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May|June 2004
A Bold Stroke By Emily Bazelon
Medea's Shadow By Charlotte Faltermayer
The Sword of Spitzer By Nicholas Thompson

The Sword of Spitzer

A little-known law called the Martin Act gives New York's attorney general extraordinary power, yet for 75 years this Excalibur has been left to rust in its scabbard. Now, Eliot Spitzer is wielding it against the biggest players on Wall Street. Should such a powerful weapon be left in anyone's hands?

By Nicholas Thompson

FOR THREE-QUARTERS OF A CENTURY, an unspoken gentleman's agreement bound the moneymen of Wall Street and the New York attorney general's office. The AG got to use an astonishingly powerful state securities law called the Martin Act, but not against the big boys. Acceptable targets through the years included shady pharmacists, Ponzi schemes, and peddlers of fraudulent Salvador Dali lithographs.

Two years ago, Eliot Spitzer, New York's current attorney general, broke the deal. He took the Martin Act, the securities legislation that is the legal equivalent of King Arthur's Excalibur, and plunged it into the guts of Merrill Lynch. Then he turned his saber on Salomon Smith Barney and the rest of New York's investment banking industry. This past fall he speared several large players in both the hedge fund and mutual fund industries. Others worry that they will face similar fates in the remaining two years of Spitzer's present term. They should.

The purpose of the Martin Act is to arm the New York attorney general to combat financial fraud. It empowers him to subpoena any document he wants from anyone doing business in the state; to keep an investigation totally secret or to make it totally public; and to choose between filing civil or criminal charges whenever he wants. People called in for questioning during Martin Act investigations do not have a right to counsel or a right against self-incrimination. Combined, the act's powers exceed those given any regulator in any other state.

Now for the scary part: To win a case, the AG doesn't have to prove that the defendant intended to defraud anyone, that a transaction took place, or that anyone actually was defrauded. Plus, when the prosecution is over, trial lawyers can gain access to the hoards of documents that the act has churned up and use them as the basis for civil suits. "It's the legal equivalent of a weapon of mass destruction," said a lawyer at a major New York firm who represents defendants in Martin Act cases (and who didn't want his name used because he feared retribution by Spitzer). "The damage that can be done under the statute is unlimited."

Spitzer and his allies, of course, see the law the opposite way, lauding its unlimited capacity for good. Given the deep slumber of the SEC and other important financial regulators since 2000, the glaring improprieties of mutual funds and stock analysts—improprieties that disproportionately harm small, trusting investors—might not have been documented and addressed if Spitzer hadn't forcefully applied the Martin Act.

Either way, there's no question that a little-known New York law, intentionally rendered anemic when first passed in 1921, has morphed into something remarkable, helped along the way by ambitious supporters, neglectful opponents, and generous court rulings. The Martin Act has also given Spitzer the stature he needs to run for governor of New York in 2006—and perhaps, one day, something higher.

THE FIRST STATE STATUTE CRACKING DOWN ON FRAUD IN SECURITIES, or speculative investments, was passed in Kansas in 1911. It was nicknamed a "blue-sky" law after hustlers who, the story went, would sell shares of the blue sky if they could. Other states quickly followed, pushed by public concern about fraud as well as by self-interested lobbying from small banks, which worried that money which would otherwise be deposited was being put into securities.

By the end of World War I, the state that served as home to the world's financial capital decided it had to join in. Swindlers stalked Gotham's streets, fleecing the people who were investing with solo speculators and putting money into the stock market for the first time in a burst of postwar patriotic fervor. Much as when shares of Amazon.com hit the NASDAQ, newcomers were everywhere—and they quite frequently lost their bowlers.

New York's legislature was one of the last to pass a blue-sky law, letting through a deliberately enfeebled version. It gave the AG power to counter fraud once it was committed, but left that office with minimal control over who could sell securities in the first place. To the big financial companies that dominated New York politics, a registration law was a bureaucratic burden to be avoided. A simple fraud statute seemed like a good way to swat down small-time sharks and keep the field open for themselves. The weak law went into force in May 1921, bearing the name of Louis M. Martin, its sponsor in the state assembly.

New York barely made use of Martin's act for the first four years of its life, spending almost nothing on enforcement. The attorney general did try to apply it on several occasions in 1923, going after firms like the Multi-Insert Mailing Machine Corporation, which sold stock after spuriously claiming to have developed machines that addressed, folded, and handled envelopes. But he was tripped up by a clause in the Martin Act that granted automatic immunity to anyone who testified under it or even answered questions. "It is said that the Martin law has teeth. It has, but they are an ill-fitting set of false teeth," snapped New York City's district attorney Joab Banton to The New York Times.

In 1925, the law found its first aggressive user, Attorney General Albert Ottinger, who was also successful in pushing for legislation that dramatically limited the act's immunity provisions. Spitzer's forebear in many ways, Ottinger sought out high-profile fraud cases and used the Martin Act to shut down the Consolidated Stock Exchange, a lowbrow offshoot of the New York Stock Exchange. His actions riled major financiers and led to several prominent court challenges. "In this proceeding, if such it may be called, the Attorney General is . . . the complainant, the prosecuting officer and the magistrate before whom the proceeding is instituted," wrote Louis Marshall, a prominent constitutional lawyer, who led the charge against the act.

But Ottinger beat Marshall in the courts and continued his crackdown. At the end of his term, the AG summed up his political record as follows: "Hammer, hammer, hammer, at every manner and means of fraud and dishonesty, the prevention and assertion of which the Legislature has assigned to the Attorney General." Despite the popularity of Ottinger's hammering, however, he lost a close race for the governor's office in 1928 to a former assistant secretary of the Navy named Franklin Delano Roosevelt.

Ottinger left a two-part legacy for Spitzer. He'd set an example for how an AG could use the Martin Act with vigor. And the court challenges he'd faced ended up bolstering the law. The judges who heard them believed that fraud was so endemic that the law needed to be broadened. In the 1926 case People v. Federated Radio Corp., the New York Supreme Court declared proof of fraudulent intent unnecessary for prosecution under the act. Following up, in People v. F.H. Smith Co., the court gave prosecutors a practically blank check by saying that the act should "be liberally and sympathetically construed in order that its beneficial purpose may, so far as possible, be attained." Since then, courts have liberally interpreted every important term in the act—including "security," "material," "public offering," and "fraud"—and have declared that they don't have the authority to review the attorney general's discretion under the act because he is the state's chief law enforcement officer.

Despite its broad powers, the Martin Act was left dormant in the 1930s and 1940s. Then, in 1955, another hyperambitious attorney general, Jacob Javits, hurdled into office. Javits hadn't campaigned against securities fraud, but he saw a great political opportunity. He quickly assigned a lawyer named David Clurman, three years out of Columbia Law School, to rewrite the statute. Clurman decided to make the law as fierce as he could, using as his template mail-fraud statutes written by Learned Hand early in the century before he became a judge. The bluntness of Hand's laws intrigued Clurman. "They just said, 'thou shalt not commit fraud,' " he observed in a recent interview.

Clurman drafted a provision giving the attorney general the power to prosecute people criminally, in addition to civilly, and inserted clauses relieving the AG of the responsibility to prove that any buyer was actually defrauded or that any sale actually took place—allowing the AG to prosecute scams before they had any victims. Clurman also wrote in the broadest definitions of fraud he could think of. And he did his best to avoid ambiguity about the law's intent. "If I repeat myself three times in one paragraph, the court knows what I'm talking about," he said. "I'm not interested in writing well. I am interested in winning cases."

Javits didn't get to use his new weapon. Like Ottinger before him and Spitzer after, he had his eye on a higher office, and two years after becoming AG he moved on to the U.S. Senate. His successors, Louis Lefkowitz and Robert Abrams, largely left the dignitaries of Wall Street alone over terms that together spanned 36 years. With two exceptions from the '70s—Lefkowitz's investigation of financial auditors for failing to conduct surprise audits and his arrest of several American Stock Exchange traders for cooking their books—both AGs limited their focus to quirky hustlers.

A 1978 report sums up the state of the Martin Act before Spitzer. In the late 1950s, the AG's office "was concerned with uranium boiler rooms and promoters of shady Canadian mining stock," wrote Orestes Mihaly, a lead prosecutor under both Lefkowitz and Abrams. Over the years, criminal prosecutions under the Martin Act had expanded to cover "cheats and swindlers" including "the perpetrators of Ponzi schemes upon upstate New York farmers" as well as "rock festival promoters" and "commodity option boiler rooms." In the mid-1970s, Mihaly added, the AG's office was "investigating the latest in investment scams—diamonds and worm farms."

These investigations benefited the public, and often they were daringly carried out. But they used the act only as a tool to go after small-time fraud. And by the end of Abrams's term in 1993, budget cuts had severely reduced the staff of lawyers prosecuting Martin Act cases, sending the act into hibernation. Asked why he didn't use the law aggressively, Oliver Koppell, Abrams's successor, noted that no one on his staff proposed a Martin Act charge to him. He added, "I didn't know it had all these powers."

The act's long siesta helps explain its current strength. A conservative court or one aligned with Wall Street could well have blunted much of the law's edge. But few high-profile cases have come before New York's courts at times when they might have been inclined to dull the Martin Act's sharpest elements. The law's laxity about registering sellers of securities also helped. Always loath to make doing business tougher, Wall Street has had a compelling reason not to call for the Martin Act's replacement with, for example, the Uniform Securities Act, a standardized blue-sky law followed in 37 other states and jurisdictions that has higher registration standards than the Martin Act but vests much less power in the state AG.

All of this history meant that in 1998, the Martin Act lay ready and resting, waiting for the right young knight to take it into battle.

ELIOT SPITZER FIRST RAN FOR ATTORNEY GENERAL IN 1994, at age 35. He had decent qualifications: The son of a very rich real-estate tycoon, he'd excelled at Princeton and Harvard Law School and gained some prominence while working for Manhattan district attorney Robert Morgenthau. There, Spitzer ran a sting on the Gambinos, a mob family that controlled shipping in New York City's garment industry. Ingeniously, the assistant DA set up and managed his own sweatshop, which enabled him to penetrate the family and then bust it for illegally restraining trade.

But Spitzer wasn't a natural politician. "I thought that Eliot would be a professor or a mergers-and-acquisitions lawyer," said Alan Dershowitz, whom Spitzer had helped represent the accused murderer Claus von Bulow after law school. In his first race for AG, Spitzer spent millions of his family's money and campaigned on some creative ideas that now seem ahead of the curve, like stamping numbers on bullets to make them traceable. But he never got traction and showed no common touch. When asked about his favorite Beatle, for example, he mentioned Brahms. He came in fourth out of four in the Democratic primary.

Undeterred, he ran again in 1998. "He felt it was better to lose for a good office and try again if he must than to win for a lower one and rot away," said Dick Morris, a Spitzer family friend and Bill Clinton's former political adviser. Spitzer spent millions more of his family's money and ultimately won a nasty race against the incumbent Republican, Dennis Vacco. At the end, trailing in the polls, Spitzer claimed that his opponent had insulted Hispanics and, he implied, Jews as well. Ironically (it now seems), Vacco accused Spitzer of violating the Martin Act by borrowing money against an apartment building he owned without telling the tenants.

Once in office, Spitzer showed the same tactical creativity and original thinking he had shown in the sting that nailed the Gambinos. He used an obscure section of the Clean Air Act to challenge Midwestern power plants that were polluting New York's air. He sued gun manufacturers under public nuisance laws, which no state had done before. When he took on General Electric for defiling the Hudson River in 1999, he didn't accuse the company of pollution, for which the evidence was mixed. Instead, he charged GE with disrupting river traffic, a move that led the company to agree to dredge the river's most contaminated section.

Given his tenacity and cleverness, Spitzer was perfectly positioned to rediscover a little-known law that gave the AG extraordinary powers. When a securities lawyer and fellow Morgenthau alum named Eric Dinallo talked about the Martin Act during a job interview, Spitzer grasped its potential in a way that his predecessors hadn't. Not long after, Spitzer and his team demonstrated the law's force and effect when they went through the e-mails of a blowhard stock analyst at Merrill Lynch named Henry Blodget.

IN JANUARY 2001, DINALLO SENT A MEMO TO SPITZER laying out proposed priorities for the coming year. Investigating stock analysts was at the top of the list. Two months later, a Queens pediatrician named Debases Kanjilal brought a case against Merrill, arguing that following Blodget's advice about Internet stocks had led him to lose half a million dollars.

The AG's office started a Martin Act investigation in April. But it didn't crank into full gear until July, when Merrill settled the case on terms highly favorable to Kanjilal, suggesting that the company had something to hide. After that settlement Spitzer's team got in touch with Kanjilal's lawyer, Jacob Zamansky. "They really needed to be walked through the business, so I basically drew a map for them, where the bodies were buried, where the conflicts were," the lawyer said.

Early documents and interviews yielded little, but Spitzer's team kept digging and subpoenaing more information. It called in Blodget for lengthy interviews late that summer.

Under the Martin Act, any refusal by Blodget to answer a question posed in the interviews would, unless rebutted, count as proof that he had committed fraud. In addition, Blodget had no right to counsel. Spitzer let him bring a lawyer to the interviews, but the rule still had an effect. "When you are in one of these sessions, they make it clear that you don't have a right to be there and you are there at their pleasure," said a defense lawyer.

Eventually, after subpoenaing every e-mail Merrill's Internet analysts had sent since 1997, the Spitzer team found the mother lode: e-mails from Blodget and others showing that their stock recommendations were influenced by whether the companies in question had promised banking business to Merrill. At one point, in a fit of pique, Blodget had written to the head of Merrill's research department threatening to "just start calling the stocks . . . like we see them, no matter what the ancillary business consequences are."

With that smoking gun in hand, Spitzer soon had Merrill negotiating over possible settlement terms, including how the e-mails should become public and what the company could do to rebuild the wall between its analysts and its bankers. In early April 2002, though, the two sides hit an impasse. With negotiations stalled, Merrill pulled out a big weapon, dispatching former New York mayor Rudy Giuliani to lobby Spitzer. The attorney general, however, pulled out Excalibur.

The same morning that he spoke with Giuliani, Spitzer quietly sent Eric Dinallo to see a New York state supreme court justice, bearing a 38-page complaint against Merrill. With the justice's signature, the Merrill investigation would be conducted under a different section of the Martin Act, and the private negotiations would be replaced with a public investigation—to be analyzed nightly on CNBC.

By midday, to the company's utter surprise and consternation, Spitzer had put out a press release about "a shocking betrayal of trust by one of Wall Street's most trusted names." Merrill's stock price plummeted and its market value dropped $5 billion in a week. For a few anxious hours until a judge stayed his order, Merrill thought that it would have to shut down its entire division that managed assets because of a law that prohibits such activities while a company is under court order. Imagine a wrestler in a tight spot who gets the referee to tie his opponent's legs together: Like that wrestler Spitzer suddenly found himself with all the leverage. Merrill could do nothing but settle on Spitzer's terms. The deal was done within a few weeks.

With Wall Street trembling over Merrill's fate, Spitzer used the Martin Act to bring a similar public case against Salomon Smith Barney and then against the entire investment banking industry. New York's 10 biggest investment firms were forced to pay a total of $1.4 billion in fines. Spitzer next deployed the act to crack down on hedge funds. Then, reacting to a tip from an insider, he nailed the mutual fund industry for its practices of late trading and market timing, which skimmed profits from small investors while passing windfall profits to a lucky few big ones.

Spitzer's boldness has attracted great attention, and talent, to his office. "When we were prosecuting worm farms, it didn't make the front page of The Times, and law students weren't coming to us," said Assistant Attorney General Elizabeth Block, who has worked in the office since 1978. Now, "it's the attorney general and his staff of 15 lawyers going up against the whole mutual fund industry."

That energy isn't likely to dissipate. With two years left in his present term, Spitzer will probably run the Martin Act through a few more opponents.

THE PUBLIC HAS CLEARLY BENEFITED from Spitzer's merciless investigations. Future stock analysts won't act as scurrilously as Blodget and his colleagues did. Mutual funds will take better care not to siphon money from their small investors. Other hucksters no doubt have been and will be deterred by the flames that engulfed Merrill Lynch.

Just as important, Spitzer acted when Wall Street had hypnotized a number of other watchdogs, in particular the SEC. Harvey Pitt, the SEC chair when Spitzer took on Merrill, was more inclined to serve tea and cookies than subpoenas to financiers. The whistleblower who alerted the attorney general's office to the mutual fund industry scams, Noreen Harrington, says that she approached Spitzer because she didn't trust the SEC to act on her tip.

Spitzer also took a bold political risk, something few Democrats have done in recent years. "You rarely run for attorney general successfully by prosecuting the biggest corporations in your state, represented by the best law firms, with the best PR firms spinning it," said Scott Harshbarger, a former Massachusetts AG.

Spitzer does have sharp critics, particularly off the record. "He's completely reckless and he's completely ruthless. He's a pig and he'll screw you for everything he can to get publicity," said a former director at a major Wall Street corporation. The criticisms may be self-interested, but they have a point to make about Spitzer's overreach. Blodget and his ilk were a sideshow in the dot-com collapse, and their crimes were known to many. A month before Spitzer launched his Martin Act investigation, The New York Times wrote that Blodget was "following Wall Street's custom" when he gave positive ratings to the stocks of companies that chose Merrill to manage their IPOs.

Merrill was certainly in the wrong, but the AG used the Martin Act to almost put one of the nation's most important financial firms out of business for what were venial sins, not mortal ones. When Merrill's customers tried to follow Spitzer's lead by suing the company for losses suffered because of suspect advice—suits that might not have been possible without the documents Spitzer had unearthed—they found themselves tossed out of court. "The facts and circumstances," wrote U.S. District Judge Milton Pollack last July in one such case, "show beyond doubt that the plaintiffs brought their own losses upon themselves when they knowingly spun an extremely high-stakes wheel of fortune."

It's also not clear that Spitzer's fraud squad is the best way to regulate markets, and it's odd that a state-elected official has the power to bring about huge swings in the Nikkei Index, as Spitzer did in April 2002. In addition, the penalties that Spitzer has imposed in the mutual fund case don't seem to match the harms. As part of the settlements with mutual fund companies, Spitzer has demanded that the funds reduce their fees, arguing that the fee structure was inextricably linked to the crimes since small investors were charged relatively more than big ones. That was nice for investors and appealing to voters, but it was a bit incongruous. High fees had little to do with the original problem, and demanding their reduction was a bit like busting a restaurant for health-code violations and then demanding that it lower its prices.

ULTIMATELY, SPITZER MAY LEAVE AN ENTIRELY DIFFERENT LEGACY than his foremost forebear did. Albert Ottinger strengthened the Martin Act, but abandoned a promising political career after losing his bid for governor in 1928. Spitzer, on the other hand, is one of the most popular politicians in the state, thanks to the investigations that the Martin Act made possible. He won re-election in 2002 by 35 points over his Republican opponent, and he has already raised impressive sums for his next race. In the 2004 Democratic primary season, his name was floated for both vice president and U.S. attorney general.

But if Spitzer's timing is good for him, it may not be good for his chosen weapon. He unleashed the Martin Act's wrath on Wall Street at a time when conservatives control most of the country's political system. Last summer, and then again this winter, Congress tried to pass a bill that would have prevented states from settling with Wall Street on terms that differ from SEC regulations. The efforts were beaten back largely because Spitzer called out the Republicans for spending decades trumpeting state power, only to reel in the states once they had taken control of Capitol Hill. Still, expect the federal legislation to have several more lives.

Yet Spitzer is nonchalant about what could happen to the Martin Act once his term ends. At a recent speech to alumni of New York University School of Law, he admitted the potential pitfalls of allowing 50 states to regulate the international financial markets. Diminishing the states' power would be okay, he said, as long as it didn't happen in "the next three years"—a period that conveniently stretches until January 2007, when Spitzer might well have a new job in Albany. Later in the speech, he reiterated his point with striking confidence. "In three more years," he said, "I'll move on to other things."

Spitzer's victories may mark the beginning of the end for the Martin Act. It's also possible, though, that with Spitzer gone the act will return to its former quiescence. Legend has it that after King Arthur fought his final battle, he had Excalibur thrown back into the lake in which he had found it.

Nicholas Thompson is a senior editor at Legal Affairs.

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