Nearly one-fourth of 250 finance industry professionals surveyed by a New York City law firm recently said they would likely engage in illegal insider trading to make $10 million if they could get away with it. It is not known whether billionaire hedge fund owner Steven A. Cohen was one of those questioned, but if he was and if he answered honestly then surely he was one of those willing to break the law for a good-sized profit.
Not only would Cohen trade on illegal inside information, but he actually did often and at a substantial profit, according to the criminal indictment unsealed in federal court in Manhattan on Thursday [July 25] against his hedge fund, SAC Capital Advisors. The 41-page indictment depicts SAC Capital as an insider trading machine, whose outsize profits depended on “widespread solicitation and use of illegal inside information” and “an institutional indifference” to violations “on a scale without known precedent in the hedge fund industry.”
Cohen himself was not indicted he was identified only as “SAC Owner” but the indictment puts him and his $15 billion fund in the government’s crosshairs for the second time in a little over a week. The Securities and Exchange Commission (SEC) filed an administrative proceeding against Cohen on July 19, charging him with failing to investigate suspicious trading activity at SAC or to take steps to prevent illegal conduct.
Together, the government actions, if successful, could bar Cohen from managing investor funds and force SAC Capital to disgorge profits linked to illegal insider trading. SAC pleaded not guilty to the indictment on Friday; Cohen’s attorneys have vowed to contest the administrative proceeding. In the meantime, however, some investors are reportedly voting with their wallets by withdrawing money from the fund.
Far from being the clueless head of a company rotting from the bottom, Cohen is depicted in the indictment as the rot at the very top. SAC Capital’s hiring policies, trading operations, compliance systems, and compensation practices combined to make insider trading a way of life at the fund, according to the indictment.
To start, SAC sought to hire portfolio managers and research analysts “with proven access to public company contacts likely to possess inside information.” One new hire came with the recommendation that he had a house share with the chief financial officer of a Fortune 500 company and was “tight with management.” Richard Lee was hired at Cohen’s insistence in April 2009, over the objections of SAC’s legal department, despite information that he had been part of an “insider trading group” at the hedge fund where he had been working. Lee pleaded guilty to federal conspiracy and securities fraud earlier last week [July 23].
Employees were “financially incentivized,” according to the indictment, to recommend to Cohen “high conviction” trading ideas in which SAC would have an “edge” over other investors. As one example, research analyst Jon Horvath recommended selling Dell stock on Aug. 26, 2008, because of a “second hand read” from contacts inside the company about an upcoming unfavorable earnings report. Cohen liquidated his $12 million holding within 10 minutes after receiving the recommendation. Horvath pleaded guilty to conspiracy and securities fraud in connection with Dell trades in September.
In another example, Cohen liquidated $700 million in holdings in two drug companies, Elan and Wyeth, on July 20, 2008, after health care analyst Matthew Martoma passed along inside information about the soon-to-be-announced negative results of clinical trials of a new drug. By selling and shorting the stock, Cohen realized $276 million in profits or avoided losses. Martoma was indicted in December in connection with the trades. Cohen allegedly knew Martoma was paying a doctor involved in the drug trials for the tips.
SAC’s compliance systems reflected what the indictment calls “a lack of commitment” to address the insider trading issues. The indictment notes that up until 2009 the compliance department did not do keyword searches of employees’ e-mails for terms suggestive of insider trading. In the only insider trading violation uncovered internally, two portfolio managers were found to have used inside information to trade on a health company stock in July 2009. They were fined, but allowed to keep their jobs; no report was made to regulatory authorities.
Cohen and SAC Capital are Exhibit Number One of the ethics gap in the financial services industry identified by the survey released in mid-July by the law firm of Labaton Sucharow, which specializes in representing plaintiffs and whistleblowers in securities fraud litigation. More than half of the financial industry professionals surveyed 52 percent thought their competitors probably engaged in unethical or illegal behavior. Nearly one-fourth 24 percent thought some of their co-workers had done so. Substantial numbers viewed compensation systems as encouraging unethical conduct (26 percent) and top officials as likely to turn a blind eye to improper conduct by a “top performer” (17 percent).
Back in baseball’s steroid era, true fans knew the home run records were too good to be true. Financial experts know that some of the returns posted by hedge funds and individual investors are similarly too good to be true. Baseball can at least claim to be trying to clean house; the government's moves against SAC are one step in cleaning up the ethical rot on Wall Street.