Inside the trading scandal at SAC

One of the best-known hedge fund managers is incredibly close to civil charges from the Securities and Exchange Commission. Steven Cohen, who runs the $14 billion SAC Capital, told investors on a call Wednesday that the firm received a Wells notice, meaning regulators are closing in on an insider-trading case.

Let’s recap from the Wall Street Journal:

Speaking on a Wednesday conference call with its investors, SAC President Tom Conheeney said the Securities and Exchange Commission sent the firm a so-called Wells notice last week indicating that the regulator may bring charges, the people familiar with the call said.

The SEC and federal prosecutors have accused Mathew Martoma, who worked for SAC’s CR Intrinsic unit until 2010, of obtaining tips about a clinical trial for an Alzheimer’s drug from a neurology professor working on it. The complaints allege that he traded on the information and advised SAC’s billionaire founder, Steven A. Cohen, who was referred to as the fund “owner” but not named in criminal and civil complaints. Mr. Cohen wasn’t charged.

Mr. Cohen opened Wednesday’s call with a one-minute defense of his actions, before yielding the floor to Mr. Conheeney, the people said.

“We take these matters very seriously, and I am confident that I have acted appropriately,” Mr. Cohen said, according to one person.

Mr. Conheeney told investors that the firm’s trading activity related to Elan Corp. one of the stocks at the heart of the government’s case against Mr. Martoma, was consistent with how Mr. Cohen has invested for decades, people familiar with the call said.

Here’s a great explanation of the SEC actions from Bloomberg:

The SEC sends a Wells notice to a company or an individual after its staff has determined that sufficient wrongdoing has occurred to warrant civil claims being filed. The notice gives the recipient a chance to try to dissuade the SEC from taking action.

Prosecutors say SAC, one of the best-performing hedge funds, reaped $276 million in profits and averted losses by trading stocks of Elan Corp. and Wyeth LLC in 2008 based on inside information Martoma received, and that Cohen traded those shares in his own portfolio and discussed the stocks with Martoma.

Control-person liability is a provision that Congress created in 1988 that introduced liability for managers who fail to maintain a system to discourage and detect insider trading by subordinates, according to James Cox, a professor at Duke University School of Law in Durham, North Carolina. That provision doesn’t require the SEC to prove Cohen knew about the trades, just that the compliance system broke down, Cox said.

Last week’s claims mark the sixth time a current or former SAC employee was linked to insider trading while working at the Stamford, Connecticut-based company.

Read that last sentence again. The sixth time? While obviously nothing was proven, it still amazes me that investors continued to give money to a fund with questionable practices.

Here’s part of Cohen’s defense, again from the WSJ:

Mr. Conheeney added that Mr. Cohen wasn’t an expert on the health-care industry, and relied on others, the people said. He said that Mr. Cohen had been deposed by the SEC on the allegations, and answered all of the regulator’s questions.

He also said that any short positions, or bets against, the stock of Elan and Wyeth would have been intended as a hedge while the firm was selling off its stakes in the companies, according to an investor.

A spokesman for SAC said that Mr. Cohen and the firm “are confident that they have acted appropriately and will continue to cooperate with the government’s inquiry.” He declined to comment on the SEC’s possible civil action against the firm.

In an interesting column yesterday, the New York Times’ Andrew Ross Sorkin wrote about so-called expert networks and how close they come to the line of insider trading. It’s an interesting problem that he outlines (I’ve skipped some paragraphs below, so read the whole column):

The investment was unusual because Gerson Lehrman, a so-called expert network firm that links hedge fund investors with experts in various fields, had been under scrutiny by regulators and the press for creating a business model that some said was tailor-made to foster insider trading on Wall Street.

A hedge fund manager could call up Gerson Lehrman, ask to speak with an expert — often a current or former employee of a company that the hedge fund was considering investing in — and, for prices as high as $1,000 an hour, the “expert” would, with luck, divulge what he knew. A front-page article in The Wall Street Journal in 2006 provided a series of anecdotes of questionable information being sought by Gerson Lehrman’s clients.

And yet here we are: last week, federal prosecutors announced what they said was the largest insider trading case in its history, charging Mathew Martoma, an employee at the hedge fund SAC Capital Advisors, with using inside information about drug trials from one of these experts, Dr. Sidney Gilman, a neurology professor at the University of Michigan Medical School who had been hired byElan and Wyeth to oversee the drug trials. The transfer of information was made possible by Gerson Lehrman, which had played matchmaker. If this expert network did not exist, it is not clear that Mr. Martoma and Dr. Gilman would ever have found each other. More on that in a moment.

The criminal case against Mr. Martoma suggests that he used Gerson Lehrman’s services repeatedly, paying a total of $108,000 to Dr. Gilman, who was paid about $1,000 an hour for his expert counsel — or his dispensing of inside information, as the government sees it. Dr. Gilman, 80, entered into a nonprosecution agreement in exchange for providing information on his discussions with Mr. Martoma to the government.

In fairness to Gerson Lehrman, the various complaints against Mr. Martoma make clear that the firm put Mr. Martoma and Dr. Gilman through a number of compliance programs and repeatedly provided them with notices — boilerplate e-mails — that Mr. Martoma was not to seek inside information and Dr. Gilman was not to provide it.

As Sorkin writes, here’s the crux of the problem:

On one side, there is a good argument that these firms help investors and others find one another — consider it a high-priced Facebook for consultants. Gerson Lehrman has expanded its business beyond simply working with investors; it now helps corporations looking for experts, or advertising agencies looking for help ahead of a big pitch.

There is clearly a market for matchmaking, and without a Gerson Lehrman, it is very possible that some interactions would take place over beers or expensive dinners — without the compliance efforts and audit trails that the firm provides. With the advent of LinkedIn and other social networks, there are increasingly new ways to find experts.

But investors don’t pay hundreds of thousands of dollars a year for information that isn’t material — at least, material to them. In the best of worlds, the expert network business model is about pushing clients as close to the “line” as possible without crossing it. That’s a tough thing to do consistently — and a precarious way to run an enterprise.

Well said, Andrew.