The Washington Post, by David A. Vise and Steve Coll

In Six Years At SEC, Shad Spurred Radical Change

(All stories credited to David A. Vise and Steve Coll.)

On March 19, 1980, John Shad, a chain-smoking bulldog of a man with an imposing manner, ushered future president Ronald Reagan through the New York Stock Exchange -- across the boisterous trading floor, up to the exchange club and finally to a richly appointed conference room full of select leaders from business and Wall Street.

Shad waited outside. After 31 years on Wall Street, rising to become a multimillionaire and vice chairman of E.F. Hutton Inc., he was restless. He was no politician, but he wanted to make his mark in government.

The door swung open. Laurence A. Tisch, who would later become chief executive of CBS Inc., came out first and flashed a "thumbs up" sign -- the group approved of Shad's candidate.

Eight months later, Reagan won the White House and rewarded the 58-year-old Shad by making him chairman of the Securities and Exchange Commission, Wall Street's top cop. Shad resigned from Hutton and headed for the capital, the first Wall Street executive to chair the SEC in 50 years.

When he departed six years later, the SEC, Wall Street, the stock market and the economy had undergone radical changes -- spurred in many ways by Shad's policies, and shaped by his forceful, passionate personality.

Shad's policies contributed to fundamental changes in the nation's stock markets that cannot feasibly be reversed. He quickly cut a political deal that gave birth to new, highly speculative financial products. While Shad brought a record number of insider trading cases, he chose not to use the SEC's considerable powers to aggressively regulate the debt-financed hostile takeovers that rocked the economy. He redirected the SEC's vaunted enforcement division, seeking to prevent large companies from being prosecuted for wrongdoing by individual employees. He threw out SEC regulations that he considered duplicative and expensive for companies, freeing billions of dollars for other uses.

Without the SEC peering as closely over their shoulders, some of the biggest investment firms witnessed a breakdown in discipline among their stockbrokers, especially in the area of fraudulent sales practices. Many institutional investors evaded federal rules designed to control speculation in the new financial products, a contributing factor in the 1987 stock market crash. While Shad's actions alone did not cause the crash, they helped unleash economic forces that went beyond what he anticipated or any government agency was able to control.

This is the first of four articles examining how John Shad remolded Wall Street and the SEC between 1981 and 1987, a period that witnessed a record rise and fall in stock prices and the biggest Wall Street corruption scandal in history, involving Ivan F. Boesky and Drexel Burnham Lambert Inc. The series is based on more than 200 interviews with present and former SEC officials, Wall Street executives and others, as well as an examination of commission documents, court files and congressional testimony.

Shad's legacy at the SEC and in the financial world amounted to much more than deregulatory tinkering: he pushed to redefine the purpose and character of the commission and its work.

In the 1970s, the SEC had become a free-wheeling, self-described enforcer of morality in the nation's corporate boardrooms, pursuing a broad mission "in the public interest." Shad believed the agency's main purpose should be narrower: to protect and enrich stockholders by making sure the financial markets were fair and orderly.

From the beginning, he met with stiff resistance from the SEC bureaucracy. He waged a kind of guerrilla warfare at times and lost many battles along the way, particularly on Capitol Hill.

Yet he was hardly one-dimensional in his thinking. Nor were his ideas strictly a proxy for Wall Street. He believed fervently in aspects of deregulation and the Reagan administration's attempt to promote freer markets, but he pushed legislation through that created stiffer penalties for insider trading.

He had made it from Mormon Utah, where he was born, to a plush apartment on Park Avenue in Manhattan, but his years on Wall Street did not smooth away all the rough edges. He had none of the elan of an investment banker, usually mumbling and chain-smoking his way through testimony before Congress, his bulldog face reflecting a deadly earnestness, not pleasure. SEC staff members talked openly about how difficult it was to understand him when he spoke.

Behind his austere demeanor was a flair for living that surprised many of his colleagues. He drove fast, whether cars or boats. He took physical risks, going skydiving and shooting white-water rapids. He loved to bet, sometimes going out with fellow commissioner Bevis Longsteth to wager on a game of Pac-Man at the Little Tavern restaurant on Wisconsin Avenue in Georgetown. And when Michael Jackson came to town for a concert, Shad went alone to the show at RFK stadium to see what the excitement was about.

He came to Washington in 1981, eager to sample the social privileges that come with being a top-ranking official in the capital. Within a few weeks, however, his wife Pat suffered a paralyzing stroke. Shad abandoned plans to buy a house in Northwest Washington, took his wife back to New York and endured a dual existence for the next six years, living in District hotel rooms during the week and commuting to Manhattan on weekends.

In the capital, he often worked past midnight, then rode alone in a cab to his hotel to eat Campbell's soup heated on a stove in his room.

Come the weekend, he flew to New York and dined with his family, sometimes getting together as well with Wall Street's wealthiest bankers and lawyers.

To some of the SEC staff in Washington who opposed vigorously the changes underway at the commission, Shad's weekly commute became a disquieting metaphor: After years of proud warfare between Wall Street and the SEC, Shad had ushered in a new era of shuttle diplomacy aimed at bringing them closer together.

An Alliance Is Born

During his many years on Wall Street, John Shad often told friends that he planned to finish his career in public service, a goal he credited to his Mormon grandmother, who had said a person should spend one third of his life learning, one third earning, and one third serving.

By the late 1970s, Shad had accomplished the earning part: he had built a fortune of more than $10 million. But his career at Hutton had peaked and Shad wasn't sure what he would do next.

All that started to change when Shad took a summer vacation with some Hutton colleagues at the Bohemian Grove north of San Francisco, an exclusive, all-male summer camp for business and political leaders. One day, Shad had a chance meeting with the former governor of California, Ronald Reagan, who was wearing cowboy boots and sat perched on a railing, absorbed in a performance by the ventriloquist Edgar Bergen.

When the show ended, the two men took a walk and ended up at a part of the camp known as The Hillbillies, where Shad had lunch. His waiter was George Bush, who was taking his turn that day serving tables at the Grove.

Shad's brief talk with Reagan that day flowered into a political alliance. During Reagan's campaign for the presidency in 1980, his campaign approached Shad and asked him to handle the candidate's fundraising in New York.

Few on Wall Street or in the boardrooms of the Fortune 500 -- few of Shad's peers -- supported Reagan that early. Most favored Bush or former Texas governor John Connally. But Shad had been impressed by Reagan's positions on key issues. He made it known within the campaign that he wanted a job in Washington if Reagan were elected.

Shad was pegged for the SEC chairmanship because of his strong background in finance and because he "was probably the first businessman on Wall Street that came out early for Ronald Reagan," said former White House personnel chief E. Pendleton James. He breezed through his confirmation hearings.

On Wall Street, Shad had tried and failed to gain the top job at Hutton. It had been a painful defeat. Now, finally, he was in charge of an institution.

A Contest of Wills

John Shad was in many ways naive about how Washington worked. He didn't realize how much resistance he would encounter from the SEC's vast bureaucracy and its supporters in Congress. Shad was undaunted. He was used to battling until he got his way. One top aide nicknamed him "the Russian" because he was always negotiating for other people's turf.

The SEC that Shad took over in 1981 had been dominated for a decade by the ideas and personality of Stanley Sporkin, the commission's longest-serving enforcement chief. Sporkin had pushed the SEC to regulate corporate behavior through aggressive and creative law enforcement. Some on Wall Street and elsewhere believed Sporkin, who left the agency just before Shad arrived, had overreached.

Shad's early decisions signaled a new era. The chairman's office turned down a 1982 recommendation by the SEC's market regulation division to investigate alleged tax fraud at the Philadelphia Stock Exchange and the Chicago Board Options exchange. Shad made it known that the commission would not pursue cases unless they related directly to the securities laws.

While approving some corporate misconduct cases left over from Sporkin's time, Shad pushed the enforcement division to change its priorities -- he wanted the commission to go after individual crooks, especially those who engaged in illegal insider stock trading.

At times Shad seemed to regard some of the SEC staff as his adversaries, and relied on friends who were Wall Street lawyers or corporate directors for advice. Early on, Shad invited Johnson & Johnson Chairman James Burke, a classmate of Shad's at the Harvard Business School, and other corporate leaders to talk with SEC staff about what they thought the agency should be doing. Wealthy Omaha investor Warren Buffett came to discuss accounting issues with a selected group of the SEC staff.

Throughout his tenure, he talked regularly with Wall Street takeover experts such as attorney Martin Lipton about SEC policy issues. Rather than selecting Sporkin's successor from inside the SEC, as was traditional, Shad hired John Fedders, a corporate lawyer from the outside, to be his enforcement chief.

To those inside the commission, in the Reagan administration and on Wall Street who supported Shad's drive to remold the SEC, the staff's resistance was seen as an act of bureaucratic self-preservation. "John Shad had the unusual habit of asking why," Fedders said. "The staff disliked him for that at first. They were used to an unfettered environment in which they got everything they wanted."

The SEC staff learned early on that John Shad hated wasting time in transit -- he called it purgatory. He held meetings in his car on the way to National Airport. He harassed taxi drivers about their speed and route selection. Returning from La Guardia Airport in New York one time during his days at Hutton, Shad instructed the taxi driver on the quickest way to reach 60th Street and Third Avenue, predicting the cost of the ride. The driver told Shad he was wrong. Shad offered to bet -- double or nothing the final amount on the meter.

"It was a real contest of wills and the cabbie agreed to do it," recalled Clarke Ambrose, a Hutton executive who was along for the ride.

When they arrived, following Shad's directions, the meter showed Shad had won. Shad paid the fare anyway but "the cabbie was so upset he couldn't speak," Ambrose recalled.

Shad charged around Washington the same way. He raced up to Capitol Hill and announced bold plans: He intended to cut the SEC's staff, change its internal budgeting procedures, and put in a new computer system to speed corporate filings.

Shad believed that regulation should be evaluated closely in terms of its costs and benefits -- and he believed the regulations requiring companies to make repetitive disclosures were more costly than beneficial. Shad pushed his changes through despite the opposition of several major Wall Street firms, which feared they would lose lucrative business if the process were changed.

At the same time, he rejected a Reagan transition report that recommended dismantling the SEC's enforcement division in Washington and sending the staff to the regional offices. And he dismissed the theories of some conservative economists who said, among other things, that insider trading should be made legal because it would help the stock market.

But the Democrats in Congress wanted no part of Shad's programs, and they tore into him. Rep. John Dingell (D-Mich.), the powerful chairman of the House Energy and Commerce Committee, initiated investigations of Shad's personal finances. He found nothing wrong. On the budget issue, there was no conciliation -- Dingell and other Democrats fought to defend the legacy of Stanley Sporkin, which they feared was being erased.

One day early in Shad's tenure, he was summoned to a basement conference room in the House's Rayburn Office Building for a private conference with Dingell and Rep. Tim Wirth (D-Colo.), then chairman of a key finance subcommittee and now a senator. Wirth was refusing to cut the SEC's budget.

"Shad was trying to figure out if I was serious about not cutting the budget," Wirth recalled. "I figured I'd bring in the big gun . . . .

"Dingell said this is what it is going to be and Shad got the signal loud and clear. Shad was almost shaking."

Shad moved firmly to control both the commission's internal processes and the policy positions it took in public. At times he discouraged other commissioners from testifying before Congress.

It appeared to some SEC staff and commissioners that Shad deliberately passed out copies of his own testimony, containing important policy pronouncements, at a point when it was too late for them to comment on its contents. Commissioner Aulana Peters finally insisted in 1985 that unless the full commission approved congressional testimony before it was given, it had to be labeled as personal opinion.

The effects of Shad's program were not immediately apparent outside the commission. It wasn't until 1984 and 1985 that radical changes began to occur in the stock market and the economy, influenced in part by Shad's policies, as the economy recovered from recession and roared ahead, speculative stock trading bubbled, and debt-driven hostile corporate takeovers boomed.

In the early years, Shad had few allies on the commission -- the four other commissioners had been appointed by previous administrations and they did not share Shad's fervor for change. Eventually, in the mid-1980s, their terms began to expire and free-market allies of Shad were appointed, giving him an effective working majority on controversial economic issues such as takeovers.

'The Oddest Thing' Inside the SEC's headquarters, shrouded by the secrecy that surrounds nearly all the commission's deliberations, an incident occurred in early 1983 that demonstrated just how much had changed under Shad.

The SEC staff was locked in a dispute with the insurance giant Aetna Life & Casualty Co. The staff thought Aetna's bookkeeping had been improper and wanted to wipe $200 million in profits off Aetna's publicly filed accounting statements, contending that this would give investors a truer picture of Aetna's financial health. Aetna officials said its books were accurate. A stalemate developed, and in January 1983 the issue was scheduled for consideration at a closed SEC meeting.

Outsiders are routinely barred from closed SEC meetings. Not only does the commission refuse to discuss or acknowledge closed cases, it does not permit defendants in enforcement cases to appear before the commission. A defendant's argument, if one is made, is submitted in writing.

Not this time. After consulting with the SEC's general counsel, Shad had agreed to allow John Filer, Aetna's chief executive, and Joe Flom, one of Wall Street's leading takeover lawyers and a personal friend of Shad's, to attend the meeting in the commission's sixth floor hearing room and present a defense. There was virtually no precedent for Shad's decision, the general counsel said, but it wasn't a violation of any rules.

There was an awkward moment as the meeting began. Nobody knew where Flom and Filer should sit. There were no assigned seats for outsiders.

Flom plopped down in a high-backed swivel commissioner's chair. Two were empty; the commissioners had withdrawn from the case because they had done work for Aetna before joining the SEC.

From his perch, Flom argued that the SEC shouldn't force Aetna to make the $200 million bookkeeping change in dispute.

"It was improper," said former SEC commissioner John Evans, a Republican, of Flom's appearance. "I didn't see any reason just because it was Joe Flom to let them in -- perhaps even more so because it was him." Added David Schwiesow, an SEC staff attorney who attended the meeting: "It was the oddest thing I ever saw."

Shad said the only reason Aetna was permitted to appear with counsel before the commission was because of the magnitude of the issues to it and the insurance industry.

Flom and Filer left the meeting room when the commission called for a vote. Aetna lost, 3-0. Shad voted last and joined the majority. He had made statements during the debate that some staff saw as expressing support for Aetna's position.

The image of Joe Flom in a high-backed commissioner's chair lingered long after the vote.

"Everybody was very embarrassed about it," Schwiesow said. Given the strong emotions that were stirred, it was a testament to the SEC's strong culture of secrecy that word of the incident was never leaked to Shad's Democratic opponents in Congress. Since the staff had prevailed, some in the agency said they felt no harm was done.

But others said they wondered where else John Shad's priorities -- and the complicated web of ideas and friendships he had brought with him from Wall Street to Washington -- would lead next.

(Courtesy of The Washington Post.)

Shad Fought SEC Cases He Thought Unfair

The Securities and Exchange Commission meeting room for cases closed to the public was packed when SEC Chairman John Shad arrived. Word of his impending confrontation with Bobby Lawyer, chief of the SEC's San Francisco office, had spread through headquarters, and the staff had come to the sixth floor to see who would prevail.

It was a winter's day early in 1985, and finally, after a two-year investigation and weeks of heated internal discussions, Lawyer was about to make his case that the SEC should lodge securities-fraud charges against Merrill Lynch & Co. Inc., the largest brokerage firm in the country.

If anyone from the public had known to ask, the SEC wouldn't have acknowledged that a discussion about Merrill Lynch was taking place. But inside the agency, the case had grown into an important symbol. The debate that day reflected nearly four years of tension between the SEC bureaucracy and Shad, who came to Washington from Wall Street believing that the SEC sometimes treated big brokerage houses unfairly. He adopted a new standard that made it tougher to bring charges against companies for wrongdoing by employees.

Shad's actions reflected his desire to steer the SEC away from what he viewed as excessive interference in the daily business of Wall Street, part of his broad interest in freeing brokerage firms and the stock exchanges from what he felt was overregulation that restrained the nation's economy.

Lawyer and other SEC staff attorneys felt that the Merrill Lynch case was a matter of law, not ideology. They argued that the firm had failed to act on accusations that a stockbroker had defrauded customers out of hundreds of thousands of dollars, and that the company should be punished. Shad objected; a firm as large as Merrill Lynch shouldn't be charged with fraud for a single employee's alleged wrongdoing, he said.

When Shad tried to block the charges against Merrill Lynch, Lawyer and the San Francisco staff insisted that they be allowed to come to Washington to present their case. They couldn't believe it was even necessary to debate the issue. Before Shad was appointed by President Reagan to head the SEC in 1981, the five-member commission had routinely approved charges such as the ones proposed against Merrill Lynch.

Shad, a self-made multimillionaire who had spent much of his career at the E.F. Hutton Inc. brokerage firm, changed all that, imposing a new policy on when such cases should be brought. Now, the staff proposed charges only in what they considered to be the most flagrant instances.

As the debate began, tensions ran high. Some of the staff members were afraid that John Fedders, the agency's enforcement chief and a Shad loyalist, would swing the vote against Lawyer. But the staff also knew that Shad sometimes found it difficult to muster the support of a majority of the other commissioners.

Although Lawyer had never appeared before the commission at a closed meeting, the overflow audience suited him fine. Ever since college, when he lived in Harlem and earned his tuition delivering carts of clothing to Manhattan's finest department stores, Lawyer told others that he wanted to be the kind of trial attorney he saw on television and at the movies -- one who could dominate a crowded courtroom and triumph with dramatic cross examination.

Who's Responsible?

It was a letter to Bobby Lawyer's office in San Francisco that began the whole affair. It arrived on May 17, 1982, from Jan Haraszthy, a retired wine merchant and a Merrill Lynch customer. Haraszthy complained that a Merrill Lynch stockbroker in San Francisco named Victor Matl had made a $ 15,000 transaction in Haraszthy's account against his expressed wishes and while he was out of town. Haraszthy also said that Matl's superiors had been unresponsive to his complaints.

This was the core of the SEC's regulatory and enforcement work: protection of individual investors against alleged fraud, inspection and supervision of brokerage firms, and enforcement of detailed rules governing how a brokerage should treat its customers. It was less glamorous than the headline-grabbing insider trading cases then being developed at headquarters in Washington, but such work occupied much of the time of SEC attorneys in the regional offices.

Shad thought the SEC had an important role to play in protecting investors from fraud, and had vowed to crack down on insider trading, but he pulled the commission back from close scrutiny of Wall Street brokerages' operations, particularly sales practices. As a longtime executive at E.F. Hutton, Shad believed that investment firms -- and the stock exchanges to which they belonged -- were well equipped to police themselves. He felt that transferring some responsibility to the stock exchanges would free up SEC resources, making the agency more efficient. The SEC would do its part by monitoring how well the stock exchanges handled their new duties.

A number of the SEC staff thought Shad's approach only exacerbated the conflict within Wall Street firms between their drive for profits and their obligations to the law. Shifting enforcement responsibility to Wall Street and resisting proposals to file charges against big brokerage firms for wrongdoing by employees resulted in a breakdown of discipline at the largest investment firms, these SEC staff lawyers felt.

The debate had far-reaching implications: It raised a basic question about who was responsible for detecting and preventing fraud on Wall Street. The issue took on added significance toward the end of Shad's tenure at the SEC, when the biggest Wall Street corruption scandal in history erupted, focusing in large part on charges of fraud by employees in a branch office of Drexel Burnham Lambert Inc.

Some staff attorneys and commissioners thought the Merrill Lynch case demonstrated that the stock exchanges and brokerages could not be relied upon to carry the burden of enforcement. Lawyer, while agreeing to answer questions about his background, declined any comment about the investigation of Matl or the debate over whether to file charges against Merrill Lynch.

For Shad, Lawyer's enforcement approach was an example of how the commission's staff sometimes tried to punish big Wall Street firms unfairly. "When one out of 10,000 account executives violates the law the question is whether it is sufficient to justify sanctioning a major securities firm," Shad said in an interview. "During this period there were a thousand other situations that were properly handled by the firm. If the firm has to be perfect the cost is enormous and it has to be passed on to the investing public. I have a basic visceral reaction to sanctioning the firm for one bad account executive."

Shad said, however, that any stockbroker who abused his customers "should be prosecuted to the full extent of the law."

Lawyer dispatched SEC investigator John Bruns to the Merrill Lynch branch in the San Francisco financial district on June 15, 1983. When Bruns arrived, he found a file of 35 complaints about Matl, raising questions in Bruns' mind about Matl's conduct as a stockbroker, about the extent of Merrill Lynch's investigation into the complaints and about the company's decision to retain him.

Max L. Christensen, an Episcopal priest, complained that Matl had defrauded him of $ 35,000 by making unauthorized trades and by pushing him into risky investments. Robert Reeves, a junior high school principal, said that he had told Matl his goal was to earn enough money through cautious investments to help his children buy homes, but that Matl pushed him into speculative stocks, causing him to lose about $ 10,000 in three months.

SEC records do not reflect Matl's response to these specific complaints, but Matl said on several occasions that he was authorized to make the trades that customers were complaining about. Without admitting or denying wrongdoing, Matl settled an SEC lawsuit in 1985 and was permanently barred from the regulated brokerage industry. His lawyer declined to comment.

As Lawyer's staff took testimony from Matl's customers, they thought they discovered part of the answer to the question of why Merrill Lynch had not launched a vigorous investigation when the complaints first came in: Matl was one of the top five salesmen in the booming San Francisco office. Between 1977 and 1983, he generated about $ 1.8 million in sales commissions, of which his share was about $ 600,000.

When the SEC's investigation began, several of Matl's customers had retained lawyers to press legal claims. Merrill Lynch had settled with six customers, paying about $ 75,000.

In response to questions submitted by The Washington Post, Merrill Lynch said in a statement that Matl's productivity as a salesman did not influence how the company handled the complaints against Matl. "It is our policy that any employee's production is not a factor when reviewing potential or alleged improprieties on the part of the employee," the statement said.

After the SEC's surprise inspection, top officials from Merrill Lynch's New York headquarters flew to San Francisco and interviewed Matl and his supervisors at length. Matl promised to change his practices and Merrill officials, who concluded that he was a talented salesman, required him to go to New York at his own expense for a weeklong refresher course on the law governing stockbroker behavior.

Ten months later, new complaints against Matl arose, and he was fired.

"Stock brokerage firms have an inherent conflict of interest," said Cary Lapidus, then an SEC attorney assigned to the Matl case and now in private practice in San Francisco. Lapidus declined to comment about the Matl case, but noted that brokerage firms "are profit-making entities operating under a self-regulatory system. When a highly productive broker commits violations, sometimes a firm believes it is more profitable to settle or litigate customers' claims rather than to fire the broker."

In its statement, Merrill Lynch said it was "committed to the highest standards of professional and personal ethical conduct" and that its systems of employee supervision are "second to none." The statement said, "While the Matl situation was a unique one, we believe our firm acted reasonably and responsibly in dealing with it based on what was known at the time."

Off the Calendar

For more than a year, the investigation of Merrill Lynch by the SEC's San Francisco office proceeded amid tight secrecy. For nine months after the SEC's inspection, Matl continued to do business with his old clients and solicited new accounts. Neither the SEC nor Merrill Lynch warned Matl's customers of the complaints or the investigation.

The commission keeps nearly all its investigative work private. Officials at the agency say that secrecy facilitates vigorous internal debate and protects the privacy of innocent parties. Because the SEC settles most of its cases, releasing only a carefully worded document that often is the subject of extensive negotiations with defendants, it is often impossible for the public to assess whether its settlements are fair. For its part, Merrill Lynch had no desire to make public the SEC's investigation -- exposure might invite civil lawsuits or provoke competitors to use the allegations to win business. "The problem is that when a firm is charged with fraud, account executives of other firms solicit their clients," Shad said.

By conducting investigations in private, SEC staff and commissioners avoid scrutiny of their decision-making processes. Such scrutiny from Congress or the public would be potentially uncomfortable -- it might bring pressures on the commission to speed up, slow down or drop cases. In a few instances during the 1980s when word of a controversial SEC decision was leaked, some commissioners were publicly criticized by members of Congress who disagreed with how they evaluated evidence accumulated by the staff.

Merrill Lynch mustered its resources to stave off fraud charges. Shortly after Labor Day, 1984, as the case neared its final vote at a closed SEC meeting, the brokerage firm sent former commissioner and enforcement chief Irving Pollack and former staff attorney Robert Romano to meet with SEC enforcement chief Fedders and other staff in Washington. In a conference room at SEC headquarters at 450 5th St. NW, Pollack and Romano argued vigorously that neither Merrill Lynch nor its managers should be charged. On Oct. 19 they submitted a confidential 40-page memo with about 25 exhibits to bolster their position.

Every SEC division that reviewed the case agreed that fraud charges should be filed against Merrill Lynch, including the agency's counseling group, a unit of SEC lawyers that reviews all regulatory and enforcement recommendations headed for a commission vote. Shad was adamant that the brokerage should not be charged. He temporarily pulled the case off the commission's confidential calendar, saying that Lawyer needed to provide more information about why Merrill Lynch should be charged.

Meanwhile, Shad ordered the counseling group, through a subordinate, to draft a memo opposing charges against Merrill Lynch, according to two staff attorneys familiar with the case. "I do not recall asking somebody to oppose charges against Merrill Lynch," Shad said.

The counseling group was established by Shad's predecessor as SEC chairman, Harold Williams, largely to curtail the power and policies of Stanley Sporkin, the best-known and longest-serving SEC enforcement chief. Dismissed by some as a zealot, lauded by others as the consummate public servant, Sporkin had a far-reaching impact on business and law during the 1970s.

He established his reputation by pursuing corporations and their top executives for paying overseas bribes, maintaining political slush funds and engaging in other major frauds. "We did it in enforcement with limited dollars, high impact… . You can do a lot by bringing the critical kinds of cases," Sporkin said in an interview.

By the late 1970s, a growing number of people, especially in the corporate world, felt that Sporkin had gone too far. When he was appointed to the SEC chairmanship, Shad was urged to dump Sporkin. But Sporkin didn't need to be pushed; he already was frustrated by the growing resistance to his policies. In the spring of 1981 he became general counsel of the Central Intelligence Agency. He now is a federal judge.

When Shad took over as SEC chairman, he moved decisively to change Sporkin's approach. He asked the counseling group to develop a new policy describing when it was appropriate to charge corporations for wrongdoing by employees. Generally, the staff had to find evidence that the company had acted in bad faith or that the accused employees were top-level officials.

In 1983, in a "cooked books" case involving the Baltimore-based spice company McCormick & Co., Shad argued against naming the corporation publicly as a defendant. In 1984, he opposed charges against the Wall Street firm Thomson McKinnon Securities Inc. In 1985, at the same time the Merrill Lynch case was generating controversy inside the SEC, Shad fought with the staff about a similar case against Smith Barney Inc.

In each of those cases, charges were filed against the firms and they agreed to settle the matters without admitting or denying the SEC's allegations. In some instances, there was heated debate between Shad and the staff -- charges against Smith Barney, for example, were approved after hot debate and a 3-2 commission vote.

But while the staff sometimes won individual votes, many SEC attorneys felt that Shad was gaining ground fast. The enforcement staff grew reluctant to initiate investigations of sales practices at big Wall Street firms because it knew such cases faced stiff resistance from the chairman's office, according to interviews with more than a dozen staff attorneys. Some investigations either never got off the ground or were dropped along the way. So strongly did the chairman feel about the issue that there were even battles about whether to put the names of big Wall Street firms on SEC subpoenas during investigations, before any decision was made about fraud charges. Shad thought the practice was unfair to the firms.

Shad's views about enforcement against large Wall Street firms were sincerely held, but they angered some staff lawyers who felt he was choosing to ignore the federal statute that empowered the SEC to bring such charges as preventive and disciplining measures -- even when there was no evidence of companywide fraud. "Shad didn't fully grasp the purpose of the failure to supervise provisions of the securities laws," said Jared Kopel, the enforcement attorney in charge of the Smith Barney case, now in private practice in Palo Alto, Calif. Kopel declined to comment about the Smith Barney matter.

In Shad's view, the SEC brought more "failure to supervise" cases from 1981 to 1987 than in other six-year periods and implemented a better system for responding to investor complaints.

Bobby Lawyer became a champion of the staff's cause late in 1984. While some in Washington cautioned against pushing Shad too hard over the Merrill Lynch case, Lawyer refused to compromise -- he insisted on coming in from San Francisco to argue at the commission table. Lawyer and his staff received some help behind the scenes from commissioner Aulana Peters, a Democrat who opposed Shad on some enforcement issues but maintained a friendly personal relationship with him. When the Merrill Lynch case was removed from the commission's calendar, Peters and her staff made repeated inquiries. Shad later rescheduled the matter for a vote.

At the Table

Shad and Lawyer sat across from each other at the commission's oval-shaped meeting table. The debate lasted about 45 minutes. At the start, there were presentations from Lawyer and David Schwiesow, a counseling group attorney who had been designated to present the chairman's views. Schwiesow was a somewhat reluctant advocate, since he and the rest of the counseling group opposed Shad's position that Merrill Lynch shouldn't be charged.

Shad said he didn't understand how a firm the size of Merrill Lynch -- one with tens of thousands of employees and offices all around the world -- could be held publicly responsible for the actions of one stockbroker in San Francisco. How could that be fair? There had not been a systemic breakdown at Merrill Lynch, Shad said.

Lawyer countered that Merrill Lynch had only one system for compliance with the securities laws -- a system that depended on close involvement between the branch offices and the firm's headquarters. In this case, Lawyer said, the system hadn't worked. The failure was systemic, he argued.

About 15 or 20 minutes into the meeting, enough commissioners had spoken up in Lawyer's favor or asked sympathetic questions to make it plain that Lawyer had the three votes necessary for a majority. Fedders, too, spoke up for the staff's position. At one point, an attorney present recalled, Shad acknowledged that he was beginning to "feel a little bit lonely on this." The vast majority of SEC votes are unanimous, but this time Shad stuck to his dissenting position. The final tally was 4-1 to charge Merrill Lynch.

Informed of the SEC's vote, Merrill Lynch agreed to settle the case in 1985 without admitting or denying the commission's allegations, a standard formula that helps the defendant avoid additional liability in civil courts. Merrill Lynch accepted a censure and the head of its San Francisco office was suspended for two months. Former stockbroker Matl, who had entered law school in San Francisco, applied for a summer job at the SEC. He was turned down.

Bobby Lawyer's victory was celebrated by staff members in San Francisco and Washington, but they knew they were far from winning the war. "It was always very easy to bang the little [brokerage] houses, but if it was a big firm there was a reluctance to do anything under Shad," said Ira Lee Sorkin, who between 1984 and 1986 was head of the SEC's New York regional office with jurisdiction over Wall Street. "If it was a little firm, you could name the firm, but if it was a big firm you knew you would have a problem."

Staff researcher Melissa Mathis contributed to this report.

(Courtesy of The Washington Post.)

Soon after John Shad became chairman of the Securities and Exchange Commission in 1981, he clambered into a bus one afternoon with a half dozen of his senior staff and headed for the race track in Charlestown, W.Va.

At the track, Shad made a proposition: For their convenience, the SEC officials could make bets with Shad rather than wagering at the betting windows. Shad played ''the house,'' paying off on winners and raking it in on losers.

But it wasn't the money that seemed to excite him -- it was the risk. He rarely went to the race track or to a casino, but he loved to wager. ''Shad would bet on anything,'' said Clarke Ambrose, who worked with him at the E.F. Hutton brokerage firm. ''He would bet on two cockroaches crossing the floor.''

Shad's affection for betting paralleled his views about the stock market: some increased speculation was good and necessary. Partly as a result of his policies as SEC chairman between 1981 and 1987, speculation boomed on Wall Street. New and exotic products mushroomed in the markets and corporate takeovers attracted a new breed of professional speculator who traded rapidly to capture quick profits. Technology played a role, too, as computers speeded up the action.

Speculation and computerized trading have been blamed for contributing to the October 1987 stock market crash, but an important cause of change has gone unnoticed: Regulators did not enforce federal rules designed to control speculation by large institutional investors. In this loose environment, usually conservative institutions such as pension funds and university endowments became bold speculators, according to interviews with dozens of stock market professionals, regulators and exchange officials.

''There have to be more stringent controls'' on speculators, Fred Grauer of Wells Fargo Bank, a leader in the use of computerized stock trading, told federal regulators at a hearing in late 1987.

Shad believed that some speculation enhanced the stock market's efficiency. One of his favorite words was ''liquidity,'' which he used to conjure up the image qj of money flowing through the stock market and the economy like water through a fertile delta. Shad thought of faltering economies as dry gulches where the flow of money had been cut off; the solution was to open a spigot and let cash pour again, until it lapped into every parched corner and brought barren land to life.

Speculators helped promote liquidity by spilling cash into the market, Shad thought, and liquidity helped the economy by making it easier for companies to find money to pay for growth.

There were times when Shad's views about liquidity sounded almost religious. ''The millennium to which mankind can aspire is that great day when capital will be permitted to flow, with safeguards against fraud and with the ease of water, into every nook and cranny of economic opportunity, first within nations, second throughout the Free World, and ultimately throughout the earth,'' Shad declared.

Cutting a Deal

On a summer day in July 1981, in a rear booth of the Monocle Restaurant on Capitol Hill, John Shad lunched with Philip Johnson, chairman of the Commodity Futures Trading Commission, or CFTC, and talked about making a deal. Shad loved to make deals -- he had spent a lifetime at it on Wall Street. When the meal was finished, groundwork had been laid for an agreement that would end years of regulatory bickering, reshuffle the roles of their respective agencies and change the character of the U.S. stock markets.

Shad and Johnson had much in common. They were newcomers to Washington -- Shad from Wall Street, Johnson from law practice in Chicago, where he advised that city's freewheeling commodity exchanges. Both were steadfast believers in the ''new beginning'' promised by their president, Ronald Reagan.

Early in 1981, when Shad was picked to head the SEC, Johnson was nominated to be chairman of the CFTC, which regulates the commodity markets.

The SEC and CFTC had been at each other's throats for several years over which agency should have authority to regulate newly invented products called financial futures.

Neither agency could agree on what these futures were. SEC staff lawyers said they were like stocks and bonds, and thus should be regulated by the SEC, while CFTC attorneys said they were like commodities such as silver and gold, and thus should be overseen by the CFTC. The dispute had finally spilled into the courts.

Shad and Johnson, both free-market enthusiasts, decided that day at the Monocle to solve the problem. It took months of interagency negotiations and a big fight in Congress, but finally the deal was signed.

The agreement had many pieces, but the most important part gave the CFTC undisputed authority to regulate stock index futures. By the end of John Shad's tenure at the SEC five years later, stock index futures had become a major force in the U.S. financial markets. For many big institutional traders, stock index futures were more important than the underlying stocks themselves.

But in 1982, when Congress debated the deal cut by Shad and Johnson, about the only people who suspected that stock index futures might alter the market fundamentally were a handful of sophisticated Wall Street investors and economists. ''The regulators have always been a good six or seven years behind the university (economists) in understanding these complex financial devices,'' said Gregg Jarrell, a former chief economist at the SEC.

A few people sounded early warnings. ''In my judgment, a very high percentage -- probably at least 95 percent and more likely much higher -- of the activity generated by these (stock index futures) will be strictly gambling in nature,'' investor Warren Buffett cautioned the House Energy and Commerce Committee in a letter submitted during the 1982 congressional debate. ''In the long run, gambling-dominated activities … are not going to be good for the capital markets.''

But few paid much heed. The deal seemed to solve a nagging regulatory dispute and, perhaps most important, hardly anyone in Congress knew how stock index futures worked.

Transfering the Risk

To understand stock index futures and how they changed the stock market, it helps to think about the weather.

A century ago, violent storms, howling tornadoes and devastating droughts gave rise to the ideas that still underlie the nation's futures markets and may help explain what went awry in the stock market during the mid-1980s.

The seasons and the weather formed a repeating, treacherous economic cycle for farmers, who have always depended on rain at the right time and in the right amount. In the spring, a farmer went deeply into debt to buy seed, fertilizer and other supplies for planting. If the weather cooperated, he profited. At harvest time late in the summer, he hauled his crop to market, sold it at the prevailing price, paid off his debts, and stashed away the profits. Next spring, he began again.

But if the weather failed, he was ruined. If it rained too much and there was a bumper crop, plummeting prices caused by the oversupply prevented him from earning enough to pay off his debt. If it rained too little and his crop failed, he might not have enough to sell to pay back his spring borrowings. Every year, then, the farmer involuntarily gambled on the weather.

In Chicago and Kansas City and other midwestern cities, a free-market answer to the farmer's predicament sprang up. Fly-by-night speculators and profiteers came west and offered to make deals with farmers. In the spring, at planting time, a farmer might contract with a speculator to ''presell'' the crop he would harvest later.

The farmer would get the speculator's cash, receiving the prevailing market price for wheat or whatever crop was to be planted, and agree to deliver the goods at harvest time. The speculator was betting that crop prices would rise so that he could make a killing.

The deal between the farmer and the speculator involved what economists call ''risk transfer.'' The risk of bad weather was shifted from someone who couldn't afford to bear it, the farmer and his family, to someone who was perfectly willing to gamble -- the speculator.

As time went on, the speculators started to swap crop contracts. The modern futures markets in Chicago actually began in loose, raucous crowds of speculators who gathered in the mud near the railroad depots where the crops came in. Liquidity of the sort imagined by John Shad began to develop; money changed hands ''with the ease of water'' among the speculators, and it became increasingly simple for farmers to minimize the risks of weather by preselling their crops in the futures markets.

It wasn't a perfect system. The speculators began to cheat. There were rigged trades, price squeezes and myriad other manipulations -- some of the same kinds of alleged fraud now under investigation at Chicago's two largest futures exchanges.

Until the early 1970s, the Chicago futures exchanges were regulated by a small, ineffective office in the Agriculture Department. In 1974, a series of scandals led Congress to create the CFTC. The CFTC's earliest challenge was posed by Leo Melamed, a science fiction writer and speculative trader who had lost his shirt in Chicago's futures pits on more than one occasion.

Stimulated by economic thinkers at the University of Chicago, Melamed realized that the risk transfer that arose so naturally a century earlier between farmers and speculators could be applied to other areas of the economy. What was the difference between a farmer worried about changes in the weather and a giant, multinational bank concerned about fluctuations in the value of the dollar in Japan, where the bank might have huge loans outstanding? The price of the dollar relative to other currencies was just as unpredictable as the weather.

Melamed, sensing that he had stumbled onto a potential bonanza, began to forge answers to these questions with officials of the Chicago Mercantile Exchange, which had long been dwarfed by the larger Chicago Board of Trade. He and his competitors came up with futures for currencies, Treasury bonds, Treasury bills, corporate bonds, mortgage-backed securities and, finally, stocks -- a pension fund, for example, could hedge against a drop in the overall stock market by ''preselling'' some of its stocks.

The Chicago exchanges discovered that it was theoretically possible to transfer almost any economic risk on earth.

'Bless You, My Son'

As the variety and volume of financial futures grew, some regulators became unnerved by what they saw as ''an unthinking crusade for every last drop of hedging, liquidity and efficiency, even when those goals become self-defeating,'' as former CFTC chairman Jim Stone, an outspoken opponent of financial futures, put it. ''The definition of hedging is so broad that it encompasses any transfer of risk.''

From that definition arose the idea of stock index futures.

Stock index futures are contracts containing promises about the future. Everycontract has a date on it: an exact day, month and year sometime in the future guaranteeing the delivery of the financial value of stocks for a price negotiated in the present. The ''index'' part of the contract refers to the basket of stocks to be delivered. The most popular basket is the Standard & Poor's 500, made up of the stocks of 500 big U.S. corporations.

Shad wasn't even sure that stock index futures would ever become popular. Large institutions that owned a lot of stocks -- university endowments, pension funds and mutual funds -- tended to view the Chicago futures exchanges as seedy hotbeds of speculation. Why would a big trader abandon the venerable New York Stock Exchange for a market that started along Chicago's railroad tracks?

The answer, it turned out, was that they could buy more with less.

It takes less cash to buy a stock future than it does to buy the corresponding 500 stocks. The Federal Reserve, which regulates the use of borrowed money in the stock market, requires an individual investor buying a stock to put up at least 50 percent of the purchase price in cash. Banks and big Wall Street firms, by taking advantage of certain loopholes, can reduce their required down payment for buying stocks to about 20 percent. But the CFTC, which regulates futures, requires even less than that.

The down payment required of a speculator who wants to buy a stock futures contract today is about 15 percent. In contrast, the down payment required of an officially certified hedger is just above 1 percent. Official hedgers get more bang for their buck than anyone in the stock market, just as a home buyer with $ 20,000 on hand can buy a bigger house if the required down payment is 1 percent rather than 20 percent.

Stock futures regulation is based on the assumption that hedgers, who try to protect themselves against potential losses, are preferable to speculators, who tend to be treated as a necessary evil. Speculators are policed every step of the way lest they abuse the markets, but hedgers enjoy several privileges. The most important is that they can control more stock market value for less cash than other investors.

In the 1980s, nearly every Wall Street firm and sophisticated institutional investor in the stock market wanted to be an official hedger. It was easy to become one. An investor must fill out two applications: one at the Chicago Mercantile Exchange, where the S&P 500 contract is traded, and another at the investor's brokerage firm. The Merc form does not require the investor to provide much information; the brokerage firms' forms vary.

''Those things are almost a joke in some respects,'' said Howard Schneider, a leading futures lawyer in New York. ''You file them and the exchanges say, 'Bless you, my son, you are a hedger.' ''

The futures exchanges and the CFTC assert that hedging rules are enforced in vigorous audits, but a broad range of market professionals said in interviews that such audits rarely focus on whether an investor was hedging or speculating. A 1987 report by the research firm Equidex Inc. found that 90 percent of the institutional investors it surveyed who officially declared themselves to be hedgers were speculators.

After it obtained control over stock futures regulation, the CFTC assigned enforcement of the hedging rules to the Chicago exchanges. But the exchanges stood to lose business if they cracked down on speculators posing as hedgers.

''If you're Salomon Brothers and you're generating all the business at the exchange, (Chicago Merc executive) Leo (Melamed) and his boys are not going to come in for an audit,'' said Jack Barbanel, head of futures trading at the Wall Street firm Gruntal & Co. ''You can't blame the users and the (Chicago Merc) because there's an inherent conflict of interest.''

Moreover, as stock futures boomed during the 1980s, few people were sure anymore what was hedging and what was speculating. The complex, multifaceted stock and futures trading strategies practiced by many sophisticated investors, sometimes drawn up by computer programmers, made it hard to tell.

''I can argue that a hedge is speculation and that speculation is a hedge,'' said John D. Brookmeyer, vice president of Prudential Life, which owns a multibillion-dollar stock portfolio and trades actively in the stock futures markets. ''The distinction is easy to blur.''

Speculation grew like a soap bubble as institutions poured more of their cash into the stock and futures markets. Money managers and big investment firms became increasingly competitive, trading in and out of the futures markets, speculating in short-term strategies designed to outperform their rivals. Computers helped to link prices in Chicago and New York, causing stock prices to gyrate more rapidly than they ever had before.

By 1985, some on Wall Street, in Congress and at the SEC fretted that small investors were being squeezed out and that the markets were headed for collapse. Shad, from his vantage point at the SEC, was concerned about these developments. He discussed with Federal Reserve Board Chairman Paul A. Volcker ways to dampen the volatility in the market, including the possibility of higher down payments in the futures market. But no action was taken.

Neither Shad nor any of his staff publicly expressed concern that the speculation augured disaster. Shad did not want any dramatic changes that would eliminate the benefits of liquidity, including the ability of large, institutional investors to sell big blocks of stock easily.

As the exchanges took steps to combat the growing volatility, the speculation continued. By 1986, the annual volume of S&P 500 stock futures contracts traded had increased fivefold from 1982. On an average day in 1986, the underlying value of the S&P 500 stock futures contracts changing hands at the Chicago Mercantile Exchange was well over $ 1 billion, surpassing the value of daily stock trading at the New York Stock Exchange. ''It really is a substitute for the (stock) market,'' said Barbanel. ''The futures have been a spectacularly cost-effective proxy for the (stock) market.''

Stock futures changed the way the New York Stock Exchange functioned. In the days before stock futures, a floor trader at the NYSE stood next to his post and talked about prices with other traders who gathered around him with their orders. A big order that ''moved the market,'' or changed prices unexpectedly, was rare.

In the mid-1980s, as computer-driven trading grew, orders arrived at the floor trader's post in giant electronic bundles, whipsawing prices up and down. Money washed through the markets in great swells.

The stock market was certainly more liquid, as John Shad wanted it to be, but the waves kept getting larger and larger.

Dispatching Telegrams

There were some people who saw it coming. John Phelan, the New York Stock Exchange's chairman, warned publicly in the spring of 1987 that the markets had been exposed to a potential ''financial meltdown'' because of speculation and the growth of computerized stock futures trading. Some dismissed Phelan's warning as sour grapes -- the New York exchanges were losing business to the booming Chicago futures markets.

In one of Shad's last appearances before Congress in May 1987, Sen. Donald W. Riegle Jr., D-Mich., asked the SEC chairman whether stock prices could possibly fall as much as 500 points in a single day. ''I would say I think it's highly remote, very remote,'' Shad said.

Five months later, the Dow Jones industrial average lost 508 points on Oct. 19, the largest one-day drop ever. The crash occurred after the Dow average posted gains of more than 400 points between the May hearing and the market's peak in August. Later, Shad would agree with those who said stock index futures should be put under the more rigorous supervision of the SEC, but he was convinced it was politically impossible to undo the deal he had cut at the Monocle Restaurant.

The crash disturbed the tranquility of the U.S. Embassy residence in The Hague, where Shad, who became U.S. ambassador to the Netherlands in June 1987, now lived. Shad dispatched telegrams to White House chief of staff Howard H. Baker Jr. and SEC Chairman David S. Ruder and wrote articles urging higher cash down payments to decrease speculation in stock futures. Shad wanted to raise the down payment so that it was 25 percent, similar to the level required in the stock market -- a change that the Chicago exchanges warned would put stock futures out of commission.

''Action is needed now,'' Shad wrote.

(Courtesy of The Washington Post.)