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…” (http://epsilontheory.com/schrodingers-portfolio/). 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.
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.
