Insider Trading

The Insider-Trading Cloud Hanging Over SAC Capital’s Steven A. Cohen

Daniel Gross on how a massive insider-trading case has ensnared hedge-fund legend Steven A. Cohen.

Steven A. Cohen is a mythic figure in the hedge fund world. With an estimated net worth of $8.8 billion, the secretive 56-year-old investor is 40th on the Forbes 400. His compound in the back country of Greenwich, Ct., is filled with so many recreational amenities it has been referred to as Chelsea Piers (PDF), and he’s a major collector of modern art and a philanthropist. Children’s hospitals on Long Island and New York bear his name.

But in recent years, as the Securities and Exchange Commission and Preet Bharara, the U.S. Attorney for the Southern District of New York, have ramped up investigations into insider trading, Cohen’s name has kept popping up. More than half a dozen people have been convicted or accused of insider trading who were former employees of the massive Greenwich hedge fund Cohen runs, SAC Capital Advisors, or who were SAC employees at the time of their wrongdoing. Last year, Sen. Charles Grassley (R-IA) called for an investigation into SAC’s trading. And on Monday, Matthew Martoma, a one-time analyst at SAC, appeared in Federal Court in Manhattan on charges of alleged insider trading and was released on a $5 million bond.

The indictment (PDF) alleges that SAC reaped a huge windfall by trading on confidential, nonpublic information about poor results of an Alzheimer’s drug trial. Martoma allegedly obtained the information from Sidney Gilman, a physician who helped run the trials. (Gilman is now cooperating with the government.) Based on the information, the government says, SAC quickly sold huge positions it had amassed in two companies, Elan and Wyeth, that were developing the drug—and then bet the companies’ stock would go down. The actions allegedly led to “over $276 million in illegal profits of avoided losses in July 2008 by trading ahead of a negative public announcement” on the drug, according to the indictment.

The episode is noteworthy not just for its size, but for the alleged involvement of Cohen, who appears to be an indirect target of the indictment.

Hedge funds are a brutal business. Finish the year up, and you get a big bonus. Lose money for a year or two, and you’re out. Investors don’t hesitate to pull out their funds after a lean year, even if it has been preceded by several fat years. Every hedge-fund portfolio manager has to have an edge—some secret sauce, experience, or domain knowledge that helps him profit in highly volatile markets.

But in an industry with a high degree of mortality, SAC has thrived and evolved into an institution. It is one of the largest hedge funds in the world. Thanks to its superior performance, SAC charges higher management fees than most of its peers.

Many observers and industry participants believe that Cohen’s edge is simply trading skill. Several hedge-fund professionals tell me they believe Cohen is simply the most talented trader out there, one who can process information more intelligently and effectively with his peers. After all, the markets are highly unpredictable. Stocks can go down on goods news and rise on bad news. Cohen is an excellent sailor in choppy waters.

Lots of people at SAC work extremely hard to ferret out good investing ideas. As one hedge-fund manager notes, people who are doing more research than their peers aren’t necessarily cheating. And many believe that SAC, because of its size and the amount of trading activity it conducts, is able to glean important bits of useful market information from Wall Street trading desks.

Still, for many traders, the edge turns out to be an ability to gain insider information and a willingness to trade on it. Cohen hasn’t been charged with anything, and there is no suggestion in the indictment of Martoma that Cohen knew the information was confidential. But the high-end world of private equity and hedge funds is a cynical one. “People have always been suspicious of their activities,” says one private-equity veteran. Indeed, the roster of former SAC employees who have had brushes with the authorities suggests that Cohen’s company may have poor judgment when evaluating the ethics of employees.

Another explanation holds that SAC has created an environment in which portfolio managers sometimes felt compelled to take the enormous risk of violating insider trading laws. SAC is described as a Darwinian world in which individuals and groups fight for capital and survival. Martoma, for example, earned a $9.4 million bonus in 2008, the year in which he allegedly traded on the confidential information on Elan and Wyeth. But he was pushed out in early 2010. As the indictment notes, Martoma was regarded by an SAC official as a “one-trick pony with Elan.”

There’s something different about this indictment. In the previous episodes involving SAC employees or former SAC employees, Cohen had plausible deniability. He didn’t have any firsthand knowledge of the illegal activity. But in the complaint, the U.S. government, alleges that Martoma, after receiving information about Elan and Wyeth, told “portfolio manager A” (generally assumed to be Cohen) that the firm should first unwind its large position in the two stocks, and then go short—i.e., bet that the stock would go down. SAC proceeded to do so, thus avoiding millions of potential losses and racking up profits.

Did portfolio manager A know the information was ill gotten? Reading between the lines of the indictment, a former U.S. attorney says, it is clear that Cohen is a target. The indictment describes a sudden, massive, and highly confident change in sentiment on the part of SAC. The hedge fund didn’t just sell off its large position in the two companies, it put new money at risk by shorting them. When a fund shorts a stock, it exposes itself to potentially unlimited losses. Martoma, the indictment alleges, was able to suggest making such risky trades because he knew that negative information about the drug trial would be forthcoming. So what precisely did he tell portfolio manager A in phone calls and conversations to convince him of his position?

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We don’t know. To go after Cohen, the government would have to prove that he knew the information was confidential. But unlike the case with Galleon Group head Raj Rajaratnam, who was convicted of insider trading, there are no taped phone calls or wiretaps. If the government is to make a case against Cohen, it will have to convince Martoma to cooperate. And that may help explain some of the wording in the indictment. A former U.S. attorney notes that the gratuitous line about Martoma being a “one-trick pony” telegraphs to Martoma that SAC ultimately didn’t value his contributions despite his helping to earn the fund large profits and avoid big losses in 2008. Prosecutors, in other words, seem to be reminding Martoma that the guys at SAC aren’t his friends and that he owes them little loyalty.

For now, the jeopardy to Cohen and SAC seems to be reputational rather than legal. If Martoma fights the charges and goes to trial, it is likely Cohen would be called as a witness. At some funds, the mere suggestion of impropriety can prove fatal, as investors flee. “If I had a manager with this kind of excellent track record, and this kind of ethical/criminal questions surrounding him, would I feel comfortable investing my own and my partners’ money with him?” asks a manager of a fund of funds who has not invested with SAC. Public pension funds, endowments, and other institutional clients whose board members are worried about their reputations are usually the first to jump ship when such accusations are made. Of course, much of the money in SAC belongs to Cohen himself, so SAC is in a better position to weather withdrawals.

All of which means that Martoma’s appearance in court on Monday may simply be the first act in a long-running play on lower Broadway.