Saturday, August 10, 2013

The Indictment of the hedge fund SAC

  Last month, federal prosecutors indicted the large and profitable hedge fund SAC, labeling it a criminal enterprise. The indictment charges that the firm and its portfolio managers, under the direction of its owner, Steven A Cohen, engaged in substantial insider trading; that is, soliciting and trading on material information about companies that was not in the public domain. As the indictment reads, “This insider trading was substantial, pervasive and on a scale without known precedent in the hedge fund industry.”

While the charge is severe, it actually reflects the prosecutor’s failure to indict Steven Cohen directly as someone who solicited and or paid for inside tips. This, despite the fact that the prosecutors wiretapped his home phone for two weeks and the Securities and Exchange Commission combed through all of the firm’s trades and emails. Instead, they took the unusual step of arguing that the firm’s purposes were criminal and that its ill-gotten gains, when mixed with legitimately acquired profits, was evidence that it was laundering dirty money. The last time prosecutors charged an enterprise, rather its officers or employees, was when the accounting firm Arthur Anderson was charged with helping executives from Enron, the energy company, to cook its books. Anderson collapsed shortly afterwards, as its clients took back their business. Thousands of people lost their jobs. As a result, prosecutors have been very reluctant to charge enterprises rather than individuals. However, had they not filed these charges in July, the statute of limitations against the firm and against Steven Cohen would have expired this summer.

The indictment notes that four one-time SAC employees pleaded guilty to insider trading while at the fund, while five others have been implicated in such conduct. In the most damming instance, a portfolio manager, Matthew Martoma, got information from a physician, who was privy to the results of a trial of an Alzheimer’s drug. The physician has admitted giving Martoma this information. Believing at first that the drug would prove to be effective, Martoma had urged Cohen to buy shares of the two drug companies sponsoring the trials.  But when the physician tipped Martoma off that the drug trial had failed, Martoma, the prosecutors charge, told Cohen, during a twenty-minute phone call, to sell his shares; this only days before the trial results were to be presented for the first time publicly at a scientific conference. (Prosecutors know the timing of the phone call, not its contents.) As one journalist notes, “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.” As the journalist notes, when an investor shorts a stock, “it exposes itself to potentially unlimited losses,” since it is borrowing shares and then selling them, betting that its price will fall, when it fact its price could rise without limit. It takes considerable conviction to short a stock. SAC avoided losses of $194 million by selling its shares, and made $82 million on the short sale. Prosecutors charge that Martoma’s conviction was not based on good detective work but on inside information. Few observers doubt Martoma’s guilt, though he is pleading not-guilty. But no one but Martoma and Cohen know what they said to each other during that twenty-minute phone call. 

Prosecutors have taken the risk of charging SAC with being a criminal enterprise in part because SAC, under Cohen’s direction, has earned extraordinary returns over its lifetime. For example, SAC earned 70% returns, “riding the high tech wave of 1998-99 and then even a more mind boggling 70%, betting against the very same stocks in 2000.” In 2006 his fund returned 32%, and in 2007, 14%, while the S&P index earned only 16% and 5% in those same years. The fund has had only one down year, 2008, in the midst of the financial crisis, and since 1996 has averaged annual returns of 25%. This compares favorably with Warren Buffet’s earnings of 8.5%. If, as many academicians argue, stock prices move for the most part randomly, SAC, prosecutors concluded, must be getting inside information.

Yet few people doubt that Cohen is a preternaturally gifted trader. As one person noted, “Let me tell you, as his clearing agent, I’ve seen all his records, hundreds of thousands of trades, all of it, and my conclusion is simply that the guy is an artist. He looks at a stock market in chaos and sees order. He was just right over and over and over. I’ve sat and watched him trade, watched him stare at his terminal in silence, and I can tell you, without a doubt, he is the best that ever was at what he does.” Cohen, like many great traders, was a master poker player in high school and college and became fascinated by stocks when he was 11 years old. When he began trading he was characterized as a superlative “tape reader." He could look at the “ticker-tape” as stock names, volume traded,  prices and price changes moved across the screen, and discern organized patterns of buying and selling. As he once described it, “I’m not looking at anything. Just the numbers on the screen. I couldn’t even tell you what the company did, and I don’t care. I’ve always been intuitive like that. It was always seat-of-the-pants.” In his early years he developed a day-trading style, moving in and out of particular stocks, cutting his losses quickly and speculating on movement and catalysts. As he once noted, “We trade fast. It’s not growth investing. Its short term catalyst investing.” Similarly a colleague describing his trading style, said that, “He is fundamentally a speculator. He does not care if a stock is worth 10 or 100, he wants to know if it going from 10 to 11 or from 10 to zero.”

His skill may appear less magical if we think of its as a feat of abstraction, seeing in numbers themselves, without reference to their substantive meaning, the signatures of emotions that drive trading. In some degree this is what “chartists, (people who look at charts of stock movements without reference to the underlying value of stocks) try to do. But it appears that Cohen can do this close to instantaneously. Certainly, there have been famous mathematicians, such as Benoit Mandlebrot, who had a preternatural ability to see patterns in pure numbers. It is also plausible that his poker playing skills, the ability to control impulses and play purely based on probabilities, helped him regulate his feelings as he watched the tape.

Yet, if we believe that his artistry was the precondition for his early success, it also seems reasonable to conclude that he could not grow a firm based on his talent alone. It would be impossible to train others to trade as he did, so his profits would be limited by his own available time and attention. Interestingly, it appears that he tried. He hired a psychiatrist and performance coach, Arie Kiev, to help his traders regulate their feelings as they bought and sold stocks. But sometime in the early nineties, he developed a new conception of his firm as an “information gathering machine,” and described his trading as “information arbitrage.” According to a marketing document SAC circulated to investors, SAC by 2009 had more than 90 research analysts covering two-dozen industry sectors.” The firm's “edge," the brochure added, included, "over 60 portfolio management teams with deep industry networks."

In addition, by paying investment banks and brokers good money for their trading services, Cohen got good market information from them. As one journalist writes, “SAC is different because it is of the Wall Street system. The firm reportedly pays more total brokerage commissions every year than any other group on earth…brokerages and analysts bombard SAC with ideas, edges, speedy fills and every other micro-advantage that comes with being a target customer.”

Similarly, another journalist writes, “SAC was able to demand preferential treatment from its friends on Wall Street. These were not even illegal confidential tips but the stuff the average investor can’t get at home, such as market chatter about large trades and other bits of trading intelligence available only to the big Wall Street firms and shared with only their best customers.” In addition, “Former traders and rivals say one way Cohen built his business and relationships with brokers was by buying secondary offerings, when public companies decide to bring more shares to market, on which brokers receive around 40 cents to $2 a share on a built-in sales commission. ‘If you take down a million shares of a secondary, you've just paid your broker $1.5 million,’ says a fund manager. That's how Stevie started off paying the Street." Finally, “former SAC employees have started at least 31 other funds, in which Cohen often invests, and the expectation is that the former traders will continue to feed SAC information, which is why one SAC alumnus calls Cohen 'the Godfather.'”

We can consider this business model the outgrowth of Cohen’s instinctive game playing ability; the willingness and ability to use inducements, and the threat of withdrawing them, to stimulate cooperation and reciprocity. Combined with his capacity to absorb information and see patterns in numbers, one can see how he was able to build an information arbitrage machine.  

But in 2000, the context for gathering information on Wall-Street changed significantly. In that year the Securities and Exchange Commission, released a regulation that forbad companies, investment bankers, Wall Street analysts, company employees or a company’s lawyers from releasing material information selectively to some investors or traders before informing all potential investors. For example, if they held a conference call on their earnings, everyone had the right to dial in.

But yet, to gain an edge, traders need to acquire non-public information. The question then becomes whether that information is “material enough” to give a trader an unfair advantage. Many traders advanced what became known as the “mosaic theory,” which holds that traders could obtain non-public information, for example that a company’s shipments by rail have slowed down, which becomes material only when added to other pieces of information. The SEC did not intend to quash traders' and analysts' everyday activity, such as attending conferences, tracking companies and speaking to experts, Indeed, as the following chart shows, after the regulation was passed there was a significant increase in the number of firms, called “expert firms” that hired experts, often employees of fortune 500 companies, to consult with analysts and traders on industry and company trends. Indeed, the physician who tipped Martoma was in the employ of an expert firm. 


It is a common phenomena that when rules and injunctions are unclear, it falls upon individuals to do the work and take the risk of interpreting them as best as they can. But if my colleague Ben Hunt is right, the SEC has also, and perhaps unwittingly, criminalized the process of obtaining any private information on public companies. As Hunt notes, Obtaining private information on public companies has been largely criminalized today. Since the SEC's adoption of Reg FD in August 2000, any investment perspective based on 'getting to know management really well' has skirted the borders of legality…” (  But we know what happens when typical behavior is criminalized, such as pot smoking or prostitution. It creates either contempt for the rules and/or moral quandaries and psychological conflicts for individuals. 

Contempt may account in part for why SAC’s compliance department, despite its size and the reputation of its head, had limited impact on trader’s practices. A former employee, Noah Freeman, who gave testimony in another insider trading case “suggested that some SAC employees were adept at evading compliance efforts. They seem to have routinely used private e-mails and kept notes on encrypted drives ‘so that in the event of a subpoena or government investigation, there wouldn’t be notes on the central corporate servers that the government could get their hold of,’ Mr. Freeman testified.” This may be one reason why, despite the number of SAC portfolio managers and research analysts who have pled guilty to insider trading, “SAC’s compliance department contemporaneously identified only a single instance of suspected insider trading by its employees in its history.”

One question is how did Steven Cohen respond to this change in the legal context for acquiring information. What did he think of the day-to-day dilemmas now facing his own portfolio managers and research analysts? The prosecution’s theory, is that as the head of a criminal enterprise he organized the firm and its flow of information so that he could deny knowing that traders’ and analysts’ ideas came from insiders. This enabled him to keep the pressure on his portfolio managers to supply with him good trading ideas without risking his own legal standing. One fact supporting this theory is that, as one author writes, “Sometime around 2002 SAC began decentralizing the information flow among the various specialized groups at the fund, moving Cohen, who would directly manage just a portion of the SACs money, away from the center of information flow.” (Charles Gasparino, Circle of Friends) In addition, Cohen pushed his managers to specify with what level of conviction, on a scale of 1 to 10, they believed in a particular trading idea. From the prosecutor’s point of view this was a veiled way for a trader, who answered with a  “9” or “10,” to communicate that his idea was based on private information obtained from trusted insiders.

I want to propose an alternative to the prosecutor’s theory, based not on Cohen’s presumably criminal impulses, but rather on this character and psychology. As a master poker player, committed to winning, Cohen’s relationships with others were transactional, based simply on whether a person could help him win. In this setting one employee noted, “The rules here are simple, “win and you get rich and lose and you get fired.” Matthew Martoma who helped Cohen make the $82 million on the pharmaceutical short sale, got a $9.5 million bonus, but was promptly fired the next year when he failed to come up with a new winning idea. As the journalist notes, “Mr. Cohen, a mercurial master, has been known to fire money managers for making one bad trade even if they had made him billions before.” Cohen as I have suggested, learned to see his corner of the world through numbers, without considering their link to substantive truths, He could translate the emotional drama that underlies investing -- the cycles of hope, greed, fear, elation and panic-- in a manner that could not touch him emotionally. Indeed, his trading room is famous for the fact that phones never ring, they flash, and that the temperature is kept cool to keep people alert.

In addition, as a reporter who interviewed Cohen notes, “(in this early years) Cohen quickly became known for the volcanic temper he displayed when anything went wrong. ‘People say they’ve never been spoken to the way I spoke to them on the phone,’ he says with a shrug.” In other words, he is not burdened by concerns for other people’s feelings, at least not when they are willing players in the trading game and become obstacles to his winning.

It would be too rash to conclude that he is in general indifferent. He has four children with his second wife to whom he has been married for 21 years. Rather, if you are in the game, you’re meaning is assessed along only one dimension; are you a winner or a loser.  Thomas Conheeney, SAC’s president, once remarked that “Steve doesn’t really understand his own persona, this iconic status he has. We try to get him to go talk to these business groups, and he goes, ‘Why would they want to hear anything I have to say?’” I don’t think this is a matter of modesty. Rather I suggest it reflects his disinterest in what most people think and feel about him.

So consider my psychological hypothesis. If I am right about this character, Cohen would have limited or no interest in the complexities and challenges his traders, analysts and portfolio managers faced in threading the needle between material and non-material information. He was not tuned to their experiences, only toward their utility. This enabled him to sidestep the meaning of the new regulation while continuing to pressure his employees to give him “high conviction” trading ideas. Or let me put it this way. A different hedge fund owner, an alternate Steven Cohen, may have had the same impulse -- to deny the substantive impact of the regulation on his traders’ everyday experiences, -- but his psychological connection to his traders and analysts would have quashed that impulse. Empathy would link him to their quandary, so that should he benefit from their misconduct ,he would feel guilty and burdened. This alternate Steven Cohen would have had to have faced the implications of the new regulations and take some responsibility for his subsequent stance.

This hypothesis helps account for Cohen’s disinterest in the issue of insider trading and in his fund’s policies on compliance. Giving testimony in a deposition on a different case in 2011, Cohen said, “The way I understand the rules on trading on inside information, its very vague.” When asked about his firm’s compliance manual he answered, “..when you’re trading securities it’s a judgment call. Whatever the compliance manual says, it probably doesn't take into account every potential situation.” There is of course a sense in which these answers are correct. But they reflect I suggest a lack of interest in the rule’s impact on decision making and behavior.

Frequently, people benefit from the misconduct of others while feeling no direct responsibility for the misconduct itself.  For example, employees of Apple benefited when Apple executives conspired to fix the price of e-books with publishers. After all, Apple’s higher profits created more resources and rewards for its employees. But I imagine that very few Apple employees quit rather than benefit from the company’s unlawful conduct. They felt far too removed from the decision to fix prices. Many of us benefit from the unethical conduct of clothing manufacturers who give business to factories in Bangladesh, where costs are low because factory conditions are unsafe. Yet many of us continue to buy this clothing on the presumption that we are bystanders.

I hypothesize that Cohen, rather than being the mastermind, as prosecutors saw him, acted as if he were a bystander, failing to connect the pressure he put on his employees with the constraints they faced in navigating a messy ethical terrain. This failure I suggest was motivated by his emotional detachment from people who like him were “playing the game” though it also advanced, at least in the short run, his self interest. If my hypothesis has merit, it was Cohen’s character flaw to be so close to the action, yet experience himself as a bystander. It is striking in this regard that when the investigators tapped his home phone they discovered to their surprise that he had few friends. They expected a mastermind to have a wide network of friends and acquaintances. This had been true of
Raj Rajaratnam,  a hedge fund owner who, with the aid of wiretaps, was successfully convicted of insider trading. Rajaratnam had in fact a keen interest in other people's psychology, if only to assess their weak points and seduce them into conspiring with him. This is how he ensnared Rajat Gupta, the one time head of Mckinsey, the consulting firm, and a person of high repute. 

It is useful to ask why we should consider the psychological hypothesis at all, when an explanation from self-interest, call it the politics hypothesis, is sufficient. Moreover, the politics hypothesis often has the merit of being simple, whereas the psychological hypothesis is not. Cohen, the prosecutor argues, benefited from insider trading and so he developed a system of extracting it from his traders while maintaining his “plausible deniability.”

But the merit of the psychological hypothesis is that it stimulates our  empathy and identification and helps create a more human understanding of someone else’s decisions and motives. For example, following my hypothesis we can come into touch with how at times we are all bystanders who benefit from the misconduct of others. Ironically, the prosecutor’s theory shares the same limited or “transactional” view of human behavior that Cohen brought to his experience of trading. In this view, a person’s self interest is the best guide to understanding his behavior. A person has either broken the law or has not. Perhaps this simplified understanding of human motivation explains why, to their frustration, the prosecutors could not find direct evidence of Cohen’s culpability despite the wiretap, and at least five years of investigating him and his firm.  It was just not that simple.

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