Why Are the Feds Protecting SAC Capital's Investors?

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Apparently SAC Capital Advisors have "reached out to prosecutors in New York to say that SAC founder Steven Cohen is interested in settling the civil and criminal cases against him and his company" for fines in the neighborhood of $1 billion.

This makes sense, since $1 billion is (for Cohen!) rather less than "everything," but if you've been following this story closely you might remember that time (March!) when SAC reached a $600 million settlement with the SEC to put an end to its insider-trading-investigation troubles. That worked for four whole months. Then the SEC sued Cohen in July, and a week later the Justice Department brought a criminal case against SAC. One possible takeaway here is that SAC overestimates, or the investigators underestimate, the binding effect of settlements. I predict a billion-dollar settlement followed by new charges by Christmas. SAC investigations aren't ending until everyone now at the SEC retires.

The weirdest part about this may be that, according to Sheelah Kolhatkar at Bloomberg Businessweek, "One of the factors being considered in determining financial penalties is the desire to inflict monetary pain on Cohen personally without damaging other parties, such as his investors." I mean, wait, that isn't weird at all: Cohen, if you believe the charges, ran a business built on crime, hiring accomplished insider traders from elsewhere and fostering a supportive environment in which they could develop their insider-trading and nodding-and-winking skills. Also, he's worth a gazillion dollars. Meanwhile SAC's outside investors didn't do anything wrong, and many of them are* pensions and endowments and other sympathetic sorts. So it makes sense that everyone would want to protect them: that prosecutors would want to negotiate a settlement that doesn't punish them, and that SAC would indemnify investors so that the management company (owned by Cohen) rather than investors would pay any fines.

On the other hand! Here you can read Andrew Ross Sorkin's column about how JPMorgan's gazillion dollars in settlements for its endless list of naughtiness all comes out of shareholders' pockets:

But on the merits of the case, the settlement, [Columbia Law professor John C.] Coffee said, begins to look a lot like bribery -- to some degree, on both sides. Without a strong case against any individuals, the S.E.C. looks as if it held the firm for ransom. And on the other side, the firm's senior management appears to have bribed the S.E.C., using shareholder money, not to bring cases against individuals.

Sure! The theory behind fining a corporation -- meaning its shareholders -- for its employees' misdeeds is ... well, it's a dumb theory, I guess? I mean it goes something like:

  • shareholders own the firm and elect its directors who appoint its officers who hire its employees who do its stuff;
  • the shareholders should keep an eye on the directors who should monitor the officers who should supervise the employees who should not commit crimes;
  • fining shareholders great giant gobs of money if the employees commit crimes will incentivize the shareholders to elect directors who will appoint and monitor officers who will hire and supervise employees who will not commit crimes.

You get the sense that a lot of securities regulation was designed for frictionless systems. Why, yes, these fines will give your grandmother who owns 10 shares of JPMorgan Chase stock an incentive to make sure that Julien Grout is properly supervised. But, um. Those shareholders tend to be passive, dispersed and limited in their supervisory power by corporate law. Your grandma had no chance against Grout, and frankly BlackRock (with 6.43 percent of JPMorgan), Vanguard (4.75 percent), State Street (4.6) et al don't have much more chance either. Remember how a lot of JPMorgan shareholders wanted Jamie Dimon to stop being chairman, and he just said no?

Meanwhile though let us talk about SAC Capital. I assert:

  1. A hedge fund's investors have rather more power over the hedge fund than a public corporation's dispersed shareholders do. This is debatable -- hedge fund investors tend not to get to vote, for one thing -- but the thing is that the hedge fund's investors can pull out their money.** For most hedge funds, though maybe not SAC (which is mostly Cohen's and his employees' money, especially now), this would present a bigger problem than the average nonbinding shareholder vote of disapproval at a corporation's annual meeting.
  2. A hedge fund's investors are supposed to be more sophisticated than a public company's. Oh I mean BlackRock and Vanguard and State Street are pretty pretty smart, but any goober can buy a share of JPMorgan stock. To invest in a hedge fund, as the SEC will helpfully tell you, you need to be an accredited investor, which, while it is substantially less impressive than it sounds, is at least supposed to mean something under the securities laws. The standards to invest in SAC Capital are, one gathers, rather higher: Every SAC investor is probably more sophisticated than most of the thousands of individuals who hold JPMorgan stock.
  3. A hedge fund's investors tend to have more insight into its strategies than do an investment bank's. How many JPMorgan shareholders knew about the London Whale strategy? I mean, the SEC fined JPMorgan('s shareholders!) for concealing the details of that strategy from its shareholders. Good stuff. Hedge funds are "secretive," I suppose, but no one is unaware that SAC does mostly fundamental long/short equity investing through decentralized teams of investment professionals. No one who invests in SAC is unaware that it makes bags and bags of money, far in excess of typical equity long/short returns. Nor are they unaware that it charges above-market fees. It is pretty hard to consistently beat the market by investing in stocks. If your hedge fund does, you're sort of on notice that it's doing something unusual. What could it be? You might ask.

Did people invest with SAC because they figured SAC was probably insider trading on their behalf and they could plausibly deny that they knew about it? Oh I don't know, maybe, maybe not. (Certainly some people invested with Bernie Madoff because they figured he was front-running on their behalf; illegality is not a strict deal-breaker.) Did people invest in JPMorgan stock because they think that traders in JPMorgan's chief investment would make large undisclosed bets in credit derivatives and then fraudulently mis-mark those bets in order to conceal losses? I'm gonna go with a confident "no" on that one. So why punish the JPMorgan shareholders, over and over again, while leaving the SAC investors alone?

* Were. Most of the outside money is gone now , though some remains. Presumably illicitly obtained money already paid out to cashed-out investors could be clawed back though.

** Though it may take them a while. Public shareholders can't pull their money. I mean, they can sell their shares if they think the company is bad. But that doesn't punish the company directly (it might drive the stock price down, but it's not like the company has to come up with cash to redeem them).

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To contact the author on this story:
Matthew S Levine at mlevine51@bloomberg.net