It was only a matter of time. Hedge fund titan Steve Cohen’s SAC Capital Advisors last week received what’s known as a “Wells notice” from the Securities and Exchange Commission. That’s a signal that the agency is opening a file on the company’s activities that may well lead to some kind of civil action.
For years, since the SEC began its far-reaching investigation into insider trading within the hedge fund universe, its probe has led to civil and criminal charges against former SAC traders and investment managers. David Ganek and Anthony Chiasson left SAC to set up Level Global Investors, becoming among the first Cohen protégées to emerge as star hedge fund traders in their own right. Two years ago, however, the insider trading investigation reached Level Global, and the FBI raided the company’s offices and ultimately brought insider trading charges against Chiasson, who was by then playing little role in the fund’s daily activities.
Ganek and the firm were never charged, but only a few months later Ganek returned capital to investors and closed Level Global – a dramatic turnaround for a former high-flyer who had weathered the financial crisis and had been planning to raise new funds and expand his operations.
As for Chiasson, he’s on trial in a Manhattan federal court for trading tech stocks like Dell (DELL) on tips and information from analysts that prosecutors claim he should have known contained confidential corporate data. Prosecutors allege Chiasson and Todd Newman, a former portfolio manager with Diamondback Capital Management, made more than $60 million in illegal profits from such trades over a two-year period; lawyers for the two men say they didn’t realize that the data was confidential.
Other former SAC folks have been hit with civil and criminal charges related to either their personal trading or their new ventures after leaving Cohen’s firm. Richard Choo-Beng Lee, co-founder of Spherix Capital, another hedge fund, pled guilty to insider trading charges linked to the Galleon Group case that ended up sending Raj Rajaratnam to prison for 11 years.
Cohen himself has not been accused of any wrongdoing, but each new case has brought the SEC and FBI closer to SAC itself. Last week, regulators and federal prosecutors accused Mathew Martoma, who worked for a division of SAC Capital, of obtaining confidential data about a medical trial for a new Alzheimer’s drug. According to the complaint, the regulators claim that Martoma not only traded on the information on behalf of the SAC unit (resulting in a net benefit of $276 million in either outright gains or losses that were averted) but advised Cohen of what was going on. Neither the civil nor criminal complaints filed against Martoma, CR Intrinsic (the SAC entity) or the physician referred to Cohen by name or brought allegations against him or SAC itself.
The long string of insider trading cases brought by U.S. Attorney Preet Bharara since the summer of 2011 does shed a light on the challenges that hedge funds like SAC Capital face in the current market environment. Cohen is one of the biggest and wealthiest hedge fund managers out there today: He has built a multi-billion dollar fortune and can virtually dictate his own terms to his investors, including hanging on to nearly half of the profits made with their money (according to individuals familiar with details of some of the funds he has raised). Cohen himself has described what he does as “information arbitrage.”
The problem? In today’s financial markets, public information is ubiquitous and cheap – it has become almost impossible to build a viable competitive edge using information that can be obtained with complete legality. A number of hedge fund traders who specialize in arbitrage and other strategies that depend on getting early access to solid company-specific information acknowledge that increasingly they do business in what may be thought of as a “gray area.” They look for clues to what might be going on in an idle comment by someone in a position to have access to information, and then look for independent evidence confirming the insight they gleaned from that random comment.
Hedge fund gurus like Cohen are demanding employers, pushing their traders to bring ideas to the table along with the evidence to support them – but not demanding details on how that information was obtained, those involved in the industry say. In the Chiasson case, lawyers for Ganek have said that Level Global’s founder was “outraged that an employee was passing off his own work with what he now reveals was inside information.” Prosecutors have identified what they believe to be networks of informants. Sandeep Goyal, a former Neuberger Berman technology analyst, has already pled guilty to insider trading charges and testified that he passed on information obtained from Dell ahead of the company’s earnings release to the hedge fund traders involved in the case.
Part of the broader problem – the part that regulators can’t solve – is that all the incentives right now seem to favor blurring the line between obtaining insight into corporations that might affect their share prices and obtaining confidential information that is almost certain to do so. Hedge funds are able to charge hefty management fees and collect big chunks of profits in the form of “carried interest” (which then is taxed at a favorable rate) only if they can demonstrate that they deliver “alpha,” or risk-adjusted return, on a consistent basis.
In other words, the pressure is on Cohen and his peers to beat the market, consistently and with no regard to which types of stocks are in favor or whether shares in general are plunging, as in 2008, or rallying sharply, as occurred a year later. Under that pressure, it’s hardly surprising that Cohen is notoriously demanding of his traders, insisting that they justify their own salaries and bonuses by coming up with a steady stream of topnotch trading ideas. That’s exactly the kind of environment in which a trader, desperate to prove his value, will take that final step into illegality, in the same way that someone else might become a rogue trader in hopes of covering up a loss that might cost him his job or bonus.
Whether or not the SEC ever levies charges of any kind – civil or criminal – against SAC or Steve Cohen, these realities mean that the agency and the U.S. attorney will face limits to their ability to prevent insider trading in future. Bharara has achieved some remarkable victories, charging 46 individuals with insider trading and securing guilty pleas in two-thirds of those cases. The SEC also has done its part.
But just as the wave of successful insider trading prosecutions in the 1980s changed little on Wall Street, there is no reason to suppose this will be much different. Until investors suddenly start accepting lesser gains, hedge fund managers are unlikely to set aside incentives that can lead traders to disregard the rules in search of an edge. If you think that is likely to take place any time soon, well, I’d like you to consider buying this bridge across the East River at a very, very affordable price that I happen to be able to offer you for today only….