SEC Charges Steven Cohen With Failing to Properly Supervise His Employees

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Steven Cohen / Getty

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/ By Clive Minchom/

On July 19th, 2013 The Securities and Exchange Commission (SEC) announced civil charges against hedge fund adviser Steven A. Cohen for failing to supervise two senior employees of his company SAC Capital Advisors (SAC), and prevent them from insider trading under his watch. According to the SEC’s announcement “…the administrative proceedings will determine what relief is in the public interest against Cohen, including financial penalties, a supervisory and financial services industry bar, and other relief.”

Criminal insider trading charges have already been made against two of his employees Mathew Martoma and Michael Steinberg, but these have not been directly linked to Cohen to date, and for these the statute of limitations to proceed against him runs out at the end of this month. The new proceedings brought by the SEC are therefore an alternative format for them to now follow against him, with lesser but albeit still very difficult burdens of proof. The case has been filed as an administrative proceeding at the agency rather than as a lawsuit in federal court, possibly reflecting its view that while it may be a difficult case to actually prove it may nevertheless be an effective way to achieve two secondary objectives – first to put him out of the business of managing money for outside clients, and second to act as a strong deterrent to others. It is thought that more than 40% of the US$15 billion in funds his firm manages is actually his own money; outside institutional clients have become increasingly skittish in 2013, however, and some have already left him – despite his investment returns reported to being amongst the highest in the industry.

The SEC’s Division of Enforcement alleges that Cohen received highly suspicious information that “should have caused any reasonable hedge fund manager to investigate” the basis for certain trades in the stock of two pharmaceutical companies – Elan and Wyeth – based on their joint clinical trial of a drug with the potential to treat Alzheimer’s disease made by two portfolio managers who reported to him – Mathew Martoma and Michael Steinberg. According to the SEC Cohen ignored obvious “red flags” and allowed Martoma and Steinberg to execute the trades. Instead of scrutinizing their conduct, which the SEC alleges Cohen should have done more carefully, Cohen is alleged to have instead praised Steinberg for his role in what the SEC alleges to have been suspicious trading and even rewarded Martoma with a $9 million bonus for his work. Cohen’s hedge funds earned profits, and avoided losses, of more than $275 million as a result of what turned out to be illegal trades according to the SEC complaint.

“Hedge fund managers are responsible for exercising appropriate supervision over their employees to ensure that their firms comply with the securities laws, ” said Andrew J. Ceresney, Co-Director of the SEC’s Division of Enforcement. “After learning about red flags indicating potential insider trading by his employees, Steven Cohen allegedly failed to follow up to prevent violations of the law. In addition to the more than US$615 million his firm has already agreed to pay for the alleged insider trading, the Enforcement Division is seeking to bar Cohen from overseeing investor funds.”

Stephen Cohen obviously begs to differ, and in response SAC says the charges are unfounded…..”The SEC’s administrative proceeding has no merit, ” Jonathan Gasthalter, a spokesman for SAC said in a statement… “Steve Cohen acted appropriately at all times and will fight this charge vigorously. The SEC ignores SAC’s exceptional supervisory structure, its extensive compliance policies and procedures, and Steve Cohen’s strong support for SAC’s compliance program.”

According to the SEC’s order instituting administrative proceedings against Cohen, which is an internal SEC investigation under the aegis of an administrative law judge, portfolio managers Martoma and Steinberg obtained material, non-public, information about Elan and Wyeth in 2008, and they traded on the basis of that information. The SEC charged Martoma and the person who allegedly tipped him (called a “tipper” ) with insider trading in an enforcement action last year, and charged Steinberg with insider trading in a complaint filed earlier this year. In connection with those cases, CR Intrinsic, an affiliate of Cohen’s firm SAC, agreed to pay more than US$600 million in the largest-ever insider trading settlement. Another Cohen affiliate, Sigma Capital, agreed to pay nearly US$14 million to settle insider trading charges.

The SEC’s Division of Enforcement alleges that by engaging in the conduct described in the SEC’s order, Cohen failed reasonably to supervise Martoma and Steinberg – specifically with a view to preventing their violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.

Reactions from the legal and financial community have been somewhat skeptical of the SEC’s chances of success with the new suit.
“I think they don’t have the evidence for insider trading so they brought this, ” Thomas Gorman, a partner at Dorsey & Whitney a law firm that is not connected to the case, told Reuters of the SEC charges against Cohen. “Bringing a case like this under circumstances here is going to be a difficult proof problem for them.

“They are going to have to show that Mr. Cohen was not only in charge but that basically he didn’t act in good faith, ” Gorman added. “If he acted in good faith and did not induce these acts directly or indirectly, then he’s not liable.”
It is too early to tell whether the latest charges will put pressure on some of SAC’s 1, 000 employees to look for other jobs. That has not happened so far.

“They are obviously trying to shut him down, ” said one investor with SAC Capital who declined to be identified. The investor said it would appear there will be no criminal charge against Cohen, but regulators have decided to use what they can to force him out of business.

It is also not impossible that in the mean time Federal prosecutors and the FBI may be continuing to try to build a criminal case against SAC, depending on whether they can dig up any more evidence as a potential “smoking gun” or persuade either, or both, of the two traders so far charged to turn against Mr. Cohen, which so far they have refused to do.

The bottom line, however, is that the SEC seems to be tackling the issues of insider trading and other regulatory malfeasances on Wall Street with much greater energy than many initially expected when Mary Jo White was appointed to Chair the SEC by President Obama in April of 2013.

Chairman White was US Attorney for the Southern District of New York from 1993 to 2002, where she specialized in prosecuting complex securities and financial institution frauds and international terrorism cases. She is also the only woman to hold the top position in the 200-year-plus history of that office. After leaving her U.S. Attorney post, Chairman White crossed over and joined the private legal community to spend the last ten years as Chair of the litigation department at Debevoise & Plimpton in New York, where she led a team of more than 200 lawyers.

The SEC now is currently listing on its web site more than two dozen enforcement actions directly arising out of the financial crisis alone. One should indeed be wary when the fox turns game keeper! In this context the case against Steven Cohen, win or lose for the SEC, may indeed have as much to do with deterrence as prospects for conviction. Like big-five Auditor Arthur Andersen in the Enron fake-energy profits case before it a few years ago, the government clearly wants to hang a very large scalp on a very high pole now that everybody on Wall Street can see in order to deter others. Then they got a conviction, here they may not even need one.