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Insider-Trading Probe Looms Over Hedge Fund Titan

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The long string of insider trading cases brought by US Attorney Preet Bharara since the summer of 2011 sheds a light on the challenges that hedge funds like SAC Capital face in the current market environment.

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The problem? In today's financial markets, public information is ubiquitous and cheap – it has become almost impossible to build a viable competitive edge using information that can be obtained with complete legality. A number of hedge fund traders who specialize in arbitrage and other strategies that depend on getting early access to solid company-specific information acknowledge that increasingly they do business in what may be thought of as a "gray area." They look for clues to what might be going on in an idle comment by someone in a position to have access to information, and then look for independent evidence confirming the insight they gleaned from that random comment.

Hedge fund gurus like Cohen are demanding employers, pushing their traders to bring ideas to the table along with the evidence to support them – but not demanding details on how that information was obtained, those involved in the industry say. In the Chiasson case, lawyers for Ganek have said that Level Global's founder was "outraged that an employee was passing off his own work with what he now reveals was inside information." Prosecutors have identified what they believe to be networks of informants. Sandeep Goyal, a former Neuberger Berman technology analyst, has already pled guilty to insider trading charges and testified that he passed on information obtained from Dell ahead of the company's earnings release to the hedge fund traders involved in the case.

Part of the broader problem – the part that regulators can't solve – is that all the incentives right now seem to favor blurring the line between obtaining insight into corporations that might affect their share prices and obtaining confidential information that is almost certain to do so. Hedge funds are able to charge hefty management fees and collect big chunks of profits in the form of "carried interest" (which then is taxed at a favorable rate) only if they can demonstrate that they deliver "alpha," or risk-adjusted return, on a consistent basis.

In other words, the pressure is on Cohen and his peers to beat the market, consistently and with no regard to which types of stocks are in favor or whether shares in general are plunging, as in 2008, or rallying sharply, as occurred a year later. Under that pressure, it's hardly surprising that Cohen is notoriously demanding of his traders, insisting that they justify their own salaries and bonuses by coming up with a steady stream of topnotch trading ideas. That's exactly the kind of environment in which a trader, desperate to prove his value, will take that final step into illegality, in the same way that someone else might become a rogue trader in hopes of covering up a loss that might cost him his job or bonus.

Whether or not the SEC ever levies charges of any kind – civil or criminal – against SAC or Steve Cohen, these realities mean that the agency and the US attorney will face limits to their ability to prevent insider trading in future. Bharara has achieved some remarkable victories, charging 46 individuals with insider trading and securing guilty pleas in two-thirds of those cases. The SEC also has done its part.

But just as the wave of successful insider trading prosecutions in the 1980s changed little on Wall Street, there is no reason to suppose this will be much different. Until investors suddenly start accepting lesser gains, hedge fund managers are unlikely to set aside incentives that can lead traders to disregard the rules in search of an edge. If you think that is likely to take place any time soon, well, I'd like you to consider buying this bridge across the East River at a very, very affordable price that I happen to be able to offer you for today only...
Editor's Note: This article by Suzanne McGee originally appeared on The Fiscal Times.

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No positions in stocks mentioned.
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