The Indictment of S.A.C. Capital Advisors

Where Was The Auditor, PricewaterhouseCoopers?

This column was originally posted on retheauditors.com on July 26, 2013.

What a difference a week makes.

In the space of only seven days, the Securities and Exchange Commission charged Steven Cohen, owner of hedge fund S.A.C. Capital Advisors, with “failing to supervise two senior employees and prevent them from insider trading under his watch,” and the Department of Justice charged Cohen’s firm with “criminal responsibility for insider trading offenses.”

Which global audit firm serves S.A.C. Capital Advisors, an investment advisor registered with the SEC that gave S.A.C. a clean opinion on its most recent report?

PricewaterhouseCoopers LLP.

Last week’s announcements add to prior SEC charges against S.A.C. portfolio managers Matthew Martoma and Michael Steinberg, who allegedly obtained material non-public information about publicly traded companies in 2008, and traded on that information. The SEC charged Martoma and his tipper with insider trading in an enforcement action last year, and charged Steinberg with insider trading in a complaint filed earlier this year. CR Intrinsic, an affiliate of S.A.C. Capital Advisors, also agreed to pay more than $600 million related to those charges, in the largest-ever insider trading settlement. Another Cohen affiliate, Sigma Capital, agreed to pay nearly $14 million to settle more insider trading charges.

Also last year, Diamondback Capital Management LLC, a hedge fund started by alumni of S.A.C, agreed to pay more than $9 million to settle SEC’s insider-trading charges related to some of the same investments named in the latest S.A.C. complaints. PricewaterhouseCoopers LLP. also audited Diamondback, which closed up shop at the end of 2012.

The SEC alleges that S.A.C. owner Steven Cohen ignored “red flags” after receiving “highly suspicious” information from Martoma and Steinberg that should have caused any reasonable hedge fund manager to investigate the source. Instead of setting a proper “tone at the top” and scrutinizing his employees’ conduct, Cohen praised them and rewarded Martoma with a $9 million bonus for the tip. According to the SEC complaint, Cohen’s funds earned profits and avoided losses of more than $275 million as a result of the illegal trades.

“Hedge fund managers are responsible for exercising appropriate supervision over their employees to ensure that their firms comply with the securities laws,” said Andrew J. Ceresney, Co-Director of the SEC’s Division of Enforcement. “After learning about red flags indicating potential insider trading by his employees, Steven Cohen allegedly failed to follow up to prevent violations of the law. In addition to the more than $615 million his firm has already agreed to pay for the alleged insider trading, the Enforcement Division is seeking to bar Cohen from overseeing investor funds.”

The Department of Justice, in its criminal complaint against S.A.C. the firm, says numerous employees, over more than a decade, allegedly traded in the securities of more than 20 publicly-traded companies based on inside information. The DOJ says so many illegal acts were possible because of the “institutional practices that encouraged the widespread solicitation and use of material, non-public information”.

In particular, S.A.C and its affiliates were subject to “limited” compliance policies and procedures that would have detected or prevented insider trading by S.A.C. staff. Compliance staff failed to routinely monitor employee e-mails for indications of insider trading until late 2009, a common industry practice. To his credit, it seems S.A.C.’s head of compliance had recommended such monitoring to management four years earlier.

Given what we know now about tons of cases of insider trading at S.A.C. – there were guilty pleas by six former S.A.C. Portfolio Managers and Research Analysts for repeated insider trading over long periods of time – it’s incredible that S.A.C.’s compliance department only identified one instance of suspected insider trading by its employees. In that one case, according to the SEC, those employees did not lose their jobs and S.A.C. did not report the conduct to regulators or law enforcement.

U.S. Attorney for the Southern District of New York Preet Bharara:

“A company reaps what it sows, and as alleged, S.A.C. seeded itself with corrupt traders, empowered to engage in criminal acts by a culture that looked the other way despite red flags all around…To all those who run companies and value their enterprises, but pay attention only to the money their employees make and not how they make it, today’s indictment hopefully gets your attention.”

To that statement I would add “To all those who audit companies but pay attention only to the fees paid by the clients…”

Investment advisors are not required to have an independent audit of their financial statements. S.A.C. Capital Advisors paid for a big-time audit by PwC because its investors probably demanded it. According to S.A.C. Capital Advisors most recent SEC Form ADV, the hedge fund provided investment advisory services for thirty-one clients, 84% of which are non-US residents, and had $50.9 billion under discretionary management.

Why does the SEC require disclosure of the auditor on Form ADV?

Perhaps two cases, in addition to Madoff’s strip-mall auditor that lied to its state board about auditing anyone at all, may help explain the rationale. In SEC v. Grant Ivan Grieve, et al., a hedge fund adviser was alleged to have fabricated and disseminated false financial information for the fund that was “certified” by a sham independent back-office administrator and phony accounting firm. In the Matter of John Hunting Whittier the SEC settled an action against a hedge fund manager for, among other things, misrepresenting to fund investors that a particular auditor audited certain hedge funds, when in fact it did not.

According to the Investment Advisers Act rule 206(4)-2, investment advisers that have custody of (the authority to access) client funds or securities are, however, now required to undergo an annual surprise examination by an independent public accountant to verify clients’ funds and securities. S.A.C., and private equity firm Bain Capital Partners, another PwC audit client I wrote about last year in a column at American Banker, are required to hire an “independent” auditor to do a “surprise” examination of the funds they have under custody. The auditor that performs the “surprise” examination must be registered with the PCAOB and subject to its inspections. The PCAOB, however, currently has no authority to review the “surprise” examination.

S.A.C. has not yet filed an auditor’s “Surprise Examination Report” form covering its controls over the custody of client assets.

Although an investment advisor is not obligated to have a full audit by an independent auditor, S.A.C’s private funds are required to be audited and its Form ADV says that financial information was prepared according to GAAP, its auditor PwC is “independent” and is registered with its regulator the PCAOB, and PwC is subject to inspections by the PCAOB. (PwC was recently cited by its regulator for very poor audit quality, in particular significant lack of professional skepticism.)

According to a recent SEC report, there are 10,754 advisers registered with total assets under management of $49.66 trillion.

Unfortunately, regulatory supervision of investment advisors, broker-dealers, and their auditors leaves a lot to be desired.

The audit regulator, the PCAOB, inspected ten broker-dealer audit firms and 23 audits performed by those firms between October 2011 and February 2012. The firms to be inspected were chosen before the bankruptcy of MF Global and the inspections were performed before the news of the fraud and failure of PFGBest. While we were waiting for this report, almost $2 billion of customer funds that are legally required to be segregated from the broker-dealers’ accounts went missing at MF Global and PFGBest’s Wasendorf stole hundreds of million of customer funds.

Customers of broker-dealers and investment advisors can’t count on the self-regulatory regime to cover their risks. In fact, according to Janet Tavakoli, investors may even be subject to clawbacks:

Now that Stevie Cohen’s “No. 1 goal is not getting personally indicted” for insider trading, where does that leave his investors?

If the SEC can prove its case and find that SAC’s gains were the result of a criminal activity, investors will likely face clawbacks. If investors accessed SAC through a fund of funds or a multi-advisor fund, they will likely sue the managers of those funds.

The SEC alleges that insider trading resulted in “hundreds of millions” of dollars in illegal profits.

According to the SEC’s 2011 annual report, the SEC and Self-Regulatory Organizations (SROs) like the National Futures Association have been doing fewer and fewer exams of broker-dealers during the last five years. The SEC also admits that sufficient coverage of investment advisors will never happen:

The anticipated decline in the number of registered investment advisers following the effective date of Title IV of the Dodd-Frank Act — the Private Fund Investment Advisers Registration Act (“Title IV”)12 — could result in a greater percentage of registered investment advisers being examined. The amount of any potential increase in examination frequency, however, may be offset by the need to divert examination resources to fulfill new examination obligations that the Commission was given by the Dodd-Frank Act. Moreover, the Staff expects the number of registered investment advisers to grow in subsequent years. While the Commission’s resources and the number of OCIE staff may increase in the next several years, the number of OCIE staff is unlikely to keep pace with the growth of registered investment advisers.

As a result, the Staff believes that the Commission likely will not have sufficient capacity in the near or long term to conduct effective examinations of registered investment advisers with adequate frequency. The Commission’s examination program requires a source of funding that is adequate to permit the Commission to meet the new challenges it faces and sufficiently stable to prevent adviser examination resources from periodically being outstripped by growth in the number of registered investment advisers.

Looks like investors can’t count on “independent” auditors like PwC, also MF Global’s “independent” auditor, to spot illegal activity either.

Steven Cohen paid casino magnate Steve Wynn $155m for “Le Reve”, a portrait of Picasso’s mistress Marie-Therese Walter. The photo on the main page comes from this Telegraph story about that purchase.