Insider trading

The major stock markets function by trying to ensure that all listed companies announce key information publicly, so that everyone in the market hears about it at the same time. Insider trading means trading on information that is non-public – if you are the employee of a listed firm or an investment bank, say, and you learn during your work that Company X has had a disastrous quarter it will announce tomorrow, it is insider trading, illegal in many markets – to rush out and sell your Company X shares before the announcement. It is also illegal for you to tell a friend who then makes the transaction. Why is this illegal? It might look, after all, like a victimless crime – you make a profit on the deal, and no one is the wiser. The reason is that insider dealing is a kind of stealing; the victims are the other investors involved who have not been able to benefit from the inside information and, by taking a profit on a deal you are, in effect, taking something from them, just as you would if you took money from, say, an office Christmas-party fund or any other sum of money that was being held on behalf of a group of people.

There is some theoretical controversy about insider trading. Some academics, for example the monetarist economist Milton Friedman, have argued that insider trading benefits the market as a whole by increasing its efficiency: if the directors of Company X suddenly start buying as many shares as they can in their company, this insider buying will soon be noticed (directors have to disclose such transactions) by the market, which will respond accordingly. Thus, the argument goes, insider dealing is just one of the many competitive forces that ensures price-sensitive information will reach the market as quickly as possible. There may be something in this argument, but investors do not like to feel that some insider, with special information, has been able to profit at their expense, and in many countries at least some forms of insider dealing are now illegal.

Ivan Boesky and Dennis Levine

During the 1970s stock market regulation was quite heavily enforced, but in the 1980s the emphasis changed, especially in the US, where the SEC (the Securities and Exchange Commission, the main US stock market regulator) aggressively pursued investigations and prosecutions of financial wrongdoers. In the 1980s there was a boom in company mergers and acquisitions, providing enormous opportunities for individuals to make quick profits by insider dealing, which developed rapidly into an epidemic.

Drexel Burnham Lambert was an investment bank at the heart of the merger mania, and one of its employees, Dennis Levine, was one of the largest insider dealers ever uncovered. Levine had met Robert Wilkis, then a lending officer at Citibank, in the 1970s, and when they later found themselves both working in Europe, they became intrigued by the lack of prohibitions against insider trading in many European countries. The pair both had access to price-sensitive information through their jobs, and decided to open bank accounts in Switzerland to trade on this information secretly. They agreed to share information with each other, but that they would trade separately to avoid discovery. When he wanted to buy or sell securities, Levine would telephone his Swiss bank from a public telephone, using a codename, and give his order. Many of the trades were staggeringly simple; one or other of the duo would hear some information about a company that would positively affect the share price when it became public – for example, that another firm was launching a takeover bid against it – and then Wilkis and Levine would purchase shares in the target firm, selling later after the takeover bid had been announced and the shares in the target company had consequently gone up. According to Levine, even though he researched the information carefully after receiving it, some of his investments suffered losses. Overall, however, Levine made money, building $39,750 up to $11.5 million through insider trading once or twice a month over a seven-year period. After some time Levine’s Swiss bankers asked him to move his account, and he switched to another Swiss bank, Bank Leu, at its subsidiary in the Bahamas.

An important innovation of the 1980s was the introduction of a liquid market in ‘junk bonds’ by Michael Milken, a financier at Drexel Burnham Lambert. Junk bonds are simply company bonds that for one reason or another have been deemed to be below investment grade. Junk bonds tend to produce a higher yield (the equivalent of interest) because they are considered to be higher risk, and Milken’s initial innovation was to show that many junk bonds belonging to ‘fallen angels’ (companies whose financial situation had worsened since their issue of investment grade bonds) were in fact worth considerably more than their current valuation. Later, as the junk bond market grew, Milken and Drexel began to use them as a financing mechanism in mergers and acquisitions, arranging for the issue of bonds that were graded as ‘junk’ at the outset and finding willing buyers for them. Each year, a ‘Predators’ Ball’ was held in Beverly Hills that attracted the movers and shakers in the mergers and acquisitions (M&A) business, including the predators themselves (corporate raiders like Ron Perelman and Carl Icahn), institutional buyers of junk bonds, and senior managers from companies interested in M&A. One of the star guests was Ivan Boesky, known as an ‘arbitrageur’ who specialised in making speculative profits in merger plays; Levine met Boesky at the Predators’ Ball of 1985, and soon they were exchanging information about the market.

According to Levine, at first there was no acknowledgement that any of the information might be ‘insider’, but eventually Boesky offered to give Levine a percentage of the profits he was making. According to Levine, ‘Despite my own illicit activities, I was flabbergasted. I couldn’t believe he would risk exposing himself so blatantly, by proposing something clearly illegal on its face.’ Levine claims not to know why he eventually agreed to cooperate with Boesky for money. The SEC alleged that the deal was to give Levine 5% of profits Boesky made using Levine’s information, and 1% of the profits he made if he maintained or increased an existing holding. Levine provided insider information on various deals, including the merger of Nabisco and RJ Reynolds, and a bid for Houston Natural Gas by InterNorth. Unknown to Levine, Boesky was also paying others for insider information, including Martin Siegel, a senior executive at Drexel, who was a major architect of mergers during the 1980s, and had been secretly receiving suitcases full of cash from Boesky in return for juicy tips. Boesky, known for his ‘uncanny’ ability to spot which companies would be the target of a takeover bid, became the subject of the SEC’s interest when it became clear that he was making huge profits on nearly every major merger he speculated in (for instance, he netted $28 million on Nestlé’s take-over of Carnation). For the SEC, Boesky’s success as a speculator was just too good to be true, but they could not find any evidence of wrongdoing.

Then, in July 1985, Merrill Lynch passed on to the SEC an anonymous letter claiming that two of the firm’s brokers in Venezuela were committing insider trading offences. According to Levine, bankers at Bank Leu in the Bahamas had been copying Levine’s trades – apparently because they guessed that Levine was trading on inside information – and had been using Merrill Lynch for their own transactions. Brokers at Merrill Lynch appeared to have been copying the Bank Leu trades and had attracted suspicion. The SEC conducted a ten-month investigation, but Bank Leu refused to divulge any information about the suspect accounts. The SEC applied legal pressure on the bank until it finally agreed, in May 1986, to give the SEC the name of the account holder in question: it was Dennis Levine.

SEC pressure on Dennis Levine soon persuaded him to cooperate and he provided information on Boesky’s misdeeds. The SEC then turned to Boesky, who also decided to cooperate, fingering Michael Milken and even going so far as to wear a wire at a meeting with Milken in an effort to implicate him in the insider dealing scandal. Milken was eventually convicted of relatively minor reporting violations, but not of insider dealing. Boesky and Levine both received relatively short jail terms but massive fines for insider dealing.

The reason why these insider dealing revelations were so shocking in the 1980s was they were associated with the excitement and innovation in a rapidly expanding financial world. In the 1980s investors wanted action in the markets, and the merger and acquisitions mania was the way to get it. It was also the idea that people central to the M&A action – investment bankers abusing confidential information, institutional dealers who piggybacked on insider trades – were abusing their positions of trust, and a hero of the M&A game, Ivan Boesky, who had so publicly preached a philosophy of ‘greed is good’ in the mergers world, had turned out to be an insider dealer. The SEC had confirmed itself as an effective, perhaps even over-enthusiastic, enforcer of stock market regulations.

Back in the 1960s and 1970s, however, the investment world had more of a Wild West tinge than it does today. The US was by far and away the most modern and prosperous of the major economies, and western Europe was only just beginning to get back on its feet. One colourful US entrepreneur, Bernie Cornfeld, built up a vast offshore mutual fund sales company, initially to draw upon the savings of the thousands of American expats and servicemen working in Europe after the Second World War, but it later attracted many investors from Europe and Latin America who, at that time, had few attractive investment opportunities and were suffering from draconian rules on moving funds abroad. Capital controls, which means governments preventing their citizens from moving their money abroad, were a major, and very frustrating, barrier to prosperity for businesspeople in the 1960s – at one point British subjects (not ‘citizens’ until 1983) were forbidden from taking more than £50 abroad, which made it virtually impossible even to go on a foreign holiday, let alone buy US shares directly. By the 1960s Cornfeld controlled a number of mutual funds from Switzerland, including what may have been the first ‘fund of funds’ (a fund that exclusively invests in other funds). Cornfeld served 11 months in a Swiss prison on fraud charges relating to a share issue of one of his funds, but was eventually acquitted; the vast sums of cash he controlled, however, attracted an even hungrier predator: Robert Vesco.

Robert Vesco

Robert Vesco was an Italian American, the son of a Detroit car worker. In the early 1960s Vesco had used borrowed money to acquire a series of car industry manufacturing units cobbled together into a conglomerate called the International Controls Corporation (ICC). In 1971, with Cornfeld in trouble, Vesco succeeded in a hostile takeover of Cornfeld’s Investors Overseas Service (IOS). Most of IOS’s assets were held in four funds with a total value of over $400 million, and were mainly invested in US securities. IOS was in trouble and needed cash, and Vesco, through his firm ICC, which was listed on the American Stock Exchange, loaned IOS money to keep going, In return, Vesco was able to purchase 45% of IOS preferred shares and 28% of its ordinary shares during 1971, and was voted in as chairman of the IOS board.

IOS, with its large sums of investors’ money invested in blue chip US companies, looked like a cash cow to Vesco, who – allegedly – promptly began transferring money out of the blue chip firms and into various offshore schemes he controlled. In October, IOS’s main banking business was transferred to a new corporation based in the Bahamas. In December, IOS’s real estate and insurance assets were transferred to another Bahamas company controlled by Vesco. Many of IOS’s investors were known to have invested money illegally (by violating their own countries’ capital controls and tax and investment laws, which at that time were strict) and it was thought that as much as $150 million in the funds would not be redeemed by such investors.

In the following year, Vesco took a new tack, attempting in a series of complex manoeuvres involving interrelated firms, many of them shells, to separate IOS funds from ICC, and to alter the funds’ classification so that it would be hard for investors to get their money out, while continuing to retain ultimate control of the funds. At almost every turn, lawyers and officials involved in the process advised Vesco that what he proposed was unethical and failing in IOS’s fiduciary duties to the original investors, most of whom were not wealthy; Vesco seems to have ignored them.

This activity, along with Vesco’s lavish lifestyle, which included a private jet complete with sauna and disco, attracted the attention of the SEC.

Unlike the incompetence and bureaucratic mishandling that has characterised the SEC’s recent investigations, the SEC of the early 1970s acted vigorously, accusing Vesco of having embezzled more than $200 million of investors’ money. The dirty politics of the Nixon era was in evidence later, however, when G. Bradford Cook, the Chairman of the SEC, was forced to resign after it was discovered that he had ordered, at the behest of Nixon cronies, the removal from the SEC complaints against Vesco of any reference to Vesco’s illegal $200,000 contribution to Nixon’s campaign fund. This amount, it was alleged, was an attempt to bribe the Nixon administration to get the SEC off Vesco’s back.

The story now begins to take on a tawdry glamour, becoming like a kind of movie version of how slippery financiers are supposed to behave. By 1973, things were getting too hot for Vesco in the US. He told his pilot that ‘from now on we’ll be operating in the Caribbean and Central and South America. They’re breaking my balls here in the US. I don’t have to stand for that kind of shit.’ In February Vesco fled to Costa Rica, continuing his legal battle with the US authorities. His company, ICC, was put under court supervision and had its shares suspended from stock market trading.

Then, as now, there were a number of violently anti-US regimes in Latin America. However, the centre-left government of José Figueres in tiny Costa Rica was not one of them. Figueres was a constructive reformer who, while willing to cooperate with the US in some areas, was determined to improve the country’s economy. Vesco seems to have offered him a deal: investment in Costa Rica in return for some measure of protection against the US. The first investment was $2.15 million into Sociedad Agricola Industrial San Cristobal, an agricultural firm founded by Figueres that was a major employer in the country. Other investments followed, especially in high tech, as Vesco established himself in style, acquiring large estates and ranches, a fleet of vehicles and a small army of bodyguards, and did his best to win over Costa Rican opinion by spreading the money around. Bizarre stories began to emerge that Vesco was building a movie-villain stronghold in the country, even equipping his 54-foot yacht with souped-up engines, state-of-the-art navigation systems and mounted machine guns. In 1974 two US businessmen testified to a Senate hearing that they had met Vesco to discuss the possibility of building a machine-gun factory in Costa Rica. One stated he had been told by Figueres’s son that the factory would supply the Costa Rican army – quite plausible, perhaps, except for the fact Figueres had famously abolished the Costa Rican army permanently in the 1940s.

Although Vesco quickly became a household name and also the man whom numerous loony revolutionary schemers around the world claimed, probably falsely, was aiding them, it is still unclear why the US was unable to extradite him. There was an attempt in 1973 that failed when a Costa Rican judged ruled the fraud charges against Vesco were not covered by the extradition treaty – this is in fact common in extradition treaties – and another US application to extradite Vesco from the Bahamas, where Vesco also owned property, failed for the same reason. It is true that in March 1973 the Costa Rican parliament had passed a law banning the extradition of any foreigner on the basis of a simple request from a foreign country – known as ‘the Vesco law’. This was seen widely as having been intended to protect Vesco specifically and prompted a riot of 2000 students in the Costa Rican capital. Nevertheless, the two extradition attempts, in Costa Rica and the Bahamas, had been refused on perfectly legitimate grounds.

So, was the US government not really trying to get Vesco? The Chairman of the relevant US Senate subcommittee, Senator Henry Jackson, certainly complained that the extradition efforts had been ‘half-hearted attempts’. Costa Rica’s new President, Oduber, also remarked that the extradition request seemed to have been intended to fail. The suspicion was that the Nixon administration was not overly keen to have Vesco back in the country just when the Watergate scandal had erupted – especially given that the money Vesco illegally contributed to Nixon allegedly went to pay for the Watergate operation. Further fuelling suspicion was the curious fact that Richard Nixon’s nephew, Don, was working in Costa Rica as Vesco’s personal assistant.

In 1974 People magazine depicted a dreary scene chez Vesco in Costa Rica, with his wife and four children edgy and uncomfortable in their walled mansion, surrounded by luxury but unsure of their future. Although Vesco was making an impact as a plutocratic benefactor in the region, he certainly does not seem to have thought of himself as untouchable, given his elaborate security arrangements. Vesco mounted a PR campaign, giving interviews for the US media from Costa Rica, and buying time on Costa Rican television, to proclaim his innocence. Nixon resigned as US President in August, and his successor, Gerald Ford, pardoned him; according to Vesco, general outrage at Nixon’s pardon made it impossible for him, Vesco, also to receive a pardon from Ford as he had been promised.

Life in Costa Rica was not easy or cheap for Vesco, still only in his late thirties, and it was said to be costing him $500,000 a year. There were stories that the US had sent assassins to kill him. He had to pay off as many people as possible in the country, without having any discernible effect on his increasing unpopularity; his aircraft were getting seized by US creditors; the new President, Oduber, seemed less sympathetic towards him than Figueres had been; and some IOS investors had had the temerity to sue him in Costa Rica for the return of their money. If he could stay in the country for five years, he would be eligible for citizenship, which might provide some protection from the US authorities – he was still determined to stay out of the US. Then, in 1977, President Oduber was worried about getting re-elected, especially after major scandals revealed not only that Vesco’s money had indirectly helped him to win his first presidential term, but also Vesco’s companies had made fortunes during Costa Rica’s 1975 privatisation of its oil and gas sector. Evidently Figueres’ protection could no longer save Vesco, and Oduber asked him to leave the country – a move likely to prove hugely popular in a country that had come to detest Vesco, who, after failing to obtain Costa Rican citizenship amid wild protests and demonstrations, finally left the country in April 1978.

In the US, Jimmy Carter was now President, and his administration said that they still wanted to get Vesco. Vesco had other plans; three businessmen from Georgia, Carter’s home state, had offered to try to smooth things over with the US government. If Vesco could get out of his problems with the US, he believed that he might be very useful in helping to conclude the Panama Canal Treaty, which was then being proposed. Meanwhile, Vesco’s appetite for wild international schemes continued – it was essential to his modus operandi to generate a multitude of deals and try to play them off against each other. In 1979, newspaper reports appeared claiming that Vesco had visited Colonel Gaddafi in Libya several times in pursuit of an arms deal and that he had tried to arrange commissions to be paid by Libya to President Carter’s unstable brother, Billy, who was also trying to do business with Gaddafi. It was also claimed that Vesco was attempting to arrange the release of eight transport planes Libya had purchased from Lockheed, but the US government had blocked; his commission on this deal was said to be worth $5 million. The ‘Billygate’ scandal was made much of at the time, and it was certainly suspected by many that Vesco had been trying to get at the White House through the President’s incompetent brother; Jimmy Carter, however, was no fool, and it is quite clear that he did not allow Billy to have any improper influence over government policy. This sheds some light on Vesco’s mentality. He seems to have been most at home with corrupt businessmen and shady politicos, and to have completely misread the likely behaviour of the Carter administration.

Vesco moved to Antigua in 1981, where he attempted to purchase part of the island of Barbuda with the help of politician Lester Bird, later to become prime minister. It is alleged that Vesco was able to obtain an Antiguan passport in a different name, and the Bird family assisted him in trying to set up an independent state on Barbuda. Discovering his presence in Antigua, the US instituted extradition proceedings. Vesco had to move on quickly. Trying to set up your own country is a very bad idea, unless you have powerful forces behind you, and Vesco didn’t; he was losing his grip. He moved to Nicaragua, then ruled by a strongly anti-American regime, and got involved in drug smuggling to the US with Colombian, Nicaraguan and Cuban involvement (many Latin American revolutionaries supported drug smuggling as a way of attacking US society from the inside).

The decline was palpable. Soon there was nowhere for Vesco to go, except for the one great thorn in America’s side: Castro’s Cuba. It has been claimed that Vesco bribed Castro for permission to stay in Cuba, but this seems unlikely or, at least, unnecessary: Vesco, as a highly visible annoyance to the US, was clearly politically useful to Castro. He was also ideologically acceptable – as Castro told one interviewer, ‘If he wants to live, let him live here. We don’t care what he did in the United States.’ Life in Cuba, however, was no paradise. Much of the money had leaked away, and, although living well by Cuban standards, Vesco’s lifestyle had taken a substantial turn for the worse. Most of the planes, boats and bodyguards were gone and, by the 1990s, Vesco was living in a modest house far from the beach, surviving on whatever deals he could cobble together – but perhaps part of this humility was just a front to please the communist Cubans.

Then, out of the blue, Don Nixon, Richard Nixon’s nephew, who had been Vesco’s gopher in Costa Rica, made contact. ‘Don Don’, as he is nicknamed, claimed to have found a miracle drug, Trioxidal, that had cured his wife of arthritis and cancer, and couldn’t get the backing of drug companies to conduct clinical trials in the US. Could Vesco help him arrange them to be done in Cuba? This was not a completely mad idea; under Castro, Cuba had during the 1980s put a lot of resources into trying to become a biotech powerhouse and the collapse of the USSR in 1991 only added to the economic incentives for making the Cuban industry work. Indeed, Cuba had even had some successes, for example the development of the first vaccine for meningitis B by Concepcion Campa Huergo, who first tested it on herself and her children.

Vesco and his hero-worshipping assistant ‘Don Don’, described by one commentator as having ‘the demeanor of a hyperactive teenager’, went into the drug development business in Cuba. It was not a success. In 1995 Vesco was arrested and put on trial on a range of charges that were eventually whittled down to fraud relating to Trioxidal. According to some reports, this was just an excuse – Vesco had broken too many rules during his time in Cuba, and the authorities had become tired of him. Another version has it that, following the end of the Cold War and the tidal wave of US businesspeople trying to do deals with Cuba, Castro no longer had any need of Vesco as a middleman, and Castro had never actually trusted him. Yet another alleges that Vesco was shopped to the Cuban authorities by a partner, Enrico Garzaroli, who had discovered Vesco did not have permission from the Cubans to operate. Whatever the truth of these stories, it is certain that Vesco was sentenced to 13 years in prison by a Cuban court in 1996; footage of his appearance in court shows a gaunt and haggard figure, a shadow of his former self. He was released in 2005 and died two years later of lung cancer.

Plus ça change …

We, the investing public, need to have confidence in the markets. If we are naïve, we may believe that all investment business is properly run all of the time. If we are hopelessly paranoiac, we may believe that all investment business is crooked all of the time. Neither of these extremes are true, of course, but the fact remains that the financial services industry attracts more than its share of amoral greedy people, in the same way that show business attracts a disproportionate number of inordinately vain people. Knowing that there will always be some crooks, we need investor protection and anti-fraud measures on top of the main burden of regulation, which is to maintain orderly markets.

The aim of this chapter has been to explore two cases of high-level financial chicanery during two distinct periods in the past, during which the investment environment was very different from what it is today, and to show how difficult it can be to prevent or rectify such issues.

During the M&A boom of the 1980s, people who were excited by the stock market wanted to believe that there was nothing wrong with leveraged buyouts (buying companies with debt secured on the target company’s own assets) even though wiser heads warned many of these companies might eventually collapse under the burden of excessive debt, as indeed eventually occurred. But stock market bulls (people who think prices are going to go up) were more interested in the purported brilliance of people like Michael Milken, who found a new way of financing these deals, of Ivan Boesky, who made money jumping in and out of the companies that were ‘in play’, and of Drexel Burnham Lambert, the investment bank that drove the M&A process in the 1980s. Milken was disgraced, probably justifiably; Ivan Boesky was fined and jailed, entirely justifiably as he had made much of his money by cheating through insider dealing; and Drexel was put out of business after pleading no contest to a range of stock manipulation charges. Dennis Levine was essentially a small fish practising a rather obvious form of cheating, as the other financial professionals who piggybacked on his transactions clearly recognised. It was not, in the 1980s, terribly brilliant for Levine to try to hide his transactions by putting them through foreign banks, because the very impetus that had created the environment for an M&A boom in the 1980s – financial de-regulation – also made it much harder for foreign banks to resist US pressure to reveal the identities of their clients. The US markets were where the action was and, from a foreign bank’s point of view, giving up one naughty client was preferable to being forced to withdraw from the US markets.

Banking secrecy, which these days is a busted flush, was much more of a reality in the 1960s and 1970s when the Cold War was in full swing, providing a strong demand for official and semi-official banking secrecy from both sides of the Iron Curtain. Bernie Cornfeld exploited this banking secrecy, and the fault lines between regulatory regimes in different countries. His firm, IOS, became a very large organisation, employing thousands of salespeople, and operating its own mutual funds as well as investing in funds owned by others. By the late 1960s it was heading for trouble as the stock markets started to drop after a long bull run. The mishandling of the money raised by an IOS public offering in Canada, driven by pressure from the sales force that had been given shares in the firm, led to cash shortages. The problems of an unorthodox commission system based on investment returns, rather than on the sums invested, were revealed by 1970, when it emerged that returns in 1969 had been much lower than predicted. IOS might have staggered on for years, but, as Richard M. Meyer, a mutual fund lawyer, has commented, Cornfeld ‘only looks good when you compare him to his successor, Robert Vesco. He championed taking a buck from anybody, without scruples.’

The extraordinary swoop on IOS made by Robert Vesco really was one of the major embezzlements of all time. It is unlikely that he could have done it today, at least in Europe or the US, given the better transparency, regulatory oversight and investor protection schemes that are now in place. It is difficult to see how Vesco thought he was going to get away with the scam unless one considers his age and personality. In 1971, the year he got control of IOS, he was only 35, a rip-roaring wheeler-dealer from a blue-collar background, on the make and in a hurry, running a ramshackle, debt-ridden conglomerate, ICC, by the seat of his pants.

Looting IOS might have been a great way to save ICC, but Vesco, according to the SEC, took a vast chunk of the money for himself. We don’t know his motives; given his amazing capacity for rapid, big-time deals, it may merely have been that he thought he would be able to wriggle out of any SEC investigation. His relationship with the Nixon administration is not well understood – the only things we know for certain are that he did make an improper contribution to the gloriously named CREEP (Campaign to Re-elect the President), and he employed Nixon’s nephew. A 1972 story in the Washington Post claimed that a key Nixon aide, John Erlichman, had warned ‘Don Don’ at length not to do anything to embarrass the President when he went to work for Vesco. A number of CIA memos from 1973 refer to a ‘Research Project on Robert L. Vesco’ and show an interest in IOS. It is possible that the connection is rather less sinister than meets the eye: what may have seemed to be a definite bribe to Vesco may have seemed to the Nixon team to be only a vague promise to see if anything could be done about Vesco’s situation as an important international businessman with a little legal difficulty back home. Vesco was not politically sophisticated, as his subsequent relationships with Latin American politicians were to show.

In the next chapter we will look in detail at two types of fraud that you are likely to encounter as an investor: Ponzi schemes and Pump and Dump operations.