Selling America Short

And, of course, long before the events of these last turbulent years led many to question whether the stock market is at bottom a huge confidence game that can collapse as abruptly as a carnival tent in a windstorm.

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also gave me insomnia and migraines and a reluctance to believe any opinion on American business and its regulation that has taken on the color of consensus.

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Or engaged in some category of conduct denounced in a recent speech by an agency notable. Or stupidly admitted his transgressions before retaining counsel. Then it takes more work.

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A short sale is a bet that a stock will decline because of negative facts not yet apparent to the market. Management is making up the numbers. Or the company’s key product is a passing fad. Or its business sector is due for a fall. Soon others will see this and the stock will tumble.

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don’t. A worm’s-eye view into the follies of the American financial behemoth as it marches boldly from crisis to crisis. The perennial frauds reborn for each generation, changing only in outward appearance over time. And the fables we are told to make us believe the dislocations and disruptions, from the most minor to the catastrophic, are in every case the fault of others—never ourselves and those we choose to lead us—and will not happen again.

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The issue was resolved by drawing constrictive lines around the rules that were enforced, buttressed by onerous procedu ral hurdles to frustrate any potential deviation from accepted practice, no matter how slight. In this, it was not unique among government agencies.

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Economists are like accountants, only more so. They do not count beans so much as argue over whether the beans exist and, if so, which among them deserve to be counted.

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It has been suggested that, during this period, the FTC could see no harm to the American public in any practice not involving actual gunplay.

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But there is a fine line between not doing anything and not accomplishing anything. In government, the former is sternly frowned upon, but the latter not so much.

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Typical of these scams was a Venice, California, operation that pumped out mailers promising the recipient “a four-person outboard motor boat” in return for participating in a market survey. The boat, constructed of “pneumatically pressurized compartments,” was described as “suitable for ocean fishing.” Those who called to claim their prize were told yes, the boat was theirs. There was, however, the small matter of a $300 fee to cover incidental expenses: taxes, the cost to ship the boat “by commercial carrier,” and charges for “transfer of title.”

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Judges were usually accommodating in this way—as I discovered after similar experiences in courtrooms across the country—especially once they recognized the defendants’ social stratum (white trash) and the consequent near-certainty that no one would challenge the orders. The company was located a few blocks off Venice Beach. The building, when I found it, looked abandoned: paint peeling from salt breeze and sun, screens torn, litter decomposing in the alcove beside the entrance. But the sign on the door for American Nautical Adventures looked new and, inside, the place was jumping. Rows of young men in T-shirts and cut-offs slouched in surplused office chairs, each with a telephone cradled between shoulder and ear as he earned his rent.

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He had answers for everything. The phrase “pneumatically pressurized” meant you had to blow the thing up. What else? And what he sought to convey by the phrase “the costs of transferring title” was, well, what you paid for the boat. The “commercial carrier” that tossed the boat onto your doorstep in its little plastic bag was the very reputable United Parcel Service. And it was also nothing less than the truth that the company was conducting a market survey. That is, it was a survey to determine if people would be more willing to buy a boat if told it was being offered as part of a market survey than if someone just called them up and asked if they wanted to buy an inflatable boat.

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October 19, 1987, is remembered on Wall Street as Black Monday. The New York Stock Exchange fell over 22 percent, the biggest one-day drop in its history. Other countries’ exchanges also took a beating in a worldwide contagion of panic selling. Sales orders came in such torrents that the NYSE’s order entry system was overwhelmed and the tape reflected prices from some uncertain point in recent history. For one day, everything was broken.

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Program trading is exactly what it sounds like: feeding buy and sell orders into a computer to be executed when portfolio positions hit specified price points. Although a helpful tool in managing a fund with numerous positions, its role in the 1987 crash has been portrayed as much like that of the evil computers in the Terminator movies. Take a long weekend in the Hamptons and what happens? Artificial intelligence takes over from the human variety and goes haywire. You return to your office to find a smoking ruin.

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Portfolio insurance was one of those something-for-nothing schemes peddled by Wall Street technocrats that work wonderfully … until they don’t. The idea was to build into money management a one-way ratchet that would limit potential losses without similarly reducing potential gains. The appeal was obvious: Heads I win, tails I don’t lose much. Portfolio insurance came in different flavors. The most straightforward involved simply going to cash should the investor’s positions decline to hit its predetermined loss tolerance and, conversely, moving increasingly from cash to equities as prices rose. Other varieties directed that the investor respond to market declines by writing futures contracts on the Standard & Poor 500 index. The cash received for selling the S&P futures would supposedly offset losses to the firm’s equity positions. Should the market go up, on the other hand, the cost of honoring the futures contracts would in theory be more than offset by portfolio gains.

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What these investors did not consider, however, was the systemic risk that occurs when many investors respond to a certain set of circumstances by doing the same thing at the same time.

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Portfolio insurance—a “trend-following dynamic hedge”—res ponds to changes in portfolio value by trading in the same direction as the market. In a rising market, this means adding to the upward mo mentum, perhaps helping to inflate a bubble. In a falling market, such as that occurring in mid-October 1987, it means dumping equities.

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As Nobel laureate William Sharpe put it, “We learned in the 1987 market crash that if everyone wants the upside and no one wants the downside, then everyone can’t get it.” Under the versions of portfolio

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The following day, the Federal Reserve Board (under its new chair man, Alan Greenspan) turned on the liquidity spigot and the market reversed course and began a lengthy recovery. Thereafter it became an item of faith that the Fed would come to the rescue to halt major mar ket declines. This faith and the Fed’s dutiful attempts to justify it are suspected by those sensitive to concerns of “moral hazard” to have en couraged a culture of indifference to some forms of financial risk, the painful consequences of which are very much with us today.

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The regulators responded to the October 1987 market break by dealing with the mechanical side of the problem, providing “circuit breakers” to halt trading during rapid market drops and measures to handle spikes in trading volume. There was no serious attempt to come to grips with the bigger issue: the destabilizing effects of widespread adoption of new investment techniques.

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common theme in each case has been the systemic risk presented by financial innovation. These unruly creatures have included the highly leveraged hedge fund and various new forms of derivates, including complex asset-backed products and credit default swaps. First out of the pen, however, was a simpler financial beast—the junk bond.

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And the dark wizard most responsible for loosing these financial demons upon the land was a balding introvert from Encino, California: Michael Milken. If not a straight-up criminal like master pyramid-builder Bernie Madoff, he nevertheless played the capital markets and their regulations like a pinball machine, with the Tilt function disconnected.

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First among these was the perception that the risks and rewards of own ing low-grade corporate debt become more predictable when spread across a number of different bonds. This was nothing more than ba sic portfolio theory applied to junk bonds. A similar insight—however misapplied—lies behind the recent boom and bust in subprime mort gage loans. It was contended by various academics that the average risk- adjusted return on “high-yield” corporate debt was disproportionate to that of other asset categories. Buyers were scarce, however, because of the serious likelihood of default—and the lack of reliable information—on individual bonds. Milken perceived there was money to be made in packaging these assets in a way that fit within the risk tolerance of major financial institutions and other potential buyers—or at least seemed to do so after the application of Milken salesmanship.

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It also trafficked in management-led leveraged buy-outs that bled to death target companies by draining off cash to pay for their own acquisition. In theory, the cor porate takeover provides a means of giving the shove to entrenched and complacent management. In practice, it has often eroded shareholder value through the short-sighted cashing in of assets to service debt or turn a quick profit, and was attended by job losses and other social costs. Here the “creative destruction” of capitalism had nothing creative about

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Milken’s influence grew until he dominated every facet of the junk bond market. This allowed him to control both supply and demand in particular issues, and thus their prices. The result was an increasingly artificial market. His ministrations imparted an inflated value to many of the bonds he bought, sold, brokered, and underwrote that could not be sustained forever.

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That was to be expected. The ideal enforcement attorney combines the expertise of a seasoned litigator with that of a law professor, a forensic accountant, and a Wall Street trader. No such animal exists and, if it did, would not work for what the government can pay. So the SEC takes what it can get. In most cases, happily, this is a reasonably talented and motivated young attorney who in time gets more things right than wrong.

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As for spotting the next big problem before it results in headlines and red-faced congressmen, the record of the other divisions disappoints. The Division of Corporation Finance, which scrutinizes corporate fil-ings, famously passed on reviewing Enron’s filings because they were so long. It was much easier to meet the quota by reading only short filings. The Division of Investment Management failed for years to notice that some mutual fund complexes allowed select investors to “market time” their funds. Being able to skip in and out of funds in response to arbitrage opportunities, while mom-and-pop investors were in for the long haul, provided easy profits to the favored few. The discovery in 2003—by New York Attorney General and soon-to-be tabloid star Eliot Spitzer—that

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although that exists in abundance. SEC attorneys handle information that can move stocks. Not as often as the public believes, but now and then. A small indiscretion to an outsider can have serious consequences. Fear of such incidents is one reason that SEC attorneys often travel in groups, like nuns.

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happens, furthermore, that people with an interest in an investigation will try to lead the staff in a direction beneficial to themselves, and not always honestly. When it comes to tips from outsiders, SEC attorneys are taught to mistrust anyone who might have an interest in steering them wrong. But who in his right mind would go near a government agency except out of self-interest? Whether motivated by a desire to make a buck, get even with a hated former employer, or validate a theory of extraterrestrial infiltration of the capital markets, everyone who approaches the SEC has an ax to grind.

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The SEC dealt with the matter programmatically. It demanded all the major players sign orders—generated by the staff in assembly-line fashion—pledging never to do again what many insisted they had never done before. So much for

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They knew things. They not only understood business dynamics but were decent lay accountants, with a nose for when something made so little economic sense that it might even violate the accounting rules. The result was the sort of field intelligence that the government rarely generates for itself.

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Over time, this has been the predictable outcome of short-seller investigations. It is unlikely any other type of case has proved so consistently unrewarding, while a surprising number of companies known for complaining about short-sellers later blew up from financial scandal. Nevertheless, allegations of short-seller conspiracy retain their power to beguile. The story is so compelling that the agency seems unable to resist. Like Charlie Brown with Lucy and the football, it always believes that next time will be the charm. Next time the shorts will be caught at their nefarious game.

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had some background in asset valuation, but no understanding of the multitudinous dodges, grifts, evasions, scams, contrivances, and studly frauds practiced to improve a company’s paper performance. HealthCare Services went a distance toward remedying that deficiency in my education.

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It makes sense that most accounting frauds involve bogus revenue. Phony sales filter down through corporate income statements to inflate other critical metrics, including operating income, net income, and earnings per share.

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This served to double its income for the period preceding the offering. It also violated a basic accounting rule that companies can’t realize profits from transactions in their own stock.

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By inflating the charges for the equipment—which, if legitimate, could be booked up front—and reducing those for services by the same amounts, the company fast-forwarded revenue at no additional cost to its customers. Various software companies have run a similar scam by combining a sale of software with a contract for consulting and other services, and misallocated costs to favor the sale over the service component. HealthCare did it with mops, pails, and washing machines.

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Another was at the end of an unpaved road in rural Georgia. After this investigation, I asked my wife, should it ever appear I needed to be placed in a nursing home, to please shoot me instead.

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Nothing in the accounting rules says you can’t provide cash inducements to customers, so long as you don’t call them something they aren’t. Yet few companies include in their financial statements a line-item for “bribes, pay-offs, and kickbacks.” HealthCare did not disclose these payments.

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The FBI agent it assigned was alarmingly well-armed at all times—even when questioning witnesses in a high-security federal building. That may have been strategic. White-collar types who shrug off SEC penalties as a cost of doing business experience bowel-loosening terror at the thought of criminal charges. A holstered automatic is a reminder of how much worse things can get.

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complained that placing witnesses under oath merely focused their attention on the importance of lying well, he advised me that “bullshitting the SEC is the most popular indoor sport in this country.” He discounted, also, the odds that the Medicare case would pan out. The term “Medicare fraud,” he said, was redundant, and the regulations rarely enforced.

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looked at that as a pretty fair accomplishment for my first real case for the SEC. The Bartons, however, were of a different mind. The company was still in existence and its officers not in jail. What sort of bang for the taxpayers’ buck was that? Pathetic!

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Short-sellers, as a group, have approximately the same willingness to forgive and forget as the Almighty in the Old Testament. The wages of financial sin, in their view, should include, at the very least, the career death that comes of banishment from the industry. Also, penury would be good: all assets seized and auctioned in the public square.

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If this seems harsh, consider. The Bartons have long since given up shorting stocks, finding it too punishing a way to make a living. Many other short funds have thrown in the towel for a variety of reasons. Some come quickly to mind: Corporate disclosure failures that continue for years, blatant pump-and-dump schemes ignored by regulators, manipulative trading by company insiders and cronies, institutional analysts pimping for investment banking business for their firms with bogus “buy” ratings—not to mention companies that use lawsuits and smear campaigns to play whack-a-mole with their critics.

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Add all these together and it should be clear why short-sellers may grow a tad vindictive.

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This was a lesson in itself. Most of what happens in the market is a puzzlement even (or perhaps particularly) to the people who regulate it. From its deep waters, things now and then float to the surface that can be identified as requiring a certain treatment under the law. Other pieces of market flotsam, when seen, are harder to classify. But what lies beneath the surface for the most part remains unknown.

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To belabor this metaphor, the financial regulators stand in the shallows and peer into the depths, wondering what they may contain. Little comes of this. From time to time, however, someone comes along who, in a remarkable gesture, hauls forth from below a grand curiosity and drops it on the shore at their feet. Such people are rare but useful indeed.

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Marc Cohodes was a different breed altogether. Raised by a single mother in Chicago, he was a beefy guy in his 40s who bore a passing resemblance to the actor John Goodman. His wardrobe favored Bermuda shorts and well-seasoned T-shirts. He would later become an early adopter of Crocks footwear in a rainbow of colors. His tonsorial upkeep consisted of running an electric clipper set at “fuzz” around the circumference of his head. He loved the Oakland Raiders, stock car racing, and the R&B band Southside Johnny and the Asbury Jukes. A diehard fan, he hit more Southside Johnny concerts than anyone except the man himself. While Rocker could be intense and outspoken, he was a conventional money manager next to Cohodes, with his disarming candor and high-octane mouthiness.

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The investment model for Rocker Partners was expressed in the motto “frauds, fads, and failures.” The three Fs. The idea was to buck the giddy bullishness rampant in the market by shorting companies so utterly porcine no amount of hype could long delay their dates with insolvency. This was no easy task. In those years, before the tech-bubble burst and the NASDAQ shed 80 percent of its value, no one remembered the market had a reverse gear. People still believed sell-side analysts truly loved every profitless dog they hyped.

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Rocker was known for asking blunt questions in conference calls. Cohodes, in one legendary episode, appeared at a shareholder meeting in a striped referee shirt and, after every management statement he deemed misleading, blew a whistle and threw a red penalty flag. More than money managers chasing profit, they, like other short-sellers, saw themselves as stock-market vigilantes out for truth and justice. As the Financial Times put it: “for a group that is supposed to be composed of deeply cynical, self-serving, sharp calculators, short-sellers tend, in their eccentric way, to be the most idealistic class of portfolio managers. They take corporate malfeasance and incompetence personally.”

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all. I had learned years before that self-interest did not preclude good research. To the contrary, the one often led to the other. Cohodes was a guided missile directed at the Belgian software company Lernout & Hauspie. It was, he assured me, the fraud of the century, a “dastardly,” “despicable,” and “demonic” operation run by evil Eurocrooks. He was convinced the company’s numbers were phony “beyond belief.” His descriptive efforts started at the

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Cohodes had stumbled onto Lernout by chance. His son Max was born with cerebral palsy and Cohodes was always looking for new technology that might help Max cope with the challenges of his disability. Voice recognition had obvious potential. When he heard about Lernout’s products, he hustled to check them out. He went to trade shows, read industry publications and bought whatever was on the market. He was not impressed. The technology didn’t perform and he suspected the company’s public demonstrations were rigged. That led him to question the company’s claims more broadly.

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As a foreign company with a U.S. listed stock, Lernout was subject to relatively loose reporting standards. Its annual reports, for example, were not due until six months after its fiscal year-end and omitted information that is required of U.S. companies. We allow foreign companies to file stale and incomplete information because otherwise they might not grace our markets with their securities, depriving the NYSE of a revenue source, and denying our investors the opportunity to make ill-informed investments in companies they probably can’t sue if things go wrong.

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Lernout was a serial acquirer of other companies. Acquisitions are a fertile ground for abuse because the accounting rules are squishy, making it possible for management to stash bloated reserves (booked as liabilities), which can later be reversed and bled back into income as needed. Roll-ups of software companies present additional temptations to earnings chefs because the assets acquired are mostly intangible and their value subjective. On top of this, a big chunk of the Lernout’s sales came from related parties, specifically private companies it helped finance. This gave rise to the suspicion Lernout was buying product from itself through circular transactions, or parking product with compliant third parties.

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short position in Lernout and he resented the buoyancy of its share price. From early 1999 to March 2000, it went from a few bucks to $65. This was a short-seller’s worst nightmare. While a long buy can never result in more than a 100 percent loss (should the stock go to $0), losses on a short position are theoretically infinite. A short that goes on a wild run can turn into a black hole sucking down the fund’s assets to meet escalating collateral calls. Which was not my problem.

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There are some countries whose regulators are suf ficiently tight with the SEC that they will provide assistance without a lot of red tape. Others require a request under a treaty (approved by the U.S. Senate) before handing over anything to a foreign government. International treaties often address criminal violations exclusively and are therefore useless to the SEC, a civil agency, unless someone at the De partment of Justice can be persuaded to take an interest, real or feigned. Finally there are countries that will provide information to U.S. law enforcement at about the time that curling becomes the official sport in hell. Some are fraud havens whose economies are based on hiding assets for crooks and tax cheats. I was also cautioned that, merely by calling into some countries without permission, I, as a government official, could face criminal charges should I thereafter be caught within their borders. France was a case in point.

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The company took the familiar hedgehog approach. Its lawyers did what securities defense lawyers do best: stall and evade. When we asked for documents, we were told the amount requested was unmanageably large. When we asked about specific transactions, we were told that would violate confidentiality agreements with customers. To increase our leverage, we obtained authority from the commission to issue subpoenas. Because Lernout had a U.S. office, we could serve it without going through an international treaty. Its lawyers said they would start looking and keep us informed of their progress.

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The company’s auditors were also no help. KPMG Belgium flatly refused our request for their work-papers (the files auditors must keep to prove they really did an audit), citing Belgian client-confidentiality laws. In the United States, auditors are prohibited from releasing client files without a subpoena or the consent of the client. We badgered Lernout management into providing a letter of consent. KPMG Belgium, however, claimed that wasn’t enough to protect it from liability. Someone else might decide to sue them. A customer perhaps. We asked a Belgian law firm for its opinion and were told the law was unclear. I would eventually form the opinion that all Belgian law is unclear and therefore there is little to be gained from hiring local attorneys. Subpoenas made no difference. KPMG, like other international accounting firms, is legally compartmentalized on a national basis, like fifteenth-century Medici banks. We were told there was no formal legal relationship between KPMG Belgium and other national offices, including the U.S. operation. That they share the designation “KPMG” is little more than coincidence. Try to get documents from KPMG Belgium by serving a subpoena on anything in the United States—other than a partner on a family vacation at Disney World—and prepare for a lecture on the sheer ignorance behind such a wildly ill-considered and legally inappropriate action.

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The auditors were lied to or at least given faulty information. Management, also scambling to get a grip on things, will of course claim that the problems were so the auditors’ fault or, failing that, the fault of previous management or, failing that, the fault of lower management.

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This situation is pure joy if you’re a government investigator. Everyone fingers everyone else in individualized variations on the SODDI defense (“some other dude did it”) and you get a good idea of the story early on. This allows you to guide the investigation without false starts and wasted effort and puts important witnesses in the bag.

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This meant Lernout no longer qualified for the relatively lax disclosure standards otherwise applied to foreign companies, and had to comply with the same rules as U.S. companies. When, in June 2000, Lernout filed reports under the more exacting standards, it disclosed for the first time the geographic distribution of its sales. And the house of cards that was Lernout & Hauspie began to tremble.

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It mattered because these figures defied common sense. It was not plausible South Korea could gobble up as much of the company’s speech-recognition software as the entire rest of the planet. What’s more, a huge percentage of the company’s sales from the previous year had come from Singapore. This, too, made little sense.

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The stock dropped precipitately with the article’s publication, wiping $1 billion from Lernout’s market cap.

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That prospect, however, vanished in early November when the company announced it would amend its financial statements for the previous two and one-half years to fix “errors and irregularities.” This is accountant-speak for “okay, yes, the books are cooked.” There was no longer any doubt Lernout & Hauspie was in trouble. The question was whether it was a real company that had done some bad things or a complete fraud destined to vanish under a scrim of lawsuits.

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This profoundly unsatisfying answer was to receive no elaboration from Joo. His interview with Duerden ended in melodrama when three men stormed into the room, yelling and gesticulating wildly. They grabbed the struggling Joo and frog-marched him into an adjacent office. From the shouts and bangs that came through the wall, Duerden concluded Joo was being soundly thrashed by the intruders. Finding himself an unwilling character in an Eric Ambler novel, he paused only long enough to urge other employees to call the police before he scampered for the airport.

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By the end of 2000, Lernout was in bankruptcy in the United States and Belgium, its share price had fallen by 99 percent, Mssr. Hauspie was hospitalized for depression, and the Belgian authorities had announced a criminal investigation. Unfamiliar with the Belgian justice system, I called the U.S. Embassy in Brussels and spoke with its legal attaché, a friendly FBI agent. I asked which of the various Belgian law enforcement agencies was involved. As near as she could tell, she said, it was all of them. This was the biggest scandal to hit Belgium since King Leopold’s misadventures in the Congo. Everyone wanted a piece of

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The “legat” set me straight. She said the last big Belgian financial fraud was 10 years ago and was still nowhere near trial. Something involving a carpet company. The Belgian government, she said, is completely incompetent. The Belgians will admit this when drunk. Many want to go to America, where things work most of the time. Of course, they hate us too. What do you expect from a country whose only major artist was a surrealist? And as for expecting any help from the authorities—ha!—they don’t even know how to help themselves.

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The same goes for government investigators. They have to start somewhere. Nothing comes from nothing. No one finds anything from cold readings of SEC filings, which amount to millions of pages a year. Without leads from outside the bureaucracy, ignorance reigns. So the door is left open to the plaints of disgruntled employees, pissed-off investors and repentant corporate stooges. Even short-sellers. Much of what rolls in is junk. But ignore the lot and you also miss out on the occasional rare find that elevates the job beyond routine into an adventure charged with a genuine sense of purpose.

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When Rich hurt his foot in a skiing accident, he milked the situation to wear sandals and Bermuda shorts around the office for a good six months, much to the chagrin of elements in the Division’s front office. I let him get away with stuff for the simple reason that, like everyone else outside uber-management, I liked Rich. Plus he accomplished things. He was smart, energetic, funny, and fearless. He would go up against anyone, including his supervisors, and generally prevail.

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Okay, good. That sounds plausible. And the guy is very professional. Cordial and articulate. But he doesn’t know anything about the SEC. He asks if we are a criminal agency. When I say no, strictly civil, his tone is regretful. Their laws only permit them to render assistance to foreign criminal agencies. So there probably isn’t much that can be done.

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his early 30s is somewhere close to the top of its securities fraud unit. I know him from another case and remember him as extremely able. None of the assistant U.S. attorneys I’ve dealt with are exactly party animals. You don’t get those positions without being a full-blown workaholic with a minor in delayed gratification. These guys live on the edge—of obsession. So it is with Peikin. He has the relentlessly terse approach to conversation of someone who is trying to get more done in a day than is humanly possible. In his silences you can hear the wheels turn in his head. But a nice enough guy—as long as you don’t try to jerk him around.

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Typically, once money has gone offshore, it is in the wind. It can be moved electronically from country to country in an instant, while tracing a single transfer can take months or years. So funds easily can be sent many jumps ahead of anyone chasing them. But here—glorious luck—we know at the outset where a big chunk of the cash is parked.

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tell Rich that I don’t care what he does, how many hours he spends, how many toes he squashes, so long as we bag the $200 million. The money has to come home. That will mean a lot. It will make up for a

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So far, so good. The next and we hope final stage requires tracing the money out of New York and into the specific Swiss banks that, in turn, transferred it into the Isle of Man. That will close the loop. But our luck does not extend that far. The New York bank effectively slams the door in our face. It makes hundreds of thousands of transfers into the Swiss banking system, it tells us, but not to individual Swiss banks. Instead, the funds go into a general clearing service—much like the Depository Trust Corporation in the United States—and the New York bankers have no way of knowing which Swiss banks are credited with particular transfers into the pool. We might eventually get this information from the Swiss authorities, but the turnaround on such requests takes years. We will be lucky to have weeks.

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What they have is precisely what we need: a single sheet of lined paper, pulled from someone’s desk drawer, containing the handwritten names of Swiss banks and their corresponding five-digit identifying codes. The banks that received the funds from the Poyiadjis stock sales are the very banks that effected the transfers into the Isle of Man, and in approximately the same total amounts. The loop is closed.

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The trustees apply to the Deemster for permission to convert the dollars in the account into “any other currency,” arguing that other currencies earn more interest. Whether this makes sense as an investment matter, it suggests another scheme for grabbing the money. We are advised by people who are supposed to know such things that the only way the trustees can convert that much U.S. currency into something else is to wire it through one of two banks in New York. During the six seconds the funds exist only as electronic impulses clearing the New York banking system, it might be possible to seize them under the SEC’s asset freeze order. This approach has been used successfully in drug cases. Officials of the

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But how likely is that, really? I can’t quite make myself believe it. The Law so often disappoints those who think themselves its rightful beneficiaries. A game of snakes and ladders that will give a tumble to those it first pretends to favor … just to show it can. Its process feeds upon itself, and prefers those with the money and time to indulge its worst proclivities. Here that is not us. The cost of this litigation is straining the budgets of our agencies and the issue of indemnifying the Isle of Man AG looms large in the background. A few more delays and reversals and we may be forced to throw in the towel.

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First up for the trustees is a prominent but ancient trusts-and-estates lawyer. Stooped and white-haired, he leans his shrunken figure against the podium for support. His voice is brittle and his speech achingly slow. One can almost hear the sands of time sifting between his words. His role is to impart an air of legitimacy to his clients. Tedium is his chosen in strument. The trustees, he opines at length, are dedicated fiduciaries pro tecting the interests of their clients. Not—perish the thought—money launderers helping a crook hide money from his victims.

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limited his observations to pointing out issues with its basic performance ratios. Accounts receivable, for example, were increasing at a rate more than twice that of revenues. This is a red flag to financial analysts. It often signals poor quality earnings: invoices the company has booked but can’t collect. It is of less concern if the company has reserved against the possibility that some of its receivables will never be collected. ACLN had no such reserves.

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This is a phrase defense lawyers have macroed into their word processors, like “the suit is without merit and will be defended vigorously by the company.” In fact, the cooperation we received was of such poor quality it felt more like obstruction.

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We also tried to get information from Africa. A contact at the State Department told us that might work—assuming we were prepared to wait two or three years. Michael had a friend who knew someone who knew someone who knew the president of Benin. He started to work that angle and eventually reached, not the president of Benin, but a local lawyer supposedly capable of getting things done in that benighted country. His price to check out ACLN’s business dealings there would be $500,000. When asked what method he used to set his fees, he said: “The French method. I charge what I think it is worth to you.” We passed.

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The only ACLN officer in the United States is the erstwhile CFO. When we hustle him in for testimony, we meet a baby-faced 27-year-old with a pink tie. Despite his title, he says he does nothing with the company’s books. His remote access to its computer system doesn’t include any part of its accounting records. He lives close to the little office ACLN rented in West L.A. and commute to work—wouldn’t you know it—by skateboard. As the session goes on, he becomes increasingly distraught. It dawn on him he has been used as a front. When we show him the Tunisian arrest warrant on Labiad, he dabs at his eyes with a napkin. “My whole world is turning upside down,” he blurts. “Now I don’t know what to believe.” Heidi feels bad about making him cry. I tell her it might have been worse. I’ve had witnesses throw up.

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for dirty money and their stock market corrupt. But that perception is largely correct. Cyprus has earned notoriety for sucking in cash from Russian mobsters and former Serbian president Slobodan Milosevic. And the Cyprus stock market has been rocked repeatedly by financial scandals, one of the largest involving Kyprianou. They explain that the government’s attempt to prosecute him failed because of an antiquated legal system that makes it nearly impossible to bring complex financial cases. They compare it to that of England’s system of a hundred years ago. They also have difficulty obtaining documents from foreign sources. Swiss banking records would be helpful in their case against Kyprianou, but they don’t have a treaty with Switzerland. The United States does, which has already paid off in our investigation of AremisSoft. Unfortunately, however, its terms forbid sharing its products with other governments. No matter how much we may want to do so.

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Questioning accountants from the large international firms is usually a migraine-inducing activity. Every word is parsed by a platoon of defense attorneys. The slightest possible ambiguity means you won’t get an answer.

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than the pink-sheet detritus traditionally caught cooking the books—these accounting scandals had given a queasy feeling to the investing public. Not wanting any more of that, Congress had imposed in the Sarbanes-Oxley Act of 2002 a grab-bag of new rules for public companies, their officers, directors, and auditors. Meanwhile, the SEC and the Department of Justice ramped up their efforts to nail corporate malefactors.

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Ignoring the First Law of Holes—“When you’re in one, stop digging”—the city begged SDCERS to lower the trigger provision from 82.3 percent to 75 percent. This would have allowed San Diego to fall even further behind on its contributions. But this time it got no takers. The pension system’s actuary and outside counsel were (finally) troubled by the city’s efforts to shift risk onto the pension system, which the enticement of more benefits only exacerbated. So the board said no.

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increasingly acrimonious e-mails to Webber, city officials argued the mistakes weren’t material and therefore needn’t be disclosed. Materiality is one of the more slippery concepts in the securities field. The crib-sheet version, however, is that information is material if it might affect investor decisions to buy or sell the securities at issue. Caporicci & Larson agreed with the city, pointing out that the errors had only a minor effect on San Diego’s financial metrics.

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These were nervous days for auditing firms. In 2002 Arthur Andersen—once the gold standard in public accounting—had been convicted of obstruction of justice for shredding documents related to its work for Enron. In 2005 the Supreme Court would reverse that conviction but, by then, Andersen was history. It’s demise would cause the remaining firms to experience inklings of mortality, further cranking up the anxiety levels of entities that, as classic deep-pocket defendants, have long been a favorite prey of the nation’s plaintiffs’ lawyers.

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I’ve often wondered what we could have done to avoid that embarrassing experience. After San Diego, I realized our mistake was in choosing the wrong reason for the conflict that destroyed that unlucky American town. We should have proposed something even more implausible than a football rivalry. Say a dispute over the local retirement system.

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Business was always welcome. Going from the SEC to a firm means building a clientele from a standing start. You begin with no clients and a number of entities that don’t like you because at one time or another you sued them, at least if your time at the SEC was well spent. And being on the defense side makes it particularly challenging to keep the billables up because it tends to be a one-shot practice. Clients rarely say: “I so much appreciate the work you did in resolving my previous SEC problem that I plan on getting myself in another jam so we can renew our very enjoyable relationship.” Even those who once promised to name their firstborn after you forget you exist once the crisis has passed.

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rejected that view over twenty years ago. Concerned that, by denying analysts their potential reward for drilling down on public companies, the SEC’s approach would lead to a decline in market transparency, the Court held that anyone other than an insider can trade a company’s stock from sunrise to sunset, no matter what nonpublic information he has ferreted out, so long as he didn’t lie, cheat, or steal to get it. So that there could be no misunderstanding as to who should be paying attention, the Court added: “without legal limitation, market participants are forced to rely on the reasonableness of the SEC’s litigation strategy, which can be hazardous… .” Other cracks in the staff’s theory were hard to miss. Insider trading requires trading on material information—information that can move a stock—not just anything nonpublic about the company. The day the suit was announced, JCPenney stock went up. Also, JCPenney stated it did not expect

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Gradient flags companies for scrutiny through computerized “screens” that sift through the companies’ financial statements for signs of weakness or business decline. Common examples would be negative trends in cash flow, inventory turns, or receivables aging. After the SEC, in the 1990s, required public companies to file reports electronically, this became a common approach to stock analysis for those with the necessary technology, but with many ways to slice and dice the available information.

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is tempting to wonder what he might have accomplished if his energies had been more fully directed toward, say, making a success of Overstock. Indeed, his father, Jack Byrne, made essentially this comment when he quit the Overstock board of directors. But then history is replete with gifted people with eccentric beliefs. Theosophy, orgone boxes, serial incarnation—whatever. Perhaps the world is simply too colorless for these individuals without added dimensions of mystery and romance.

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Taking up the cudgels against Overstock would prove a costly mistake. It set Gradient on a course that would nearly destroy it. Rocker Partners would later whistle down the same dark alley and receive a similar mugging. The pain both experienced was not the result of Overstock’s success in showing up its critics. In coming years it would rack up losses in the hundreds of millions of dollars. Rather, it was because Gradient and Rocker Partners unwisely ignored the old adage “Never get in a pissing contest with a skunk.”

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Remarkably, he would win the unwitting assistance of the California court system, a committee of the U.S. Senate, and the SEC. His efforts provided a stress-test of the ability of various organs of government to recognize and resist a sophisticated campaign to hijack their procedures for dubious ends—a test that each would fail.

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Given Overstock’s continuing losses, cash-flow problems, and repeated failures to meet Byrne’s rosy projections, Rocker Partners saw the company as similar to bubble-era Internet start-ups, relying more on aggressive self-promotion than a viable business plan. This made it seem a promising short.

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vindicated. By late 2004, the financial press was treating Overstock and Byrne with skepticism. Byrne assumed it was part of the short-seller-led conspiracy against him and responded by attacking journalists. In a Red Herring interview, he referred to them as “condoms,” used and discarded by hedge funds.

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Short investments often follow a path of long-term pain followed by sudden jubilation when the short-seller at last “gets paid” for his trouble and patience. Timing, as in stand-up comedy, is everything, and hard to get right. Warren Buffet has said it’s easier to pick bad companies than to predict when they will come to grief. They can blow up without warning or their faults can escape notice for longer than anyone who believes in efficient markets would think possible. Even egregious flaws in a company’s business model or bald distortions in its public disclosure can remain unrecognized for years. Reasons come readily to mind. The government is slow to catch abusive companies, investigative journalists are few in number and often ignored, and sell-side analysts are limited in their research skills, conflicted in their incentives, and afraid to become targets of issuer retaliation should they prove overly critical. Thus short-sellers often endure years of shelling out interest and dividend payments to support what will eventually prove prescient, if premature, calls. As Cohodes enjoys saying, “Being early is the short-seller’s disease.”

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After the 2007 collapse of the subprime mortgage industry, the financial press would dwell in detail on the bacchanalia that had gone before, and NovaStar would feature prominently, having cost any number of investors their life savings. New York Times reporter Gretchen Morgenson detailed NovaStar’s underwriting outrages, disclosure failures, and violations of HUD rules. Among the company’s misdeeds was its failure to inform borrowers that it paid mortgage brokers what were in substance kickbacks to arrange loans with higher than competitive rates. This violated both federal and state

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The Internet has made a great deal of information available to the investing public. This includes everything from SEC filings to the insights of prominent financial pundits. It has also provided a forum for individuals whose opinions might otherwise be confined to the walls of public restrooms, and has given outright crooks access to millions of potential pigeons.

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intellectually curious, the site provided a lengthy but muddled explanation of the ability of the company’s business model to deliver, apparently in perpetuity, generous returns with no appreciable risk. That a mortgage company in Kansas City could overturn a fundamental principle of market economics was presented as unremarkable. NovaStar cheerleaders, following O’Brien’s lead, suggested buying the stock with credit cards. This would allow investors to capture the margin between the interest rates on the cards and the historically higher yield provided by NovaStar stock. It was a good thing for the small investor, they advised, that the big hedge funds had not yet discovered this sure-fire strategy.

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Byrne’s “hatchet job for hire” thesis also failed the common sense test. Gradient reports are typically highly detailed and cleanly sourced to public documents: not shallow rumor sheets that could easily be tricked up to order. The majority of Gradient clients are hedge funds or mutual funds with mainly or exclusively long positions. They look to Gradient to flag potential problems with their stocks, not to churn out hit pieces that would cause them to lose money on their positions. Its ability to obtain and keep its clients—which have included major investment banks and mutual fund families—rests on its reputation for accuracy. A few bad calls to please short-sellers and that reputation would be gone. This is aside from the question of how Gradient could help some clients by fobbing off tainted reports on the rest who, if they too saw Gradient as “a hatchet job for hire,” would hardly be taken in.

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But whistleblowers always have an ax to grind. That doesn’t mean they’re always wrong. If these purported whistleblowers were blowing mostly smoke, knowing why they were willing to put their signatures on these documents was critical.

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Some of his statements, like those of the other declarants, were banalities phrased to sound shocking. For example, he implied that Gradient tracked the history of the stocks it covered to demonstrate its ability to affect the price of those stocks. In fact, Gradient did so to demonstrate its predictive abilities. But other statements, if true, would go a long way toward validating Byrne’s

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Much of this was nonsense. SEC subpoenas are not delivered by federal marshals. They come in the mail. And it was most unlikely the Commission was contemplating a criminal action against anyone. As a civil agency it has no criminal enforcement powers. Also, the agency has hundreds of “formal” investigations going at any time and hasn’t the resources to launch a full-court press in each one. Still, no one could claim that for Gradient or Rocker Partners the investigation was a good thing.

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Two other witnesses undercut the antishorting agitators. A representative of a hedge fund lobbying group made the points that short-sellers add liquidity to the market and have a history of spotting bad companies before the sell-side wakes up from its well-compensated slumbers. Marginal companies have whined about the shorts since the lava cooled, he said, but their complaints rarely pan out. This point was seconded by Yale academic Owen Lamont. In a number of papers he had championed short-sellers as “a disadvantaged minority.” True, dat. He pointed out that, in an earlier congressional hearing, three companies had claimed they had been destroyed by lying, conniving, colluding short-sellers. Two of the three were later convicted of securities fraud. Professor Lamont did not see this as a statistical anomaly. “A notable feature of the data,” he said, “is that many of the firms fighting with short sellers and analysts are subsequently revealed to be fraudulent.”

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Nor do I deny the existence of age discrimination in the legal profession, including government practice. To the contrary, it is as unquestioningly accepted as was racial discrimination a few decades back. Unlike racial discrimination, however, it is not based on blind prejudice. There is a practical reason legal recruiters tend to be most welcoming to the young—and it is similar to the reason the military seeks young men barely out of adolescence. They like their cannon fodder eager and malleable. Legal employers look for a certain commodity in their new hires: conventionally motivated overachievers who do well in highly structured work environments (i.e., ass-kissing grinds). The older the applicant, the more likely it is he or she has picked up independent habits of thought, outside interests or life values not easily subordinated to the desire of his employers to simultaneously maximize partner contentment and billable hours. In government practice, this translates into general quality of life enhancement to supervisors. Exceptions are made, but therein lies the bias faced by older applicants.

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Pamplona detoured through a dinnerware outlet. They admitted Aguirre was both smart and diligent. The problem, as they saw it, was that these are positive attributes only when properly directed, by them, not when fielded without restraint by an aging obsessive out to save the world—or at least the capital markets—before his next retirement. His contention that they had caved to political pressure in closing the Pequot case was flatly denied.

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As someone once said, never assume there’s a conspiracy behind events that can be explained by simple incompetence.

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Internet is the ultimate populist medium, available to everyone with a laptop, an ISP account, and fingers. Should one’s object be to discredit or annoy selected others, the Google Corporation provides a product that can be greatly empowering. Internet search engines allow completely false allegations that a certain individual, say, cheats on his taxes, is a closet Dolly Parton impersonator, or runs an illegal mink ranch in his basement to be seen by thousands, perhaps millions. Nothing is screened for accuracy.

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“The incredible 40,000-word screed has been described as Joycean, though some readers have found the style less stream-of-consciousness than manifestation-of-apophenia, making spurious connections among unrelated matters and then drawing or inviting specious conclusions.”

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