The Devil’s in the Details: The SEC’s Case Against Steven A. Cohen

We’ve all seen the headline: “SEC charges S.A.C. Capital’s Steven A. Cohen.” There has been so much press about this investigation, particularly the criminal side of it, that it almost feels as though the SEC had to charge him or risk looking weak. The SEC’s had a rough go of things the last few years, facing lots of post-Madoff criticism. But I’ll be honest, the SEC enforcement staff that I know are smart, capable lawyers.

Still, when I saw that the SEC had brought charges, my first thought was: how strong are they?

Let’s take a look at exactly what the SEC claims Mr. Cohen did wrong.

The Basics of the Claims

The SEC did not file a lawsuit against Mr. Cohen in federal court. Instead, it instituted a formal administrative proceeding under the Investment Advisors Act of 1940. The order instituting proceedings claims that he failed to supervise two employees “with a view to preventing their violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.”

The very first paragraph of the order pretty much sums it up:

Cohen—the founder and owner of hedge fund investment advisors that bear his initials (S.A.C.) and that until recently managed portfolios of over $15 billion—failed reasonably to supervise two of his senior employees, who engaged in insider trading under his watch.

According to the order, Mr. Cohen knew of “highly suspicious behavior” and “red flags of potentially unlawful conduct,” but did nothing.

Note that the SEC does not charge Mr. Cohen with causing or aiding and abetting the violations. It does not charge him with directly participating in the violations. It does not even claim that he did not follow internal compliance procedures. Nope, it only charged him with failure to supervise.

Mr. Cohen’s Supervision of Two Key Portfolio Managers

The two senior employees are Mathew Martoma and Michael Steinberg. They were both portfolio managers at S.A.C. and both have been indicted for (and pleaded not guilty to) insider trading.

The order claims that Mr. Cohen, as CEO, “directly supervised” Martoma and Steinberg. It has to make this claim or else he can’t be held liable for failure to supervise. In support of this claim, the order says only that he had the authority to hire and fire them, helped determine their compensation and would ask them to “update Cohen on their stock trading.”

The allegation of direct supervision seems to be a stretch. Yes, technically, every CEO “directly supervises” everyone else through some escalating chain of command. But the expectations of the CEO’s supervision—likely several levels removed from the employee—should be a lot different from the expectations of the employee’s immediate supervisor. And every CEO can presumably hire and fire people, determine their compensation and ask for updates.

Under the SEC’s theory, pretty much any CEO is potentially liable for failure to supervise.

Elan/Wyeth Trades: The Details

With respect to the supposed illegal trades in Wyeth and Elan, there are several allegations that the SEC uses to implicate Mr. Cohen in the allegedly illegal trades.

  • Mr. Cohen apparently knew that Mr. Martoma “had spoken to a doctor who implied he had access to material, nonpublic information about[a] clinical trial” for a drug to treat Alzheimer’s.
  • There is a text message from Mr. Cohen to other analysts saying that Mr. Martoma “has a lot of good relationships in the area.”
  • Mr. Cohen allegedly encouraged Mr. Martoma to talk with the doctor that may have had inside information, though the order does not claim that Mr. Cohen asked him to obtain illegal inside information.
  • Mr. Martoma and Mr. Cohen remained “bullish” on Elan and Wyeth even though one of S.A.C.’s subsidiaries had a different view of its prospects.
  • Mr. Martoma apparently told the sub’s analysts that he had “black edge,” which is defined by the SEC as “illicit, nonpublic information.”

In the end, the order alleges that Mr. Martoma had nonpublic information but never alleges that Mr. Cohen knew that Mr. Martoma had this information. It goes only so far as to say Mr. Cohen did not take steps to investigate whether Mr. Martoma had inside information before allowing the trades.

The Dell Trades: The Details

The allegations with respect to S.A.C.’s trades in Dell stock are a bit more directly linked to Mr. Cohen than the ones at Elan and Wyeth. The allegation of Mr. Cohen’s knowledge of possible insider trading came in an email from an analyst at a subsidiary of S.A.C. The analyst emailed an S.A.C. portfolio manager and copied Steinberg stating that:

I have a 2nd hand read from someone at the company [Dell] – this is 3rd quarter I have gotten this read from them and it has been very good in the last quarters. They are seeing G[ross] M[argin]s miss by 50-80 [basis points] due to poor mix, op ex in-line and a little revenue upside netting out to an [earnings per share] miss . . . Please keep to yourself as obviously not well known.

The email was forwarded to a research trader who then forwarded it to Mr. Cohen’s home and work email addresses. The research trader also talked with Mr. Cohen a few minutes later. About a half hour after the above email was sent, “Cohen began selling shares of Dell” and by later that afternoon had “sold his entire Dell position.”

According to the SEC’s order, the email was “highly suspicious” but Mr. Cohen did not take appropriate action to determine whether “an employee under his supervision was engaged in unlawful conduct.”

Where Does This Leave Us?

My take on the order: Yes, the SEC has a case against Mr. Cohen. But it’s not an open and shut case, and he’s going to have very good (and well-funded) lawyers on his side fighting every step of the way.

If the focus of the SEC ends up on S.A.C.’s lax compliance policies—because it cannot prove outright that Mr. Cohen knew of insider trading—it is a dull case. But that does not mean the SEC won’t extract a huge penalty from him. The real question is whether Mr. Cohen will decide that since his company has already paid $616 million to resolve the same allegations, there is little to lose by putting the SEC to the test of proving its allegations.

He strikes me as exactly the kind of person to do that.

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