Every publication today ran a story about how SAC investors are harrumphing around about pulling all their money out of SAC since the words “SAC” and “insider trading” seem to keep showing up in the same sentence and that sentence is sort of miscellaneously bad. Here is my favorite harrumph:

“Patience will be wearing thin among some investors after this latest accusation,” said Vidak Radonjic, managing partner at Beryl Consulting Group LLC in Jersey City, New Jersey, which advises clients on investing in hedge funds. “There is a pattern of potential compliance breaches and the money involved is getting bigger.”

I say unto you, the operative phrase there is “the money involved is getting bigger.”1 And I ask also unto you: if you were a passive investor in a hedge fund, and you found out and/or strongly suspected that your hedge fund was insider trading successfully, what would you do? I know what I’d do! You probably know what I’d do too.

Here is a hypothesis that may or may not be consistent with the facts:
(1) Insider trading is a way to get consistent above-market returns.
(2) But it also carries some risk of jail.
(3) So if you like returns but don’t like jail, you would prefer to contract with someone to insider trade for you, in a way that totally shields you from risk of jail.
(4) You’d have to pay them a lot though, since they probably don’t like jail either, though there are comparative-advantage issues.2
(5) In fact you’d have to pay them even more than you’d pay a regular hedge fund.
(6) Like 3 and 50?

That proves nothing of course – it’s hard to disentangle “pay extra for extra skill and legitimate performance” from “pay extra for extra insider trading and accompanying risk of jail.”3 And in fairness people do seem to pull their money from funds caught or accused of insider trading, though this seems to be driven by worries about future performance (with principals distracted and/or imprisoned) than any sort of moral reaction to the insider trading. Lots of people who invested with Madoff assumed he was doing illegal things; their mistake was that they assumed the wrong illegal things.

Anyway. One way to read the charges against SAC analyst Mathew Martoma is as a list of institutional protections set up specifically to create plausible deniability about insider trading. Sure Martoma could have just called up a doctor who supervised drug trials for Elan and, like, asked him how the trials were going. But that’s obviously illegal. It looks much better to schedule those calls through Gerson Lehrman Group, an expert network that provided “training on the prohibitions of the federal securities laws,” “repeatedly reminded Gilman not to share nonpublic information with clients,” and sent him emails listing those trials as a topic that he was “not allowed to discuss.” With all of that, how could they possibly be talking about inside information?

Also those conversations with Portfolio Manager A – like the 20-minute Sunday-morning call where “Martoma indicated to Portfolio Manager A that Martoma was no longer ‘comfortable’ with the
Elan investments” and then they were rapidly dumped – I mean, who can say what happened? (Lots of people can guess!) You’re under no obligation whatsoever to believe Noah Freeman that it was “understood” at SAC that you’d give Cohen inside information, but: that’d be a good system.4 “Understanding” is better than, like, saying “go get some inside information and have it on my desk by morning.”

That’s a bunch of suspicious things to believe and you’d be within your rights not to believe them. Innocent until proven etc., plus arguably there’s a lack of hard evidence, other than the self-interested testimony of his alleged tipster-doctor, against Martoma. Perhaps each stage in the transmission of information was not a cynical design to create the appearance of innocence, but was just regular old innocence. Perhaps Gerson Lehrman’s warnings against insider trading were actually warnings against insider trading, not knowing winks. Perhaps Martoma really was having innocent conversations with Gilman about other stocks, while separately developing an unusual prescience about Elan. Or perhaps – and this is what the SEC charges say, more or less – Martoma had inside information, but convinced Cohen to sell Elan without mentioning his source of discomfort.

Or maybe everyone was in one big criminal conspiracy. But if you’re going to be cynical about the expert network and Martoma and Cohen, why not be cynical about the investors? They made a lot more money (in aggregate) off of Martoma’s Elan trades than he did. (Though less than Cohen did!) And instead of risking jail, as he is, they get to stand around harrumphing about their lack of patience with insider trading. A cynic might think that’s what they were paying for.

Cohen’s SAC Faces Client Querries [sic!?] as Investigators Circle [Bloomberg]
Legal, financial fallout loom for SAC in insider trading case [Reuters]
Loyalty of SAC Capital Investors Tested by Latest Insider Investigation [Deal Journal]

1. Though “patience is wearing thin” is funny too; like, “we were willing to work with you through one or two insider trades, but at some point …”

2. Viz. you have lots of money, lots of desire not to go to jail; they have less money, less desire not to go to jail. This breaks down with the big hedge funds where they have more money than their (non-inside) investors; SAC is 60% employee money and Steve Cohen is very very rich.

3. If I were to add to the hypothesis:
(7) Also you want your profits whether or not they get caught.
(8) So in exchange for that 3 and 50 they’d not only have to run the risk of jail but also have to agree that any insider-trading profit disgorgement would be their responsibility, not yours.
Would that change your calculation? Why or why not? (Is that any more or less disentangle-able than the 3 and 50 thing?) Anyway, “A person familiar with Cohen’s fund said Cohen recently indemnified investors making sure that the management company that oversees the operation of his investment funds would be liable for any claims – and not individual investors.”

4. Also, semi-relatedly, this is a great thing to read about insider trading generally and SAC in particular:

He built the exact business that any of us in the news game should envy, an aggressive information machine. But the truth is that here, in the information age, information has a bad name. Information is money and is in similar disrepute. People who have too much information, who are too adept at getting information, are thought of as dangerous and amoral people.

Comments (15)

  1. Posted by Cow Jones | November 26, 2012 at 6:32 PM

    First

  2. Posted by Guest | November 26, 2012 at 6:58 PM

    I'm not sure if I'm more disappointed in myself for believing we had found a case where Matt wouldn't defend egregious insider trading, or in Matt for ACTUALLY trying to take Stevie's side on this one.

    …Actually, yeah it's the former. Should have seen this coming.

  3. Posted by Avid Reader | November 26, 2012 at 7:29 PM

    Absolutely correct, Matt! Hedge fund investors LOVE insider trading…once the Feds started busting people for it, the investor community spent most of its time griping about lower HF returns rather than tut-tutting about the criminal activity…

    …which, you know, we know you don't think is really SO criminal.

  4. Posted by Jimmy | November 26, 2012 at 7:54 PM

    Who is hurt by insider trading? Really, just other active PMs, no one else.

  5. Posted by MP. | November 26, 2012 at 8:08 PM

    I would say history is on Matt's side on this one. The willful ignorance of investors wins the day.

  6. Posted by Of Course. | November 26, 2012 at 8:31 PM

    Bernie's investors thought he was front-running trades, hence his outsized and consistent returns. It was all "nod, nod, wink, wink, say no more." They were fine with someone getting fucked, they were pissed (and broke) when they realized that his illegal activity wasn't what they thought it was, and that it was they who were being fucked. Lat down with dogs, and all that. (Apologies to Dennis Kneale).

  7. Posted by Disillusioned | November 26, 2012 at 10:12 PM

    Wow, another firm that has used GLG!

    I thought that was how my firm generated alpha!

    :(

  8. Posted by nycstatarb | November 27, 2012 at 8:27 AM

    SAC was set up so that SC could select for PMs using insider information without ever having to ask them or know whether they were insider trading. Its really hard to stick around in a firm where you lose half your risk budget if you lose more than 5% from your daily peak and are fired if you lose more than 10% from your daily peak. If you just hired and fired managers based upon the above criterion you'd probably end up selecting a bunch of guys relying on insider info.

  9. Posted by Coors Light Analyst | November 27, 2012 at 8:27 AM

    So…they were not exactly who we thought they were?

  10. Posted by Footnotes! | November 27, 2012 at 9:16 AM

    Bess, you rock, i missed your pithy analysis pieces (and footnotes) over the last few weeks.

  11. Posted by S's | November 27, 2012 at 9:18 AM

    SAC… SEC…. Both guilty of fraudulent negligence…. hmmm…..

  12. Posted by PermaGuestII | November 27, 2012 at 9:31 AM

    I don't think he's really defending SC by pointing out that the behavoir of the investors here bears a more-than-passing resemblance to that of Capt. Louis Renault of the Gendarmerie National du Maroc closing an illegal casino while pocketing his winnings.

  13. Posted by ILM | November 27, 2012 at 10:32 AM

    How do you know it was GLG? I was trying to find which expert network it was but haven't been able to, and the SEC doc doesn't actually name any network…

  14. Posted by ILM | November 27, 2012 at 10:34 AM

    Nevermind, found the guy's résumé…

  15. Posted by Switch | November 27, 2012 at 2:48 PM

    These days I skip over Bess' posts to read Matt's. Not so much a ding on Bess as it is a pat on the back for Matt. Kudos !