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 original.)
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 research].
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 Catapano.
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 the stock.
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 analysts.)
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 million.
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.