succeed in legitimate business but who remained fixated on creating great success and a lavish lifestyle. He found a little corner of the market to exploit by establishing a bank whose operations were mostly offshore and selling certificates of deposit to victims in Latin America and the United States. Perhaps one should not engage in comparing the insidiousness of one financial crime with another, but there are some noteworthy points of difference. Unlike Bernie Madoff’s victims, who tended to be wealthy individuals and institutions, Stanford’s victims were quite varied and counted among their ranks those of moderate to minimal means who purchased his certificates of deposit (CDs). Furthermore, a CD is supposed to be a minimal-risk asset in which one can place excess savings not intended to bear significant market exposure (unlike Madoff’s scheme of supposedly investing in the stock and derivatives markets). Last, the purchaser of a CD should not have been expected to know that Stanford’s operations were a scheme, since the purchaser was just buying CDs that did not offer egregiously high returns, whereas arguably a very sophisticated investor could have seen that Madoff’s returns were too high to be true given their low volatility.

Even the very phrase “Ponzi scheme,” used again and again in the headlines to describe the Bernie Madoff and Allen Stanford episodes, is eponymously named after Charles Ponzi, who even in his wildest dreams never thought that deceptions of such magnitude were possible.

This episode certainly taught Ponzi a lesson—but not quite the right one. He learned that financial fraud was not terribly hard to perpetrate. In those days, regulators had neither the workforce nor the mandate to scrutinize the operations of every single firm in painstaking detail, so those running some institutions could easily abuse and exploit their positions of power. What Ponzi failed to learn was that eventually the commission of financial crimes tends to catch up with the perpetrator. And so, despite being caught and serving a prison sentence, Ponzi was already dreaming up his next scheme.

Ponzi went back to the United States in 1911 and participated in a scheme to shuttle Italian immigrants from Canada to America. This plot was short lived, and Ponzi was caught once more and sentenced to serve two years in a prison in Atlanta, Georgia.³⁵ Yet again, Ponzi seemed completely undeterred by his years in prison. It was at this point that Ponzi came across what was ostensibly a fantastically lucrative arbitrage opportunity that would catapult him into orchestrating his grandest scheme yet—and the one for which he would earn his infamy.

Ponzi’s scheme relied on the market for the international reply coupon. An international reply coupon is a voucher for postage, allowing one to send mail to someone in another country and pay the cost of postage for the reply. By international treaty, a signatory country had to accept an international reply coupon sold in another nation. Ponzi realized that because of the weakness of the currencies of many European nations after the war, it was possible to acquire international reply coupons in countries like Italy for less than their value in the United States.36

It is important to note that though there was theoretically an arbitrage opportunity, it would have been very costly to exploit. It would require purchasing massive quantities of postal reply coupons in one country, shipping them across the Atlantic (if they were to be sold in the United States), and operating a business to sell the postage. Indeed, given how inexpensive postage was, generating the amounts of money required to keep Ponzi’s scheme going would have necessitated the sale of an enormous number of international reply coupons, in fact many more than were ever printed.³⁷

The key for Ponzi was that the idea was plausible enough (until one reflects more carefully on these complications) that he was able to convince many that he had the means to generate shockingly high returns. Ponzi opened a company known as the Securities Exchange Company, which offered a 50 percent return in ninety days (and later the same return in just forty-five days), and in 1919 the investors began pouring in. The inflow of capital was sustained by a large network of salespeople, who were paid 10 percent of the capital they managed to send to the firm. Ponzi wasted no time spending his newfound wealth, acquiring a mansion in Lexington, Massachusetts, a wide array of properties he could rent out in the Boston area, and expensive cars and apparel.³⁸

The government began an audit of the scheme, and the Boston Post, which had initially written about Ponzi’s operations and helped fuel its growth months before (when it did not know it was a scam), took up the task of investigating Ponzi as well. Soon, the Boston Post ran an article about how Ponzi had been prosecuted before for his previous scams, and at last, the government finished its audit and found millions of dollars missing, putting Ponzi under arrest.39 Ponzi ended up serving over three years in federal prison for the crime and later more time in state prison, and even after that, he sought out new schemes (including one to collect capital for supposed property in Florida that was just marshland). Ponzi was eventually deported back to Italy, where he would become involved in an airline affiliated with the Mussolini government that essentially moved Nazis from Germany to Brazil, where they could hide out in relative safety.⁴⁰

With respect to the evolution of laws and regulations, it is worth noting that Ponzi was actually sent to federal prison for mail fraud. Shortly after his release, he was indicted by Massachusetts for larceny. A legal battle ensued over whether the Massachusetts indictment constituted double jeopardy, as Ponzi was being pursued for the same scheme. The Supreme Court of the United States ultimately spoke in the matter of Ponzi v. Fessenden in 1922 that serving a federal sentence does not make the individual immune from prosecution for other crimes (mail fraud and larceny being separate offenses) at the state level.⁴¹ Ponzi would eventually serve seven years in Massachusetts prisons before being deported to Italy, but the whole episode makes clear that the federal government did not have the legislative tools for dealing with financial crimes that it does today. The federal government relied on an indictment on many counts of mail fraud rather than a more sophisticated legal transgression that more appropriately described Ponzi’s actions. Collectively, the federal and state governments may have punished Ponzi appropriately, but only because the state of Massachusetts became involved when it realized that the federal government’s punishment was insufficient. This was arguably an inferior institutional design, as it required two governments processing evidence and investigating to formulate a case, leaving a gap in time during which Ponzi was able to commit further crimes in Florida and prolonging the restoration of justice for victims.

Ultimately, in comparison to Ponzi’s scheme, Madoff’s scam was actually much more impressive. Madoff sustained it for decades, whereas Ponzi lasted for just over a year. Madoff managed to cause losses of tens of billions, whereas Ponzi’s toll would be equivalent to just hundreds of millions today. If schemers of yore could have idols, there is little doubt Madoff would have been Ponzi’s.

It is worth noting that while Ponzi has the distinction of having his name on this type of scheme of collecting from Peter to pay Paul, he was certainly not the first to orchestrate one. In 1899, William Miller, a bookkeeper in Brooklyn, opened the so-called Franklin Syndicate, where he offered astonishing returns on capital. He offered a miraculous 10 percent per week, a return that later gave him the nickname “William 520 Miller,” for the 520 percent one could earn in the course of a year.42 Miller claimed that he was able to earn enough return to pay out such exorbitant interest rates because he knew how to make tremendous sums of money on Wall Street.⁴³ Of course, he had no such abilities. All in all, he managed to steal some $1 million, or in today’s equivalent some $25 million.⁴⁴ Almost comically, years later when Ponzi’s scheme was still hot, Miller, who unlike Ponzi had learned the lesson to cease the constant scheming, remarked, “I may be rather dense, but I cannot understand how Ponzi made so much money in so short a time.” Dense he was not, and just days later Ponzi’s scheme collapsed.⁴⁵

Madoff, Miller, and Ponzi, though, represent only one typology of fraud, that which begins or has long gone on as virtually pure, unadulterated deception. There are many episodes, however, where operations began as legitimate and legal but turned fraudulent when the technique proved to be too speculative and the manager hoped for a rebound but found himself permanently behind and unwilling to come forward with the truth of having sustained significant losses.

The history of these schemes makes another point clear: over time, the schemes have become far more sophisticated. Today, very few people would believe returns of 520 percent per annum were remotely possible in the case of William Miller or 50 percent returns in 90 days in the case of Carlo Ponzi. Today’s fraudsters realize that the scheming has to be much more subtle to attract large pools of capital. In Madoff’s case, the subtlety was in offering returns that were not completely outlandish but in offering a consistency of returns that was unbelievable. In Stanford’s case, it was not even in offering CDs at very high rates of returns but rather in hiding behind an aura of security and personal fortune and selling a simple product to an audience who could have no way of knowing it was even a scheme because of regulatory failures. All of this means vigilance must be heightened—it is not enough to shy away from the simple huckster peddling eye-popping returns. One needs care and diligence to detect the modern financial fraudster.

An attractive prospect emerged, or so it seemed at the time, when Grant’s son Buck met Ferdinand Ward, a charismatic fellow who fooled Buck into believing he had far more skill in investment than he actually had. The two men formed a firm and named it Grant and Ward. Ferdinand Ward saw an obvious opportunity: if he could bring Ulysses S. Grant on as a partner in his firm, he could leverage Grant’s popularity to gain legitimacy. Grant plunged some $200,000, a sum representing nearly all his wealth, into the firm.46

There was a major disconnect between what Ward was actually doing and what investors thought he was doing. Grant simply believed that Ferdinand Ward had some great financial prowess that would translate readily into financial gain. Meanwhile, Ward was actually telling other investors that the firm was making money by using Grant’s influence to secure government contracts. Of course, Grant was far too noble to engage in such tactics, but investors believed Ward and thought it would be a straightforward and easy way to enjoy returns. In reality though, Ferdinand Ward took the cash from investors and engaged in simple speculation.⁴⁷

For some time, new investors were attracted to the large dividends offered and the firm’s capitalization grew steadily. Grant was quite pleased at the whole affair, believing his fortune to be in the millions of dollars, and would engage in leisurely talk with potential investors while leaving the complications of the operation of the firm to Ward.⁴⁸

Unfortunately for the Grants, Ferdinand Ward was actually inept at speculation and lost a great deal of money. In April 1884, Ward asked Grant for a $150,000 loan. Rather than admitting that the firm of Grant and Ward was on the verge of collapse, he claimed that the loan was needed to bail out a bank doing business with the firm. Grant, still trusting Ward and hoping this could put an end to the catastrophe, brought himself to ask William Vanderbilt, who inherited his father’s railroad empire, for a loan. Vanderbilt agreed but was quite clear that he did so not on the basis of the merits of the firm but rather because it was Ulysses Grant who was asking. “What I’ve heard about that firm would not justify me in lending it a dime,” he said, but, he continued, “to you—General Grant—I’m making this loan.”49

Grant returned with the money and gave it to Ferdinand Ward. The very next day Ward was gone, and it became clear to Grant that it was all over. Ferdinand Ward had lied and the whole firm was massively insolvent, with liabilities ultimately amounting to over $16 million, not even remotely offset by assets in the tens of thousands when the final calculations were made. Ward was swiftly caught, though, and brought to justice.⁵⁰

Grant was swindled along with his investors and was left effectively broke. He was forced to take up his pen to write his memoirs, with an attractive royalty agreement with Mark Twain’s publishing firm. It proved to be a lucrative endeavor, selling widely and considered by most to be written with impeccable clarity, though Grant would not be there to enjoy the fruits of his toils, perishing from throat cancer just days after he completed the draft.⁵¹

In the end, Ward was simply another charismatic character making use of powerful friends to perpetrate a scheme. Indeed, one could not imagine a better choice than a former president whose popularity, at least in the North, was still substantial. While it was not a Ponzi scheme from the very beginning, it did quickly evolve into fraud as Ward tried to recapitalize the firm with new investors who believed the mission and strategy of the company to be wildly different than it actually was.

Ivar Kreuger was born in Kalmar, Sweden, in 1880.⁵³ He was the oldest son in the family, and he gained control of the family’s match factories by 1913. Kreuger aspired to much more than just operating a few match factories, however. In time, he saw incredible potential for the expansion of the family’s holdings into a match empire that could span the world.⁵⁴

The time was right in the wake of World War I. Many countries were devastated, having witnessed their capital stock depleted by a long and destructive war. Rebuilding of the capital stock was front and center, but many governments were hard pressed to find money to initiate efforts at reconstruction. After all, imposing high taxes on an already fragile economy as a means of generating the requisite revenue appealed to few. Enter Ivar Kreuger, who began offering loans to countries, sometimes as large as $125 million. What did he ask for in return? Complete monopolistic control over the countries’ match markets. For many countries, it seemed like a small concession to make: they needed the funds, and the match market seemed like a reasonably innocuous segment of the economy to give away as a monopoly. Besides, the funds would be repaid through excise taxes on the matches, and the price of the matches would be agreed on in advance.⁵⁵

Many countries took the plunge, and soon Ivar Kreuger’s empire was growing, with complete monopolies in fifteen countries and enormous market share in nineteen other nations, serving a total of 75 percent of the entire European demand for matches.⁵⁶

Of course, Kreuger could not simply make loans of this order of magnitude from company profits. He looked to the American capital markets for help, and he sold stock and bonds as a means of raising funds. However, some of this debt bore significant interest rates—often as high as 20 percent—and this generated a sizable financial burden. It is not precisely clear at what point Kreuger began to use fraud as a means of keeping the firm afloat, but there is no doubt that the stock market collapse of 1929 and the ensuing Great Depression created extremely adverse business conditions for Kreuger. In particular, the debt markets that Kreuger relied on not only to support loans but also to refinance existing debt began to dry up. Credit just did not flow as easily as it had in the 1920s. Indeed, just as Madoff’s end was brought about by systematic calamity (in Madoff’s case, the global financial crisis that motivated many of his investors to seek redemptions to bolster their liquidity), Kreuger’s end was precipitated in part by the systematic seizure of capital markets in the early 1930s.57

While it would take a total of five long years to make sense of Kreuger’s hundreds of companies and divisions, it was clear that he was altering the books to the tune of hundreds of millions of dollars near the end. Kreuger & Toll was engaged in the complete fabrication of Italian bonds supposedly worth $142 million, not to mention consistent attempts at double-counting assets.⁵⁸ In the end, Kreuger was found dead on March 12, 1932, in Paris, shot in the heart. It was ruled a suicide, though decades later Ivar’s brother Torsten disputed this account, claiming Ivar had been murdered.⁵⁹

The frauds that Ivar Kreuger committed during his life served in part to prompt reforms designed to prevent a recurrence of this sort of deception, including more rules on auditing and other accounting regulation.⁶⁰ In particular, Congress came to the conclusion that publicly traded firms must be subject to audits by trained auditors, but they could not agree on how this should be done. The two options at Congress’s disposal were either to allow private accountants to be responsible for this task or alternatively to create a public corps of auditors. Ultimately, they decided that a corps of government auditors was not practical because the task was too large and, in the words of one partner at a prominent accounting firm of the day testifying in front of the Senate, the “type of men that are in the public practice of accountancy” would be unlikely to “leave their present practice to go into government employ.”⁶¹

Richard Whitney rocketed to fame on Black Thursday, October 24, 1929.62 Panic had hit Wall Street, and the market tumbled as trading commenced. A private meeting of powerful financiers was called to react to the crisis, attended by such prominent figures as Thomas Lamont of J. P. Morgan and Charles Mitchell of National City Bank, who decided the best plan of action was to restore confidence in the market by placing bids above the then-going price on a number of major securities. There to execute the plan was Richard Whitney, the vice president of the NYSE, who marched out onto the floor and announced, “I bid 205 for 10,000 Steel,” referring to United States Steel. He repeated the effort with dramatic flair with other stocks.⁶³

The effort did work to push up prices in the short term, but of course there were structural issues in the market and the economy unbeknownst to the bankers at the time that were simply too deep to prevent a further slide. Nevertheless, for this and for his calm management of the exchange during the market crash of 1929, Richard Whitney garnered the respect and admiration of many, and he became president of the NYSE.⁶⁴ His service in this official capacity served to boost his reputation further (as Bernie Madoff’s service as the nonexecutive chairman of NASDAQ, though less prestigious than the NYSE, certainly had).

Whitney ran a firm, named simply Richard Whitney & Co., a small brokerage firm that catered primarily to institutional clients. Whitney thought he had found a lucrative opportunity in Distilled Liquors, a firm Whitney surmised was poised to do well as Prohibition ended. To finance his acquisition of shares, he not only used his own money but also borrowed extensively, and he sunk the funds into Distilled Liquors. Whitney could have made a healthy profit if he had sold off his holdings shortly after Prohibition ended, as the price of Distilled Liquors did move up, but he was convinced the market would continue to put upward pressure on the price, and so he held on. The stock began to decline in value, and Whitney became increasingly unable to meet his financial obligations. He began to use his prominent positions to embezzle in order to cover his debts. First, it was from the New York Yacht Club, where he served as treasurer and removed $150,000 of the bonds owned by the club to collateralize a loan for his own debts. It is entirely possible that Whitney thought he could justify this action as a stopgap, for as it would later be learned, he did something similar in 1926 with his father-in-law’s estate, removing funds temporarily but putting them back before anyone knew.65

Unfortunately for Whitney, this measure was not enough. The financial hemorrhage continued. The next victim was the New York Stock Exchange Gratuity Fund, a pool of money earmarked for paying death benefits to the families of exchange members. Here, when Whitney’s firm was instructed to sell certain bonds and purchase others to replace them, he took the new bonds and used them to collateralize a bank loan (of course, with the lending bank completely unaware of what had transpired).⁶⁶

Richard Whitney’s firm was insolvent for several years before the embezzlement and fraud were discovered. The comptroller of the NYSE eventually figured out the fraud and made it known that the firm was deep in the red and had resorted to numerous illegal measures to prevent others from realizing it.⁶⁷

Whitney was arrested. During his sentencing, the judge proclaimed, “To cover up your thefts and your insolvency, you resorted to larcenies, frauds, misrepresentations and falsifications of books,” and he said that the “decent forces of America” were dealt “a severe setback” by Whitney’s actions.⁶⁸ In the end, Richard’s brother George, a partner at J. P. Morgan, paid off all of Whitney’s debts, and Whitney faded from public view on a farm in Massachusetts after serving time in Sing Sing.⁶⁹

The tale of Richard Whitney reinforces some of the recurrent patterns evident in other episodes of fraud. Whitney had a sound investment thesis, not unlike Ivar Kreuger, who tried to build a match-making empire. Whitney also had a stellar reputation from his performance during a previous crisis through effective management of the market collapse of 1929.

It is the very vagaries of the market that compel some of these individuals who never set out to commit wrongdoing to resort ultimately to fraud. The market moves up and affirms the original thesis, prompting the individual to think he is right. However, just as quickly as the market moves up, it can experience a reversal, and the buyer thinks, “Surely, the market will come to its senses soon.” Eventually this line of thinking overwhelms sound reasoning, and some manage to cross the fateful line by thinking, “It will only be for a little while. When the market behaves rationally, I will make money and nobody will ever know.” But when the losses grow, the fraud becomes unsustainable and it is no longer possible to reverse the whole affair. Hence it becomes obvious why reputation is so important to major frauds that do not begin as schemes: Those who are held in high esteem have so many opportunities to plug holes. They have ample access to credit because many are comfortable extending loans to these ostensibly worthy individuals.

The Richard Whitney affair had a comical and surprising effect on reforms. At the time, the SEC found itself at odds with the NYSE over instituting greater oversight and other regulatory enhancements, which the NYSE believed it did adequately on its own. The disagreement reached a fever pitch in February 1938, when SEC chairman William Douglas had a conversation with NYSE counsel William Jackson. The conversation transpired after an initial compromise seemed imminent over new regulations that stumbled over a failure to see eye to eye on the establishment of an outside president to supervise the NYSE, with Douglas commenting that he could simply take over the NYSE if they failed to come to an agreement.70

Born in 1915 to immigrant parents in the Bronx, Tino De Angelis was initially far removed from a life of plenty. He seemed determined to rise above his humble origins, however, and to his credit he did not shy away from hard work. He spent the days of his early career butchering, curing, and packing meats. He rose quickly through the ranks and in 1949 became president of the Adolf Gobel Company.⁷³ It was during his presidency of this previously well-respected butcher that he exhibited a striking comfort with unethical business practices. Adolf Gobel won a contract to supply meat to schools as part of the National School Lunch Program, designed to offer healthy meals to students in need through partial or complete subsidy. De Angelis provided the program with meat not properly inspected for food safety and overcharged the government for the meat it received. This infuriated the supervising agency, and Gobel paid $100,000 in fines and lost its school lunch contract. De Angelis lost his post for a time, but he avoided personal fines or jail time, and he became president of the firm again in 1958.⁷⁴

In the meantime, De Angelis started another project: Allied Crude Vegetable Oil Refining Corporation. De Angelis started the firm in 1955 with a simple thesis: there would be tremendous value exporting vegetable oil under the US government’s Food for Peace program, which permitted countries deficient in food and funds to purchase subsidized American-grown agricultural products.⁷⁵ Operating out of northern New Jersey, De Angelis grew the company to considerable size, transacting in about three-quarters of US vegetable oil exports by 1960.⁷⁶

It appeared at the time that he had earned his reputation as the “Salad Oil King” (so named, of course, because vegetable oil is the basis of salad oil).77 Meanwhile, however, there was a sinister plot afoot. What De Angelis really desired was to corner the market in vegetable oil. The means to manipulate the price, he figured, was by transacting heavily in soybean oil and cottonseed oil futures.⁷⁸ However, if he was to have any chance at seriously moving these markets, he needed substantial capital. Enter the American Express Field Warehousing Corporation, a relatively new player in the business of inspecting goods and providing owners of those goods with warehousing receipts, which certified the existence of that stock and which the owners could then use as collateral for loans. De Angelis saw an opportunity: he could use American Express’s service, later provided through a subsidiary called American Express Warehousing Ltd., to inspect his facility and deliver warehouse receipts that he could then bring to brokers to extend him margin to participate in these commodities markets in an arrangement collateralized by the stored oil.⁷⁹

There was just one problem for American Express: De Angelis simply did not have anywhere near the oil he said he did. Many of the storage tanks were filled with water rather than oil, completely unbeknownst to the inspectors from American Express who signed off on the warehouse receipts. There were a variety of tricks De Angelis deployed to maintain the façade of having far more oil than he did: using tanks with false bottoms, installing pipes to move oil from one tank to another during the inspection so the surveyors would be looking at the very same oil in the second tank, and putting a layer of oil on top of a tank full of water, exploiting the fact that oil is less dense than water.⁸⁰

By November 1963 the game was over. De Angelis could no longer continue a successful manipulation and lost far too much money as the market moved against him. Panic ensued on Wall Street. Which firms had dealings with De Angelis? Which would be adversely affected indirectly as those that transacted with him directly failed? What would the effect of the insolvency of brokerage houses be on other investors? The destruction was wide, motivating the bankruptcy of some two hundred firms, and it was lengthy, taking many years to settle the last of the cases.⁸¹ Among the failures was the brokerage house Ira Haupt & Company, which failed in large part because it had allowed De Angelis to make large margin payments with warehouse receipts instead of cash, relying on the purported accuracy of the receipts.⁸²

Of course, the inspectors themselves certainly deserve some of the blame for failing to adequately perform the audits. Indeed, in the wake of the scheme, it was revealed just how numerous the inspection errors were. Amex Warehousing believed De Angelis was storing an amount of oil far in excess (by about 425 million pounds) of what the tanks were even capable of holding.83 Further, during the inspections, firm employees who were aware of the scheme (there were some) would get on the tanks, drop a tape measure into the oil, and announce a number for the inspectors to record, without the inspectors performing the procedure themselves.⁸⁴

For these errors, American Express faced substantial legal liability. The company’s stock was ravaged by the affair, falling more than 50 percent. It was at this time that Warren Buffett made his famous play in American Express, buying the stock with the thesis (later proven quite correct) that these liabilities would be small relative to what the company stood to gain by the trend toward broader credit card usage.⁸⁵

And while firms failed and many employees lost their jobs, the perpetrator himself may very well have gotten off lightly. De Angelis served just seven years of his twenty-year sentence in a federal prison in Lewisburg, Pennsylvania.⁸⁶

There are a number of valuable lessons to learn from the Salad Oil Scandal. For one, it reaffirms the obvious lesson (but one that we continue to have to relearn) that prominence does not assure legitimacy. First, the inspectors, knowing they were dealing with a large and ostensibly successful customer, assumed that he was acting honestly. Second, this case demonstrates that the answer to the oversight of financial activities at the regulatory level is not nearly as simple as privatization. American Express, a private firm, which had a tremendous amount of money on the line, failed in its inspection. Third, perpetrators of large-scale, successful frauds typically do have a history of operating in moral gray areas and breaking the law, as seen in De Angelis’s attempt to scam schools into buying unsafe and low-quality meat early in his career.

To what degree does empirical work support the anecdotal conclusion of the relevance of a history of transgressions of law and ethics? This question, among others, has been studied in the slightly different context of hedge funds in recent years. Stephen Dimmock and William Christopher Gerken study characteristics of investment managers to see which traits are significant predictors of later fraud. In their paper entitled “Finding Bernie Madoff: Detecting Fraud by Investment Managers,” they showed that previous civil or criminal activity, past fraud, and past compliance issues were statistically very significant predictors.87 There are, of course, practical policy implications: notably, that repeat offenses are common among those who commit fraud. This does not mean that an enforcement body should be lulled into concentrating only on those firms with past issues, of course, but that patterns of behavior are meaningful here and those entities should be treated with heightened vigilance. Undoubtedly, our enforcement efforts will be bolstered only by further empirical work into the mind and modus operandi of the individual who commits fraud.

Before moving off the subject of fraud entirely, we consider another form of fraud of a rather different character than these other episodes: trading frauds. Commonly called rogue traders, these individuals fraudulently misrepresent or simply obscure their trading positions or the total amount of exposures from the bank or institution that employs them. These are different than the other forms of financial fraud discussed here, as they tend to be internal to a given organization rather than external to outside clients or individuals. They are still worth highlighting briefly, however, because there have been occasions when such frauds have crippled and even destroyed otherwise well-capitalized financial institutions. While there has been a litany of such episodes, two cases will be explored: Nick Leeson (Barings Bank) and Jérôme Kerviel (Société Générale). The Leeson case will be explored because of its role in the undoing of an old and venerable financial institution, and the Kerviel episode will be discussed because of its sheer size as one of the largest such trading frauds in history.

However, Leeson was not just executing client trades and performing arbitrage; he made simple speculations on the direction of indices and currencies. Rather than performing small market arbitrages, Leeson put on trades that were entirely unhedged to attempt to capitalize on what he believed to be the direction in which the markets were likely to move. In the very beginning, Leeson appears to have made some money for the bank through these trades, which helped enhance his reputation internally and appears to have reduced suspicion now that he was well regarded.88 However, this soon changed, and Leeson’s losses began to mount. Although he would occasionally make the money back by taking on ever-greater amounts of risk, this was not a sustainable strategy, given that this was mere blind speculation.

Leeson covered up the losses through a variety of means, including entering nonexistent trades among the bank and its clients to make it seem as though the positions were all hedged, as well as having his personnel simply enter fabricated information into the system. Leeson also opened what would later become the infamous 88888 account—so named because of 8’s representation of good fortune in Chinese culture—very shortly after Barings was admitted as a SIMEX member.⁸⁹ This account should, in effect, have been a bookkeeping account to net out the trading book as a result of trading errors, which in and of itself was permissible. However, this was the account in which he hid the gains and, later, enormous losses from speculation.

Leeson’s losses were exacerbated by the Kobe disaster in January 1995, when a powerful earthquake claimed several thousand lives and caused widespread property damage, causing the index to fall when Leeson was on the wrong side of the move. In the end, Leeson’s total losses were $1.4 billion, wiping out the capitalization of Barings. And so Barings Bank, founded in 1762, met its end as an independent institution in February 1995 and was swiftly sold to ING for a grand total of £1.

Leeson initially fled to Malaysia with his then wife, leaving a note on his desk stating, “I’m sorry,” just days before he turned twenty-eight years old. Leeson wanted to get back to the West so that he could avoid serving a jail sentence in a Singaporean prison. He made it to Germany but was ultimately extradited to Singapore, where he served three and a half years.90

In the end, Barings exhibited some complicity not by action but by ineptitude. That is, there were a number of managerial errors Barings made that could have at least mitigated the likelihood that the losses would completely spiral out of control. Perhaps the most significant oversight was the failure to bifurcate Leeson’s job responsibility of overseeing the trading and settling the trades. The reason this segregation between the front office and the back office is prudent is straightforward: an independent person should be overseeing the trade settlements to ensure that the trading is consistent with the guidelines and risk expectations of the bank. Because Leeson was given both functions in a single role, absent this independent supervision he was able to hide the enormous losses for an extended period of time. Further, Leeson continued to convince Barings headquarters that ever greater amounts of funds were needed for the normal course of business as the margin calls from the SIMEX exchange mounted. The fact that Barings believed that Leeson needed more funds as a normal course of business suggests that his superiors simply did not genuinely understand the mechanics of market arbitrage between Japan and Singapore. Last, the lack of robust and consistent auditing of Leeson’s activities suggests an environment that was far too careless in managing its risk.

Kerviel’s actions were similar to Leeson’s in that he was supposed to be engaged in arbitrage rather than taking outright positions on instruments on an unhedged basis. However, like Leeson, he put on trades that were entirely speculative rather than mere arbitrage. It is interesting that Kerviel’s trades turned out to be massively profitable before 2008. In 2007, Kerviel made a staggering €1.4 billion in profits, but he reported only €55 million to his superiors knowing that booking such a monumental profit—equal to more than six months’ revenues of the firm’s equities group—would make it clear that he had taken on far more risk than he was permitted. In January 2008, Kerviel had a book with over €50 billion of exposure to stock indices, which soon resulted not just in his giving up the 2007 gains but in generating a loss of billions of euros. Société Générale officially became wise to what had happened when Kerviel tried to enter a fake trade for over €30 billion worth of exposure to the German stock index. The move raised a red flag because if the trade were real, the brokerage firm on the other side of the trade would have been required to put up an enormous amount of cash on margin for Société Générale, well in excess of what would otherwise be extended.⁹² An internal group at Société Générale was put together to look into the trade and soon discovered that Kerviel was obscuring actual positions well in excess of this fake trade. Between the time the group got to the bottom of the trade at the end of the week and the time the market opened the Monday thereafter, equities markets in Asia were down and Société Générale exited the trades at unfavorable prices, with Kerviel’s trading activities ultimately costing the bank €4.9 billion.

As investigations later revealed, Kerviel avoided earlier detection by manipulating inputs into the firm’s risk management system—called Eliot—as well as booking hedges that did not exist against existing positions so that it appeared that all the exposures netted out.93 Kerviel was convicted of breach of trust and forgery, ultimately receiving a sentence of three years but serving a total of only about five months before being released on the condition that he wear an ankle bracelet.

Like Barings, Société Générale shares some blame for such a delayed discovery of these unauthorized trades. The examination of the external auditor PricewaterhouseCoopers revealed failures in the trade clearing system to appropriately book and analyze transactions, overly manual processing by back office staff, and insufficient seniority in the back office to conduct the requisite oversight.⁹⁴ Kerviel has also long contended that senior personnel in the company knew about some of these nonarbitrage trades and looked the other way. This is entirely possible, but even if true, senior personnel would likely not have looked the other way on exposures of this immense scale that could jeopardize the entire business itself.

Ultimately, the prevention of rogue trading is difficult because such trading so often arises from cracks in the middle- and back-office functions that the trader learns to manipulate for an extended period of time. In some scenarios, the prescriptive is easier than others, such as with Leeson and the vital need to prevent a single employee from controlling both trading and settlement positions. But in most cases, prevention ultimately requires firms to understand that it is in their best financial interests to implement best practices to ensure that traders adhere to their job role and stay within their risk limits. Otherwise, as happens in many rogue trading situation, what begins as a small loss or gain quickly spirals out of control as the trader tries to cover his footsteps by taking on ever-greater amounts of risk, potentially jeopardizing the entire enterprise.

Duer’s rise to prominence began when he entered the timber business and established a sawmill near Albany, New York, the first in the region. Duer also began to express interest in advancing the cause of revolution. He served as a representative from New York in the Continental Congress and worked primarily on issues related to the purse. However, it became clear that Duer was in pursuit of profit above all and would sacrifice morality and allegiances to support that end. In 1783, after the American Revolution was settled, Duer won a contract to provide supplies for the remaining British forces, a prospect many loyal to the revolutionary cause flat out refused because it was seen as aiding a former enemy.⁹⁶

Nonetheless, Duer managed to stay in the good graces of many of those overseeing financial matters for the new nation, and he was offered a position with the Treasury Board. It was in this capacity that Duer decided he could simply issue himself a warrant from the Treasury in order to secure a personal loan in 1788. Given this sort of questionable behavior, it is surprising that the ethically minded Alexander Hamilton extended Duer the opportunity to become assistant secretary of the Treasury, which Duer gladly accepted in 1789. Despite Congress’s clear hope and attempt to prevent Treasury employees from engaging in public securities transactions during their employment, Duer could not resist the potentially extremely lucrative prospect of buying state debt, which was then trading at small fractions of its face value (as the market considered it exceedingly risky), on the basis that the federal government was considering assuming these debts. When Duer was caught, he resigned his post, but he still managed to make a considerable sum from the trade in late 1790.97

Duer made this unethical trade during his tenure, but his actual manipulation of markets would come later. Duer’s first major act of market manipulation was in the strategic dissemination of information to the market regarding the plans of the Bank of the United States, which had equity that was publicly traded at the time. Duer bought this equity in massive quantities, securing an estimated 6 percent of the total outstanding issue. He then persuaded the bank’s directors to announce at a meeting in Philadelphia the opening of many other branches all across the United States, realizing that such an announcement would drive up the price of the stock and thus the value of his holdings. When the price soared, Duer cashed in half of his position.⁹⁸

Successful in this market manipulation, Duer set his sights on an even greater one: to influence the price of the stock of the Bank of the United States and of federal bonds by cornering the market for these securities. At first glance, the debt of the United States and the stock of the Bank of the United States should not be structurally related. However, Alexander Hamilton created a provision for buying the stock of the Bank of the United States that involved several payments in US bonds. Unlike today, when one must have the cash (or cash and margin) available to buy a security, the stock of the Bank of the United States could be purchased by making one payment in cash and three payments in US bonds, with the hope that this would broaden bond ownership. Duer thus realized that if he could buy up enough government bonds, he could manipulate the market for both the Bank of the United States stock and the federal debt. Duer borrowed tremendous amounts of money, first from banks and other institutional lenders. When that credit ran dry, he turned to a man by the name of Isaac Whippo to peddle notes to the general public, including the financially unsophisticated, who were paid an incredible interest rate of 5 to 6 percent per month.⁹⁹

Duer’s plot, however, was foiled by a major reduction in the money supply purposefully undertaken by the Bank of the United States. Hamilton realized that the headquarters of the Bank of the United States in Philadelphia had made too many loans too quickly, thus expanding the supply of money that was pushing up securities prices. Hamilton was quick to realize the connection and on January 18, 1792, wrote to William Seton, who worked at the Bank of New York, “I have learnt with infinite pain the circumstance of a new Bank having started up in your City. Its effects cannot but be in every view pernicious. These extravagant sallies of speculation do injury to the Government and to the whole system of public Credit.” It was ultimately decided that the way to induce the needed reduction of money supply was simply not to renew some of the recurring loans—and it did work, much to the pain of Duer. The market realized Duer was not able to meet his contractual obligations in early March 1792, beginning a panic and a spiraling downward of the market. (The debt market Duer tried to corner fell some 25 percent within two weeks of his default.) In the end, Hamilton was able to stabilize the situation brilliantly, but Duer’s attempt at market manipulation was a significant contributor to Wall Street’s first major financial crisis, thereafter known as the Panic of 1792.100 Duer would live out his days in debtor’s prison.¹⁰¹

The story of William Duer is critical for three reasons. First, it speaks to how early market manipulation manifested itself in the American capital markets. Second, it makes clear just how much a threat market manipulation was to the entire economy at the time. Third, the whole situation reveals how much of a Wild West early capital markets could be. There was an incredible insufficiency of regulatory control and institutional standards on what constituted proper and ethical behavior, such as the consequences of a Treasury official speculating in securities whose valuations his work would influence, the ability to sell notes to unsuspecting buyers to acquire more credit, and the failure of the government to respond directly to the prospect of price manipulation itself. As will be seen, though it is true that some market manipulation continues to this day, it is of a radically different flavor; it is generally far more subtle, usually involves collusion of multiple parties (as most markets are too large and deep to corner with one or two actors), and does not generally threaten the entire financial system.

The story of the Erie War begins with Daniel Drew, a steamboat operator who acquired infrastructure on both the eastern and the western portions of the Erie Railway line and effectively forced the Erie’s board of directors to grant him a seat. Drew proved very early on that he was ready and willing to manipulate the price of the Erie Railway stock for his own gain. For example, after taking a short position in the company, he began a rumor that the Bergen Tunnel construction project (part of planned improvements for the railway) was going to exceed the estimated costs and that the company might have to abandon the whole project. The manipulation drove the stock price down significantly, and Drew profited handsomely. He would take similar actions many times during his tenure on the board, as he admitted proudly in later writings.102

Drew would surely have loved to continue in this capacity of enriching himself at the expense of the company he supposedly served, but Cornelius Vanderbilt, the railroad magnate, set his sights on the Erie. Vanderbilt was far more adept than Drew at operating railroads, having run several others successfully, and he thought he could apply the same principles and add an attractive asset to his growing holdings. To do this, he started purchasing the stock discreetly and slowly gained enough shares to exercise control over the company. Drew finally learned of what was afoot and knew the board was about to be removed by Vanderbilt, so he went to New York to meet with him. Drew managed to persuade Vanderbilt to keep him on the board and to grant seats to two of his friends, Jay Gould and Jim Fisk.¹⁰³

Vanderbilt did not realize how great a mistake he had made. Drew, aided by Fisk and Gould, plotted to retake control of the company. To do so, they came up with a list of substantial improvements that would have to be funded by raising new capital. Drew realized that bonds that were convertible into stock would be the best way to flush out Vanderbilt. Drew, Fisk, and Gould issued millions of dollars in convertible bonds and had many of them immediately exchanged for stock. Vanderbilt had given his brokers orders to purchase any shares they could, and seeing the new stock available, his brokers complied with his request. However, Vanderbilt quickly got wise to the scheme and learned that the perfidious Drew had been diluting Vanderbilt’s ownership and control, effectively lowering the portion of the company owned by Vanderbilt.104

Thoroughly incensed, Vanderbilt sought legal channels to have the three men brought to justice. A warrant went out for Gould’s arrest in New York, but the three simply moved across the Hudson River to New Jersey, where they could temporarily avoid capture. Using the extra time, they called upon the corrupt William Tweed, who was then at the head of Tammany Hall, the New York political machine that became infamous for accepting bribes and awarding favors. They asked Boss Tweed to help them pass legislation legalizing their attempts to dilute Vanderbilt’s stake. After a bribe, the political boss complied.¹⁰⁵ Although Drew later settled with Vanderbilt, Fisk was murdered by his mistress’s other suitor, and Gould was arrested and forced to return much of his earnings, this political manipulation helped the trio extend their extraordinary scheme a while longer.¹⁰⁶

This episode speaks once again to the utter lack of an effective body of regulations against market manipulation. Not only was Drew able to manipulate Erie Railway stock, but he was also able to hatch a plan to alter its capitalization so radically that it diluted controlling interests and, further, to follow it up with a successful attempt to make the scheme legal ex post facto.

The foregoing two examples involved prominent individuals manipulating securities of real size. The next story is slightly different, involving a man manipulating many smaller securities through false information about the prospects of companies of more modest scale. Indeed, it could be said that most modern boiler room–style market manipulation has Walter Tellier as its historical forebear. Tellier was no master of finance, but he certainly was an aggressive and talented salesman. He spent his early years selling cosmetics but in the 1920s found himself turning to the securities markets, where he worked peddling securities for several decades.¹⁰⁷

It was when the 1950s rolled around that Tellier really began his scheme. Tellier ran one of the first major boiler room operations, either taking a position in existing penny stocks or underwriting new issues entirely and by aggressively selling others on the supposed “merits” of a significant investment in them, pushing up their prices. When the stock price had been manipulated well over its fundamental value and well beyond where it had previously been trading, Tellier would exit his holdings for a tidy profit.108

Tellier was brilliant at it, taking out advertisements in major newspapers and on the radio, soliciting prospective buyers by having members of the public return coupons to his office containing their contact information.¹⁰⁹ A sense of his promotional techniques can be gleaned from one of his ads discussing Consolidated Uranium Mines: “No one ever made any money without taking some risk, so if you can afford to speculate and want a stock which has the best growth and profit possibilities we have seen in over twenty years of Wall Street experience—again we say, buy Consolidated Uranium Mines common stock now around 70 cents per share. Remember just two years ago the stock was around 15 cents—it’s your guess what it will be two years from now.”¹¹⁰

He also instructed his employees and affiliates to probe his prospects to discern their approximate net worth, thus enabling him to figure how much the prospects could afford to buy and how worthy they were of further pursuit. From this information, he built lists of potential victims on which he could unleash his marketing team.¹¹¹

Just when Tellier was living the high life in a well-to-do New Jersey suburb, the government caught on to his schemes. As the government prepared to make its case on the basis of violations of the Securities Act and mail fraud, Tellier attempted to buy off a witness. It was to no avail.¹¹² At the end of 1955, Tellier was indicted on Securities Act violations and mail fraud, for which he was sentenced to four and a half years in prison.

Of course, similar schemes still persist today in the equities markets. Fortunately, most tend to be small. Indeed, current empirical work on market manipulation suggests that such schemes are largely limited to relatively illiquid markets. Work attempting to uncover market manipulation in equities markets suggests that it occurs mostly in very small market capitalization issues, such as those listed in the pink sheets and those sold via the Over the Counter Bulletin Board.¹¹³ Regulators like the SEC, the Financial Industry Regulatory Authority (FINRA), and NYSE Regulation Inc. (a nonprofit subsidiary of the NYSE that helps to maintain the integrity of NYSE-listed securities and NYSE affiliates) are involved in the detection of market manipulation.

The scandal began when two British firms, Guinness and Argyll Foods (a large supermarket operator), went head-to-head to try to acquire Distillers Company, then the world’s largest Scotch whiskey producer.114 Argyll offered the equivalent of $2.74 billion for the purchase of Distillers in December 1985, and Guinness offered the equivalent of $3.2 billion a little more than a month later in January 1986.¹¹⁵

The basic plan behind the scheme was to increase the price of Guinness stock so that the proposed deal would be more attractive. Because Guinness’s offer included stock in Guinness for owners of Distillers, the higher the Guinness stock price was, the greater the value the sellers of Distillers would receive if they elected Guinness rather than Argyll as the acquirer. As such, it was in the best interests of Guinness to pump up its stock’s price in order to make the acquisition more likely. Guinness reached out to allies in both London and the United States, including Ivan Boesky (who would shortly thereafter go to prison for separate crimes of insider trading and who tipped off regulators to what was going on because he was already under scrutiny), to buy secretly millions of dollars in stock with the understanding that they would be recompensed for any losses they experienced. For their involvement, four businessmen were convicted. Three went to prison while the fourth, due to health problems, was only fined and stripped of his knighthood.¹¹⁶

Besides speaking to the fact that market manipulation is frequently subtler in the modern era than it was in the past, the Guinness scandal also makes clear just how iterative the process of improving securities law tends to be. It is often not until a practitioner or several practitioners push up against or cross the line of what is proper that the law changes. This lack of clarity was apparently obvious to those involved. As Gerald Ronson, who controlled two firms that received money for helping move the stock price (though Ronson quickly returned the funds once investigators announced that his companies were involved), stated, “This did not seem to me at the time to be in any way unusual or sinister.”117 Although it would, of course, be far better if regulators could identify weaknesses beforehand, this tale underscores how the securities law framework’s flaws, ambiguities, and shortcomings are exposed when these episodes arise, prompting legislatures and agencies tasked with oversight, if they are responsive and adept enough, to rectify the situation.

The Guinness scandal had both immediate and longer-term effects on regulations. The set of principles that regulated these situations in the United Kingdom was the City Code on Takeovers and Mergers. The immediate effect of the scandal was to induce some changes in its list of principles. The item that remained the subject of long debate, however, was the precise enforcement of these rules. The takeover code was enforced by a voluntary panel, the so-called Panel on Takeovers and Mergers, which was assigned the task of ensuring that the codes were followed. However, this panel had no statutory authority at the time. It was, in effect, a form of self-regulation, and technically the panel possessed no legal powers of enforcement. It would not be given true statutory authority until the passage of the Companies Act in 2006, but the Guinness scandal was one piece of evidence that proponents of this statutory footing cited for years.¹¹⁸

LIBOR, the London Interbank Offered Rate, is intended to represent the interest rate major banks would charge each other for loans. The LIBOR system was implemented in 1986 by the British Bankers’ Association, in large part simply to provide a benchmark that banks could look at in the process of setting rates. Currently, there are a total of 150 different LIBOR rates published daily for ten different currencies and fifteen different time horizons.¹²⁰

The fundamental problem with LIBOR is that the number is calculated by a survey of the banking institutions themselves, not by analyzing actual transaction data. Indeed, the US-dollar LIBOR is calculated via a survey of major banks in which the highest four and lowest four values are discarded, with the remainder in the middle then averaged to get the rate.121 If a bank has an interest in LIBOR being either higher or lower, it can manipulate the value it reports so as to influence the rate. Of course, if just one or two banks do this to the extreme, it should make no difference by design. However, if many banks are engaged in this practice of purposefully changing the reported rate, the process of removing the outliers may not be sufficient to arrive at an unbiased value.

This is precisely what happened repeatedly with many banks, as recorded in e-mails and other electronic communications among colleagues. For instance, at UBS a trader told an outside broker that if the broker held LIBOR constant that day, he would repay the favor by giving him tens of thousands of dollars.¹²² At the Royal Bank of Scotland in August 2007, a trader told the head of yen-related investment products in Singapore that he could set LIBOR “where you would like it,” given the firm’s trading positions. Two other traders suggested it should be lower, so the first trader replied, “OK, I will move the curve down 1 basis point, maybe more if I can.”¹²³

Of course, the other reason the LIBOR scandal is so important is because so much money is tied to LIBOR. Indeed, as MIT professor Andrew Lo has pointed out, LIBOR was never intended to serve as the basis of such a large volume of financial contracts.¹²⁴ Among the contracts it affects are mortgages, interest rate swaps—where one party agrees to exchange a fixed interest rate for a variable rate that is a certain number of percentage points higher than LIBOR—student loans, and other debt arrangements. In all, some $300 trillion worth of contracts is tied to LIBOR, and, as such, a tiny manipulation of a single basis point translates into enormous transfers of wealth.¹²⁵

The LIBOR scandal demonstrates another important feature of typical market manipulation today: in highly liquid markets, some form of collusion is typically required. Further, it demonstrates just how important an effective legal framework is to the proper functioning of markets. The LIBOR scandal underlines once again that when the incentives for even ever-so-slight deception are so great, some people will succumb to the temptation. It is thus critical not only to be vigilant about overseeing this behavior and administering punishment accordingly but also to be creative about redesigning contracts that are prone to manipulation so that the allure is reduced in the first place.

We begin with Ivan Boesky, the man whose likeness was caricatured as Gordon Gekko in the acclaimed film Wall Street.126 He was the man who famously proclaimed, “Greed is all right, by the way. I want you to know that. I think greed is healthy. You can be greedy and still feel good about yourself.” The comment was met with some chuckling and an ovation when Boesky made it at the University of California, Berkeley, School of Business Administration in 1986.¹²⁷ Looking back, however, it is difficult to see precisely what “good” Ivan Boesky’s greed has done society.

Boesky’s father was a Russian immigrant who ran nightclubs near Detroit, Michigan. During his youth, Boesky sold ice cream out of a truck. He cut corners early in his life, not heeding the conditions of his ice cream vending license by continuing to sell past 7:00 P.M. He went on to college, but he failed to graduate from any of the three schools he attended: Wayne State, Eastern Michigan College, and the University of Michigan. He then went on to attend the Detroit College of Law, where no undergraduate degree was needed, and married Seema Silberstein, whose father, Ben Silberstein, was wealthy from real estate investments.¹²⁸ Ben Silberstein never thought particularly highly of Ivan, calling him “Ivan the Bum.”¹²⁹

Soon Ivan found himself in the securities business. He did not exactly have successful opening acts to his career. In his third finance job, one of his investments lost $20,000, and he was asked to leave. In his next job, he manipulated stock prices by buying up large volumes and received a $10,000 fine from the SEC for illegal short selling.¹³⁰ Time and again, Boesky seems to have sought the quick way to gain.

Boesky soon launched his own investment firm, the equity of which was funded primarily by his wife’s family’s money. This time Boesky found success. He was soon taking a limousine to work, living in a ten-bedroom home in Westchester County, New York, on 200 acres, and spending lavishly. Even more than lead an opulent lifestyle, Boesky also tried to cultivate an aura of great financial sophistication. He liked to claim that his success was due to mastery of strategies like merger arbitrage, a concept about which he had heard from a former classmate. Later Boesky even published a book entitled Merger Mania with a subtitle of Arbitrage: Wall Street’s Best Kept Money-Making Secret.131

The strategy itself was relatively simple. In the basic form of merger arbitrage, investors purchase debt or equity in a corporation that might soon be the target of a merger or acquisition. The investors do this in anticipation of a spread between the offer price announced in the deal and the price at which the target’s securities were trading before the announcement. In the strategy’s more complex form, investors buy and sell securities and derivatives related to a merger or acquisition after the deal has been announced, carefully evaluating the relative value of the various instruments and, above all, the risk that the transaction will not be consummated (due to failure to gain shareholder approval, regulatory sign-off, or sufficient financing for the deal or to another obstruction to the process).¹³² Although this strategy is well known and well understood today, it was much more esoteric in the 1960s when Boesky first pursued it. The real secret to his wealth, though, was not brilliant utilization of a merger arbitrage strategy; it was instead a strategy as old as time—to play “hardball” to stay ahead.¹³³

Boesky consistently relied on insider information and failed to disclose who else was working with him to influence the market. Figures like Dennis Levine, Michael Milken, and Martin Siegel, whose firms had access to information—for example, by virtue of being retained in an advisory capacity on merger and acquisition deals—clandestinely and illegally worked with Boesky to pass along information on what to purchase so that they could share in the profits.¹³⁴

Illustrating how Boesky’s schemes worked, an early deal Martin Siegel fed Boesky involved Diamond Shamrock, a chemical company that was at the time interested in expanding its operations in oil and planning to do so through an acquisition. Siegel’s employer, Kidder, Peabody, served as the adviser and was privy to a list of possible companies Diamond Shamrock might attempt to buy. Siegel passed the name of one candidate, Natomas Company, to Boesky, thinking that Boesky could accumulate a sizable position well in advance of an announcement (because Diamond Shamrock was still in the phase of exploring acquisitions) and thus not raise red flags for the SEC. Boesky did precisely that and made millions when the deal eventually went through.135

The SEC became wise to all of these ostensible acts of prescience by Boesky when it charged Dennis Levine, an investment banker at Drexel Burnham Lambert in New York, with insider trading in 1985.¹³⁶ Levine cooperated, and the SEC was made aware of Boesky’s involvement.¹³⁷ Boesky ended up getting a generous deal from the SEC in return for his help turning their attention to what the SEC seemed to regard as an even bigger fish: Michael Milken, also at Drexel Burnham Lambert. In the end, though he did pay $100 million for his transgressions, Boesky was even allowed to sell off his investments, saving him a great deal of money.¹³⁸ He was sentenced to only three years of jail time.¹³⁹

Boesky managed to receive minimal punishment largely because of his cooperation. Although there is little doubt that the nature of financial crimes is typically sufficiently convoluted that cooperation does aid in the success of prosecutors bringing high-profile criminals to justice, undoubtedly more thought is required to determine how to balance the cooperation needed to make cases against others with a need to punish even the smaller offenders. Boesky’s case might speak to a failure of striking the right balance, and though he ended up getting some jail time, the punishment may not have entirely fit the crime. There is some consolation in the fact that laws were passed in the wake of Boesky’s crimes (and the 1980s merger mania episode more broadly) that give more teeth to prosecutors. Nevertheless, as the Boesky episode shows, prosecutors must possess the inclination to use them.

Rajaratnam spent the beginning of his career studying technology stocks, and he quickly ascended the corporate ladder at the investment bank Needham & Co., landing positions as the head of research in 1987, COO in 1989, and president by 1991. He eventually broke away from the firm, and he started Galleon Group in 1997 with several coworkers from Needham. Galleon was extremely successful despite the bursting of the technology bubble. In fact, the firm was up over 40 percent from 2000 to 2002 when the Standard & Poor’s 500 (S&P 500) was down 37.6 percent.¹⁴¹

And here is where Rajaratnam’s story becomes so similar to many of those of others convicted of insider trading. The striking feature of almost all inside traders is that they were either already successful or seemed poised for success. They simply did not need to engage in insider trading to prosper. The question asked almost invariably is, why did they cross the line? Why were they dissatisfied with the returns they could earn legitimately?

Yet, though the question why seems so logical in retrospect, the answer is typically quite straightforward: they thought they had a “sure thing”—a sense of certainty about where the market was headed is normally elusive in the industry—and believed they would not be caught. Investigators relied on wiretaps to build the case against the offenders in this case, and the tapes reveal a tremendous arrogance among the actors. Danielle Chiesi, one of those convicted of having given Rajaratnam insider information, remarked about a conversation she had to acquire the information, “I just got a call from my guy. I played him like a finely tuned piano.”¹⁴² They saw themselves as slick and masterful at their craft, and the prospect of being caught seemed scarcely to enter the equation.

David Pajcin, the son of Croatian immigrants, earned a full scholarship to Notre Dame and achieved academic success there, graduating cum laude. After college, he found himself in a desirable Goldman Sachs position working on commodities, but he left after a few months to work in different firms in the industry. Eugene Plotkin transferred to Harvard from the California Institute of Technology after his first year. The two of them met at a Goldman Sachs training session and, despite being on trajectories for success, abandoned their upward paths to devise some of the most egregious schemes to acquire and trade on inside information.143

The first scheme began in 2004, when Pajcin and Plotkin placed advertisements online asking for factory workers and received a reply from a man by the name of Nickolaus Shuster of New Jersey. They wanted Shuster to get a job at Quad/Graphics, a commercial printing firm that printed BusinessWeek. According to plan, Shuster managed to get a job as a forklift operator. The target of the scheme was a weekly article, “Inside Wall Street,” that gave analysis on stocks and was sufficiently widely read that the column’s recommendations moved stock prices. The goal was to get an advance copy of the article so that Plotkin and Pajcin could establish positions before it was released to the public. The scheme worked quite successfully, and on Thursday mornings Shuster would take a copy of the magazine and contact the two with the contents. The group made over a quarter of a million dollars in the eight months from November 2004 to July 2005.¹⁴⁴

The group did suffer some setbacks, however. One scheme to hire strippers to prevail upon bankers to give up information on pending mergers or acquisitions they knew about was completely unsuccessful. Another failure occurred when a long-time friend of Pajcin called him to say that he had been serving on a grand jury that was intended to get to the bottom of accounting anomalies and possible frauds at Bristol-Myers Squibb. The friend told Pajcin that a senior official at the company was likely to be indicted, which Pajcin figured would cause the stock to drop, and thus he took a short position in the stock. However, a deal with prosecutors was made and the indictment never materialized, causing the group to lose money.¹⁴⁵

One of the most lucrative trades the two managed was sourced by Stanislav Shpigelman, a contact Plotkin had who was employed in mergers and acquisitions at Merrill Lynch. When Plotkin and Shpigelman met at a Russian bathhouse near Wall Street in late 2004, Shpigelman began to boast about a corporate takeover he was helping with at Merrill. The takeover was the acquisition of Gillette by Procter & Gamble. Plotkin realized that the timing was not quite right yet, though, and he waited for a call from his contact when the deal was closer to being announced. About eight weeks later, Shpigelman told Plotkin that the time to act had arrived, and Plotkin started purchasing call options on Gillette. The group made a significant amount of money on this trade, and with other tips from Shpigelman, repeated this kind of success with at least three other deals. However, unbeknownst to Plotkin and Pajcin, they raised red flags when they attempted to do this yet again with Reebok. They purchased call options on Reebok that were not only close to their expiration but that were also far out of the money. This means that the position would profit only if Reebok moved upward substantially in a short amount of time. The SEC’s Market Surveillance Unit found it unusual how many of these out-of-the-money calls were purchased and it tracked them, only to discover other anomalies. The group was using an account registered in Croatia but being accessed in New York. Plotkin and Pajcin thought they had covered their tracks, but their scheming caught up with them. Regulators realized the trades were too perfectly timed and, after an extensive investigation, uncovered many (and sometimes unbelievable) other instances of acting on inside information.146

In the end, it was remarkable that two successful men, educated at Harvard and Notre Dame and employed at one time by Goldman Sachs, would go to such lengths to procure inside information when they would likely have had bright futures if they had not resorted to this duplicitous behavior. Indeed, they made a whole business out of it. But, as Pajcin would confess later, he was looking for the fast way to wealth, much more pleasant, he believed, than the long hours that would be necessary for the legal path. As he explained to SEC regulators, “I was like, no, I can’t handle this. I just didn’t want to wait like four years and then still be on the floor.”¹⁴⁷

But just like Raj Rajaratnam, Plotkin and Pajcin never thought they would be caught. They thought they had been careful. Who, after all, could trace an advertisement for a factory worker back to them? Who would connect the dots between them and trades made in a Croatian brokerage account?

Today people like Raj Rajaratnam, David Pajcin, and Eugene Plotkin are convicted criminals. They broke the law, they undermined the principle of a fair market, and they enriched themselves at the expense of the law-abiding investors taking the other side of their trades.

Wiggin formed three vehicles through which he could conduct his securities transactions: the Shermar Corporation, the Murlyn Corporation, and the Clingston Co. Inc., all of which were owned in their entirety by either him or family members. Wiggin traded the stock of the Chase Bank and profited handsomely from it, making over $10 million transacting in the shares of Chase companies from 1928 to 1932. The most egregious incident of all, however, was not just the trading of the stock while he was chairman but what transpired during the Crash itself. Just when the Chase financial institutions joined other banks in trying (though futilely) to inspire confidence in the market and started buying, Albert Wiggin sold his personal shares. He claimed that he sold them to reduce his family’s exposure to the stock. That seems perfectly reasonable, but that was not all Wiggin did. He sold more stock short to profit explicitly from the decline in Chase stock. In other words, he sold more than he owned to take advantage of the decline. Wiggin profited handsomely from it.¹⁴⁹

Wiggin’s actions were not taken well by the general public when they were revealed by the Pecora Commission, a group devised to ascertain the fundamental causes of the Crash of 1929. Indeed, Wiggin decided under public pressure not to accept his annual pension of $100,000.150 Of course, this was a small concession, given that he profited by more than $4 million from the short sales made at the end of 1929 alone.¹⁵¹

It actually was not illegal for Wiggin to transact in stock essentially whenever he deemed it beneficial to his financial interests. The value in the tale about Wiggin thus is not really about him, but about the nature of the time and just how far we have come. There was once an era when the only real remedy to actions thought to be unfair and dishonest, like insider trading, was public disapprobation and shame.

Remarkably, there was an 1868 court ruling in New York that stated that the directors of a publicly traded company did not actually have to make the market aware of nonpublic information (or otherwise await the time when that information would come to light) before acquiring or disposing of shares for their personal accounts.¹⁵² This same idea was echoed in 1933 in Goodwin v. Agassiz, a Massachusetts case that would affect thinking on insider trading and information for several decades thereafter. In Goodwin v. Agassiz, the plaintiff had sold his stock in a mining company. The plaintiff learned later that the company’s directors, meanwhile, had purchased stock in the open market after they had learned from geological studies that land the firm owned was likely to contain significant amounts of copper. The court ruled that the directors were not required to make this fact known to shareholders before trading.¹⁵³

It was President John F. Kennedy’s appointment of William Cary as chairman of the SEC in 1961 that would alter the trajectory of insider trading laws. Cary was a brilliant scholar. He graduated from Yale, where he was both an undergraduate and later a law student, followed by Harvard Business School. He served a short stint in intelligence during World War II, working for the Office of Strategic Services posted in Romania and what was then Yugoslavia. Soon, though, it was back to the law, and he eventually became a law professor at Columbia, the university where he would spend much of his career.¹⁵⁴

To get a sense of how the man operated, consider a speech Cary made in 1962. To the chagrin of many in the industry, in the speech he declared that the NYSE, “though a public institution, still seems to have certain characteristics of a private club.” Indeed, his success emerged from his fierce drive to reform the thinking on securities oversight, regardless of how much he ruffled feathers along the way.155

It would later be said that Cary had an exceptionally short agenda for the SEC, but among his goals was undermining Goodwin v. Agassiz.¹⁵⁶ The major blow Cary dealt Goodwin v. Agassiz was a decision in 1961 known as In re Cady, Roberts & Co. The Cady, Roberts decision involved a firm named the Curtiss-Wright Corporation, which was a publicly traded company. The board of directors of the Curtiss-Wright Corporation voted to curtail the dividend payment for the quarter. One of the men who sat on the board was J. Cheever Cowdin, a partner in Cady, Roberts & Co., which offered brokerage services and managed money for clients. Cowdin told Robert Gintel (also a partner at Cady, Roberts) that Curtiss-Wright had voted to cut its dividend, and Gintel, realizing this would cause the stock to drop, sold many shares of stock owned by his clients.¹⁵⁷

The SEC maintained that Gintel’s action was an infraction of SEC Rule 10b-5,¹⁵⁸ created in 1942 to prevent fraud in the purchase or sale of securities. At the time, it was obvious to the SEC commissioners that the rule should be instituted: it passed unanimously, and the only comment made was by Sumner Pike, a commissioner at the time, who remarked, “Well, we are against fraud, aren’t we?”¹⁵⁹ It was William Cary who changed the interpretation of Rule 10b-5. The commissioners almost certainly never imagined that twenty years later this rule would be invoked by their successors to bring about an end to insider trading. However, Cary realized that congressional inaction meant he had to do something, and he made a vigorous and compelling case that the rule should be applicable beyond the most flagrant, cut-and-dried versions of fraud.¹⁶⁰

The Cady, Roberts decision introduced two critical changes in the treatment of insider trading. First, it made it clear that “tipping,” or the passing along of inside information to others for trading (as Cowdin did for Gintel), was illegal. The other change was that trading based on inside information was banned even for transactions on an exchange. It was previously thought that trading on inside information would be prosecuted only in cases of face-to-face transactions rather than “impersonal” transactions on an exchange. The SEC rendered invalid this line of argument. Corporate insiders who had inside information could thus not transact so long as the information was material and nonpublic.¹⁶¹

And so Cary had laid the cornerstone for modern regulation regarding insider information. Fortunately, this would be followed by a string of other victories improving upon his early success. The next major victory came in 1968 with SEC v. Texas Gulf Sulphur, again involving a mining company, just as in Goodwin v. Agassiz. Texas Gulf Sulphur was conducting a geological survey to assess the viability of a potential mine in Canada. The survey identified a region where it was possible there would be lucrative mineral deposits, and, in response, the firm ordered drilling there. It was determined that the potential site did, in fact, have extremely rich deposits. Without making disclosures to the public, officers within the company purchased shares. This, in turn, set off more buying by many members of the public who saw the insider activity and believed there must be a good reason for it. The officers then put out a statement to the public denying the discovery to try to stop the buying by outsiders, and this statement was later determined to have failed to properly represent the results of the drilling operation. Eventually, the correct results were released, but the appropriate disclosures did not happen until well after the insider purchases. The SEC brought suit, and the case went to the Second Circuit Court of Appeals, which found for the SEC. In the decision, the court stated that the law should ensure that “all investors trading on impersonal exchanges have relatively equal access to material information” and, furthermore, that “all members of the investing public should be subject to identical market risks.”162

Enforcement of these regulations was given real teeth in 1984, when Congress passed the Insider Trading Sanctions Act of 1984. The law allowed the SEC to pursue treble damages, or three times the amount of money gained by trades based on inside information. The law came during the 1980s, a difficult decade marked by financial improprieties of many kinds. It was these laws that would aid in making examples of people like Ivan Boesky, Dennis Levine, and Michael Milken, who were extracting enormous fortunes from illicit informational edges and manipulation.¹⁶³

In recent years the SEC has consistently been denied adequate resources to do its job. Its mandate has only grown under the Dodd-Frank Act, and yet, as a study conducted by the Boston Consulting Group found, it is at least several hundred employees short of what it requires to properly oversee the markets.164 It is no secret that vastly trimming the budget of the SEC has been a priority of some with a laissez-faire worldview. Almost comically, the House Appropriations Committee substantially scaled back the budget request for fiscal year 2012 and provided only the same amount of money as it had in fiscal year 2011, despite the new challenges presented by Dodd-Frank. Most puzzling of all, however, were some of the reasons cited by the committee for the decision, including that it “remains concerned with the SEC’s track record in dealing with Ponzi schemes.”¹⁶⁵ The solution to the commission’s inability to properly identify and prosecute more cases of Ponzi schemes clearly was not to leave it even more bereft of resources than before.