Fortune's Formula (31 page)

H
ALE SAID THAT
P
RINCETON
-N
EWPORT
had been selling securities at a loss to Milken’s operation. The sales were recorded on the books, with every
i
dotted. But there was a verbal understanding that these sales were just for show. Princeton-Newport would later buy the securities back from Milken at close to the same price, no matter what the market price was.

This was called stock “parking.” It was done because the fund’s hedges sometimes created peculiar tax situations. In a typical trade, Princeton-Newport would buy one security and simultaneously sell short another. When a fund sells stock short, it is actually borrowing the security, which must be purchased later. Thus one security in a trade is actually purchased later than the other. This meant that it was possible to have a
short-term
capital gain on one side of the trade and a
long-term
capital loss on the other. The two would not offset each other as they would if they were both the same kind of loss or gain.

The stock parking was a pretend sale to convert a long-term loss to a short-term loss. The artificial short-term loss offset the existing short-term gain so that the fund would owe taxes on its net profit only.

As tax dodges go, this was not especially villainous. It was, however, illegal, as most people understood the existing tax code. Hale knew this and was uncomfortable. His supervisor, Paul Berkman, had brushed aside Hale’s qualms. Berkman said that the IRS “didn’t have the manpower to sort out these types of trades.” To play it safe, Berkman instructed Hale to camouflage the trades by buying the parked securities back at slightly different prices.

It was Hale’s job to maintain the list of parking transactions. The list was known as the “parking lot.” For their part in helping Princeton-Newport cut taxes, Milken’s people at Drexel Burnham earned an interest charge that was built into the buyback price. As part of the arrangement, Princeton-Newport was expected to do trades through Drexel and buy its junk bonds. Hale said that Princeton-Newport had a similar parking arrangement with Merrill Lynch.

Hale let it be known that he didn’t want to participate in the parking. Because of that, he was fired.

Hale was able to identify two people in Milken’s office who were directly involved in the Princeton-Newport stock parking. They were Bruce Newberg and Lisa Ann Jones. Jones was Hale’s counterpart, keeping track of the parked trades for Drexel. Newberg was Jones’s superior. Hale said that Princeton-Newport routinely made audiotapes of its traders’ phone calls. This was in order to have a record in case of any later dispute.

It was December 17, 1987, and Christmastime in Princeton. Seasonal decorations lined the streets of the college town’s shopping district. In the middle of town was a new colonial-style building. The passerby might never know that it was home to one of the world’s most successful hedge funds. There was no need for window-shoppers to know. Princeton-Newport had no need for attention, least of all the kind it was about to get.

Vans pulled up in front of the building. They contained about fifty federal agents of the FBI, Treasury Department, and Alcohol, Tobacco and Firearms. They were armed and wearing bulletproof vests.

The building’s elevator had not been built to handle a militia. Agents went up in groups. They pushed past the glass doors of the partnership office. They showed a warrant. The agents ordered employees to remain in the building until they were through. They went through the filing cabinets, packing documents into three hundred boxes. They were under orders to look for audiotapes especially.

At about 9:50 that evening, Pacific time, Thomas Doonan knocked on the door of Lisa Jones’s apartment in Sherman Oaks, California. Doonan identified himself as a federal agent. Jones let him in. Doonan began asking specific questions about 1985 trades in which Princeton-Newport had sold securities to Drexel and bought them back thirty-one to thirty-three days later. As Doonan had intended, Jones had not yet heard of the raid in New Jersey. She admitted participating in the trades.

“Were you parking for them?” Doonan asked.

“Yes, I was,” Jones said.

“Was it for tax purposes?”

“No, it wasn’t.” Jones belatedly realized she was in trouble. She told Doonan that she wanted to see an attorney.

Doonan’s reaction was to sigh and say, “We were hoping you would be willing to cooperate with us in this investigation.” He left a subpoena.

Jones was afraid to use her phone in case it was bugged. She got in her car and drove to a pay phone to call an attorney.

W
HEN
E
D
T
HORP
heard the news, his initial reaction was that it was nonsense. He had followed the string of arrests on Wall Street like everyone else. The raid seemed to be some publicity stunt on the part of Giuliani.

Ominously, Regan did not have much to say to enlighten him. “Everybody lawyered up,” explained Thorp. “Everyone talked in their own circle; they wouldn’t talk outside the circle, so getting information was very difficult. Trying to run a partnership was very difficult under the circumstances.”

Actions spoke louder than words. Some of the East Coast partners took about $15 million out of the fund and replaced it—under the names of their wives.

Giuliani had hit pay dirt in Princeton. Hale had said that the partnership’s audiotapes were kept just about six months. It turned out that someone had saved some tapes from December 1984. Stock parking would normally take place at the end of the tax year.

The tapes included plenty of evidence backing up Hale’s allegations. They implicated Regan and a Princeton-Newport trader named Charles Zarzecki. They also incriminated two of Milken’s people at Drexel Burnham, Bruce Newberg and Cary Maultasch.

Berkman’s comments to Hale suggest that he saw the stock parking as tax roulette. They were gambling that the tax savings were large enough to justify a small chance of being caught. Not all of the stock parking was for tax reasons, though. In 1985 Princeton-Newport had parked some stock in the toy company Mattel. A Drexel trader sold Mattel stock to Princeton-Newport with the understanding that he would buy it back with 20 percent interest. Concealing a Drexel financial interest in Mattel suggested a conflict of interest, for Michael Milken was then helping Mattel to recapitalize.

Drexel had also been doing a convertible bond offering for a Minneapolis company called C.O.M.B. that bought discontinued products for practically nothing and sold them to the public at bargain prices. Drexel wanted Princeton-Newport to help push down the price of C.O.M.B. stock.

In one of the tapes, Robert Freeman mentioned a recent trip to Atlantic City to Zarzecki. “It’s not fun anymore,” he complained. “I guess I’ve been in this business too long. I’m used to having an edge.”

Another conversation recorded a parking transaction between Zarzecki and Newberg. “You’re a sleaze bag,” said Newberg.

“You taught me, man,” said Zarzecki. “Hey listen, turkey—”

“Welcome to the world of being a sleaze.”

A
T THE TIME
of the raid on Princeton-Newport, Giuliani was planning his next career move. New York’s Republican senator Alfonse D’Amato had been urging him to run for senator against Daniel Patrick Moynihan. “I think I’d be very good” as a senator, Giuliani told
The New York Times
. “I don’t have any question that I could do the job in an innovative and creative way.” A few weeks later, he backpedaled: “I cannot leave unless I’m sure that the right person succeeds me.”

Giuliani’s biggest concern was that the Wall Street investigation would fall apart. Convicting Michael Milken was to be his crowning achievement as U.S. Attorney. As long as Giuliani’s successor followed through, Giuliani could point to the achievement for the rest of his career, wherever that might lead him.

But not every potential successor shared his zeal in prosecuting Wall Street corruption. As Giuliani’s mentor, D’Amato had assigned his own attorney, Mike Armstrong, to screen possible replacements. Armstrong’s favored candidate was Otto Obermaier. Both Obermaier and Armstrong published articles in the
National Law Review
blasting Giuliani’s heavy-handed tactics against securities firms. Armstrong had reason to complain: he represented Lowell Milken in the Drexel investigation. It appeared that all the attorneys Armstrong and D’Amato thought suitable to replace Giuliani represented Drexel people or Drexel clients.

Milken in fact hosted a fund-raiser for Al D’Amato in Beverly Hills. Drexel’s investment bankers chipped in about $70,000. D’Amato was on the Senate’s securities subcommittee considering reforms in the junk bond industry.

On February 8, Giuliani announced he would not run for the Senate after all. “It would be wrong for me to leave this office now,” he said, “whatever the allure of another office or opportunity, because it would adversely affect some very sensitive matters now in progress.”

After being coached for two days by Drexel-supplied attorneys, Lisa Jones went before a grand jury on January 11, 1988. She requested additional time to prepare. This was granted. She returned two days later. Almost immediately she took the Fifth Amendment.

The government was ready for that. They granted her immunity, forcing her testimony. Jones denied that any stock parking had taken place.

She did not know that the government had the discussions of parking on tape. During a break, a prosecutor warned Jones’s attorney that his client was risking perjury charges. The immunity was for past crimes only—not for lying to this grand jury.

Bruce Baird asked James Regan to come in to his office. He wanted to play the tapes for Regan. Baird hoped the taped evidence would be enough to get Regan to testify against Freeman and Milken.

Regan showed up as defiant in dress as in manner. He wore casual clothes and a cap with the words shit happens. Regan listened to the tapes with little emotion.

One of the taped conversations had Regan and Newberg quibbling over the Mattel parking. “I carried plenty of positions for you, in case you haven’t been realizing it,” Newberg said to Regan. “I’ve been charging you my cost to carry.”

“What I carry on my books now is your position,” Regan said. In other words, Drexel had parked stock for Princeton-Newport, and now Princeton-Newport was returning the favor by parking the Mattel stock for Drexel. While this exchange may sound cryptic, it was more explicit than a prosecutor could normally hope for. It would impress a jury.

Regan had little to say and left. To friends, he made it clear that he was not about to be a turncoat and testify. Freeman was his college roommate, and Milken was a longtime business associate. There was no way he could be convicted. The charges were “too complicated” for a jury to understand.

Thorp got one call from the prosecution team. They wanted him to come and testify in New York.

“If I do, I’m going to take the Fifth,” Thorp said.

The prosecutor’s reply was, “Why are we not surprised?”

The U.S. Attorney’s office took no further direct action against Thorp. “My theory on taking the Fifth was, I didn’t know anything,” Thorp told me. “I had no upside in going and plenty of downside. The downside was that I might so aggravate one of the defendants that they might falsely incriminate me, just as a revenge matter.” The decision not to testify was “just a prudent calculation.”

In midsummer 1988, Giuliani announced that he was filing RICO charges in the Princeton-Newport case. It was the first time the organized crime law had been used against a securities firm. At one of his frequent news conferences, Giuliani maintained that the use of RICO against Princeton-Newport was “not a novel approach” and was used “when we believe the magnitude of the crime warrants it.”

According to Paul Grand, attorney for Princeton-Newport’s Charles Zarzecki, Giuliani had initially presented an ultimatum. He threatened to file racketeering charges unless at least two Princeton-Newport officials testified for the government in two other continuing investigations.

“You’d have to be a fool,” Grand said, not to know that he was talking about Michael Milken and Robert Freeman.

Giuliani later told
The Wall Street Journal
that he had not made any such offer.

Defense attorney Jack Arsenault also claimed that Baird told him the government had no interest in prosecuting Princeton-Newport—it was all about Drexel Burnham. “If you cooperate, fine,” Baird supposedly said. “If you don’t, we are going to roll right over you to get where we want to go.” This comment too appeared in
The Wall Street Journal
along with Baird’s denial of having said it.

Since RICO had never been used against a security firm, it was unclear exactly how it would work. Did the government have the right to freeze the assets of people accused of crimes only, or of the unindicted partners and investors as well? This raised the specter of the government seizing the assets of the Harvard endowment fund, or Weyerhaeuser’s pension fund. Regan’s attorney, Theodore Wells, called the use of RICO “frightening.” “It seems clear that Mr. Regan is being used as a pawn in a chess game being played on a much larger board.”

In order to invoke RICO it is necessary to prove that an ongoing pattern of criminal conduct existed. The government’s best evidence, the tapes, was limited to December 1984. It might have been a reasonable guess that the stock parking had been going on for some time, but suppositions are not evidence.

Giuliani’s office explored charges of tax fraud, mail fraud, and wire fraud. It discovered that Princeton-Newport had inadvertently reported some income twice on its 1985 and 1986 tax returns. The overstatement was nearly $4 million. The stock parking at issue had created a $13 million understatement of income. The accounting error did not lessen the seriousness of the charges, but it made Princeton-Newport’s tax people look like the gang that couldn’t shoot straight. The fund subsequently applied for (and got) a refund on the overpaid taxes.

There was talk of Regan stepping down until his name could be cleared. The two partners failed to come to a deal. “My personal opinion is that he was afraid that I’d run off with the firm and he’d be unable to get it back,” Thorp said. “He didn’t know me. So he didn’t know that that was an impossible act for me.”

Meanwhile Giuliani’s solo was in danger of turning into a duet. The SEC had been conducting its parallel investigation of insider trading. Much of the evidence against Levine and Boesky had been the SEC’s legwork. In late July, the SEC’s Gary Lynch called Giuliani and announced that he was ready to act against Milken.

Giuliani threw a fit. He told Lynch that if the SEC filed, he would side with the defendants and support a motion to dismiss the case.

Lynch was astounded. After Giuliani cooled down, he reversed himself. No, of course he would never sabotage the SEC’s case. Lynch agreed to wait awhile longer.

Formal charges would give Drexel the right to see the government’s evidence. Giuliani believed that would decrease the prospect of getting a few of Milken’s closest associates to testify against him. It would also mean that the SEC and not the U.S. Attorney’s office would command the spotlight. Giuliani was thinking of running for mayor of New York. As a Republican in a very liberal city, there would be political mileage in running as the man who had cleaned up Wall Street.

On August 1, the government played the Princeton-Newport tapes for Lisa Jones and her attorney Brian O’Neil. The next day, O’Neil wrote a letter saying that hearing the tapes had refreshed Jones’s memory. She did participate in the trades after all, and the trades were part of a scheme to avoid taxes. She had discussed this with at least one Princeton-Newport employee.

Giuliani felt this was too little too late. He announced that the prosecution of Jones for perjury would continue.

Later in August, a grand jury returned RICO indictments on Regan and four other Princeton-Newport people: Jack Rabinowitz, Charles Zarzecki, Paul Berkman, and Steven Smotrich. Also prosecuted was the former Drexel junk bond trader Bruce Newberg.

While Thorp was not charged with anything, his hedge fund was mortally wounded. With RICO charges looming, the fund’s investors wanted out. In December 1988, Thorp and Regan dissolved the partnership. Positions were liquidated and the money returned to the investors.

Thorp was aware, of course, that the fund took aggressive tax positions. He says he knew nothing of the stock manipulation and the parking to subvert credit requirements. He blames the situation on a dysfunctional partnership: “We didn’t really connect well as people,” he said of himself and Regan. “That was probably the crack in the edifice. If we had, if I’d realized that actions were being taken that were more aggressively bold, closer to the line than I’d dare contemplate, the whole thing wouldn’t have happened.”