When Mathew Martoma needed to get rid of more than 10 million Elan (ELN) Corp. shares in July 2008 without drawing attention, his trader turned to dark pools, the government says.
Martoma, a former fund manager for Steven A. Cohen’s SAC Capital Advisors LP who prosecutors said ran the biggest-ever insider trading scheme, wanted to sell in a way “so as not to alert anyone else,” according to a complaint filed in federal court in Manhattan yesterday. SAC used algorithms and dark pools to keep the trades quiet, the government alleged.
While the tools may have prevented his sales from moving the stock, they didn’t keep Martoma from landing in the sights of prosecutors, who said he was part of a scheme that netted as much as $276 million for the hedge fund. Dark pools, which don’t identify the brokers and institutions that buy and sell on their systems, and algorithms, which break up orders to disguise their size, have drawn scrutiny in the past from regulators for potentially reducing transparency in American capital markets.
“Doing it piecemeal through algorithms and in dark pools may make it much harder to detect,” Tony Cherin, a professor of finance at San Diego State University, said in a phone interview. But “it’s the use of insider trading that makes it illegal, not the way the trades are done,” he said.
More than 40 dark pools operate in the U.S. The venues are mostly designed to give institutional investors a way to buy and sell large amounts of stock without being exploited by faster competitors. One key feature is that they don’t name the brokers and institutions that buy and sell on their systems. Dark pools account for about 30 percent of U.S. equity trading per month, according to data compiled by Tabb Group, a New York-based consulting firm.
The platforms cloak trading requests by keeping them out of public view until the moment a transaction is completed. SAC’s senior trader helped unload Elan shares representing more than 20 percent of the stock’s volume in the week before it announced bad news, the complaint said.
“This was executed quietly and effectively over a 4-day period through algos and dark pools and booked into two firm accounts that have very limited viewing access,” the trader wrote to Cohen on July 27, 2008. “The process clearly stopped leakage of info from either in or outside the firm and in my viewpoint clearly saved us some slippage.”
Martoma was an exceptional money manager who succeeded because of hard work, his lawyer, Charles Stillman, said in an e-mailed statement. He will be fully exonerated of the government’s allegations, Stillman said. Neither Cohen nor SAC were charged in the complaint. They were referred to instead as “the hedge fund owner” and “the hedge fund.”
Dark pools and algorithmic trading are byproducts of the computerization of U.S. equity trading that swept markets over the last 15 years following reforms intended to loosen the dominance of the New York Stock Exchange and Nasdaq Stock Market. While they rose to prominence during the same decade as practices such as high-frequency trading, they have become routine tools of brokers seeking the best prices for clients.
“What they’re detailing in the complaint is very typical of how any institution would go about trying to execute a sizable order,” Adam Sussman, head of research at Tabb Group, said in a phone interview. “There’s nothing in that description that strikes me as interesting. It’s standard operating procedure to try to execute a large trade.”
Martoma, 38, traded on inside tips about clinical trials of bapineuzumab, a drug intended to treat Alzheimer’s disease, prosecutors in the office of Manhattan U.S. Attorney Preet Bharara said in a criminal complaint.
Relying on the data, he allegedly bought shares of Elan and Wyeth for his portfolio. Cohen also bought Elan and Wyeth, based on Martoma’s recommendation, prosecutors said. By the end of June 2008, SAC held about $700 million in the two stocks.
In mid-July 2008, Martoma received secret data showing that bapineuzumab failed to halt progression of Alzheimer’s in patients in the clinical test, the U.S. said. He instructed the fund’s senior trader to begin selling Elan, “and do so in a way so as not to alert anyone else,” according to the complaint.
Martoma was arrested at his home in Boca Raton, Florida, at 6:30 a.m. yesterday, said Peter Donald, a spokesman for the Federal Bureau of Investigation in New York. He appeared before U.S. Magistrate David Brannon in West Palm Beach and was released on $5 million bond secured by two family members, said Mary Delsener, a spokeswoman for Bharara’s office. Martoma is scheduled to be in federal court in Manhattan on Nov. 26, Bharara said.
“Executing shares in a dark pool doesn’t help facilitate any illicit activity,” Sussman said in a phone interview. “The same reporting mechanisms are in place whether you execute in a dark pool or on an exchange. At the end of the day, regulators know who the broker dealer was and the broker dealer knows who the client was.”
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