Indeed, the structural change didn’t affect his performance—it was still amazing. The pool of data showing that SAC had a knack for snapping up shares and selling them just before news broke continued. Again, was it enough to bring charges? The consensus among the government’s Cohen watchers was they didn’t have the goods to charge either Cohen or his firm, at least not yet.
There is growing evidence that today’s unregulated hedge funds have advanced and refined the practice of manipulating and cheating other market participants. The potential harm hedge funds can inflict on other market participants has no real limits. The (trillions of dollars] under hedge fund management are on steroids.”
This statement, made in 2006 before the Senate Judiciary Committee by a former SEC enforcement attorney named Gary Aguirre, wasn’t exactly news to securities regulators who were growing increasingly frustrated by their inability to bring cases against big hedge funds and Wall Street traders they believed were cheating the system. SEC officials often complained that the standard tools for investigating insider trading -witnesses, emails, and trading documents - had their limits in showing intent to commit a crime as difficult to prove as insider trading.
Aguirre, for his part, believed that something more sinister was at work. He had been fired from the SEC, he claimed, because he dared to accuse a big hedge fund manager, Art Samberg, the chief of Pequot Capital, of insider trading and then attempted to depose the person he believed was the possible source of a leak of confidential information to Samberg, Morgan Stanley chief executive John Mack. Aguirre said he was told that the SEC didn’t want to depose John Mack because of Mack’s political clout
Aguirre had been studying suspicious trading patterns among big hedge funds for nearly a year. His investigation began with an alert from the government’s market surveillance system that significant hedge fund trading just before market-moving events was nearly a daily occurrence.
He opened an official investigation into these trades, particularly as they related to Pequot. Aguirre said he couldn’t get his supervisors on board, particularly in deposing Mack, one of Samberg’s closest friends and former business partner who had powerful friends in the Bush White House and was a big fundraiser for the president,
The case was closed in November 2006, after Aguirre said his direct supervisor warned him of Mack’s political connections and after he was fired from the SEC over alleged performance-related issues. Aguirre said his firing was politically motivated and he sued the commission for wrongful dismissal. The SEC’s allegations against Aguirre were ultimately rejected by two senate committees and the SEC paid $775,000 to settle the wrongful dismissal suit.
His firing and his allegations against Mack and Samberg made its way into the New York Times, and it became a hotly debated topic on Wall Street and in Washington. At the time, the SEC claimed that Samberg traded stocks before market-moving events, but the suspicion that Mack had leaked deal information to Samberg lacked solid proof.
Thinking someone committed insider trading is very different than proving a crime notoriously difficult to pin down. As for deposing Mack, commission officials initially said they blocked it because it would have been a waste of time. The SEC eventually took Mack’s deposition only to put the matter to rest. No charges have been filed against Mack aver the matter.
On the other hand, Aguirre was clearly on to something about Samberg and he would be vindicated by subsequent events. One of the trades Aguirre was investigating involved Pequot’s purchase of shares of a company named Heller Financial, just before its 2005 purchase by General Electric. Morgan Stanley worked as an adviser on the deal, and Pequot snapped up shares of Heller just before the GE purchase when shares spiked,
Samberg earned $18 million on the Heller stock purchase,
There was also suspicious trading in shares of Microsoft in 2001, with the hedge fund placing big bucks on trades just before a market-moving event. Traders, particularly good ones like Art Samberg, don’t risk millions on bets based solely on hunches, Aguirre argued,
The SEC may have ignored Aguirre’s investigation, but not Senator Charles Grassley of the Senate Judiciary committee. During subsequent hearings, and with Aguirre as its main witness, the SEC was portrayed as a patsy for Wall Street Meanwhile, Aguirre’s own view about how Wall Street’s circle of friends operated was remarkably accurate,
The Heller case went nowhere, but Aguirre’s Microsoft investigation found new life after the committee disclosed emails between Samberg and a former Microsoft employee he had hired to work at Pequot. The employee was contacting former colleagues at Microsoft for confidential information about company earnings. The emails also suggested that the former Microsoft employee shared that information with Samberg, who traded on it
Why the SEC didn’t act on that evidence when it dropped the case in 2006 is unclear. SEC officials maintain they just didn’t have the goods to proceed even as Aguirre continued to argue the evidence was strong. More obvious is what the commission did about a year later. It reopened the probe into Samberg’s trading of Microsoft,
In 2007, Samberg settled insider trading charges with the commission, and was barred from the securities business. Unfortunately for the SEC, it couldn’t even take credit for nailing one of the hedge fund world’s most prominent players. In addition to what Aguirre pointed out, the scheme was also publicly disclosed in the former Microsoft employee’s divorce proceedings,
The bungling of the Pequot/Samberg case only ratcheted up pressure on the SEC to nail a significant player in the hedge fund business, and by 2007 the rumor mill surrounding SAC’s uncanny ability to beat the markets every year by wide margins was running full blast. Examples of what regulators believed were suspicious trades before market events made their way to the SEC, the FBI, and the U.S. attorney’s office in Manhattan almost nonstop.
Understanding the SAC information machine became part of the job requirements for regulators looking at insider trading. It wasn’t just that firms gave Cohen their best tips on the market direction because he was such a big customer. SAC was said to demand preferential treatment from it’s friends on Wall Street. These weren’t even illegal confidential tips, but stuff the average investor can’t get at home, such as market chatter about large trades and other bits of trading desk intelligence available only to the big Wall Street firms and shared with only their best customers.
The “demands,” of course, weren’t made by Cohen himself. By now Steve Cohen was an established member of the Wall Street glitterati. He had been invited to join a posh country club in Rye, New York. His fancy art collection, now among the biggest in the world, became the envy of the super-wealthy, as did his enormous wealth itself—around $6 billion and growing.
But his traders weren’t above playing hardball. Again, none of this is necessarily illegal but it does underscore how much the markets are stacked against average investors in a perfectly legal way. According to people on the Wall Street trading desks that did business with SAC, Cohen’s traders would exert tremendous leverage on their counterparts at the hypercompetitive big banks, who had no problem handing over premium market intelligence in exchange for the lucrative commissions generated by handling SAC trades. Did this market intelligence at times step over the line into inside information of the illegal variety? It is impossible to know for sure, though regulators and white-collar-crime investigators certainly believed it did. At FBI headquarters in lower Manhattan, preventing another 9/11 terrorist attack was clearly top priority, but snaring SAC started to become a priority, too, particularly for one veteran agent, a white-collar investigator named B. J. Kang.
Kang had been investigating white-collar crime since around 2004. He goes by his initials, B. J., people at the FBI say, because his real, Korean name is difficult to pronounce. A fellow colleague referred to him as a “relentless, aggressive” investigator, though one lawyer who dealt with him distinctly recalls that for a man who made a living investigating financial crimes, initially K
ang didn’t have a firm handle on how Wall Street, particularly how the hedge fund trading business, really worked.
What he lacked in knowledge he made up for in tenacity, particularly when it came to developing witnesses. His specialty was turning targets into cooperators, in a direct, intimidating manner. No yelling or raising the specter of prison rape, as was often the case when agents looked to flip a bad guy into an informant.
Kang would simply lay out the cold, hard facts: Long prison sentences and a productive life interrupted unless complete and total cooperation was given.
He also was known as a guy who could smell a rat from a mile away, and Kang was starting to believe that Cohen’s hedge fund smelled pretty bad. Kang was first introduced to the inner workings of SAC and Steve Cohen when attorneys for a company called Biovail briefed him on their lawsuit (now dismissed) against the big hedge fund.
One of the attorneys, Michael Bowe, explained the allegations made in the case: SAC, he said, manipulated shares of Biovail by hiring a research firm to publish negative reports about the company to help drive down shares and support SAC’s short position on the stock.
Bowe then explained how he believed SAC worked—which jibed with much of what Kang had already heard about the fund’s modus operandi. It was a “kill or be killed” trading shop, where people were paid to make money, and how they made it, at least to the outside observer, didn’t seem to matter even if SAC boasted it had the most sophisticated compliance system in the hedge fund world.
Biovail’s claims against SAC didn’t involve insider trading allegations per se, but as Bowe claimed in his conversation with Kang, SAC was a place that tolerated almost any activity as long as no one got caught.
All of which only increased Kang’s interest in SAC as details of the fund’s operations began to make their way into the business press. Regulators took note of a bizarre sexual harassment lawsuit involving two SAC employees, a senior trader named Ping Jiang, who made $100 million in 2006 trading for Cohen, and his assistant, a lower-paid junior trader named Andrew Tong. When investigators peeled back the tabloid fodder—the junior trader filed a same-sex harassment lawsuit accusing Jiang of forcing him to take female hormones, which were supposed to make him a better trader—court documents offered up some juicy allegations about Cohen’s operations. The lawsuit discussed SAC’s obsession with secrecy and included an allegation that his boss, Jiang, manipulated stocks.
SAC and Jiang vigorously denied the entire matter including the sexual harassment, and the case was later dismissed, but the notion that SAC played dirty wasn’t isolated. Kang spent some time investigating another case involving a lawsuit filed by an insurance company, Fairfax Financial, also a Bowe client, which lodged similar charges against Cohen and his traders. That case was also dismissed.
Kang and the FBI couldn’t make cases on either claim, but the feds now had what they considered a pretty stark account of the type of firm Cohen ran: an aggressive trading shop, Darwinian in nature, where traders are paid by performance, fired for lack of it, which seemed to perpetuate a win-at-all-costs environment.
SAC’s incredible returns (32 percent in 2006 and 14 percent in 2007, while the S&P 500 notched gains of 16 percent and 5 percent, respectively) kept adding up to support this theory that now stretched from the SEC to the U.S. attorney’s office for the Southern District of New York, to the FBI and just about every other place that investigated insider trading. There was too much smoke surrounding SAC. And the smoke kept getting thicker with each and every winning trade that seemed to defy odds. Funkhouser’s computers showed, for instance, that the fund bought shares of Genentech just days before a positive announcement concerning one of its cancer-fighting drugs spiked shares 45 percent. SAC also had a knack of selling shares before negative announcements, particularly in the biotech sector.
The firm would explain the good timing as nothing more than the result of hard work and good research—all of which also undoubtedly occurred inside Cohen’s shop. Yes, it had hired expert networks, and independent researchers like Kinnucan, to share their knowledge and insights into the various industry sectors that its funds were based on, including technology and health care. But no one piece of information would cause an SAC trader to buy shares of Genentech. Rather, the fund’s traders and analysts were experts in creating the “mosaic” that led to the successful trade by assembling many pieces of information, much of it from publicly available sources.
This explanation didn’t wash with a different circle of friends, one that involved the nation’s top Wall Street regulators. The suspicion was that SAC was at the very least bending the rules, and bending them badly because they could. The influence of big banks might be powerful in the market but SAC’s influence somehow loomed larger. Its massive size, combined with its trading frequency, already made SAC an A-list client. Add to that Cohen’s own growing stature in financial circles and the fund could exert tremendous leverage on bank trading desks for market intelligence or just about anything else.
Case in point: Other hedge funds would pay Wall Street market makers with so-called soft dollars. As a substitute for cash, they would add a Bloomberg terminal, a Wall Street Journal subscription, or even pay for the bar mitzvah of a fund manager’s son. SAC was known as a “full commission” firm, meaning it paid for those trades not in soft dollars but in real dollars—all cash. It was yet another controversial, though completely legal incentive for Wall Street firms to hand SAC its best tips, and market knowledge that gave the fund its vaunted “edge.”
“I told Cohen to stop his managers from approaching my traders with their offer to give commission in exchange for information if we execute SAC trades,” said then hedge fund manager and future convicted swindler Bernie Madoff about SAC’s business practices.
Madoff, of course, isn’t a reliable witness (Cohen through a spokesman, denies the conversation took place), but some of what he said did corroborate what federal investigators had received from other more reliable sources. By 2007, Funkhouser’s team had sent nearly two dozen referrals to the SEC to look into suspicious trading at SAC, but even more scary, at least according to Funkhouser’s data, is that SAC wasn’t the only possible bad guy in the business. Far from it. The technology developed by people like Funkhouser, as well as the commission’s own surveillance systems, underscored the severity of the problem: Insider trading had become a crime wave. And it was done in the open as shares of companies “secretly” involved in mergers would inexplicably begin to rise.
The worst part for the regulators was that the Wall Street bad guys didn’t seem to think twice about breaking the law. The Financial Times examined the suspicious patterns in an article titled “Boom Times for Suspicious Trades.” The mergers-and-acquisitions business was booming through 2006 and into early 2007, showering billions of dollars of profits on investment banks. But the M&A boom also touched off a rash of what appeared to be illegal insider trading in the form of profitable trading just before the corporate event was publicly announced, with a spike in trading volume before deals became public.
Nearly two-thirds of all deals over the past year fell into this category, the Financial Times concluded, including one of the year’s most high-profile buyouts: News Corporation’s $5.6 billion purchase of Dow Jones & Co. (owner of the prestigious Wall Street Journal).
The Dow Jones deal would eventually lead to SEC civil charges against a Dow Jones director for allegedly tipping off a prominent Hong Kong couple about the transaction. The director, David Li, paid $8 million fine, roughly the amount of profit the couple made by trading on his illegal tip. Under terms of the settlement, Li didn’t admit or deny wrongdoing.
The Li case was hardly the deterrent that the feds were looking for, however. The chatter inside the hedge fund business was that the top cops weren’t up to the job of catching the really bad guys, who were smart and well protected by amounts of money the hedge funds were doling out for the best inside tip. Informants like John Kinnucan were p
aid as much as $1 million a year for their work, and $1 million is a lot of hush money.
Meanwhile, the big traders had their handy excuse for knowing what was happening before it happened: the mosaic theory. “We would bring someone in suspected of insider trading and they would give us a million ways they traded legally, by creating a mosaic of information—not from hearing from any one source,” said one former prosecutor. “It was pretty effective because just showing that someone traded before an event is never really enough. You need more because most people on Wall Street will fight before they settle.”
For all the obstacles faced by regulators and prosecutors, the groundwork was being laid for the most successful assault on insider trading in modern history. The SEC was now regularly sharing this detailed information about suspicious trading activity at SAC and elsewhere with its counterparts in the Justice Department and the FBI—a change from the previous practice of each agency working on its own and sharing information just before a case was made and competing for the biggest headlines. A regulatory circle of friends was developing to combat the one on Wall Street. The new law enforcement triumvirate passed on tips, briefed each other on depositions, and took the first tentative steps to jointly investigate cases that would pay huge dividends in the not-so-distant future.
Why the change of heart? At the SEC, enforcement agents realized that the threat of the same relatively small fine it levied against Martha Stewart meant almost nothing to a hedge fund trader, who could make that in a single transaction. What they needed was the threat of jail time that only criminal cases could bring. Meanwhile, the Justice Department finally came to the conclusion that though the SEC might have missed some big frauds, its agents were fairly good at unearthing insider trading cases from mountains of trading data.
Circle of Friends Page 10
