Andrew Ross Sorkin and Peter Lattman have uncovered an interesting wrinkle in the SEC’s case against Mathew Martoma, the most promising part of its huge investigation into Stevie Cohen. The SEC made quite a big deal of the fact that Martoma didn’t just sell his position in two pharmaceutical companies ahead of a big negative announcement; he even kept on selling after that, building up a substantial short position.
But as Sorkin and Lattman have worked out, that’s not really the case: SAC was flat going into the announcement, rather than being short.
The NYT’s spin on this news is that it suggests “a possible line of defense for the portfolio manager”, but it’s not entirely obvious from the report what that possible line of defense is, so let me spell it out.
First, it’s worth stating quite clearly that profits are the same as avoided losses in the eyes of the law. The SEC says that Martoma made $75 million in profits and avoided $194 million in losses as a result of the trading, for a total of $269 million; in the light of the NYT’s new information, that should probably just be $269 million in avoided losses, and nothing in profits. The total amount of money is the same, so the severity of the charges is unchanged.
But here’s the thing: if your trading book is long ahead of a big announcement, you’re basically making a bet on that announcement. Similarly if you’re short. But if you’re flat, that’s the one way of not betting on the announcement. And it now seems that SAC was flat, rather than short.
Of course, if Martoma traded on inside information, then he’s guilty whatever the final position of SAC’s trading book was. But if that position was flat rather than short, it’s no longer circumstantial evidence that SAC thought the announcement was going to be negative.
And there’s another line of defense here, too. As the NYT says, “SAC is well known for its aggressive, rapid-fire trading style, and several former employees say that there is nothing unusual about the fund’s exiting a large position over just a few days.” And this is the defense that has now been opened up. SAC was sitting on substantial paper profits, on its position in Wyeth and Elan. It knew an announcement was coming, and it knew that announcement could move the stocks substantially. If it made the sensible determination that the downside was bigger than the upside, there was every reason for the fund to move to a flat position ahead of the announcement, whether it had any inside information or not.
If I were a defense lawyer here, I’d be coming up with hundreds of previous cases where SAC exited a large position in a short amount of time, ideally ahead of some big announcement. Some of those exits will have been smart, in hindsight, while others will have been silly: SAC would have been better off holding onto its position rather than going flat. But the decision to go flat and take profits (or cut losses) is a common one within SAC, and can happen at any time for any of a million reasons. And as a result, SAC’s trading activity is not in and of itself prima facie evidence of insider knowledge.
Frankly, this isn’t much of a defense. Trading activity is what the SEC uses to try to find possible abusers of inside information; it’s not what the SEC uses to try to prove such cases. In this case, the SEC is relying on the testimony of Sid Gilman, the doctor who leaked the trial results to Martoma before the official announcement.
But the news does help insulate Cohen, even if it doesn’t help Martoma very much. No one knows what Martoma told Cohen before Cohen made the decision to go flat, but SAC’s trading action is entirely consistent with a simple declaration that Martoma wasn’t comfortable being long any more. (The rest of SAC was already making a strong case against being long at this point.) If Cohen knew that an announcement was imminent, and that the one person who wanted to be long no longer wanted to be long, then it would have made sense for him to go flat ahead of the announcement, even if he had no inside information at all. And there’s no particular reason to believe that Martoma would have admitted to Cohen that he had illegal insider information.