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Wall Street: No Firm Is Above the Law

Employing many of the same techniques used to combat organized crime, the U.S. government's crackdown on insider trading has the hedge fund industry square in its sights.

  • By Amy Poster

When Steve Cohen and his investment company SAC Capital Advisors agreed to pay a record $616 million in March to settle insider trading charges by the Securities and Exchange Commission, the billionaire hedge fund manager may have thought the case and a pocketful of troubles were over. Within days of the settlement, he celebrated by plunking down $60 million for a new oceanfront home in East Hampton, Long Island; that same week news came out that Cohen had paid $150 million last fall to buy Picasso masterpiece Le Reve from casino magnate Steve Wynn.

But Cohen's troubles are far from finished. In fact, they may be just beginning. The U.S. government is considering whether to pursue criminal charges against Cohen under the Racketeer Influenced and Corrupt Organization Act, a federal law enacted some 40 years ago to prosecute organized crime. More recently, the statute has been used to prosecute criminal wrongdoing on Wall Street — most notably, Michael Milken, credited for developing the market for high yield bonds, was sent to prison by the government in 1990 on RICO-related charges. The junk bond king served two years of a ten-year prison term and paid $600 million in civil liabilities. Milken, who was charged with 98 counts of racketeering, securities fraud, mail fraud and other crimes, pleaded guilty to lesser charges of fraudulent activities involving securities trading. Although Milken avoided a longer prison term, the settlement marked the end of his junk-bond career and the demise of his former firm, Drexel Burnham Lambert.

The government has already put away a number of high-profile Cohen associates for a string of misdeeds related to insider trading. The SAC founder will be the biggest fish of all if government lawyers can land him. Using RICO as its prosecutorial bludgeon, the U.S. Department of Justice would buy time — another five years or so — to build a case that Cohen headed an empire rife with corruption.

The rumored use of RICO may well be a government strategy to delay the statute of limitations in prosecuting the case against Stamford, Connecticut–based SAC. Under standard law the prosecution has five years to bring charges, and the alleged illegal trading of two pharmaceuticals companies by SAC and its affiliates occurred in July 2008. Cohen has to be indicted before August, or the statute of limitations will run out. RICO, however, carries a deadline of ten years, giving prosecutors more time to get witness cooperation and gather evidence. The government's most recent salvo came in May, when the feds issued subpoenas to SAC president Thomas Conheeney, chief compliance officer Steven Kessler, chief operating officer Solomon Kumin, portfolio manager Anthony Vaccarino, head of trading Phillipp Villhauer and Cohen to testify before a grand jury. (The SAC founder, who maintains he has done nothing wrong, has reportedly invoked his Fifth Amendment right and declined to testify.)

"The potential pursuit of RICO charges could open the door to negotiating a tolling agreement with SAC and Cohen that gives the government more time to investigate and decide whether to file securities fraud charges," says Pablo Quinones, head of law firm Reed Smith's white-collar criminal defense practice in Manhattan and a former prosecutor for the U.S. Attorney's Office for the Southern District of New York (the arm of the DoJ leading the fight against insider trading). A tolling agreement suspends the statute of limitations to a predetermined date or precedent condition. This would facilitate a possible settlement negotiation between Cohen and the SDNY. Of course, that's just one scenario. Another — a trial and RICO-based guilty verdict — might put Cohen behind bars for years or even decades.

The RICO strategy could be an exercise in what Neil Barofsky, former special inspector for the Treasury Department's Troubled Asset Relief Program, refers to as "swinging for the fences." Barofsky tells Institutional Investor that the SDNY, which has racked up a list of stellar successes, has a culture that encourages its people not to fear losing. "When you swing for the fences, you are likely to strike out every now and then," says Barofsky, who was an assistant U.S. attorney at the SDNY from 2000 until his appointment in 2008 to head TARP.

Still, the record of the SDNY under U.S. Attorney Preet Bharara has been impressive. The 44-year-old has been on a winning streak, obtaining 73 convictions on 81 indictments in insider trading cases since he was sworn into office in August 2009. (The other eight cases are pending.) Bharara — aided by sophisticated electronic surveillance technology and the court-approved use of wiretaps — scored clear victories over Raj Rajaratnam, founder of hedge fund firm Galleon Group, and former Goldman Sachs Group director Rajat Gupta. In 2011 a jury found Rajaratnam guilty after a two-month insider trading trial; he is currently serving an 11-year sentence. Gupta, one of his informants, was sentenced to two years in prison for leaking boardroom information. Former Galleon portfolio manager Michael Cardillo received three years of probation for his cooperation with the government. In recent weeks Rengan Rajaratnam, Raj's brother, has been in plea talks with SDNY over insider trading charges filed in March. He has pleaded not guilty. (Read more: Bharara Chases Giuliani's Legacy as Wall Street's Toughest Cop )

Bharara has continued to send more hedge fund managers to jail over the past 18 months. Six former SAC employees have pleaded guilty to, or been convicted of, federal insider-trading charges. Leading the pack: Joseph (Chip) Skowron III, a doctor and onetime SAC stock analyst who in the mid-2000s headed the health care investment group at former Greenwich, Connecticut–based hedge fund firm FrontPoint Partners. In 2007, Skowron lured Yves Benhamou, a Paris-based physician he had found through a firm that provides a network of industry experts, to feed him nonpublic information on clinical trials involving a hepatitis drug. Both Skowron and Benhamou pleaded guilty, with Skowron receiving the longer sentence of five years for insider trading and obstruction of justice.

The most recent hedge fund managers to fall in the government's crusade against insider trading are Todd Newman and Anthony Chiasson. Newman, a portfolio manager at former Stamford-based hedge fund firm Diamondback Capital Management, and Chiasson, a co-founder of defunct, formerly Greenwich-based Level Global Investors, were convicted of securities fraud in December 2012. In May, Judge Richard Sullivan of the U.S. District Court for the Southern District of New York sentenced Newman to four and a half years in prison and Chiasson to six and a half years.

Mathew Martoma and Michael Steinberg are awaiting trials scheduled for late this year. Martoma, a former portfolio manager at Stamford-based SAC affiliate CR Intrinsic Investors, which settled with the SEC in March, is facing federal conspiracy and securities fraud charges for obtaining and trading on confidential information about an Alzheimer's drug developed by Elan Corp. and Wyeth. Martoma is vigorously fighting the criminal charges and has replaced his original defense team. (The SEC is separately pursuing civil charges against Martoma.) Steinberg, a portfolio manager at New York–based SAC affiliate Sigma Capital Management and a member of Cohen's inner circle, was charged by both the DoJ and the SEC with trading on inside information about PC maker Dell and video chip manufacturer Nvidia Corp.

The SEC, for its part, began aggressively cracking down on white-collar crime in 2009, when then-chairman Mary Schapiro appointed former SDNY prosecutor Robert Khuzami to head the Division of Enforcement. Under Khuzami, from 2010 through 2012 the SEC filed insider trading charges in 168 cases against nearly 400 individuals and entities, the most such actions in any three-year period in the agency's 80-year history. Still, the SEC has received criticism for settling with defendants without having them admit wrongdoing, as in the CR Intrinsic case. "It is both counterintuitive and incongruous for defendants in this SEC enforcement action to agree to settle a case for over $600 million that would cost a fraction of that amount, say $1 million, to litigate, while simultaneously declining to admit the allegations," U.S. District Judge Victor Marrero said at the time he approved the settlement.

Supporting the combined offensive by the SDNY and the SEC, the Federal Bureau of Investigation is pursuing what it calls Operation Perfect Hedge, applying some of the same techniques it has used to investigate organized crime — wiretaps, informants, cooperating witnesses — to systematically target insider trading in the hedge fund industry. According to FBI Special Agent David Chaves, who has led the operation since its 2008 inception, the name came from the fact that insider trading allows managers to create a perfect hedge by protecting against both upside and downside risk. The FBI has even enlisted the help of Michael Douglas, who played Gordon Gekko in the movie Wall Street : The actor appears in a public service video asking "anyone with information on securities fraud or insider trading to call the FBI."

By all accounts, Martoma and Steinberg face a tough road. Their testimony may determine the ultimate direction of the case against SAC and Cohen's criminal prosecution. Judging by the response to a June 3 deadline for the firm's investors to redeem, the public jury is in. There can be no clearer signal than the withdrawals by SAC's largest outside investor, New York–based Blackstone Group, and others, reducing external investor capital by several billion dollars. Although Cohen and his employees still have an estimated $9 billion invested with the firm (the bulk of which is the SAC founder's own money), the withdrawals articulate a vote of no confidence within the clubby world of hedge funds.

The recent insider trading  victories have been hard-won, especially for the SEC. In January 2009, when Obama appointee Schapiro took over as chairman, the commission was smarting from the Bernard Madoff Ponzi scheme. Madoff had revealed to authorities the previous month that he had bilked investors out of billions of dollars in a fraud dating back to the '80s, and the SEC had been widely criticized for being asleep at the switch. Schapiro knew the agency's enforcement division needed to reinvent itself, and she brought in Khuzami to do it. The former assistant U.S. attorney came with outstanding prosecutorial credentials as chief of the SDNY's securities and commodities fraud task force from 1999 to 2002, but he carried some baggage. Most recently, Khuzami had been Deutsche Bank's general counsel for the Americas, and detractors criticized him as being too close to Wall Street, whose banks were blamed by many for the then-raging financial crisis.

Khuzami, who turns 57 in August, deserves credit for modernizing the enforcement group and hiring much-needed talent with industry experience in everything from trading and operations to risk management and portfolio construction. During his tenure the SEC created five new units — covering asset management, foreign corrupt practices, market abuse, municipal securities and public pensions, and structured and new products — to address the more specialized and complex areas of securities law.

The results have been impressive. In 2011 the enforcement unit filed a record 735 cases and reported $2.85 billion in settlements. The next year the division filed 734 enforcement cases and reported more than $3 billion in settlements.

The honeymoon proved short-lived, however: Khuzami announced this January that he was resigning, one month after Schapiro, 58, stepped down. The recent departures, as well as those of several of Khuzami's key lieutenants early this year, have raised age-old concerns about the revolving door for agency staff, despite the presence of a strong new SEC chairman in the person of Mary Jo White, who was U.S. attorney for the SDNY from 1993 to 2002.

The 65-year-old White had spent the past ten years as head of the litigation department at law firm Debevoise & Plimpton in New York. As a former prosecutor, she is the Obama administration's newest poster child for prosecuting white-collar crimes. After her appointment was confirmed in April, White hired former Debevoise & Plimpton colleague Andrew Ceresney to be co-director of the Division of Enforcement. He works alongside George Canellos, who was acting director following Khuzami's departure. Both Canellos and Ceresney served under White during her tenure at the U.S. Attorney's Office.

Sustaining the momentum Khuzami built post-Madoff will be a challenge, requiring energy and vigilance from the new leadership. Ceresney and Canellos will need to deal with a caseload buildup and the staff morale issues that come with change. The agency has also suffered judicial setbacks. A recent Supreme Court ruling disallowed the SEC's request to lengthen the statute of limitations for fraud cases. In addition, U.S. District Judge Jed Rakoff of the Southern District of New York has been an outspoken critic of the agency's "no admit, no deny" policy since rejecting the SEC's $285 million settlement with Citigroup of charges stemming from the bank's role in misleading investors in a risky mortgage bond deal in November 2011; Rakoff threw out the settlement because it didn't include an admission of wrongdoing. (Historically, the SEC has allowed parties to settle claims without admitting or denying the factual allegations in the charging documents.)

In June, Canellos and Ceresney sent a memo to enforcement division staffers announcing a revision to the "no admit, no deny" policy. The SEC will now require settling parties in select cases to admit wrongdoing as a condition of resolving securities-related charges. The approach mirrors that of the U.S. Attorney's Office in criminal plea agreements. In an interview with the New York Times , White said the new policy will be limited to cases that have created significant investor harm or involved intentional, egregiously bad conduct. "In the interest of public accountability, you need admissions," she explained. "Defendants are going to have to own up to their conduct on the public record. This will help with deterrence, and it's a matter of strengthening our hand in terms of enforcement."

While the SEC has had to deal with a difficult legacy, the SDNY can point to a storied history. George Washington himself nominated the first U.S. attorney, Richard Harison, to the New York District in November 1789. Days later the Southern District was created, the first federal court in the U.S., predating the organization of the Supreme Court by several weeks.

Generally known as one of the most prestigious federal districts, the SDNY boasts distinguished alumni of the U.S. Attorney's Office that serves it — including Thomas Dewey, Robert Morgenthau, Michael Mukasey and Rudolph Giuliani. SDNY prosecutors are the Eliot Nesses of federal legal circles — crime fighters against the gamut of drug traffickers, Mafia kingpins and, most recently, Wall Street white-collar criminals. No mercy is spared by SDNY attorneys, whether they are prosecuting cold-blooded killers or domestic diva Martha Stewart.

SDNY's current leader embodies the charismatic, unrelenting and hard-driving qualities of the great U.S. attorneys before him. Bharara, who came to the U.S. from India with his family at the age of two and has a JD from Columbia Law School, joined the office as an assistant U.S. attorney in 2000 after stints at two prestigious law firms. During his first tour of duty at the SDNY, he prosecuted organized crime, including a case against the boss of the Gambino family, as well as securities fraud. In 2005 he left to take on the role of chief counsel to New York Senator Charles Schumer. Bharara's outstanding work assisting the Senate Judiciary Committee's probe of the Bush administration's firing of eight U.S. attorneys served as a watershed career event. The investigation concluded with the resignation of U.S. Attorney General Alberto Gonzales. Bharara became Schumer's easy top pick when the U.S. attorney position opened up in 2009.

By all accounts, Bharara's leadership of the SDNY is inspired. Overseeing 200 prosecutors, he has guided his office to headline-grabbing successes, prosecuting the Times Square bomber, Faisal Shahzad, and accused arms dealer Viktor Bout. The laundry list of indictments includes New York politicians and gambling companies. The record number of convictions of white-collar criminals over the past four years has been staggering.

Deputy U.S. Attorney Richard Zabel doesn't believe that the increase in insider trading cases represents a "structural" problem with the hedge fund industry. "It is more the case of not having the right people and not having the right checks and balances," Zabel says. "Getting information has both strengths and weaknesses, but without perfect integrity, a corrupt version could become the impetus for insider trading. There are instances, as in the case of [Kynikos Associates founder James] Chanos, who helped uncover [the accounting fraud at] Enron, that hedge funds could be good voices for the marketplace."

Former TARP special inspector Barofsky makes a similar observation. "There's tremendous pressure [for hedge funds] to get information. You have the expert networks, and lines get blurred, lines get crossed," says Barofsky, currently an adjunct professor at New York University School of Law. "Hedge funds are not structurally bad. Everyone looks for information advantage, and some are going to cheat."

Part of the reason for the increase in the number of insider trading cases is the wider use of wiretaps. "This all goes back to 2007, with the explosion of detection techniques," Barofsky explains. "In the past, there were resource impediments to the use of wiretaps. Generations of cases have followed, and we also see an expansion in the use and beyond. In the case of wiretaps in foreign languages, this could be very resource-intensive. You need translators, transcribers, and the FBI has to have an appetite to do it."

Wiretaps have been critical for the SDNY in securing its 73 convictions and guilty pleas on insider trading cases since 2009. They were at the center of the Rajaratnam and Gupta cases. Prosecutors used wiretap evidence to prove that Gupta provided an insider tip to Rajaratnam about Goldman Sachs during the former McKinsey & Co. CEO's time as a board member of the bank. Surveillance of Rajaratnam's cell phone revealed important evidence about the Galleon founder's network of inside sources.

On June 24 government prosecutors scored another victory when the Second Circuit U.S. Court of Appeals upheld the Galleon conviction. The defense had argued that the FBI used misleading disclosures to secure judicial authorization for the wiretaps, but the three-judge panel unanimously approved the use of wiretaps in the case.

Even as the government crackdown on white-collar criminals and insider trading rages on, both the SEC and the SDNY have to contend with issues of people and resources. Under the ongoing sequestration the SEC annual budget was cut by $108 million, and wrangling for funds to hire more examiners in 2014 has commenced.

For Bharara and White the issue of the revolving staff door is inescapable. From a practical standpoint, current compensation makes a federal legal career unsustainable, especially in the case of the SDNY. A midlevel lawyer in a supervisory or senior litigation role in the U.S. Attorney's Office receives a maximum annual salary of $155,000. That's less than the typical $160,000 starting salary for an entry-level associate in the private sector in 2012.

Salary levels at the SEC are about 30 to 40 percent higher than those at the SDNY — that same midlevel attorney might make as much as $220,000 a year — but still nowhere near the range for private sector partners of similar experience. A 2012 survey of 74,000 law firm respondents conducted by Hanover, Maryland–based legal recruiting firm Major, Lindsey & Africa reported the average partner compensation to be $681,000.

The underlying assumption at  the FBI, when it began Operation Perfect Hedge, was that the hedge fund industry functioned in much the same way as the Mafia. "FBI intelligence back in 2008 determined that the hedge fund industry had issues on insider trading," says special agent Chaves, who hails from the bureau's white-collar crime and securities fraud unit. "We had to pierce the hedge fund veil, and we needed to rely on cooperators to do this. It was difficult to plant agents or do undercover work inside the hedge funds. You had to be a 'made man' — a mob term — before they let you in their circle. Flipping cooperators was the only way we could get close to suspected targets."

The FBI's surveillance operation has been massive. The bureau has conducted countless hours of undercover operations in the past four years, following suspects through their commutes, coffee runs and other daily activities. "We got to know our targets so well that we would be standing behind them at Dunkin' Donuts and [be able to] recite their preference to the cashier — 'milk and two sugars,' " Chaves says.

In insider trading cases the crime is trafficking nonpublic information. The only way to infiltrate the hedge funds' highly insular culture is to apply the same investigative techniques used against the mob: wiretaps, electronic surveillance and cooperating witnesses. "We were able to articulate to the courts that we would fail to advance our cases using the traditional investigative techniques," Chaves explains.

The first convictions directly resulting from Operation Perfect Hedge's wiretaps and electronic surveillance were Galleon's Rajaratnam and ex-McKinsey CEO Gupta. In January 2012 the FBI's dragnet snagged seven hedge fund managers involved in trading of nonpublic information on Dell and Nvidia, including Diamondback Capital's Newman and Level Global's Chiasson. The latest catch, CR Intrinsic's Martoma, is awaiting trial.

"The industry has changed for the better from where it was five years ago," Chaves says. "The overwhelming majority of hedge funds are good. Expert networks have a legitimate business model. The failure of one [fund] does not invalidate the others. But there is a clear message: No one is above the law, no matter who you are."

Operation Perfect Hedge has contributed mightily to a majority of the 81 indictments on insider trading. Every indication points to additional wins by the government. The FBI's efforts are far from over. In February 2012 the bureau publicly disclosed ongoing investigations on 120 individuals, or "targets," and evidence being reviewed on 50 more hedge fund firms. Operation Perfect Hedge, it seems, has turned into a perfect storm for the guilty.

In the case of SAC's Cohen, the government reportedly has been unable to obtain the kind of wiretap evidence that took down Rajaratnam and other hedge fund managers. Even so, it may behoove Cohen's legal advisers to encourage the billionaire to keep a low profile. His recent buying binge may have only provoked the government's ire.

The unrelenting coverage of the SAC case, for those familiar with government proceedings, suggests that the leaks to the press may be deliberate. A former SEC official, speaking on condition of anonymity, muses that the information being circulated in the news is just a teaser. "Only the small stuff is going out," he says. "It's a smoke screen for what's really going to come down."

The recent reference in the press to the possible use of RICO to prosecute Cohen bears some discussion. Under the RICO laws a person can be charged with racketeering who is a member of an enterprise that has engaged in two of 30-odd crimes, including bribery, embezzlement, mail fraud, wire fraud, money laundering and securities fraud. Although RICO may have been enacted to target organized crime, the expansive definition of "enterprise" — which includes an individual, partnership, corporation, association or other legal entity, and any union or group of individuals — can cover a variety of criminals. The relationship of a gangster to his Mafia family can be similarly applied to a portfolio manager with his hedge fund and can be subject to criminal liability if RICO standards are met.

RICO has proved effective because the approach is comprehensive. Convicting the underlings is a means to the larger end of getting the bigger game — in the case of the Mafia, the bosses who run the families. In the government's case against Cohen, SAC Capital will likely be portrayed as a corrupt enterprise with a culture of complete disregard for the law. Criminal wrongdoing was so pervasive in the employees' business conduct, the feds will argue, that SAC alumni perpetuated such behavior in other venues. At the center of the illegal activities is mastermind Steve Cohen. That's the government's possible key premise.

The testimony by Martoma and Steinberg may prove pivotal to how the story ultimately plays out, especially if the government can persuade either man to enter into a cooperation agreement. These agreements have taken on a major role in complex white-collar criminal prosecutions. They are one of the most effective ways for the prosecution to use a defendant's information and testimony to bring a case against other defendants who are deemed to have committed greater wrongdoing — again, they help prosecutors go after the bigger game. In the event of a trial, a jury will give a lot of credibility to the testimony of a defendant under a cooperation agreement because the incentives for truth telling are so great. The defense counsel usually will construct the deal or plea bargain for more leniency — in most cases, shorter prison time.

So where does this leave the hedge fund industry overall as we await the conclusion of the SAC Capital saga? It's been five years and counting, but the resolution of these complex cases usually takes time.

The tack taken by one hedge fund embroiled in the insider trading mess, Diamondback Capital, merits a close look. Instead of putting up a fight, the principals of the firm chose to make restitution, come clean, provide full cooperation to federal investigators and hire a legal team that extensively reviewed trading during the problematic time period related to Newman's activities.

Despite the devastating effect of the scandal on the firm and its eventual closure, the principals were exonerated, with a nonprosecution agreement with the DoJ based on Diamondback's "prompt and voluntary cooperation upon becoming aware of the government's investigation." The SEC likewise commended the firm for substantial assistance in a comprehensive and exhaustive review of staff and trading records.

Reed Smith's Quinones says: "By now the hedge fund industry has learned through the collapse of major firms, such as FrontPoint Partners, that active vigilance against insider trading is and will be foremost on the minds of prudent investors whose funds they have been entrusted to manage."

There's no doubt that the recent crackdown calls for a new level of risk governance by many hedge funds. Fly-by-the-seat-of-the-pants risk management and compliance need to be replaced by a more formalized process that starts at the top. It's called principled leadership. No longer will risk and compliance remain hood ornaments — check-all-the-boxes exercises satisfying minimum requirements to operate these businesses. The new order will demand enhanced surveillance of trading activity and robust internal controls and procedures to deal with expert networks and market information.

SDNY deputy U.S. attorney Zabel has these parting words: "There has to be a culture of integrity, principles for people who run the shop. People have to be measured, not making a trade, not solely on how much money they make, but also for integrity."

That's wise advice for an industry where principles lately have been in short supply.  •  •

Amy Poster is director for risk and regulatory services at New York–based C&A Consulting ( amy.poster@caconsultingllc.com ). Previously, she worked for the U.S. Treasury Department, in the Office of the Special Inspector General for the Troubled Asset Relief Program, as senior adviser for financial markets; she also served in federal interagency enforcement initiatives. Before that she was global risk controller for credit products at Credit Suisse Group. The views and opinions stated in this article are those of the author and do not necessarily represent the views or opinions of C&A Consulting, its management or its affiliates.

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