The story of the insider trading investigation of one of Wall Street’s most successful hedge funds reads like a thriller.
I moved to Mumbai in 2005 to work in business journalism. My first landlord was an old Gujarati gentleman, who had worked all his life in the finance section of a big conglomerate. Among other things, he liked to dabble in the stock market.
It took me a few weeks to realise that he was being overtly nice to me, something that landlords in Mumbai are not known for. He would drop in every Saturday morning and chitchat about this and that. This left me confused for the first few weeks, until he put his cards on the table on a very rainy Saturday morning.
“Kabhi tip wip bhi dena aap,” he said. It took me a few moments to realise what he wanted. He basically wanted me to give him stock tips, which in simple terms meant that if I had any insider information on a stock I should pass it on to him, so that he could trade on it and make money.
A few years after this, a stockbroker who also happened to be a fund manager, gave me a long lecture on why insider trading should be legalised. “If I have access to insider information,” he said, “it’s because of my skills and I should be allowed to trade on it.”
Anyone who has lived in Mumbai long enough and dabbled in the stock markets a little seriously would know that the investing game at many levels is about insider information — knowing any material information about a company before the stock market comes to know of it, and trading and making money on it.
And from the looks of it, that is how things operate on Wall Street as well. Sheelah Kolhatkar documents this brilliantly in Black Edge.
There are basically three kinds of edges that an investor has in the stock market. The first is the white edge, where an investor or an analyst has access to readily available information like a research report or a public document that others also have. This edge doesn’t help anyone make much money because by the time he or she decides to trade, the information is already built into the price of the stock. Hence, the chances of making any money are zero.
Then there is the gray edge. In this case the information is not clear. As Kolhatkar writes: “For example, an investor relations person at a company might say something like, ‘Yeah, things are trending a little lower than we thought…’” While this information is not publicly available, it isn’t specific either and there isn’t much that an analyst or an investor, who has access to it can achieve by trading on it.
And then there is the most important black edge. This is basically a fancy term for insider information where an investor or an analyst comes to know about things like company earnings or the investment plans in advance and then trades on it profitably.
Kolhatkar’s book is about this black edge on Wall Street. It is about how hedge funds encourage their analysts to get insider information on stocks they cover, so that the fund can profitably trade on it. The book covers the hedge fund industry in general and SAC Capital in particular.
SAC Capital was one of the most successful hedge funds on Wall Street. Its founder and owner Steven Cohen was the star trader on Wall Street. At its peak in 2008, before the financial crisis struck, SAC had $17 billion in assets. Cohen on his own was worth close to $10 billion.
The trouble was that much of Cohen and SAC’s success was built on insider information. The analysts at SAC were encouraged to get insider information on stocks and then share it with Cohen, who would then trade on it on his own account. The organisational structure of SAC was circular with Cohen at the heart of it. The analysts who offered ideas (based on insider information also) had to give their idea a conviction rating from 1 to 10, something that helped Cohen get a sense of how certain the analyst was of what he was suggesting. At the same time this also helped SAC to protect Cohen from charges of insider trading.
One of the brilliant tracks in the book is about a healthcare analyst at SAC called Mathew Martoma. Martoma had been tracking a drug which was on trial. If the trial was successful, the stock prices of the two companies developing the drug would go through the roof. Martoma was betting big on the stocks and so was Cohen.
In his bid to get insider information, Martoma had befriended a doctor who was closely connected to the trial and would be presenting the final results of the trial. The doctor, Sidney Gilman, saw his dead son in Martoma, and shared insider information with him regarding the drug under development.
This allowed Martoma to come to know beforehand that the trials of the drug hadn’t turned out to be as positive as they were expected to be. This allowed Cohen, who had been buying the stocks of the two companies expected to benefit out of the drug, to quietly sell out of the position he had built. This insider information helped Cohen drive massive profits and at the same time avoid the losses he would have faced once the stock prices tanked after the results of the trial were made public.
Another interesting track in the book is about the judicial authorities going after Cohen and SAC. This included the Securities and Exchange Commission (the stock market regulator), the Federal Bureau of Investigation (FBI) and the United States Justice Department led by Preet Bharara.
The detailing of how individuals working for these institutions worked for years building a case against SAC and Cohen are what thrillers are made of. This included tapping phones as well as wiring people to record conversations which could be later used as evidence. This part is so well-written that it is bound to get some Hollywood producer excited about making a film around the book. At some points in this section, one gets the feeling that Kolhatkar was right in the room where the action was happening and recording it.
In fact, the kind of detail that Kolhatkar gets in is simply mindboggling. At one point, she tells us about what the portfolio manager Michael Steinberg, who is about to get arrested by the FBI, is wearing. “Steinberg dressed in khaki pants and a navy V-neck sweater and made a point not to wear a belt or shoelaces,” writes Kolhatkar.
After reading this line, for a moment one wondered as to what was the need of telling the reader about Steinberg not wearing a belt or shoelaces. It turns out that these can be “potential instruments of suicide… (and) were not permitted in federal detention.”
At another point, while introducing Martoma and the background he came from, Kolhatkar comes up with a very interesting piece of information. Martoma’s father had always fantasised about his son attending Harvard. As it turned out, Martoma’s grades weren’t good enough. His father was furious and on his eighteenth birthday presented him with a plaque that said: “Son Who Shattered His Father’s Dream.” While these details do not add anything to the overall story, they accentuate the pleasure of reading.
The book ends depressingly. I will not spoil it for those who want to read it. But in the end, the book reminds us for the umpteenth time, something that George Orwell said many years ago: “All animals are equal but some animals are more equal than others.”