Kidder, Peabody

ONCE CONSIDERED a conservative second-tier investment firm, Kidder, Peabody survived two insider trading scandals in the 1980s before collapsing after bond trader Joseph Jett's schemes went awry. The first insider trading scandal broke in 1984, when Wall Street Journal columnist R. Foster Winans confessed to the Securities and Exchange Commission (SEC) that he had passed tips to broker Peter Brant. In 1985, Brant pled guilty and became the key witness against Winans, Winans' roommate David Carpenter, and Brant's long-time friend and fellow broker Kenneth Felis. All eventually served brief prison sentences.

Two years later, former Kidder, Peabody investment banker Martin Siegel, who had since moved [Page 485]to rival Drexel Burnham Lambert, pled guilty to selling insider secrets to arbitrageur Ivan Boesky. Siegel's testimony implicated two bankers at Kidder, Peabody; both were arrested, but charges were later dropped. The straw that broke Kidder, Peabody's back was the $350 million in phantom trades posted from 1992 to early 1994 by Jett, the company's Man of the Year and only African-American trader. Hired in 1991 for the company's government bond desk, Jett turned around his mediocre performance late the next year, when a glitch in newly installed software provided an opening for apparent profits.

Jett dealt in U.S. Treasury securities under the Separate Trading of Registered Interest and Principal of Securities (STRIPS) initiative. STRIPS allows traders to separate a bond into its principal and its interest, then trade the two separately. A bond would be stripped for trading, then reconstituted for its maturity date. Since bonds predictably increase in value as they near maturity, the securities market ordinarily offers low profits for low risks.

A quirk in how the software handled “forward settlements”—reconstitutions that were promised now but would take place in the future—allowed Jett to create large apparent profits. The system recorded a reconstitution as the purchase of a bond immediately and the sale of its related strips on the settlement date. Since the strips are inherently worth more later, this recording method created the illusion of large profits: the further away the settlement date, the larger the profit. However, when the trade was settled, the value of the bond and its strips would be nearly equal; only a small profit from recognizing undervalued strips could actually be realized. A paper profit of $300,000 might dwindle to a real profit of $30,000 at settlement.

By late 1993, Jett was habitually flipping strips: that is, bonds were reconstituted, then stripped again before their settlement dates, resulting in new settlement dates further in the future. The software recorded profits from each transaction, pushing his 1993 profit to over $150 million on a trading position limited to under $15 million. Upon firing Jett in spring 1994, Kidder, Peabody claimed he was a lone wolf who committed fraud to boost his annual performance bonuses. Jett contends he was the cat's paw in a larger scheme to hide Kidder, Peabody's financial position from parent company General Electric (GE), which had acquired an 80 percent share in the investment house shortly before the Boesky scandal. His strips-flipping activities allowed his immediate superior, Ed Cerullo, to keep Kidder, Peabody's over-leveraged position off the books seen by GE. Jett argues that his superiors knew, approved of, even insisted on his activities. They swore to the Securities and Exchange Commission (SEC) that they never looked at his records.

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