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From Securities Regulation Daily, July 25, 2013

Federal prosecutors file criminal charges against SAC Capital for “unprecedented” insider trading

By John M. Jascob, J.D.

Federal prosecutors have charged hedge fund adviser S.A.C. Capital Advisors, L.P. and certain related entities (collectively, SAC) with four counts of securities fraud and one count of wire fraud for alleged insider trading offenses committed by several of the firm’s portfolio managers and research analysts. In an indictment filed with the federal district court in Manhattan, authorities allege that SAC's "institutional indifference" helped to bring about pervasive insider trading that was “without known precedent in the hedge fund industry." Based in Stamford, Connecticut, SAC had approximately $15 billion in assets under management at its peak in early 2013 (U.S. v. S.A.C. Capital Advisors, L.P.).

SAC's founder and owner, billionaire Stephen A. Cohen, was not named as a defendant in the indictment. Cohen faces civil charges, however, in a related enforcement action brought against him last week by the SEC. The SEC seeks to bar Cohen from the securities industry for failing to prevent insider trading by two of SAC’s portfolio managers, Mathew Martoma and Michael Steinberg.

Overview of the alleged scheme. The indictment alleges that, beginning in 1999 and continuing through at least 2010, SAC engaged in a pattern of obtaining inside information from dozens of publicly traded companies across multiple industry sectors. Prosecutors allege that SAC sought to hire portfolio managers and research analysts with proven access to public company contacts likely to possess inside information. Employees were then rewarded with financial incentives for recommending "high conviction" trading ideas in which the employee had an information "edge" over other investors.

According to the indictment, this encouragement of employees to pursue aggressively an information "edge" overwhelmed SAC's limited compliance systems. Moreover, the relentless pursuit of an informational advantage fostered a business culture within the firm in which there was no meaningful commitment to ensure that such an edge came from legitimate research and not inside information. The “predictable and foreseeable result,” according to the indictment, was systematic insider trading which garnered for SAC hundreds of millions of dollars of illegal profits and avoided losses.

Hiring practices. The indictment alleges that SAC’s focus on hiring portfolio managers and research analysts with a substantial network of public company contacts was not balanced by any corresponding effort to ensure that these employees did not use their contacts to obtain illegal inside information. On at least one occasion, SAC allegedly even hired a candidate despite a recognized reputation for insider trading. Although not identifying Cohen by name, the indictment alleges that SAC's owner overruled objection from the firm's legal department and hired Richard Lee as a portfolio manager, despite receiving a warning from an employee of another hedge fund that Lee was known for being part of that hedge fund's "insider trading group.” Lee has been charged separately with securities fraud and conspiracy to commit securities fraud for insider trading while managing a "special situations" portfolio at SAC.

Ineffective compliance programs. The indictment further alleges that SAC employed only limited compliance measures designed to detect or prevent insider trading by the firm’s employees. For example, SAC’s compliance department rarely reviewed employees’ electronic communications for suspicious terms suggesting potential insider trading. As a result, the compliance department failed to detect or prevent Martoma from using an expert network for consultations with a doctor involved in clinical trial of a drug with the potential to treat Alzheimer’s disease, even though some of the scheduling emails, which were sent through SAC’s system, expressly stated that: (1) the doctor had confidential information about the drug trial; and (2) the purpose of the consultations was to ask the doctor about the experimental medicine being tested in the trial.

Additionally, the indictment alleges that the limited number of internal investigations of insider trading by SAC’s compliance department were generally weak, thereby furthering the scheme. Despite numerous documented cases of insider trading, including the guilty pleas of six former portfolio managers and research analysts, SAC's compliance department contemporaneously identified only a single instance of suspected insider trading by its employees in its history. Moreover, SAC's resolution of the one case in which it identified suspected insider trading also reflected a lack of commitment to address the issue, as the firm failed to report the insider trading to either regulators or law enforcement and allowed the employees involved to keep their jobs.

Civil action for money laundering. Separately, the government has filed a civil action against SAC, seeking the forfeiture of the assets of both SAC and its funds and the imposition of civil money laundering penalties. The complaint alleges that, as a result of the systematic and pervasive insider trading directed by SAC’s employees over many years, illicit profits from the scheme were commingled with legitimate proceeds and formed at least part of SAC’s funding of additional criminal activity. The complaint also alleges that SAC promoted the scheme by paying year-end bonuses to the employees who engaged in insider trading, bonuses that were drawn in part from SAC’s pool of capital that included the illicit profits. The complaint notes that the majority of the capital managed by SAC belonged to Cohen, with the balance of capital provided by outside investors.

Senator Grassley’s statement. In an email to reporters and editors, Sen. Chuck Grassley (R-Iowa) praised the U.S. attorneys and the SEC for taking action against SAC. “I’ve criticized prosecutors and the SEC for not taking on big fish,” Grassley said. “They deserve credit for taking on a big, challenging case. This sends a signal that no firm is too big or too powerful to escape scrutiny.”

Companies: S.A.C. Capital Advisors, L.P.; S.A.C. Capital Advisors, LLC; CR Intrinsic Investors, LLC; Sigma Capital Management, LLC

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