Insider Trading : Wall Street Discipline Under Fire
Even today, after six years of court proceedings, people wonder how Dennis E. Greenman managed to pull off one of the largest investment frauds in history under the noses of his superiors at three major Wall Street firms.
At each one--Merrill Lynch, Paine Webber and A. G. Becker--Greenman rose rapidly to become a star stockbroker. What his superiors at the firms did not know, but government regulators say they should have been able to detect routinely, was that Greenman was operating a massive con game based on trading in stock options.
By the time he was exposed, almost by chance during an unrelated FBI investigation of organized crime in 1981, Greenman had taken about 400 investors in South Florida--including a branch of the Boy Scouts of America, several churches and many prominent individuals--for nearly $100 million.
Paine Webber’s View
Genius, master forger, supreme con artist: That is the picture of Dennis Greenman that emerged from his employers’ defenses against the scores of lawsuits that were filed against them. Paine Webber, the firm where Greenman’s scheme matured, maintains that he was so devious that he could outsmart even the most sophisticated internal controls.
The Securities and Exchange Commission disagrees. In proceedings that led to severe disciplinary actions against two of his supervisors, the agency said that Greenman left a trail that his supervisors simply ignored. It pointed to many customer accounts with identical addresses, some of them at post-office boxes, to a series of customer complaints and to reports that his sales presentations claimed preposterously high returns on investments.
Implicit in the SEC’s charges, as well as in the score of customer lawsuits over the affair, is an important question: If the Wall Street firms could not catch Dennis Greenman, whom can they catch?
Under Greater Scrutiny
The securities industry’s system of in-house surveillance and discipline, known generally as compliance, has never been under as much scrutiny as it is today.
Under the securities regulations established by Congress in the mid-1930s, the SEC and the stock exchange require investment firms to supervise their employees closely and to respond decisively to customer complaints and other signs of wrongdoing, but the system is pockmarked with countless conflicts of interest and other shortcomings.
Those shortcomings have perhaps never been as obvious as they are now. The parade of top Wall Street executives being marched through federal courtrooms on insider-trading charges has raised serious questions about the securities firms’ ability and willingness to monitor their own employees’ activities adequately .
Regulators, private attorneys, and investment executives (many of whom agreed to be interviewed on condition of anonymity) say that although the technology for in-house compliance investigations--including computers that can sound the alert on suspicious trading activity--has improved rapidly, the temptations that employees face have multiplied faster.
Not only does the superheated mergers-and-acquisitions market offer the chance to make millions of dollars in profits from a single illicit transaction, the unprecedented complexity of the markets gives unscrupulous brokers, traders and investment bankers the opportunity to commit crimes in nearly undetectable ways.
“As the industry’s expanded, with more customers, more products, more strategies,” said one prominent regulator, “that’s placed a greater burden on compliance departments, and in some ways, an excessive burden.”
Once used chiefly to monitor contacts between retail brokers and their individual clients, compliance systems at large, multiple-services firms now cover a variety of businesses that tax the comprehension even of some participants, let alone enforcement personnel.
“All the systems fall short of perfection,” said O. Ray Vass, compliance director at Merrill Lynch & Co., which last week fired its London chief of mergers and acquisitions for alleged insider trading for two years. The nominal secrecy of merger negotiations, for example, works against compliance officers. “You don’t always know what the investment banking department knows, so you may not even be able to recognize (suspicious trading activity).”
Foreign Markets Used
Lawbreakers can now use the international trading markets to disguise their transactions and, in effect, hide them from surveillance.
Without subpoena power or the ability to monitor employee trading that takes place off their premises, securities firms say, their ability to unearth illicit trading is limited.
Few regulators, for example, fault any of the three Wall Street firms that employed Dennis B. Levine for failing to notice for five years that he was building a $12-million nest egg by taking advantage of inside information: Levine did all of his illegal trading through offshore bank accounts opened under pseudonyms, and often used pay telephones for delicate conversations.
“If people are running around the world with suitcases full of cash, it’s hard to see how an in-house surveillance program will pick that up,” said former SEC Commissioner Roberta Karmel, now a private attorney and a member of a New York Stock Exchange panel that is reviewing regulatory issues.
Said the general counsel to one major firm that prides itself on strict compliance procedures but has faced SEC charges over at least one embarrassing breach of its own rules: “I’d never bet my life that I’ve insured the firm against all violations.”
Yet regulators and lawmakers alike have faulted the firms for not exercising all the powers they do have, a failure they say has allowed a freewheeling atmosphere to thrive on Wall Street.
Warning on Discipline
In a speech March 3, Rep. John D. Dingell (D.-Mich.), one of the industry’s congressional overseers, upbraided a group of securities executives for lax supervision. “If you don’t immediately set to putting your houses in order, it will be done for and to you,” he said.
The New York Stock Exchange, to which the federal rules assign extensive supervisory responsibilities, also reacted like a stern mother lecturing wayward children to the insider-trading arrests last month of three top securities traders from the firms of Kidder, Peabody & Co. and Goldman, Sachs & Co.
In a special bulletin, the Big Board ordered its member firms to improve their compliance procedures. The firms were told they must certify quarterly that all their employees’ trading has been scrutinized for wrongdoing, must report all customer complaint letters and report to the exchange annually all compliance problems and their resolutions. The exchange is also developing a qualifying examination for compliance directors, and has said it will fine any firm that does not respond promptly to its requests for information in disciplinary cases.
Still, it is a rare Wall Street firm where a compliance official’s word is law, particularly when the subject of an investigation is in a high position or a “top producer,” a broker earning exceptionally high commissions.
“Big producers do get more chances,” said the compliance director at one leading firm. “I used to think they didn’t, but that was before I’d been beaten up as many times as I have been over the issue.”
Some Alarms Ignored
Others say that the informal information network among compliance officials often identifies troublesome individuals who are moving from firm to firm, but such intelligence is often disregarded by brokerage executives thirsting after a top producer.
“I’ve heard the most cockamamie excuses for hiring some people,” said one official. “The production executives will say someone just had a ‘personality problem’ with his former boss, for example. Often a sales manager thinks he can better supervise someone who’s had a problem at another firm.”
In fact, some of the most conspicuous compliance breakdowns have involved so-called big producers. In one case, a fine detective job by a firm’s compliance staff apparently was undermined by superiors’ kid-gloves treatment of Peter Brant, a Kidder, Peabody & Co. broker who in 1983 entered into an illicit information-sharing arrangement with R. Foster Winans, columnist for the Wall Street Journal.
Brant later pleaded guilty to fraud charges. Winans was tried and found guilty; his conviction of securities fraud has been appealed to the U.S. Supreme Court.
Brant was Kidder, Peabody’s top broker in 1983, when he racked up $1.8 million in commissions. Toward the end of that year, the firm’s compliance department noticed that Brant’s--and Kidder’s--biggest retail brokerage customer had been profiting consistently from trading in stocks one day before they were mentioned in the newspaper’s daily “Heard on the Street” column of market gossip and analysis. In fact, Winans was sharing the column’s contents with Brant, who was tipping his client.
Client Switched Brokers
Kidder’s general counsel, Robert A. Krantz Jr., later testified that he visited the client, an attorney named David W. C. Clark, to ask him the source of his trading information. Somewhat to Krantz’s consternation, Clark told him he would simply take his business--worth $100,000 a month to Brant--elsewhere.
That day, Krantz went to visit Brant, but did not ask him whether he knew the source of Clark’s information or if he had participated in the trading himself. Instead, he explained his visit as “a little bit of handholding,” to commiserate with Brant for having provoked his best customer to leave the firm.
At one point, Brant asked whether Krantz saw any reason to report the suspicious trading to the SEC.
“I said no, I did not, on the basis of what we saw,” Krantz testified. “I didn’t see any basis for reporting anything to the SEC at that point.”
Krantz had already received a memo from Kidder’s outside law firm, Sullivan & Cromwell, saying that any trading linked to the Wall Street Journal column was probably illegal, but he testified that he did not tell Brant of the memo’s conclusion.
Dennis Greenman’s victims contended in court that Greenman’s status as a top salesman at the firms of Merrill Lynch, Paine Webber and A. G. Becker contributed to their failure to cut short his fraudulent activities. Evidence in the case suggests that Greenman developed his scheme while at Merrill Lynch, but undertook most of the illegal activities while at Paine Webber and an independent investment firm associated with Becker that has since been dissolved.
Settlement Is Challenged
Greenman, now reportedly selling computer software in South Florida, could not be reached for comment. Ultimately, Merrill Lynch, Paine Webber, and Becker participated in a $23-million, class-action settlement with his victims. Some investors are challenging that settlement in federal appeals court in Atlanta.
Greenman’s scheme involved what was pitched as a sophisticated options-trading system. Investors were advised that it was best they keep their participation secret even from their lawyers and accountants, lest word spread and rival traders enter the market to throw off the program’s painstaking calculations.
“He’s a very bright fellow,” said Hugo Black Jr., a Miami attorney who supervised numerous consolidated lawsuits against Greenman. “He looks like a nerd, comes across as very credible. He went to jail and was a model prisoner, first chance of parole he got out . . . He’s still wandering around South Florida while most of his customers are waiting to get their money back.”
Investigators found that Greenman’s system was a type of Ponzi scheme, in which early investors are paid out of the contributions of later investors.
Greenman was investing some of the money in options, but he was taking tremendous losses. Toward the end of the scheme, when Greenman was trading through Becker, his options volume was so large that traders on the Chicago Board Options Exchange openly called his floor broker “Jaws.”
Unanswered Question
Whether that should have alerted Becker executives to something gone awry in Greenman’s program is one question that may never be answered, since the tentative settlement has put an end to court-supervised fact-finding.
Lawyers for the plaintiffs say that they were prepared to show that Paine Webber had grown so suspicious of Greenman that it was about to fire him when he quit in 1980 to form a private firm and do business through Becker.
“We alleged that he flew the coop just before Paine Webber was going to chop his head off,” said Black, receiver for the investment firm through which Greenman was associated with Becker. “Circumstantial evidence pointed to the fact that Paine Webber had knowledge.”
Paine Webber denies that. It says that Greenman was negotiating to leave the firm for almost a year before his departure in May, 1980. Paine Webber insists, instead, that Greenman’s smoke screen was so sophisticated that no one got suspicious.
“Greenman was a genius,” said one Paine Webber attorney. “Put a piece of paper in front of him and he’d forge a signature on it. What he did was extraordinarily difficult to pick up.” The firm contended that on one or two occasions when superiors did question the trading in one of his accounts, Greenman glibly diverted their suspicions.
‘Well Nigh Perfect’
“Usually, when you’re dealing with a bad (salesman), he’ll screw up some trading,” said the firm’s lawyer, “but Greenman did all that well nigh perfectly.”
The SEC, in administrative proceedings against Philip Huber, Greenman’s immediate supervisor at Paine Webber, and Robert D. Punch, his regional manager, charged that the supervisors ignored opportunities to follow up on several customer complaints about losses. Other informants had told the firm that Greenman was making preposterous claims for his program.
In the end, the SEC permanently barred Huber from holding any supervisory job in the securities industry, and suspended Punch from supervisory jobs for six months. Administrative proceedings against a third Paine Webber supervisor are still in progress, the SEC says.
The commission’s dual role, as both top cop and overseer of Wall Street compliance departments, creates some conflicts in supervision, officials say. In fact, the relationships among the SEC, the stock exchanges and the brokerage firms create a mix of incentives and disincentives for thorough internal probing.
Perhaps the chief incentive is that a vigorous compliance effort will help dissuade the SEC from bringing civil charges against a firm when one or more of its employees are violating the rules. In such cases, the SEC can take one of three steps: It can absolve the firm of responsibility and charge only the employees; it can charge the firm with “failure to supervise” its workers, a relatively mild sanction carrying a modest fine; or it can charge the firm with substantive violations of the law. The third action can expose a firm to costly litigation and high damage claims.
Fewer Firms Prosecuted
In recent years, however, the SEC has been less willing to bring substantive charges against firms for the misconduct of employees. One reason is a recognition that companies with perhaps tens of thousands of employees cannot be expected to catch everything. Another is the difficulty of making such charges stick.
Just last month, a federal court jury in Philadelphia acquitted Shearson Lehman Bros., a unit of American Express Co., of complicity in a money-laundering scheme operated by workers in its branch in that city. The other defendants, including two Shearson employees, were convicted.
On the other hand, thorough internal investigations have a way of producing documentary evidence that regulators or plaintiffs could use in civil suits against a firm, and that possibility serves as a disincentive for firms to investigate misconduct in any formal way.
“Firms have become very defensive with the regulators,” said one regulatory official, “because lurking in the background is all this litigation. They’ve devoted more of their energy to anticipating lawsuits than to ongoing programs to anticipate problems.”
The securities industry and the SEC, in fact, have engaged in a long tug-of-war over how much internal documentation can be withheld from authorities.
Dispute Over Evidence
“There have in the past been questions about internal reports,” said Dennis Shea, the SEC’s assistant director of market regulation. “We’ve consistently believed that we ought to have access to them, and generally, we get it.”
“That’s a Catch-22,” said Theodore A. Levine, a former associate SEC enforcement director who now represents many brokerages as a private attorney. “There ought to be a qualified privilege for self-evaluation material” to allow some of it to be withheld, he says.
Otherwise, he said, firms may operate their compliance departments so as to protect themselves from litigation, and the result could be much less disciplined supervision of workers. Some firms might deal with employees orally rather than in writing, for instance, and this would undermine any attempt to foster an unambiguous atmosphere of supervision.
Regulators and securities executives believe that this year’s rash of insider-trading cases will lead to major changes in the compliance responsibilities of the firms, the exchanges and the SEC, perhaps with more pressure to monitor the industry imposed on the SEC and exchanges. Even now, the New York Stock Exchange and other markets, equipped with sophisticated programs to identify unusual trading practices, provide the SEC with the initial evidence on many major insider cases.
The stock exchanges are concerned, however, that these supervisory responsibilities may be incompatible with a world in which they compete with each other for the business of the very firms they may be penalizing.
So far, the exchanges say, they are still tightening up on supervision of securities firms. The New York Stock Exchange, for example, recently fined Kidder, Peabody $300,000, one of its largest fines in history, for years of lax customer-account supervision. Among other things, the firm was charged with using customer securities as collateral for its own borrowings.
In that case, the Big Board took the unusual step of charging two top executives with contributing to the violations. They were John T. Roche, chief operating officer of the 120-year-old firm, and Gerard A. Miller, a former director of operations. Both men were fined $25,000; Roche was censured and Miller was barred for six months from holding a supervisory position at any NYSE member firm.
