The first issue of Institutional Investor, published in
1967, provides the earliest written record of the U.S. asset
management industry. Unbeknownst to any reader at the time, it
also contains the seeds of a scandal one whose
underlying causes persist today.
A review of the issue revealed some interesting artifacts
(my favorite: The Case for Front-End Loads).
However, its an advertisement for Merrill Lynch,
Pierce, Fenner & Smith that reveals
prehistoric evidence of the structural misalignment
between asset managers and clients.
Initially and unsuspectingly, I was drawn to the ad because
of its headline: Why do so many pension funds do business
with Merrill Lynch? (The emphasis is from the
Pension funds struck me as an odd target. In 1967, U.S.
defined benefit assets (DC plans would come on the scene in
1981) totaled about $150 billion; few funds allocated to
equities, and fewer still managed assets internally.
Then my interest shifted from the headline to the ads
message, which touted the value of Merrill s industry
analysts. Specifically, the firm presented Arch Catapano
its aerospace analyst as its exemplar. Though the ad
describes Catapanos research methodology in words similar
to those used for IIs current All-America Research Team
aerospace analyst, Ron Epstein, what really caught my attention
was the picture of Catapano. His posture and visage genuinely
made me believe the claim that . . . when it comes to the
aerospace industry, we count on Arch to supply [in-depth
I looked further into Catapano and discovered that you
could, indeed, count on him for in-depth research; the SEC
would later investigate him, his employer, and numerous
colleagues for insider trading.
In August 1968 the SEC ordered an administrative proceeding,
alleging that in June 1966 Merrills research department
had passed confidential, price-sensitive information to its
institutional brokerage clients. Before the underwriting of a
new convertible debenture by Douglas Aircraft (a predecessor of
McDonnell Douglas), Douglas officials notified an employee in
Merrills underwriting group that it would experience a
significant deterioration in
earnings. Following the then-existing Merrill communication
policy, this employee passed the negative earnings
information to a research executive in the New York
institutional sales office none other than our man
According to SEC documents, Catapano acknowledged
the help the information provided in developing his knowledge
and understanding of Douglass affairs, and agreed not to
discuss the information with anyone outside of Merrill Lynch
and with no one inside the firm except two specifically
named colleagues. Ignoring his commitment, Catapano
acquainted his assistant, Carol Neves, and Phillip Bilbao, then
head of Merrill Lynchs Institutional Services Department,
with the earnings data.
At this point the dam broke: The SEC claimed that Catapano
and some colleagues had shared the negative news with a small number of institutional
investors who were interested in Douglass stock
even as Merrill was advising other investors to buy
In November 1968, Merrill consented to penalties including public censure, the
temporary closing of two operations, and the censure of ten
executives, including Catapano. (This enforcement action did
not spell the end of Catapanos career at Merrill; a 1975
New York Times story reported that
Arch J. Catapano, who heads fundamental research at
Merrill Lynch, is the man who recruited the star
The story only gets better from here. The
institutional investors who were the alleged
recipients and beneficiaries of the Douglas information were
not the aforementioned pension funds in fact, we might
presume they were among the clients being told to buy Douglas
but Merrills asset management clients, including a
group of hedge funds.
Yes, there were hedge funds in 1967. Although no definitive
directory exists, a 1970 Fortune article gave a
wobbly estimate of 150 hedge funds managing $500
Merrills clients were not just any hedge funds,
however. In aggregate, they managed more than half of all hedge
fund assets and included two founded by A.W. Jones, the father
of hedge funds, and six other funds that traced their lineage
to Jones: City Associates; Fairfield Partners, co-founded by
Barton Biggs; three partnerships affiliated with John Hartwell,
who was the subject of a praiseworthy portrait in IIs
first issue; and Fleschner, Becker Associates, whose principals had been Joness brokers
(and who later would be involved in what some call the first hedge fund blowup).
By June 1970, the SEC had censured all of them.
The Douglas Aircraft controversy is not just another case of
hedge funds using inside information for their own benefit. It
was also the earliest known enforcement case involving hedge
funds, the first insider trading case in which hedge funds were
implicated, the first class action against a hedge fund, and
the first use of the term tippees to designate
parties that receive inside information. More generally, the
case spurred the SEC to investigate ways to regulate hedge
funds and register the general partners.
The case is also significant because it serves as the
historical archetype of the structural asymmetry between asset
managers and asset owners an asymmetry that persists
today. The ad proclaims Merrills commitment to pension
funds, yet the firm was apparently acting against the
funds best interests. The ads final sentence reads:
When Arch Catapano has something to say about the
aerospace industry . . . we think it makes good sense for any
pension fund to listen.
And, apparently, do the opposite. Whats worse, that
advice is often still valid today.