Friday, July 26, 2013

Criminal Charges Against SAC: Defining an “Edge”

Criminal Charges Against SAC: Defining an “Edge”

The Government’s pursuit of SAC culminated yesterday with the filing of a criminal complaint against the company.  Steven A. Cohen was not charged.  The company is charged with securities fraud for pervasively trading on inside information and systematically hiring portfolio managers and analysts who provided SAC with inside information.   In announcing the charges, the Justice Department also revealed that another SAC portfolio manager had pleaded guilty to charges of insider trading.

Given all the previous convictions against former portfolio managers of SAC, it’s hard to see how the government won’t be able to convict SAC.  However, I am not sure the criminal charge or a conviction is going to make much difference.  SAC’s client base has been shrinking for the past several years, and at some point, Mr. Cohen would have closed the firm to outside investors.  However, Mr. Cohen and many of his colleagues would still have plenty of capital to invest, as Mr. Cohen is worth about $8 billion.  Since Mr. Cohen hasn’t been charged, and the government isn’t seeking some type of forfeiture, Mr. Cohen’s pile of capital appears to be safe.  Goldman Sachs, Citibank, and the rest of Wall Street will still be able to generate business from Mr. Cohen even if SAC is no longer around.
Not Going Well (1995)
I am interested in better understanding how the government will present its case.  The indictment talks about how SAC developed and exploited its “edge” through its hiring practices and trading strategies.  Having an edge is a critical component to being successful as an investor.  If you don’t have some specific insight or information advantage over the rest of the market, you are destined to trail the market averages.  The real question is whether your edge is legal.

The criminal complaint says that SAC sought people with excellent industry contacts and experience who were willing to bring inside information to SAC’s portfolio managers, including Mr. Cohen.   According to the government’s filing, SAC had a well-honed system, vocabulary, and culture for exploiting this inside information.

We shouldn’t confuse SAC’s alleged practices with the normal attempts by money managers to gain an edge.  Most credible money managers hire people with industry contacts and experience.  Once employed, analysts and portfolio managers are expected to dig for insights and talk to corporate executives.  When I was a research analyst and portfolio manager I did it all the time.  You have to probe into companies and talk to a lot of people if you’re going understand an industry’s characteristics and build reasonable investment models.   Obviously, there’s a line that I did not want to even approach. Pending earnings results, prospective mergers, and other inside information were simply not discussed.

The fact that SAC was looking for analysts and portfolio managers with connections isn’t surprising.  As a money manager SAC was entitled to seek talent with a potential edge.  I had assumed that these people fell into insider trading after they joined the firm.  I figured that the extreme pressure of finding Mr. Cohen highly profitable trades drove people over the line into inside information.  If the government shows that SAC hired people who were prepared from the get-go to provide inside information, they will have unmasked one of the most corrupt cultures in the history of money management.  As you know, I think there’s a lot wrong with the money management business, but SAC took things to a whole other level.

On Sunday in the Raleigh News & Observer, I’ll explore the difficult task of finding money managers with a legitimate edge.

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