Insider Trading : How the SEC Broke Huge Stock Case

Jack Nugent started the ball rolling by blabbing to Tom Peacock about his Washington lobbying firm’s hot new client. Peacock passed the word to his stockbroker, Steve Tatusko. Tatusko invited nine guys in his brokerage office in on the deal.

When an $8,700 stock option investment out of that office turned a $911,000 profit in four days, the Securities and Exchange Commission got very interested.

And that was only one phase of what became the biggest insider trading case in history.

Alhambra Oil Company

Santa Fe International, an Alhambra oil company, announced on Oct. 5, 1981, that it was being purchased by Kuwait Petroleum Co., an arm of the Kuwaiti government, for $50 a share, or twice the market price of the stock.

To determine whether investors who made millions in Santa Fe stock and options knew of the merger in advance, SEC lawyers and investigators examined reams of telephone bills and limousine receipts, credit card slips and office memos over the next 4 1/2 years. They threatened some insiders with jail terms. They pursued one group of investors through the courts of four nations.

In the end, the SEC successfully sued 22 people for securities fraud. They included one former Santa Fe board member, three executives, and some of their neighbors, business partners and in-laws.

Each of those defendants has been forced to give up all or much of the profits in question (a process colorfully known as “disgorgement”), for a total recovery of more than $10 million--an SEC record.

One Still Faces Trial

Four also were convicted of criminal charges. A fifth, former board of directors member Darius N. Keaton, still faces trial in New York on conspiracy and insider trading charges.

Now, with all of the civil cases finally concluded, most recently with the recovery in February of $7.8 million from eight foreign investors, court documents and agency records allow a unique look at how the SEC investigates such a complex case--and how a big takeover can inspire illegal stock trading despite the principals’ best efforts to keep their negotiations confidential.

Insider trading is sometimes difficult to define. For the most part, federal law prohibits anyone with material knowledge of an important corporate development from buying or selling that company’s stock before the information is fully public. Under the law, an insider might be an important corporate executive or a lawyer involved in merger negotiations. But recent cases also have involved people as remote from the executive suite as printers working on company documents. Furthermore, those who receive tips from insiders are forbidden to trade.

Most professionals agree that the SEC unearths only a bare fraction of all insider trading. The commission’s frustration is illustrated by a recent proposal by SEC Chairman John S. R. Shad that it pay a bounty to informers in successful cases. Thus, many people believe that the SEC’s success in pursuing the Santa Fe traders is exceptional.

SEC officials consider Santa Fe a keystone of their five-year campaign against insider trading for several other reasons. The five separate cases that grew out of the agency’s original probe are so diverse that they represent something of a primer in investors’ cunning. The lure of majestic profits, the SEC found, led people to litter the landscape with backdated letters, fictitious trading names, and preposterous alibis.

Swiss Give Information

The investigation also broke new ground in extracting information from the traditionally secretive Swiss. Once the SEC discovered that investors using Swiss bank accounts had turned a profit of more than $5 million, apparently on inside knowledge, it embarked on an intensive effort to unearth the names of the investors.

“This case really stands for our ability to get information from abroad,” said Michael D. Mann, the SEC lawyer who became an acknowledged expert in breaking the code of secrecy maintained by the Swiss financial community.

In the frenzy of tipping and trading, many have tried to understand what made the Santa Fe deal such an invitation to lawlessness.

“It was a conspiracy of circumstances,” says Mann. “There were stock options, they were cheap, the stock was relatively inexpensive and the offer was generous, so the potential profits were tremendous.”

For every gain in the securities markets there is, of course, a loss. Here, the principal victims were floor traders of Santa Fe stock options on the Pacific Stock Exchange in San Francisco, who are required to quote a price for every option and fill every order.

Thousands of Options Sold

In the weeks before the Oct. 5 merger announcement, these traders sold thousands of options representing contracts to sell hundreds of thousands of Santa Fe shares. Known as “out of the money” options because they gave buyers the apparently worthless right to buy shares for $30 or $35 each at a time when the stock was available on the open market for less than $25, they went spectacularly in the money on Oct. 5, when the stock jumped to nearly $50.

William Charles had been an options trader for less than three years. The expense of covering his obligations on Sante Fe options wiped out everything he had made up to then and left him with a debt of more than $1 million. He needed three years to accumulate again as much capital as he had before the merger. “It was like I worked three years for nothing,” he says.

Other traders never did recover. Although the millions disgorged through the SEC’s efforts will go into a fund to reimburse traders and others, the victims expect to recoup less than 30 cents for each dollar of losses.

Even recovering that much was no modest chore. Of all the inquiries inspired by Santa Fe trading, the most complex was the one that became known as the “unknown purchasers” case because the SEC could not more precisely identify its targets when it first sued them in New York three weeks after the merger announcement.

The agency won its first victory over these defendants by persuading a federal judge to freeze more than $5 million in profits held by a handful of Swiss banks in New York. While it would be years before Mann, the SEC lawyer, could score another court victory, in the end that single freeze order enabled him to pry loose $7.8 million in allegedly illegal gains.

Banks’ Roles Questioned

From the first, Mann says, he wondered why major banks would engage in such unpromising options trading. “These options were about to expire worthless. They were for a company in a glutted industry, whose stock price had been going down,” he recalls. “Against this indication, the banks were buying massive quantities.”

Mann’s pursuit of the answer focused chiefly on Costandi Nasser, a Jordanian who had been an agent for a Santa Fe subsidiary and a board member of the London-based International Resources and Finance Bank, one of the big players in Santa Fe options. Nasser had worked at one time for companies of which Darius Keaton was a director, and had been known as one of his business associates.

Keaton, then also a Santa Fe director, acknowledged in September, 1982, that he had bought 10,000 shares of Santa Fe stock just before the takeover. He disgorged nearly $300,000 in profits from the trade. But he maintained that he had previously pledged in writing to turn over any profits to the company and he denied passing tips to any other people.

Meanwhile, Nasser proved an elusive quarry, with refuges throughout Europe and the Mideast. He claimed as his permanent address a house in a devastated quarter of Beirut. Companies he had co-founded and on whose boards he served would politely reject the SEC’s legal summonses, objecting that they could not accept service for a “remote business connection.”

Occasionally, the commission would get an answer from Nasser’s lawyer, who would dispute its jurisdiction and maintain that his client had scant interest in the agency’s “fishing expedition.”

Names Divulged

But Mann was closing in. On April 12, 1984, he took a second deposition from John Smit, an officer of the International Resources and Finance Bank. In a 1981 deposition, Smit had refused to divulge the names of the ultimate purchasers of the bank’s stock options and specifically denied that Nasser was among them. Now, under a British court order, he allowed that Nasser ordered the options, had ordered him not to disclose that fact and had consistently expressed considerable interest in the progress of the SEC case.

Mann also was working with Swiss authorities. Switzerland had signed a 1977 treaty with the United States providing for breaching its secrecy laws in limited cases. The Swiss were also trying to tread the delicate line between protecting their reputation for discretion and discouraging criminals from using that reputation as a safe harbor.

But the SEC’s first request for the names of the Swiss account holders had been rejected because it could not prove that the traders were not insiders investing on their own behalf, which is legal in Switzerland.

By July, 1983, when the SEC filed its second request, Mann had enough information to contend that the suspects were tipped off illegally. And in April, 1984, Mann recalls, Keaton’s lawyers missed a court deadline in Geneva; within a day the Swiss sent the SEC documents showing that he had traded through a Swiss account under the name of Nadir Katir Mabrouk.

The papers also showed an intriguing transaction between Keaton and Nasser. On Aug. 11, as Nasser acknowledged in a sworn affidavit, he had bought 15,000 shares of Santa Fe stock for $460,000. On Aug. 28, the SEC discovered, according to court documents, Keaton had ordered $225,000, or about half that sum, transferred from the Mabrouk account to Nasser.

Purchase Made Day Later

Nasser made his purchase less than two days after Keaton had learned as a Santa Fe director of the Kuwaiti negotiations, and within a day after the two had spoken on the telephone. The commission alleged that the transfer was a reimbursement to Nasser for an interest in the 15,000-share order.

The Swiss Federal Tribunal subsequently approved the SEC’s second request, providing the American investigators with the names of all eight unknown purchasers--among them, Costandi Nasser. After the SEC asked a judge to declare the defendants in default, the purchasers negotiated the settlement that resulted in their disgorgement of $7.8 million.

To this day, lawyers for Nasser and the other purchasers deny that they received any tips from Keaton. Instead, says J. Barry Morrissey, the group’s Boston-based lawyer, they settled the SEC charges to end four years of exhaustion and legal bills and to get their hands on a portion of the frozen funds, which had grown to more than $10 million with interest.

As for Keaton, whose trial is tentatively set for this fall, his lawyer, Milton S. Gould, maintains, “The proof at the trial will establish that he recognized in advance that there might be questions” about his share purchases and pledged to return any profits to the company. “As for tipping others, that we deny completely.”

Another Santa Fe trader who went to extraordinary lengths to protect his gains was Gary L. Martin, a Seattle accountant who acknowledged in court that he had made a $1.1-million score on Santa Fe options after deducing that the merger was about to occur from his association with a client, Santa Fe director Stanley McDonald.

Asked About Taxes

McDonald, a Seattle businessman, owned $690,000 in Santa Fe stock. When he learned of the Kuwaiti offer, the SEC said, he asked Martin to calculate how much tax he would pay on a large capital gain.

SEC investigators believe that Martin was able to make his deduction about the imminence of the merger from his knowledge of McDonald’s assets, which included only two holdings that could produce a gain on the scale he discussed--some real property and his Santa Fe stock. McDonald’s refusal to discuss the source of the gain, the SEC reasoned, ruled out the real estate.

(Martin’s behavior presented the SEC with a difficult question: whether McDonald had been so indiscreet as to be liable for prosecution himself.

(“Obviously, the staff considered the liability of everybody who was a potential tipper or tippee,” says SEC Associate Enforcement Director John H. Sturc. Martin, however, was a fiduciary entrusted with preparing McDonald’s taxes. The SEC concluded that “Martin got the information from McDonald in a legitimate fashion and misappropriated it,” Sturc says. Although McDonald settled private lawsuits charging that he had participated in Martin’s fraud, the SEC did not charge him.)

Martin engaged in a frenzy of options purchases in the weeks before the merger announcement. In all, he bought 800 contracts, or the right to buy 800,000 shares of stock. He spent $54,000 and turned a profit of $1.1 million.

Later, subjected to a court order freezing his gains, Martin told a federal judge that they were safely stowed in municipal bonds in a safe-deposit box.

That was a lie. There were no municipal bonds. Court-appointed accountants later found that Martin had embarked on a series of disastrous investments with some of the money. He placed $255,000 in five Mexican bank accounts in mid-1982; within months, the devaluation of the peso reduced their value to about $100,000.

He claimed that about $45,000 in cashiers checks was stolen from him during a trip to Acapulco. He invested thousands in brokerage accounts under the names of friends and family members unaware of the investments. He sank $26,000 in a treasure-hunting expedition off the coast of Colombia; the receiver considers that virtually a total loss. Thousands could not be tracked down at all.

He later spent three months in jail for contempt of court for lying about his cache of municipal bonds. In October, Martin died after a long illness.

The accountants were able to assemble a fund of about $417,000 from Martin’s remaining assets and interest. Lest one think that this is available to reimburse victims of the trading, the Internal Revenue Service has the last word. It filed a tax claim against Martin’s estate for $643,000.

Risked Friends’ Careers

For gains on such a scale, people risked not only their own jobs and careers, but those of friends and family members.

In October, 1981, John M. Nugent was 37 and a rising star of the Washington lobbyist trade. He had been earning more than $200,000 as a partner in Timmons & Co. when Santa Fe, fearing that its still-secret merger plans would inspire political opposition, hired the firm to lobby on its behalf in Congress.

Nugent knew he had committed a serious indiscretion by blurting to Peacock, an old friend, that his agency had an exciting new client. Still, he assumed that Peacock was only going to invest $2,500 in stock and double his money.

Nugent later told a federal judge how unnerved he was when Peacock told him he had made more than $50,000. (In fact, Peacock had made $250,000, according to court records.)

“I was scared to death,” Nugent recalled. “Suddenly, something that just seemed small and inconsequential blossomed into something that was now worth $50,000 or $70,000. I was panicked.”

Offered Use of Cars

He tried to distance himself from the deal. Peacock “had offered me essentially one-third of everything he made on it and I turned him down. He offered me the use of cars, to put my kids in his will, a number of things,” he said in a 1983 court hearing. Only once, when Peacock peeled five $100 bills off a bankroll, did Nugent accept money--and then only distractedly, he said.

But stored dangerously in a secretary’s files, the two men knew, was a slip of paper that could identify Nugent as Peacock’s tipster. It would also cast doubt on the story Peacock and Tatusko, his broker, had told the SEC. For when they had been questioned by Bruce Hiler and Joseph Cella, two SEC investigators, about their big score, the yarn they spun had Tatusko overhearing talk of the coming Santa Fe merger one night at a local bar. The next day, he claimed, he passed the tip to Peacock and some colleagues.

That would be such a tenuous link to insiders that the group’s trading would have to be considered legal. But Hiler and Cella dismissed the scenario. Eleven investors all buying Santa Fe options on the same morning, they reasoned, had to have an inside tip.

As Hiler and Cella went through Nugent’s telephone messages from Oct. 5, 1981, the day of the announcement, they found the damning slip of paper. For Nugent’s secretary had taken a call from Peacock, one of the investors. Peacock had bought $2,500 in Santa Fe options four days earlier. Now they were worth $250,000. Finding Nugent unavailable, Peacock left him an elated message:

“Home run.”

Recalls Hiler, “I wondered how they were going to explain this one away.”

Tried to Cover Tracks

Nugent and Peacock had indeed tried to cover their tracks. According to Nugent’s 1983 testimony, they contrived a letter over Peacock’s signature explaining away the remark as a facetious reference to a meager pay-out on a real-estate deal they shared.

Nugent joined Peacock and Tatusko in the critical error of lying to the SEC. In two separate examinations under oath, he denied telling Peacock anything. “Until I was so far into it, I never saw that if I had gone in the first time to the SEC and said to them, ‘Yes, I gave the information to Tom Peacock,’ I might even have my job today.”

Hiler and Cella passed their case file to the Justice Department for possible perjury charges. In December, 1982, a year after his last SEC interview and long after he figured the case was dead, Nugent heard from his lawyer that a criminal investigation was underway.

The pressure was telling. As one investigator said, “When you’re facing jail, you look at things a lot differently from when you’re just facing disgorgement.” As Nugent recalled at his 1983 hearing, “I just had to come forth.”

The defendants’ lies proved much costlier than the truth could have been. Nugent pleaded guilty to criminal insider-trading charges and paid a $10,000 fine. He resigned from Timmons. Peacock pleaded guilty to obstruction of justice and paid a $5,000 fine. Tatusko, who also pleaded guilty to obstruction of justice, was permanently barred from working as a stockbroker. He is now a mortgage broker in suburban Virginia.

Confidentiality Difficult

Other Santa Fe cases were built on less-decisive testimony. One involved Ronald A. Feole, then and now the general counsel of Santa Fe Minerals, a Dallas-based subsidiary. His story is an object lesson in the difficulty of keeping a big deal confidential even when a company strives to limit the number of people with direct knowledge.

“We tried to keep it all very secret,” says W. Frank West, a former Santa Fe executive who participated in the earliest negotiations with the Kuwaitis. “That some executives were very smart people who guessed what was going on, in retrospect shouldn’t have surprised me.”

SEC investigators had concluded that Feole had inklings of a merger as early as August or September, 1981, when he had been ordered to determine if some contracts could be models for a sale of part of the company. (Even then, Feole’s superior took the diversionary precaution of remarking, “I think this will be deader than a mackerel.”)

Two fellow executives, furthermore, had expressed curiosity over why headquarters in Alhambra was so anxious for an otherwise-routine appraisal that it was pressing for the document repeatedly. And there was testimony that Feole may even have heard West himself, freshly back from Kuwait, joke about the improbability of Santa Fe Chairman Edfred Shannon being happy “working for the Arabs.”

“That shows that when you are a multi-city, diversified company with a big demand for information, your big deal touches a lot of people,” remarked Theodore A. Levine, former associate director of enforcement for the SEC.

Waited for Big Score

SEC officials debated whether Feole’s agglomeration of hints was sufficient to legally render him an insider. In truth, Feole had been buying Santa Fe options for more than a year and a half, letting the worthless contracts expire, waiting for a big score and promoting the stock to friends and co-workers as a great underpriced opportunity.

But the investigators concluded that his purchases had picked up in pace in the months before the merger. At one point he was so intent on buying Santa Fe options that he placed an order from a Peking telephone during a business trip. Moreover, a former neighbor and Feole’s sister-in-law and brother-in-law had plunged into the market in a big way--right after getting telephone calls from Feole or his wife.

In the end, the SEC charged Feole with illegally turning a $90,000 profit; he agreed to disgorge $58,000. The commission also sued the former neighbors and in-laws. They all settled the charges by giving up all or a large portion of the gains, without admitting or denying the charges.