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June 05, 2013

Why Does Wall Street Run When A Counterparty Is Being Investigated?

Posted by David Zaring

Money is pouring out of SAC Capital fast fast fast. When expert networker John Kinnucan told the world that he'd told two FBI agents who asked him to wear a wire to get lost, everyone stopped doing business with him.

Why does Wall Street run when it hears about an investigation? I'm not sure I know every jot and tittle of the answer, but in addition to looking into it myself, I bent the ear of former proseuctor, and current academic, Miriam Baer. Some speculations, and if there's a forfeiture law out there that I missed, let me know in the comments:

The Kinnucan case isn't so hard to suss out. The SEC/DOJ concluded that what he was doing was insider trading. Hiring someone to do market research for you, when the content of that market research will be based on tips from insiders, could make you a co-conspirator, if the government establishes you knew this to likely be the case. The government has basically killed the expert network niche with its prosecutions, and you can understand why hedge funds have stopped hiring consultants like Kinnucan. (Here, fwiw, is part of his defense: "If major banks, whose compliance departments are presumably staffed with former Securities and Exchange Commission lawyers, regularly publish industry data like iPhone build and Dell motherboard production changes, the rest of us can reasonably conclude that this must have regulators’ blessing.").
But SAC is a little harder. Investors in the fund are passive. They certainly don't precisely know whether their money is being put to work based on illegal tips obtained by the fund managers. They aren't likely to know what the fund is investing in at all. Moreover, SAC presumably has risk management systems in place meaning that its investments will either be stable or sold the moment its principals are led away in handcuffs. We don't freeze the assets of shareholders of public companies who benefit from insider trades commited by their managers, after all. Why should investors of SAC run when we can presume that shareholders of I dunno, BlackRock, have nothing to worry about?
Still, an indictment could really tie up investor resources. SAC will stop doing anything. Nearly all of the company's records will become evidence. Portfolio managers will be distracted, lawyer up, etc. That doesn't sound like a profitable opportunity.
There could be a reputation cost to staying with SAC even after it was indicted.
Or, if you want to be dark about it: all sophisticated investors assume that funds look for "black edge " (i.e., basically illegal) investment behavior. But once that fund's bad behavior becomes public, or even is subject to indictment, the fund is no longer valuable to the investor.

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The Kinnucan case isn't so hard to suss out. The SEC/DOJ concluded that what he was doing was insider trading. Hiring someone to do market research for you, when the content of that market research will be based on tips from insiders, could make you a co-conspirator, if the government establishes you knew this to likely be the case. The government has basically killed the expert network niche with its prosecutions, and you can understand why hedge funds have stopped hiring consultants like Kinnucan. (Here, fwiw, is part of his defense: "If major banks, whose compliance departments are presumably staffed with former Securities and Exchange Commission lawyers, regularly publish industry data like iPhone build and Dell motherboard production changes, the rest of us can reasonably conclude that this must have regulators’ blessing.").
But SAC is a little harder. Investors in the fund are passive. They certainly don't precisely know whether their money is being put to work based on illegal tips obtained by the fund managers. They aren't likely to know what the fund is investing in at all. Moreover, SAC presumably has risk management systems in place meaning that its investments will either be stable or sold the moment its principals are led away in handcuffs. We don't freeze the assets of shareholders of public companies who benefit from insider trades commited by their managers, after all. Why should investors of SAC run when we can presume that shareholders of I dunno, BlackRock, have nothing to worry about?
Still, an indictment could really tie up investor resources. SAC will stop doing anything. Nearly all of the company's records will become evidence. Portfolio managers will be distracted, lawyer up, etc. That doesn't sound like a profitable opportunity.
There could be a reputation cost to staying with SAC even after it was indicted.
Or, if you want to be dark about it: all sophisticated investors assume that funds look for "black edge " (i.e., basically illegal) investment behavior. But once that fund's bad behavior becomes public, or even is subject to indictment, the fund is no longer valuable to the investor.

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