Has the SEC finally caught up with SAC CAPITAL’S Steve Cohen?

Steve Cohen 

Achieving so called “alpha” in asset trading is a rather difficult task. Only a select few asset managers can seemingly achieve this over a sustained period. At the more “shady” end of the hedge fund arena in particular, it seems that by “joining” material public information together with “non-material” non-public information, these fund managers are able to get a much more detailed picture of a company’s prospects and so make trades that turn out to be somewhat more profitable than their peers. SAC Capital has been a master at this in recent years and has generated exceptional returns that have made his investors billions and turned him himself into a billionaire.

Mosaic theory

It seems however that sometimes even the best in the game need an extra hand to get those punchy returns and so they go a step further by omitting the “non” in non-material non-public information as we saw in recent years with Raj Rajaratnam in particular and who was sentenced to 11 years in prison and fined $10m (ouch!). The defence of so called “mosaic theory” (piecing together individual bits of “non” material info to form a “material” picture)has been falling hollow with regulators in the US in particular who view it as de facto insider trading.

Raj Rajaratnam

SAC Capital Advisors is one of the most well known hedge funds and is headquartered in Connecticut. Owner Steven Cohen, has an estimated net worth of around $8.8 billion and runs a company which trades a net equity position around $14 billion. It is said that in his heyday, his firm accounted for upto 20% of all trades on the NYSE.

Mr. Cohen started working as a junior trader in the options arbitrage department of a small Wall Street company called Gruntal & Co. His abilities were soon discovered and he quickly gained some leverage inside the company and started managing a group of several traders who regularly began to make more than $100,000 per day in profits.

Capital mass dilutes returns

Like many others of his ilk, Cohen soon realised that he could do much better working for himself as did John Paulson. Cohen set up a company that made his fortune. Unfortunately, it seems that for the brightest talents, trading in a market niche with a relatively small pool of capital is no problem but as assets and complexity grows returns diminish, unless of course you are taking on more risk… SAC seemingly broke the mould however, expanding the number of employees, assets under management etc but without losing its ability to generate those abnormal returns. Over two decades the company has been averaging 30% in returns per year. A stellar performance that is almost unmatched in the industry!

Bu then comes the mosaic theory. According to the U.S. Securities and Exchange Commission (SEC), former SAC traders have been abusing mosaic theory and in fact using material non-public information to achieve abnormal returns for the company. A few days ago, the company was implicated in a scandal involving insider trading relating to two drug companies – Elan and Wyeth. Mathew Martona, a former SAC portfolio manager has been accused of insider trading and the name of Steven Cohen has also been referred to in the process – not for the first time. In the past, five other former SAC employees have been implicated in insider trading deals and three of them have confessed to their crimes but so far Stevie has been like “teflon Don” and nothing has stick to him. It looks like this time it’s going to be different however.

SEC approach differs to FSA

Even though former traders and managers have been charged and confessed their illegal trading while working at SAC, Steven Cohen had never formally been accused with the same practices. The company was able to dismiss involvement stating its traders/managers have full discretion to pick up assets as they wish to, and that the company wasn’t aware they possessed material non-public information. That seems relatively odd as it is really hard to understand how a company gives such freedom to traders even after seeing some of them being charged with illegal trading. Certainly in the UK the FSA would make the supervisors culpable as a dereliction of their duties.

Mathew Martoma networked (as it sometimes is called) with many industry professionals when working at SAC. Although this networking is seen as a way of getting bona fide professional advice regarding some investments, what Mr. Martoma also got was inside information regarding the development of an Alzheimer’s drug being developed by the companies Elan and Wyeth. A doctor he contacted told him about the better than expected developments in clinical trials from the drugs being developed which had not been made public and Mr. Martoma led SAC to buy a position size of $700 million composed of shares of those two companies.

In July 2008, the same doctor told Mr. Martoma that some side effects were being identified during trials and SAC sold its full position and even reverted to a short one (probably their failing and lesson in true greed!). When the result from the trials were made public, shares in Elan and Wyeth plunged 42% and 12% respectively. Total profit from this pick has been evaluated at an astounding $276 million for SAC, and which earned more than $9 million in benefits to Mr. Martoma in the same year.

It seems Mr. Martoma was not as lucky with his networking in the following years as he received no bonus in 2009 and 2010 and was formally dismissed from SAC in 2010.

The SEC has been intensifying its scrutiny of SAC recently. There is also another insider trading case on the table, this time with two other companies – InterMune and Weight Watchers International.

In the first case, it seems a mirror image to what happened with Elan and Wyeth. SAC opened a large position in InterMune in the first half of 2010 and quickly closed it in quarter two. Shares of that company soared after a favorably review by the U.S. FDA on a medicine being developed by the company but then slumped after the company’s application for a lung treatment was rejected. “Luckily”, SAC was no longer invested in the stock at that point! The case with Weight Watchers International relates to n upbeat earnings forecast made by the company that resulted in the shares doubling in price in a short period of time. As with the prior SAC cases, the trader involved in the trade is no longer with the company.

According to SAC, the company didn’t know these traders all had insider information when they traded. In our view, allowing a trader to assume a position of $700 million in two stocks for a short period of time to speculate on some clinical trials results isn’t trading, its gambling, and hedge funds are supposed to be “smart” money not gamblers. Even with $8bn, if the SEC are determined to finally get their man then Stevie’s days as a free man seem numbered… Still $8bn probably buys a lot of sleeping tablets!