Some lessons from SAC Capital
A panel discussion held in the Cayman Islands earlier this year on the topic of insider trading was telling. It comprised of representatives from the UK’s recently rebranded Financial Conduct Authority, the US Attorney General’s office and a prestigious New York law firm.
For 10 minutes, the lawyer explained what may or may not constitute insider trading in dry legalistic terms while the official from the US Attorney General’s office, speaking immediately afterwards, was considerably blunter. He told the audience – the majority of whom were operational due diligence professionals – that the line between insider trading and quality research was not as blurred as lawyers would have managers believe and advised hedge funds conduct a simple litmus test whenever they had doubts.
Managers should ask themselves how they would feel if an email or phone-call they had made or were about to make regarding a trade was played back to them either in court or by an investigator. If there is any hesitation in that thought process, then that manager should think twice about their actions.
This all matters because hedge funds are in the firing line. The US Attorney General for Manhattan, Preet Bharara, an individual moulded in the fashion of Rudy Guilliani of old, has enjoyed enormous success over the last few years pursuing and convicting white collar criminals, the most notable example being those associated with the Galleon insider trading scandal, with much of the evidence in that case derived from wire-tapping.
Law enforcement officials now have their sights on SAC Capital, the $15 billion and highly profitable and successful hedge fund run by Steve Cohen.
The Securities and Exchange Commission’s $616 million settlement with SAC following allegations of insider trading has not blunted the resolve of the Department of Justice (DOJ) or Federal Bureau of Investigation (FBI) to claim more scalps at the firm, although Cohen has himself not been accused of wrongdoing.
Barely a few weeks after his company’s settlement, Cohen purchased a Picasso painting for $155 million, in what several industry figures described as an act of defiance to regulators, and an action that certainly added fuel to fire among regulators and prosecutors alike already hell-bent on making a successful case against SAC Capital.
While subpoenas have been sent to SAC Capital, the conclusion of this case is yet to be decided. Most journalists or experts predict SAC Capital will return all external money, opting to become a family office, although that is assuming senior personnel do not receive lifetime or temporary bans from the securities industry altogether, or worse.
Despite the severity of this investigation, SAC Capital has been sending out mixed messages. In May 2013, it promised to bolster its compliance set-up and announced it would claw back remuneration from employees who had profited through illegal information – there are presently nine current or former SAC Capital employees charged or implicated in insider trading during their tenure at SAC Capital. The clampdown and renewed focus on compliance was welcomed at the time, but the harsh reality is that such measures should already have been in place.
Barely one week later, SAC Capital alerted investors in a letter that its cooperation with the authorities would no longer be unconditional, adding it may not be able to provide investors with full transparency about the nature of the investigation. This decision by SAC Capital was not looked kindly upon by investors, many of whom include institutional names such as Blackstone and Magnitude Capital. More than half of the firm’s $8 billion external capital is likely to be redeemed this week with Blackstone reported to be withdrawing $550 million.
Investors nowadays cannot be exposed to anyone where potential non-compliance or illegality is an issue. The days when certain investors piled cash into Bernie Madoff long before his outfit was exposed as a massive Ponzi scheme, but rather when allocators assumed his consistent, steady returns were generated not by skill but front-running or some form of conflict of interest, are long-gone. While Cohen’s trading successes may or may not be legitimate, questions of his firm’s compliance procedures are circulating, and that in itself, is a massive red-flag.
Moving beyond non-compliance, a lack of transparency is another red-flag among institutions. The decision by SAC Capital to cherry pick the information it provides investors is a regressive move for an industry which has made significant strides in becoming less opaque. Any investigation of this nature is likely to be intrusive, and could have a material impact on returns and staff turnover. If ever there is a time for SAC Capital to afford complete transparency to investors, it is during a period of crisis, when rumours and misinformation are likely to flourish.
The approach by SAC Capital is likely to facilitate brutal defections by once-loyal investors, but the reputational damage will go beyond SAC, and likely impact the hedge fund industry more broadly.
It is for these reasons that compliance and transparency must be more than just meaningless verbiage at hedge funds.