SHORT-SELLERS & THE SEAMY SIDE OF WALL ST.07/22/1996
THE AMAZING STORY OF HOW IN FIVE FRENETIC WEEKS LAST YEAR SHORTSELLERS BUSHWHACKED AN IPO AND KILLED OFF NOT JUST ONE WALL STREET FIRM BUT TWO. IT'S A TALE OF SKULLDUGGERY AND POSSIBLE EXTORTION.
Beneath the glitz and general prosperity of Wall Street lie pockets of sleaze that are usually hidden from sight. But for more than a year now, a weird, tangled--and still unfinished--tale of misdoings has been oozing into view, bringing on stage a little-known, lowlife brokerage house and a second, hapless firm that processed its trades; some dubious but hot IPOs; a pack of bloodthirsty shortsellers; and even shadowy hints of the underworld.
Add to this pungent recipe greed, fear, and dishonesty, and also cameo appearances by celebrities from Dan Dorfman, whose TV broadcasts helped out the shorts, to baseball tycoon George Steinbrenner III, who was one of 66,000 brokerage customers unhappily caught up in the action, to football star Lawrence Taylor, who was a promoter of one of the IPOs. Surfacing, too, are some characters that seem straight from a Mickey Spillane novel, among them the felicitously named True Brown, an FBI agent then and now on the trail of things bad.
Some less sexy investigators are also on the case--late to the game, some might say--including the SEC and the National Association of Securities Dealers. Their top challenge: to rationalize and explain why they didn't come down many months ago on a multitude of misdeeds going on right below their noses.
When instead they fiddled, those shortsellers and that lowlife brokerage firm, Hanover Sterling, engaged in a cutthroat, gutter fight that in a frenetic five weeks in early 1995 destroyed not only Hanover but also the long-established clearing firm that stood behind it. Before the two sank, the shortsellers allegedly extorted money and Hanover indisputably draped unauthorized trades on its customers. It's comforting to report that the shortsellers haven't emerged from this disaster rich. Nonetheless, the brokerage failures are likely to hand the Securities Investor Protection Corp. (SIPC), which steps in to help with investor losses when brokers crumble, one of its bigger bills--maybe even the biggest. The toll has yet to be added up because SIPC's representatives, lawyers from New York's Cleary Gottlieb Steen & Hamilton, are deep in litigation with the shortsellers.
The fact that Hanover was financially okay when this all began--though assuredly not run by types you'd like to take home to Mom--suggests just how vulnerable a Wall Street firm can be to attack. Investors tend to think of themselves as protected by a thick skein of rules. But this mess makes it clear that the rules are often broken and that the police don't always whistle a halt. And if it happens with small-time firms, could it not also shake the large? There's no definitive answer to that, just an anxiety that's heightened by tales like this.
As our action begins in January 1995, Hanover Sterling had a tony name, but that's where the classiness ended. One of its former customers says Hanover's offices on Pine Street in downtown Manhattan were "schlocky, scummy-looking, dirty, disgusting"--in other words, done in best bucket-shop style. Financially, the firm was a bit north of bucket shop, showing equity capital at year-end 1993, the date of its last published financial statements, of $3.3 million, a figure that almost surely rose in 1994. According to SEC records, almost all that capital was the property of one Lowell Schatzer, stated as owning 93% of the firm. But today the lawyers dealing with Hanover's failure believe Schatzer was a figurehead; the real powers in the firm appear to have been the man who "motivated" the brokers to sell, Roy Ageloff, and an administrative boss, Robert Catoggio, both of whom had struck deals to share in Hanover's profits.
Ageloff, known to sometimes behave oddly, once warned a visitor to Hanover's headquarters that "the walls have ears." If so, they heard endless rounds of high-pressure, cold-call sales spiels laid out on the phones by about 150 brokers, most in Manhattan and some at a second Hanover office in Boca Raton, Florida. Almost always the brokers were superaggressively selling Hanover "house stocks," which mainly consisted of seven obscure IPOs--brought out between February 1993 and January 1995--for which the firm was the managing underwriter.
All these offerings were remarkable look-alikes: What the public bought each time was a $5 unit consisting of stock and warrants. The units sold produced $5 million or less for the selling company, after Hanover had stripped out unusually large fees and also lined its pockets with extras, such as warrants exercisable later on. Most important, none of the IPO companies had financial credentials or business prospects that made them look like reasonable investments. They were corporate gnats, with plenty of risk--which the walls predictably never heard much about.
But, hey, do facts like that necessarily kill an IPO? Each of the seven offerings leaped immediately to a premium over the $5 offering price, with opening prices ranging from $6.375 for Mr. Jay Fashions, the first sold, to an astounding $23.50 for Play Co. Toys, sold in November 1994. In there also was All-Pro Products, maker of an isotonic sports drink, whose president was the New York Giants' Taylor and whose IPO opened at $11.625. Naturally, Hanover's record with IPOs brought in new customers--some of them total babes in the woods.
To ensure peppy performance from its IPOs, Hanover also engaged in some self-help--illegal variety--by requiring that investors lucky enough to get IPO units thereafter prop the price by buying perhaps three times as much in the after-market. As that suggests, the 3-to-1 purchases weren't acts of free will. "Your broker just bought automatically," says one customer, Sean Erez, "basically without even checking with you. And then a confirmation would show up in the mail."
Now, meet the firm that was sending those confirmations. It wasn't Hanover--known as a correspondent firm--but rather the "clearing firm" it had hired in effect to be its back office. In the way that Wall Street works, Hanover's clearing firm also stood "in its shoes" on trading obligations, guaranteeing that these would be paid.
And this pigeon was Adler Coleman Clearing Corp., owner of an old Wall Street name. In 1991 this operation hired a new boss, Edward J. Cohan, now 59, a veteran Wall Streeter. Three years later, in September 1994, he led a group that bought the business outright, capitalizing it with about $12 million. Adler was then clearing for some 40 firms, with more than 50,000 retail customers, and was doing well enough that it was thinking it might do its own IPO.
Alas, Adler then met up with Hanover, which was shopping for a new clearing firm. There were red flags: Hanover had been the loser in a number of NASD arbitration cases in which customers had charged the firm with misrepresentations and unauthorized trading. But, for Adler, the firm's aggressive reputation also had a certain business appeal. Hanover had 12,000 customers, was doing hundreds of trades a day, and as Cohan says, "was growing." So not for the last time in American business, ambition prevailed, and in October 1994 Adler took Hanover on as a customer.
We come now to Hanover's last IPO and ultimately its agent of doom, Panax Pharmaceutical, a company organized in 1993 by Russian botanists, among others, to harvest medicinal extracts from plants. Panax, based in New York City, had an income statement in its IPO prospectus that was topless: The company had no revenues. Zilch. But it did have expenses and had accumulated losses of $461,000.
Panax's executives began looking in 1994 for an IPO underwriter. Who should call but Hanover Sterling, making the uncontestable point that the prices of its offerings had done well. "We went down to see them" says J.R. LeShufy, a Panax executive, "and it was a wild scene--everyone was running around." But Schatzer and Ageloff said Hanover could sell Panax's stock and do it soon. So Panax said, "Go."
Panax went public on Wednesday, January 18, 1995, and was immediately caught up in what soon seemed to LeShufy like "a movie." The cast by this time had expanded sharply, to include a convicted felon named John Timothy Moran, 43, and what he calls "rat packs" of shortsellers. A Queens, New York, native who once intended, he says, to become a priest, Moran was instead busted in 1991 for manipulating stocks. Pleading guilty, he avoided jail by negotiating a plea agreement that, among other things, obliged him to spill whatever he knew about wickedness in the securities business to the lawmen on his case, who included FBI agent Brown. The SEC moved in also, barring Moran forever from working for a securities firm.
Since then Moran has operated on the fringes of the securities industry (does Michael Milken come to mind?), where he advises small companies that want to go public or which, once they have, want to escape shortsellers. A going-public client got Moran to Hanover's Ageloff, an old friend. The two men agreed in late 1994 that Hanover's next IPO after Panax would be Moran's client Seabrite Foods, a Florida seafood wholesaler. So, to prepare the way, in mid-January 1995 Moran started turning up every day at Hanover's offices to help the levitation of Panax. Gratifyingly, whoosh went the IPO, from $5 to above $20 on day one.
Hanover, though, had gone on the field once too often with feeble fare. In swarmed the shortsellers. They'd been buzzing around Hanover for some time but had never exactly lit. Now, they seemed to sense they had the stock, the firm, and the right time to raid.
For shorts, the small-cap over-the-counter market, which was the home of all the Hanover house stocks, is a kind of juicy last frontier. In more grownup parts of the market, rules impede the ability of shorts to bombard a stock that is already headed down. But they can pound a small-cap stock with all they've got, subject only to one constraint: An investor selling short must supposedly ascertain, through his broker, where he is going to borrow the stock that he has, by his sale, promised to deliver. Were this "affirmative determination" rule followed, it would tend to limit short sales, since the amount of borrowable stock is finite. But the rule is often flouted, which means that so-called "naked short sales" are common. Moreover, the rule doesn't apply at all to bona fide market makers. As a result, a firm will sometimes claim to play that role, even though its real intention is shorting.
Legal papers charge that bogus market making and naked short sales were staples of the Hanover affair. Those same papers name the main shortsellers, and a colorful crew they were. They include Fiero Brothers of New York, a brotherless two-man outfit run by one John Fiero; Joseph Roberts & Co. of Boca Raton, whose principals, Joseph DeSanto and Robert DiMarco, contributed their first names to the firm; Sovereign Equity and Falcon Trading of Boca Raton, and Roddy Di Primo of the Bahamas, which are all alleged to have close connections with Philip Gurian, a man barred from the securities business (Gurian contends that he isn't connected to any of these businesses); and two Colorado firms, Mitchum Jones Templeton of Durango and Aspen Capital Group of Denver. In April 1995 the NASD censured, fined, and levied a 30-day suspension on Stephen Carlson, Aspen's head man, for trying to extort bargain-priced stock from a small Las Vegas company called Teletek.
Records show that after Panax floated above $20 per unit all through its first two days of trading, Aspen, Falcon, and Mitchum Jones began shorting the issue. Then came a bolt often thrown by shorts: calls to Dan Dorfman, the CNBC broadcaster, encouraging a bearish story. And on Friday, the 20th, at noon, speaking from his then office at Money magazine (which is a sister publication of FORTUNE's and which has since fired him), Dorfman reported that Steve Carlson--"a money manager who is short the stock"--thought Panax "a joke," as he also did two other Hanover house stocks, Mr. Jay and Environmetrics.
Panax's stock was getting hammered even before Dorfman spoke. A second hit came from the NASD, which responded to reports (perhaps false) that Hanover market makers weren't answering their phones by knocking the firm off Nasdaq's electronic trading system, which shut down Hanover's ability to trade. That kayoed the only market maker that really cared about the house stocks, and their shares ate more dust. Later in the day the NASD put Hanover back "on the box," as the term goes, but the damage to the stocks couldn't be made up. Almost all the house stocks fell sharply that day, with Panax tanking from above $20 to about $13.
It is probable that a death rattle set in right then at Hanover; certainly the firm had in minutes gained multitudes of shocked and disenchanted customers. Outwardly, though, Hanover didn't buckle. Instead, on Monday, it kicked up the prices of its house stocks, propping them with both its own capital and that of customers it could continue to rope in. Rising with the rest of the house stocks, Panax closed just above $17. But naturally, the higher prices again attracted the shorts, who kept on hitting Hanover with sells.
Only a few days had passed since the Panax offering. But it appears that Hanover, and also Moran, had concluded that this thing with the shorts wasn't likely to end quickly and that the firm had better mobilize for a defense. Adler's Cohan pushed Hanover to bring in more capital, which it blithely promised to do, talking about an $8 million infusion from an outside investor.
Strangely, Hanover appears never to have seriously considered "squeezing" the shorts by requiring that they physically deliver the stocks they had shorted. The sellers would no doubt have found that expensive, since Hanover's customers owned the great bulk of the shares being shorted and could have demanded high prices for giving them up. But a squeeze takes time to pull off and can, in the opinion of some, draw in still more shorts. Says Cohan today: "It's crazy to even suggest that they should have asked for physical delivery. All that would have done is create high prices that would have encouraged more shortselling."
John Moran, meanwhile, had devised his own emergency plan, which left him playing double agent. On one front, he reverted to being a government informant, making calls daily to True Brown and less regularly to other authorities to describe what he saw as a concerted, illegal bear raid that they should stop. On a second front, Moran joined in a different illegal scheme that he thought would make the shorts disappear.
Working this plan, he acted as middleman in what court papers describe as "the first extortion," though of course the shortsellers deny that it was any such thing. According to Moran, he was told early in the week of January 23 by two of the shortsellers he knew, Phil Gurian and John Fiero, that the shorts in general would go away if Hanover sold them "cheap stock" to cover their short sales. Moran says he got a bitter but resigned Ageloff to accede. All concerned agreed that the deal would be carried out on January 26 by way of Hanover selling large blocks of its house stocks to Fiero, then identified as a Nasdaq market maker in those stocks. Ageloff therefore closed up shop on the 25th thinking that he was about to free Hanover from the shorts.
But when the market opened the next morning, the shorts were still there. Ageloff erupted in fury, immediately calling Fiero and exhibiting his anger in a way perhaps not previously described in FORTUNE. Fiero, a black-haired 34-year-old, explained in a deposition what happened when Ageloff called: "He flatulated on the phone and proceeded to curse and yell, curse my mother and everything I stand for." Fiero, who stutters slightly, immediately reacted by wrathfully calling Moran, and saying, "Roy got on the phone with me and f-f-f-."
Fiero told Moran he wasn't going to take that kind of stuff, and the deal was off. Presumably that meant he was returning to shorting--or maybe, as Moran thinks, he was just angling for better terms on the trades originally planned. Moran, in any case, wasn't about to let this deal die. In a string of cajoling and even begging phone calls he got the transaction back on track.
And at the end of the day, and on the next morning, shortseller Fiero bought $12,344,000 of nine Hanover issues--stocks, warrants, or units. At the same times that Hanover was doing those trades with Fiero, it was quoting prices on the Nasdaq screen that would have brought in $13,636,000 had Hanover done precisely the same transactions with ordinary buyers. So if you want to think extortion--rather than simply smart trading, as Fiero argues--it amounted to the difference, or $1,292,000.
The Cleary Gottlieb lawyers who are today fighting the shortsellers allege that Fiero next distributed his big blocks of Hanover stocks to other shorts, thereby allowing them in on the extortion. By the end of the day on the 27th, Fiero had sold off almost all of his Hanover house issues--at markups that netted him roughly half of that $1.292 million difference--to other firms, particularly Falcon Trading, and a broker allegedly working for Falcon, A.T. Brod (which has since been put out of business by the SEC). On the following day, Fiero quit being a market maker in the Hanover issues. Fiero said he had promptly begun getting anonymous phone calls that charged him with profiteering on the trades. The whole situation, he said, had turned "ugly and violent," and he wanted out.
A Cleary Gottlieb partner, Mitchell Lowenthal, says that's bunk: "Fiero quit market making because he'd told Hanover that he'd leave their stocks alone if he got the cheap stock. So to make it look like he was keeping his word, he took his name off the box."
But in fact trading records show that Fiero kept on selling the Hanover stocks short thereafter. He just didn't trade directly with Hanover. And for their part, both Hanover and Moran quickly concluded they'd been duped.
After that, threats flew. Grousing to shortseller Gurian one day on the telephone, Moran says he suddenly realized that the phone had changed hands and that he was talking instead to a "gravelly voice"--an "underworld guy," Moran concluded--whose unknown owner yelled that the issue was now "about blood" and down to something "personal" between him and Roy Ageloff. Gurian says that this story is untrue and that Moran is a "pathological liar."
Sometime during this period, Fiero got a package he won't forget delivered to his office: a dead fish. And on February 13 he was visited memorably by Ageloff and somebody named "Bob," and then by two other Hanover people. A week later, Fiero filed a "harassment" police report on the incidents, saying that his first visitors from Hanover had questioned him on "business dealings" and that the second two had arrived to say they didn't like his answers. Growled one of the two: "I just wanted to see your face before I see you later."
Threats or no, the two sides in this gutter war had by that time swung into fixed positions. Trying apparently to wear the shorts out by denying them the plunges they wanted, Hanover set up a kind of Maginot Line on prices, propping its stocks at artificial levels that it sustained by either buying for its own account or arm-twisting new purchases out of its increasingly restive customers. Panax affords one example of a propped price: For more than three weeks beginning at the end of January, Hanover kept its Panax bid at just over $17.
And the shorts? They just kept selling. Periodically, they would face a deadline for delivering stock they'd sold short. But since Hanover still wasn't requiring physical delivery of the shares, this "fail to deliver" would be closed out by a painless no-profit, no-loss bookkeeping transaction--and the shortsellers would simply "roll," as the term goes, into a new short. As February wore on, moreover, the amount of shorting in Hanover's stocks jumped.
Obviously, the Maginot strategy was a profoundly expensive, tightrope proposition for Hanover. Why did it not just angrily concede victory to the shorts by dropping its bid way down? Because, first, there was no telling with these stocks where the cellar would have been; and, second, Hanover could stand neither the capital damage nor the prospect that its customers would start reneging on what they owed.
For that matter, Adler Coleman couldn't tolerate these consequences either. But Adler's Cohan says he didn't begin to understand the severity of Hanover's short problems until very late in the game, and did not in fact learn about the extortion--which he says shocked and horrified him--until one day before Hanover closed.
One person claiming to have sensed the disaster forming is John Moran, who was still singing to the authorities and who had even warbled about the extortion. Now he got down to pleading for action, pronto.
Sometime in February--he's not sure of the date--Moran flew to Washington at his own expense and there told Cameron Funkhouser, the NASD's deputy director of market surveillance, that he believed the shorts had progressed from thinking they could make a few million dollars to believing they could kill Hanover and thereby drive its stocks to zero. Moran averred that both Hanover and Adler Coleman "were days away from wearing toe tags" unless the regulators stopped trading in the Hanover stocks. A freeze would buy time, Moran said, and allow the regulators to unmask the shorts' illegalities.
Funkhouser then called Bruce Newman, an enforcement branch chief in the SEC's New York office, and they talked, after a time, with Moran out of the room. When Funkhouser called Moran back in, the official told him that the SEC, the only party having authority to order a shutdown, would not do so because it did not yet have enough "hard evidence" to back up that kind of extreme move.
The NASD's Funkhouser generally confirms this account but characterizes Moran's evidence as much weaker than its owner likes to claim. Newman of the SEC declined to comment. And the FBI's True Brown didn't return FORTUNE's calls.
Moran's reckoning, though, proved correct to a deadly extent: Hanover went out of business on Friday, February 24, and on the next working day, February 27, it was followed into bankruptcy by Adler Coleman.
Hanover stayed low class to the end. The Cleary Gottlieb lawyers now on the case believe that the firm recognized by no later than Friday, February 17, that it did not have enough financial staying power to survive the shorts' attack. By then, it had allegedly received new extortion demands from the shortsellers. Ed Cohan says Schatzer and Ageloff told him on the 23rd that the shorts were now demanding a $4 million payoff, plus 10% of Hanover's next two IPOs.
This "second extortion," unsurprisingly, did not come off. But what did occur in Hanover's offices in those last days was a shamble of trades aimed at getting favored customers out of the house stocks and into better merchandise. In a typical example, a Hanover broker--not always with the knowledge of his buddy customer--would sell that holder's Panax at its propped price of around $17 to another, invariably unknowing, customer. To complete the fraud, the broker would then phony up the address of customer No. 2 so that he would not get an inexplicable confirmation telling him he'd bought Panax.
Since the bankruptcies, hundreds of fraudulent Hanover trades have been nullified. But these reversals also mean that many customers who thought they'd sold the house stocks in the final days actually didn't. That doesn't include George Steinbrenner, whose Hanover account was free of anomalies, and who simply had to suffer the disruption of getting his account out of a failed firm. But the account of his son, Harold, 27, showed a sale of 13,000 Panax units at $17.25 on February 24, and that trade, totaling $224,000, is among those disallowed. Harold Steinbrenner is protesting the decision. That isn't surprising, given that his Panax units, which have continued to trade in the market but which he cannot sell because his account is frozen, are now selling for under $1 each. The other house stocks are way down also.
By all accounts, the Manhattan offices of Hanover on its last Friday in business were a madhouse, filled with people shoving each other and running around and conniving to do crooked trades. Worried about the safety of records pertaining to an investigation it by then had in progress, the New York office of the SEC sent over two staffers who gasped at the bedlam and then left, intimidated. The NASD couldn't leave, because it had to get the place closed down. But before they managed to get the job done, one NASD supervisor, a pregnant woman, was forcibly prevented by a Hanover employee from phoning for help, and two other NASD representatives were for a time locked in President Schatzer's office.
Adler's end, on Monday morning, did not come without a fight from Cohan. To this day he believes that Adler could have opened on Monday in capital compliance and next scrambled together emergency funds. But the Hanover wreckage indicated that Adler would promptly have to make good on trading obligations amounting to at least $20 million and maybe much more. And on that weekend, Adler's regulator, the New York Stock Exchange, another slow foot in this disaster, moved to the judgment that the firm could not pay. So down it went. Cohan is right now doing consulting work for brokerage firms.
Hanover's Schatzer and Catoggio won't be working on Wall Street again. They've been barred from the securities business by the SEC for manipulating the stock of All-Pro Products. Ageloff is in Florida, living in an upper-crust Boca Raton community and dodging subpoenas. His name may resurface as the regulators and the FBI move ahead with investigations they're making.
The question of how much the Hanover and Adler bankruptcies are going to cost SIPC is hung up in the courts. In March 1995, the Adler bankruptcy trustee, Edwin Mishkin of Cleary Gottlieb, made a decision to "buy in" all the house stocks that Hanover had purchased in its last weeks but that had never been delivered. In effect, that meant he was commanding the shorts to deliver the stocks they'd promised. But Mishkin and everyone else knew the shorts couldn't comply, since most of the shares at issue were in frozen Hanover accounts.
The shorts had thought the buy-in would be a bookkeeping transaction done at the low prices to which the house stocks had fallen after Hanover closed. In other words, they were sitting with Panax short sales that had been done around $17, and they expected to be bought in at, say, Panax's early March 1995 prices of about $5. They would thus have pocketed the difference of $12.
Instead, the trustee declared the short sales fraudulent and bought in the shorts at the average prices Hanover had paid--for Panax, that was $17.125. That wiped out the profits of many shorts. Certain others who had ventured short sales after Hanover failed were hit with outright losses. Overall, the shorts either gave up profits or actually incurred losses amounting to more than $17 million.
Outraged, certain of the shorts, including Fiero and Joseph Roberts, sued the trustee, claiming that the buy-ins were illegal. It is entirely possible that these suits will go to trial. It is even possible that the shorts will win. Said one regulator recently: "Some of these issues, such as what's bona fide market making and what isn't, have never been proven in a case. And then you have to prove intentional, fraudulent purpose. I'm telling you, this isn't going to be a laydown."
Much more certainly SIPC and the Adler Coleman estate are footing some bills to remember: For its first year of service, Cleary Gottlieb alone was paid $3.9 million.
Could all of this have been headed off? Ed Cohan found himself asking that the very day after Adler's bankruptcy. That was when True Brown suddenly called and said he wanted to come by. Cohan hadn't then even heard Brown's name, but he simply assumed the FBI was after information. Instead, Brown, whom Cohan remembers as clean-cut and wearing a gun, faced Cohan at a table and for about 20 minutes recited the tale of Hanover and the shortsellers, complete with all their names.
Cohan says he looked at Brown in disgusted astonishment and asked, "Well, if you knew all this, why didn't you do something about it?" Good question. We'll hold, agent Brown, for an answer, and you can find me--Carol Loomis--at 212-522-3708.
REPORTER ASSOCIATE Melanie Warner |
