Looking for Shades of Gray in a Black and White World
“You are just a grain of sand, Steven Cohen is who we want.”, Mathew Martoma testified what FBI agents told him. The jury would find Martoma guilty in history’s largest insider trade: $275 million.
From 2009–2012, US Attorney, Preet Bharara won 85 insider trading cases in a row. He had the largest conviction in history with Martoma, a high ranking portfolio manager with Micheal Steinberg’s conviction, and a hedge fund founder with Raj Rajaratmnan. But he didn’t rest.
The FBI looked at SAC and saw the Genovese.
FBI informants described SAC as an inside trading syndicate, an organization constructed to gather and trade on inside information. But SAC differed from organized crime families in several ways — organization, crime, and “family”.
Organization: Cohen organized SAC so he could be the best trader on the Street. Cohen made his own trades, in his own accounts, through his own executioner clerks.
Cohen setup SAC’s trading floor and put his desk, with its twelve monitors, at the center. He positioned his best portfolio managers/traders (lieutenants) closest to him, so he could see their trades/cards. He demanded that the best trade ideas come to him first. He configured SAC’s order management system to prevent other traders going ahead of him, he front-ran everyone.
On Sunday at 1 PM all portfolio managers reported their high conviction trades to Cohen. Cohen didn’t ask why or how just what. Some PMs like Martoma got high conviction trades through expert networks. Some of those experts disclosed inside information. Savvier PMs told their analysts (footsoldiers) to get “edgy, propriety information”.
Cohen insulated himself from explicitly receiving inside information through his organizational reporting, but he did his own trades. Everyone else traded after or under him.
Crime: Nobody dies, but insider trading is not a victim-less crime. SAC placed trades with brokers at firms like Goldman Sachs and Morgan Stanley. If an SAC trader was selling Elan or Dell, a Goldman trader was buying. When Elan and Dell tanked before the Goldman trader could pass the shares onto another fool, Goldman took the loss. Goldman had no choice but to accept the trade because it wanted SAC’s commissions. Repeated losses from being on the wrong side of an inside trade, pose a systemic risk. Goldman, like Morgan Stanley, accepted federal funds in the 2008 crisis and is routinely propped up by the Fed’s quantitative easing and zero interest rate policies, policies that harm average savers — the 99.
Family does not describe the high turnover culture at SAC. SAC recruited from other funds and from experts in the companies SAC traded. Many SAC employees left to start their own funds or were fired for performance. Crime families use deeper ties to reinforce loyalty — just when I thought I was out, they pull me back in.
The FBI found the hedgies much easier to flip than mobsters and small time lowlifes. The FBI felt all they needed to do was approach a lower ranking hedgie, scare them, and they’d get a flip. But Steinberg and Martoma didn’t flip.
“In the criminal justice system, the people are represented by two separate yet equally important groups...” — Law & Order Intro
Kolhatkar does not discuss insider trading from a legal perspective. Typically, for crimes with ten year jail terms, we codify case law through written statutes. But insider trading relies soley on case law. Insider trading case law merges the theory of fraud with the theory of efficient markets to determine that a person who trades on inside information commits fraud on the market. The tipper-tippee strain of insider trading law, where the information passes through a human chain, like the telephone game, adds the theory of accomplice liability. Another civil based theory applies the concept of duty — corporate officers have a fiduciary duty to shareholders to protect inside information and anyone, even the janitor, who comes in possession of inside information has that duty.
To make this derivation of derivations more palpable, case law added two prongs to tipper-tippee cases. First the passer, the tipper, must receive a personal benefit from the tippee and secondly. the person at the end of the chain who makes the trade must be aware of a personal benefit exchange. See my post on the evolution of insider trading law here.
The US Supreme Court has never heard an insider trading case where the trades were done for a corporate, instead of personal account. Martoma and Newman traded in corporate accounts. The Supremes could have chosen to review Newman, but chose the simpler and personal Salman case. Upholding Salman the court simply maintained the understanding of case law since their decisions in Dirks and Chiarella. See my post on the Salman case here.
At a more personal level, insider trading seems unfair to us. Why should a select group of the one percent get easy money when the rest of us scrape by? Insider trading is like athletes taking performance enhancing drugs, except the information is asymmetrical. It’s on this basic fairness level where Kolhatkar convicts Cohen.
SAC lost 28 percent in 2008. Its main strategy, day trading, did not cause or exacerbate the crisis.
SAC doesn’t appear in the top ten hedge fund lists from 2009 to 2015. Kolhatkar reports SAC ran $23 billion in 2012, that would rank it out of the top 10 behind Highbridge ($26B) and BlueCrest ($25B). Bridgewater consistently ranks #1 running up to $100B these days. Bridgewater’s founder built a business; Cohen built a trading floor. But for the feds, Cohen was the horse’s head.
10 billion at SAC belonged Cohen, given the estimated 50–100% annual growth rumors, it’s likely that most of the remaining amount came from appreciation or other SAC employees. One of its largest outside investors was another private fund, Blackstone. SAC took in relatively little outside money, further contributing to its relative anonymity. After it returned outside money SAC continued to function. SAC is the opposite of Madoff.
White Edge
Black Edge has no black edge: an inside source with material non-public information. Most of Kolhatkar’s sources come from old newspaper articles and trial transcripts. Kolhatkar did conduct many interviews, but the interviews were with the people on the side of law enforcement or low level former SAC employees.
Kolhatkar writes from the perspective of the white hats — the good guys in compliance and enforcement. She’s all for the hard working FBI agents and SEC lawyers who forgo better paying jobs to bring down the bad guys. And these bad guys live in Ferrari filled Greenwich mansions when they’re not helicoptering to the Hamptons. But that’s a little too black and white. Lead FBI agent, David Chaves, allegedly leaked information about insider traders to convict them in the press before trial. Appeal reversals have eroded Bharara’s perfect record.
Kolhatkar praises the Federal agents thoroughness and ethics, but would a savvy agent choose to wiretap a Greenwich home residence in July, when the other choices were a cell phone, office phone or house in the Hamptons?
Better Books
Other inside traders appear in Black Edge who would make better subjects than Cohen.
Raj Rajartman has more than salacious tapes and innuendo, he channeled $5 million dollars to the LTTE, a terrorist organization. Raj is Tamil, the minority ethnic group in Sri Lanka. The Tamil Tigers carried out successful assassinations on two heads state — Sri Lankan and Indian Prime Ministers. LTTE pioneered women as suicide bombers, now copied by Islamic terrorists. Raj’s jail time has slowed his terror funding trial. Raj also gave millions to US politicians: Hillary Clinton, Charles Schumer, and Barack Obama. Kolhatkar doesn’t mention Raj’s ties.
Mathew Martoma has the largest conviction in history. In between he managed to get expelled from Harvard Law and have Stanford strip his MBA degree from him. Although SAC fired him, he never had to work again. He had been Ivy-League parenting his children with his stay-at-home wife when the FBI came calling. When the FBI arrived, Martoma fainted in his driveway, his wife served as the attending physician.
Shifting the subject to Martoma still convicts Cohen by implication and still brings in the Steinberg case. In both cases Cohen went from a large long position to a large short position — he changed his mind based on that inside information, not a mosaic of data points. Given Cohen’s settlement, the state of insider trading law, the paltry direct evidence against him, the best a writer can do is convict him on paper. Kolhatkar does just this, but an oblique attack would be a better read.
The Verdict
Kolhatkar shapes a decade long FBI probe into a page turner. She sheds insight into the obscure early years of Cohen and adds colorful characters. Black Edge should be summer reading for anyone near the Street— it will give you a white edge in September, but money never sleeps.
