Monday, May 20, 2013

A Certain Naïveté: Insider Trading


A Certain Naïveté: Insider Trading

The insider trading cases continue to grind through the justice system.  Earlier this month Todd Newman, a former trader at Diamondback Capital Management, was sentenced to four and one-half years in prison.  In imposing the sentence, Richard J. Sullivan could not fathom why Mr. Newman had committed the crime:

“But it is hard to understand why someone who has reached the pinnacle of success would risk all that for more.”[1]

Then late last week, SAC Capital Advisors informed its investors that it would no longer be cooperating fully with the government as the Department of Justice contemplates potential charges against the firm and its founder, Stephen A. Cohen.  SAC also said that it would no longer update its investors on developments in the inquiry.[2]   According to The New York Times in an article this morning,[3] Mr. Cohen and other senior managers have received subpoenas to testify before a grand jury.  Apparently Mr. Cohen invoked his constitutional right and won’t testify.   So far, SAC had agreed to pay $616 million to settle two matters with the SEC, and 9 of its former or current employees have been arrested.  Meanwhile, SAC’s outside investors have been given additional time to make redemption requests, so that they can put off the decision until after the DoJ wraps up its investigation.
 
New Structure (2009)
The justice system must, of course, treat each particular instance of insider trading as an individual crime.  Thus, Mr. Newman is seen as having been an extraordinarily successful investor until, as the judge suggests, he put it all at risk.  From an investor’s perspective, this view is naïve.  There’s some chance that Mr. Newman scrupulously followed the securities laws in accumulating his wealth until he committed his one transgression. However, I tend to suspect that his overall success as a money manager might not stand up to scrutiny.

Frankly, the same naïveté appears to apply in the case of SAC.  The press reports of the last twelve to eighteen months would lead you to believe that SAC had been cooperating fully with the government up until now.  I find that hard to believe.  My guess is that SAC and its lawyers have employed every conceivable tactic to slow down the DoJ and SEC.  As a result, SAC’s announcement that it will no longer be cooperating fully is nothing more than spin.  What’s more surprising is that investors need more time before redeeming their capital.  Do they really need to see if Mr. Cohen or the firm is indicted before they ask for their money?  Do they honestly believe that the various inquiries and indictments are isolated events?  Can they actually think that the extraordinary returns generated by SAC are wholly based on legitimate trading strategies?  In my view, the last of the outside investors should have departed long ago.

Investor naïveté (or possibly greed) has enabled SAC to amass some $9 billion of its own capital, most of which is controlled by Mr. Cohen.  Given the firm’s extraordinary fee structure consisting of a 3% management fee and 50% of the profit,[4], it’s no small wonder that Mr. Cohen is a billionaire.   Of course, SAC had to create an attractive track record in order to find investors willing to accept those terms.  In my opinion, you have to be pretty unsophisticated to believe that the investment results were entirely derived from legitimate trading.

When a money manager generates a spectacularly bad return, investors immediately become critics and skeptics.  However, when a money manager turns in an incredibly good result, investors tend to anoint him with godly qualities and pay him great deference.  Most great investment performances are the by-product of simple luck.  The investment wunderkind will, in due course, revert to mediocrity.   

There are a few truly great managers who have the ability to generate exemplary returns over long periods of time.   Sadly, their ranks are peppered with money managers who have cut corners or violated the securities law in order to create the appearance of greatness.  I think it is naïve to believe that those who traded on inside information were extraordinary investment managers, expect for one transgression.

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