SAC Capital Group Faces Insider Trading Charges

Leadership at SAC Capital Group (SAC) is accused of creating a culture that encouraged the use of non-public, material information in the pursuit of high returns. And those returns have indeed been high — nearly 30 percent over the last 20 years, some of the best in the hedge fund industry.

August 2013 

By Scott Butler 

 

Leadership at SAC Capital Group (SAC) is accused of creating a culture that encouraged the use of non-public, material information in the pursuit of high returns. And those returns have indeed been high — nearly 30 percent over the last 20 years, some of the best in the hedge fund industry. SAC is headed by its founder, Steven A. Cohen, legendary Wall Street trader, 117^th richest man in the world and largest investor in the firm with more than $8 billion at stake.

 

On July 25, 2013, Preet Bharara, U.S. Attorney for the Southern District of New York, indicted the group of companies that compose SAC Capital Advisors (SAC Capital Advisors, LP; SAC Capital Advisors, LLC; CR Intrinsic Investors, LLC; and Sigma Capital Management, LLC) on one count of wire fraud and four counts of securities fraud, calling the $14 billion hedge fund a “veritable magnet for market cheaters.” In addition to the criminal indictment, the government filed a civil forfeiture action in Manhattan federal court against SAC. It alleges that SAC “engaged in money laundering by commingling the illegal profits from insider trading with other assets, using the profits to promote additional insider trading, and transferring the profits with the assistance of financial institutions.” If the indictments are successful, SAC could be forced to shut its doors.

 

On July 19, 2013, the Securities and Exchange Commission (SEC) filed a civil complaint against Cohen. It alleged that Cohen “failed reasonably to supervise two of his senior employees [Mathew Martoma and Michael Steinberg] who engaged in insider trading under his watch.” The complaint seeks to recover more than $275 million in earned profits and avoided losses resulting from suspect trades in the stocks Elan, Wyeth and Dell.

 

The two portfolio managers implicated in the complaint have also been charged with criminal insider trading and have pleaded not guilty. In mid-March 2013, SAC paid a fine of more than $600 million, the largest in SEC history, to settle insider trading charges on only two trades without an admission of guilt.

 

The government actions against SAC reflect a marked increase in cases of securities fraud brought against large investment players since the financial crisis of 2008. Raj Rajaratnam and Rajat Gupta are two of the most notable figures successfully charged for securities fraud by Bharara’s office. SAC would be the biggest win yet, and the case highlights the increased importance of compliance within the financial services industry. Despite increased emphasis on compliance at SAC since 2008, it was not enough to prevent the charges.

 

Complicated Compliance 

Bharara described SAC’s compliance system as one that “appeared to talk the talk, but almost never walked the walk.” The government argues in the indictment that SAC “employed limited compliance measures designed to detect or prevent insider trading.” Before instituting a revised document retention policy in September 2008, SAC deleted all emails not affirmatively saved after 30 days and automatically purged all instant messages after 36 hours. Before late 2009, SAC’s compliance department seldom reviewed SAC employee electronic communications for suspicious language suggesting possible insider trading, even though the SAC compliance department head recommended such searches in 2005 to management.

 

Before 2006, SAC leadership allowed the use of expert networks to obtain industry information from public company employees in exchange for payments. Management also encouraged employees to have direct contact with their own network of public company employees. Despite knowing that these networks posed a risk of insider trading, SAC compliance officers failed to properly oversee employee use of said networks. The number of internal insider trading investigations conducted by SAC compliance staff were limited and often weak; they focused on “confirming” with an SAC research analyst or portfolio manager that suspect communications had merely been badly drafted. On multiple occasions management at SAC failed to refer suspect trading recommendations to the compliance department.

 

What is SAC’s side of the compliance story? In a white paper released in response to the SEC complaint against Cohen, SAC outlines the steps it has taken to make compliance a priority:  

 

“Since 2008, the number of full-time compliance and compliance IT staff has increased from 10 to 38 persons. Members of the firm’s legal staff also dedicate a portion of their time to compliance issues. The compliance staff regularly consults with law firms, compliance advisory firms, sell-side financial institutions, and other private investment firms about best practices and evolving surveillance techniques. SAC, with the full support of Cohen, has spent tens of millions of dollars over the years on dedicated hardware, software, and other compliance infrastructure to enhance the effectiveness of its compliance efforts. Ten members of the compliance staff are devoted to managing, maintaining, and upgrading the firm’s compliance technology. The compliance department’s budget for 2013 alone is approximately $30 million ... SAC’s compliance team, with Cohen’s full support, deploys some of the most aggressive communications and trading surveillance in the hedge fund industry. These include, among others, daily reviews of electronic communications (e.g., emails, IMs, Bloomberg messages, internal write-ups) and SAC trading using keyword- and concept-based search protocols; weekly reviews of randomly-selected portfolio manager teams; review of all communications between investment professionals and their former employers for a period after commencing work at SAC; review of trading made around market moving events and corporate access events; and regular reviews of the firm’s most-profitable trades. The firm has also adopted — at significant cost, and at the risk of putting itself at commercial disadvantage — numerous prophylactic measures, as well as restricting its employees’ use of expert networks.” 

 

The government says SAC’s compliance was inadequate, and SAC says it has some of the best compliance in the hedge-fund industry. Only time will tell who is proven right, but the importance of compliance is indisputable.

 

Missed Red Flags 

What red flags did SAC’s leadership fail to recognize and what are the lessons to be learned?

Managers failed to oversee employees’ use of expert networks.  

Hiring personnel recruited employees who had proven networks of company contacts, but did not institute proper oversight to make sure employees were not using illegal inside information from these contacts. 

“High conviction” trading ideas — the best ideas from each portfolio manager at SAC, which were recommended directly to Cohen — were not properly reviewed by the compliance team to identify potential instances of insider trading.  

The compliance team did not employ sufficient measures to routinely monitor employee electronic communications for indications of insider trading until late 2009. 

 

So far six former SAC Research Analysts and Portfolio Managers have pleaded guilty to insider trading charges, but SAC’s compliance staff only suspected one instance of insider trading in SAC’s entire history. In that instance, management permitted the suspected employees to continue working and failed to report the case to regulators. To avoid securities fraud charges, compliance departments must proactively identify possible instances of fraud and notify regulators when there is a problem.

 

The story of SAC highlights the importance of compliance in today’s business environment. A robust and proactive compliance culture with the full support of management is absolutely critical in the financial services industry. Will the failure to comply with securities fraud regulations take down one of the most successful hedge funds in history? If Bharara’s record of 73 convictions and guilty pleas is an indicator of future performance, SAC should be hedging its bets.

 

 

Supplemental Videos and Documents: 

The press conference announcing the indictments against SAC:

http://www.justice.gov/usao/nys/pressconference/ 

 

Preet Bharara’s Keynote Speech at the ACFE Annual Conference:

 http://acfevideo.vzaar.me/1278182 

 

The document trail of the SAC investigation:

http://www.nytimes.com/interactive/2012/11/21/business/dealbook/20121121insider-document.html?_r=0