REVIEW: 'Black Edge' is a Smart Cautionary Tale of a Hedge Fund Gone Bad

Black Edge:  Inside Information, Dirty Money, and the Quest to Bring Down the Most Wanted Man on Wall Street by Sheelah Kolhatkar

By Jim Kaplan

Random House, 344 pp.

When I was about 100 pages into Black Edge, I began to sense a certain familiarity with its subject, which is (in a sentence) the years-long attempt by United States Attorney Preet Bharara and federal prosecutors and investigators to catch and perhaps destroy “the most wanted man on Wall Street,” Steven A. Cohen, the head of SAC Capital.  The Wall Street Journal, The New York Times, and virtually every other publication that covers business and finance seriously has been all over this story since it surfaced, in 2010 or so, and the popular Showtime show Billions is virtually a roman ȧ clef of the Cohen/SAC Capital investigation.

Kolhatkar, however, goes far more deeply into both sides of the story -- the Feds’ side and Cohen’s side — than Billions, or anyone else so far. And more significant, Black Edge clearly poses the fundamental issue concerning the whole hedge fund industry: can it be carried on legally, as a practical matter?  Black Edge strongly (and in my view, correctly) implies that it cannot be, at least as it is currently constructed.

Hedge funds have not existed all that long on Wall Street — maybe a generation or so, if the earliest, most basic antecedents are included.  They are essentially funds pursuing a straightforward goal -- the ability to generate strong positive returns in bad equity markets as well as good ones -- using both long and short strategies to take advantage of stocks that are falling as well as rising.  For almost twenty years, from the early 1980s to about 2000, there was limited appeal to such comparatively risky strategies: the markets were, as whole, moving in just one direction -- up.  There was no great need for any investment strategy but “buy and hold” when the market was returning 10-15% a year even for “safe” equity investments, such as large cap growth and value companies.

The extended bear market of 2000-2003 changed that perception.  There was suddenly more interest in strategies that "hedged" against market declines, just when vast pools of investment capital were forming. Successful finance and business executives had been earning huge sums in the 1980s and 1990s, and big institutional investors, their funds swollen by a 20-year long bull market, were also well-situated to be significant investors -- and they frequently had a legal duty to “diversify.”  With so many personal and institutional accounts of more than $100 million -- and a growing number of billionaires — seeking greater-than-market returns, and able to absorb significant investment risk, the financial landscape at the end of the last century was ideal for giving rise to the hedge fund industry.

The new hedge funds that were forming were very different from the traditional asset management that existed — and still exists — for wealthy individuals and cash-rich institutions like pension funds, endowments, and corporate treasury departments.  The traditional managers are heavily oriented toward compliance with laws and regulations.  Most important to them are the strict restrictions that exist on the kind of information about companies that they are permitted to obtain and use for trading purposes.

Traditional asset managers are essentially limited to what companies release to the general public in company press releases, SEC filings, and research reports prepared by third parties.  Public companies do permit their executives to give statements and answer questions at formal events open to the investment community at large.  But more informal sharing of company information has long been policed by government regulators and by compliance staffs working for both the companies and asset managers.  Investors who possessed significant non-public information about a company were banned from trading the company’s shares.

The hedge fund approach is a world apart from this traditional model.  As SAC Capital was structured, for example, one of the main points was evidently to gather and presumably trade based on material information that was not widely known.  Other major hedge funds were and are similar.  Simple economics and the characteristics of a highly developed and mature equity market (as in the U.S.) dictated this.  Hedge funds, as customized vehicles for the very wealthy, promised much-better-than-market returns, and correspondingly, much better compensation to those who worked for them.  But with so many bright, motivated and incentivized minds chasing a finite number of brilliant investment ideas, the traditional model of confining equity research to publicly available information meant that a money manager would probably do not much better than the market, and could not justify a hedge fund manager’s abnormally hefty compensation.

Thus, the need for information about potential investments that no one else knew about.  But knowing about material non-public information and trading on it is legally questionable under almost all circumstances, and criminal if done under certain circumstances and with reckless or deliberate intent.  Can one be successful by playing this close to the legal line, and not tip over it?

In practice, it is difficult (given human nature to act impulsively on great opportunities and the gravitational pull of greed) but possible.  But it takes a very strong orientation toward legal compliance, and concretely, probably an iron commitment to putting all significant contacts involving potential investments in writing (or other tangible form) so they can be analyzed by compliance staff and if they are found to be sufficiently material, the potential investment can be cordoned off from trading activity for an appropriate period. 

According to Black Edge, SAC did not function anything like this.  Kolhatkar portrays Cohen as having sat at the center of a spoke-and-wheel information-gathering system and personally deciding on trades of significance.  He himself would do some research, mostly by phone and recording very little on the firm’s email system or elsewhere.  The result was that not much could be gleaned directly of Cohen’s specific state of knowledge with respect to any particular buy or sell decision.  The lion’s share of research that reached him indirectly would come from analysts attached to portfolio managers around the firm, organized loosely by industry.  Analysts like Matthew Martoma, who was (unlike Cohen) eventually charged and tried criminally, were compensated very handsomely for providing information with respect to companies they followed. 

The categories of information were color-coded.  “White Edge” information was publicly available, and “Gray Edge” was inside information that was not earth-shaking (i.e., “immaterial”), or perhaps the source was at some distance from the company, i.e., not an insider, and thus, the legality of trading on the information was at least questionable.  “Black Edge” information was clearly illegal to trade on, because it was material to the company, non-public, and its source was known to be a company insider.  Black Edge” information was what was most reliable and thus most desired, but also highly sensitive — one had to be very careful about identifying its provenance in writing (or verbally, if taped).  Thus, the book’s title.

According to Black Edge, Cohen received regular reports on information from his analysts mainly through their portfolio managers (a sort of team leader) on regularly scheduled weekly phone calls.  Analysts also were instructed to provide written reports for Cohen, and from a purely legal point of view, they were highly ingenious -- really masterpieces of their type -- in ultimately insulating at least Cohen from insider trading liability.  No sane analyst who had been through even minimal compliance training would write down material non-public information with any specificity in an analyst report, of course, much less its source.  But each analyst for SAC was required to rate one’s “conviction” concerning the buy-sell recommendation on a scale of 1 (lowest) to 10 (highest).  As Kolhatkar perceptively notes:

A conviction rating of 10 was reserved for “absolute certainty,” a level that would seem to be impossible to achieve through conventional research methods.  How could a person be 100 percent certain about any event in the future, let alone the performance of a stock?  The rating was how the traders communicated the value of their information to Cohen without exposing him to the details of how they knew something.  Cohen relied on it to decide whether to buy for his own account.  The rating system had been the idea of the compliance department, which was always trying to find ways to protect Cohen and keep him from explicitly receiving material nonpublic information -- it was like a moat around the company’s most valuable asset.  A score of 9 or 10 on the conviction scale would probably mean that the info was “Black Edge” — insider material with the most “trustworthy” origin.

Nonetheless, the system described above meant that the hedge fund’s principal -- Cohen in this case -- could not be proven beyond a reasonable doubt to have traded on material inside information.  None of the analysts or managers ever stated officially that he had provided material non-public information to Cohen; no recording of inculpating oral communications -- like a phone call -- was made; and perhaps most important, there was no tangible record that would compel an inference that Cohen ever traded on specific information.

In the only case that resulted in anyone’s ultimate criminal conviction, Martoma was found guilty -- his information about an unsuccessful pharmaceutical trial came directly from a University of Michigan professor, an insider on the drug trial -- but Cohen, who appeared to be involved in the sell trade that saved the fund millions of dollars, was never even accused.  Phone records confirmed the likelihood that Cohen and Martoma had talked just before the stock trade in question.  But a reasonable inference could be that Martoma had said something like “I think you should sell, and my conviction is a 10”, and no more, and that could not support a case against Cohen because Cohen would not have known Martoma’s (illegal) basis for his strong recommendation.  In any event, the fact that Martoma never agreed to testify against Cohen would seem to at least leave open the inference that he would have nothing particularly incriminating to testify to truthfully.

In the end, SAC as an entity (not Cohen himself) pleaded guilty in 2013 to criminal charges and agreed to shutter its hedge fund.  SAC paid a total $1.8 billion in criminal fines and civil forfeitures and agreed to a five-year SEC probationary period.  In early 2016, Cohen settled the SEC civil case against him personally for failure to supervise and agreed to cease managing money for others (he could still trade his own sizable fortune, many times the size of the fines and forfeitures) for a period of two years.  The year after SAC paid the record-setting fines, 2014, Cohen reportedly made $2.5 billion trading for his own account, thus more than restoring the penalty amounts.  Cohen is looking seriously at re-establishing a hedge fund open to other investors when his period of sanction runs out in 2018, Kolhatkar says.

A word of two should be said about Cohen’s main antagonists, the Feds.  On the whole,  they are portrayed more or less admiringly, as far more restrained and certainly more ethical than the U.S. Attorney played by Paul Giamatti in Billions.  It would be entirely natural that the FBI agents, SEC lawyers and even the junior prosecutors in the Justice Department — all working on government salaries — would feel resentment about their quarry in such cases.  Kolhatkar hints at only a little of that; rather, these folks mostly work like devils and exhibit basically fair behavior in a society that often seems to value highly successful individuals who may cut a few corners over the much more modestly rewarded government employees who are tasked to stop them.

The most dramatic decision of the Feds that is recounted in the book was, of course, the one not to charge Cohen criminally as an individual.  It was made,  according to Kolhatkar, with reason and moderation, and a full (and, I think, accurate) view of the evidence.  A conviction was not fairly obtainable.  Even given the public demand for criminal prosecution of “Wall Street crooks” who “brought down the economy” while ordinary people suffered the full brunt of the Great Recession and a near global economic collapse, the no-prosecution decision appears fully supported legally, and the decision reveals something favorable, a fundamental balance in the system, especially considering how badly everyone on the Feds’ side wanted to prevail, as Kolhatkar makes clear.

In any case, given the basic conflict that is a feature (not a bug) of the hedge fund industry — that it is imperative to have better information than your competitor, while not quite enough information to clearly break the law — there will no doubt be more, perhaps many more, such cases in the future.  There will also therefore be more occasions where difficult judgments will have to be made about where to draw the line, often very hard to situate, between permissively aggressive business practice and outright corporate criminality.  By describing and carefully exploring that fundamental disjunction, Kolhatkar has written a memorable and pathbreaking account of an era that is by no means over yet.

Jim Kaplan is a Chicago lawyer, a partner at Quarles & Brady LLP, specializing in financial services, regulatory, governance, compliance, litigation, asset management, and enforcement work. He has had a 35-year career both as a lawyer in private practice and as a senior legal officer for three banks, all of which were actively involved in asset management.