In the 1970s, Miller relied on macho sports figures to help the company sell its Lite beer brand to the American public. In bringing administrative charges against the hedge fund billionaire Steven A. Cohen, the Securities and Exchange Commission is pursuing a strategy that might be termed Insider Trading Lite.
Mr. Cohen has long claimed that he was not aware of any violations at his firm, SAC Capital Advisors. So rather than try to prove an insider trading case, the S.E.C. accuses Mr. Cohen of failing to adequately supervise Mathew Martoma and Michael S. Steinberg by not responding when there were “red flags” indicating their trading was based on confidential information. Both have been indicted on securities fraud charges and will face separate trials in November.
The S.E.C.’s case focuses on Mr. Cohen’s role atop SAC, contending that lax oversight shows that he did not fulfill his responsibility as a supervisor to ensure that underlings complied with the law. The claim is based on Section 203 of the Investment Advisers Act, which authorizes charges for failure “reasonably to supervise … another person who commits such a violation, if such other person is subject to his supervision.”
By not charging Mr. Cohen directly with insider trading, the S.E.C. sidestepped the problem of showing that he knew Mr. Martoma and Mr. Steinberg had received confidential information from a tipper who was breaching a duty of trust and confidence by passing the information along. Without the cooperation of those two, the government faced a serious gap in its evidence that probably doomed the effort to prove Mr. Cohen committed securities fraud himself.
Thus, the failure to supervise case lets the S.E.C. use the lucrative trades at SAC, including nearly $ 275 million in gains and avoided losses linked to Mr. Martoma, without having to show Mr. Cohen intended to engage in insider trading.
The primary issues in the supervision case will be whether Mr. Cohen had supervisory responsibility for the two portfolio managers, and whether he acted “reasonably” in overseeing them. If the S.E.C. can show Mr. Cohen was at least negligent by not taking steps to prevent insider trading at SAC when he had notice of questionable conduct, it could be enough to prove a violation.
The first step will be establishing that Mr. Martoma and Mr. Steinberg actually engaged in insider trading. Unlike the federal prosecutors who have to prove guilt beyond a reasonable doubt, the S.E.C. only has to show by a preponderance of the evidence that the two men traded on confidential information. Even if one or both are acquitted, that would not preclude the S.E.C. from establishing its case against Mr. Cohen because of the lower standard of proof.
The case is certainly not a slam-dunk, however, because the Investment Advisers Act provides a defense to this type of charge. Mr. Cohen can avoid liability if he can establish that SAC had a system in place that “would reasonably be expected to prevent and detect, insofar as practicable, any such violation by such other person,” and that there was no reasonable cause to believe the firm’s procedures were not being complied with by the portfolio managers.
To overcome that defense, the S.E.C. charges emphasize Mr. Cohen’s interactions with his portfolio managers, including indications he received that each might have been using illicit information to trade. There is almost no mention of SAC’s compliance procedures in the charges, nor any discussion of whether there was an effort by Mr. Cohen to double-check the legitimacy of any sources. That type of evidence will be crucial to determining whether he acted reasonably.
Unlike an insider trading case, which can trigger a triple penalty based on the millions of dollars of gains and losses avoided by SAC, the penalty for a failure to supervise is comparatively light. Each violation by an individual can result in a penalty of $ 5,000, which increases to $ 50,000 if the S.E.C. can show the conduct was reckless. For a multibillionaire like Mr. Cohen, that is not much of a potential cost.
The greater concern is the possibility that he might be barred from the securities industry for a failure-to-supervise violation. But that penalty would not prevent him from overseeing his own considerable investment portfolio, even if he could no longer manage money for outsiders.
It will be interesting to see whether Mr. Cohen answers questions in the administrative proceeding. DealBook has reported that he asserted his Fifth Amendment privilege against self-incrimination in response to a grand jury subpoena, and he could also refuse to respond in the S.E.C.’s case.
The problem he faces is that asserting the privilege could be considered by the administrative law judge handling the case as evidence that can help establish the failure-to-supervise charges. Unlike a criminal case, in which a defendant’s decision not to testify may not even be mentioned at trial, claiming the Fifth Amendment can be used against the person in a civil or administrative proceeding.
Mr. Cohen’s lawyers have no doubt advised him that it is still possible for criminal charges to be filed against him. The S.E.C. faced a five-year deadline on using Mr. Martoma’s trading as part of an enforcement action if it wanted a penalty. But the Dodd-Frank Act gave the Justice Department the benefit of an extended six-year statute of limitations for securities fraud cases, allowing prosecutors an additional year to gather evidence against him.
Moreover, as I discussed in a recent post, the limitations period is unlikely to be a significant hurdle for prosecutors if there is evidence of a continuing conspiracy that involves trades within the last six years. Conduct outside the statute of limitations can be included in an indictment so long as it is part of a broad criminal agreement.
Another concern for Mr. Cohen may be the potential for a perjury prosecution if he testifies in the S.E.C. case. He has already spoken to the agency during its investigation, which is usually done under oath. The more he testifies, the greater the potential that contradictory statements could lead to scrutiny about whether he was truthful in his responses.
The government has already demonstrated the lengths to which it will go in pursuing Mr. Cohen and SAC. He cannot rule out the possibility that, if prosecutors are unable to show that he engaged in insider trading, they will concentrate on finding another type of violation involving some type of cover-up to use against him.