What’s Next in the Case Against SAC

The indictment of SAC Capital Advisors and three of its internal hedge fund companies on Thursday signals an important shift by the government away from its longstanding fear of charging an organization with a crime. The charges accuse the firms and, at least indirectly, their owner, Steven A. Cohen, of fostering a corporate culture that encouraged analysts and traders to use illegitimate means that resulted in “systematic insider trading.”

By charging the organization with wire and securities fraud, the Justice Department is using it as a surrogate to make the point that Mr. Cohen at least tolerated illegal conduct and profited from it. How much the government can do to SAC remains to be seen, but the indictment most likely signals the end of Mr. Cohen’s role as a hedge fund manager for outside investors.

Here are some thoughts about the charges filed against SAC and how the case might ultimately unfold.

The Charges

The indictment includes one broad count of wire fraud covering trading from 1999 through 2010, and then each company has a separate securities fraud charge for the particular trading that took place through it. These are standard charges used for insider trading that allow prosecutors to bring in a wide range of evidence to prove a “scheme or artifice to defraud” that is an element of the crime.

The Justice Department did not charge a conspiracy in this case but used the wire and securities fraud statutes to the same basic effect. These laws allow prosecutors to use different acts to prove the scheme as long as they are part of an overarching plan, so the government essentially proves a conspiracy without having to show a separate agreement.

There had been talk about how the statute of limitations might constrain the trades prosecutors could use, but the wire and securities fraud provisions allow evidence of conduct outside the limitations period so long as there was at least one act within that period. Thus, the trading outlined in the indictment from 1999 to 2004 involving Intel, Altera and AMD can be used to prove that SAC engaged in a fraudulent scheme.

Moreover, the government does not have to prove every trade mentioned in the indictment was based on inside information as long as there is enough evidence for a jury to find a continuing scheme to defraud. This gives prosecutors greater flexibility to identify a number of questionable trades so long as there is good evidence that at least some were based on inside information.

The Defense

In looking at the possible defenses SAC can offer, they can be described in one word: none. Although SAC has denied engaging in any misconduct, the criminal liability of an organization is very broad in the United States, and there are no effective defenses once the government proves one of its agents engaged in criminal conduct on its behalf.

The Supreme Court’s seminal 1909 decision in New York Central v. United States held that imposing criminal punishment on a corporation by what is known as “respondeat superior” liability did not violate due process. Under this approach, as long as an employee was acting within the scope of his or her duty and the conduct was intended to benefit the company, then it can be held criminally liable. It does not matter whether the person is an executive or the lowliest janitor â€" the company is responsible for the person’s action.

The indictment identifies six different employees, including one who just entered a guilty plea this week, who admitted trading on inside information while working at one of SAC’s hedge funds, which garnered the profits from the trades. That’s all the government needs to establish the liability of the organizations under respondeat superior.

If SAC won’t be able fight the charges because of the admissions of its employees, why didn’t it work out a deal with the government? The issue in this type of case is usually about the penalty and not whether the company can be convicted, so that is the likely reason why an agreement has not been reached.

Although several former employees have entered guilty pleas, the largest trades in the indictment involve Matthew Martoma, who is not cooperating and faces trial in a separate case in which he is accused of helping SAC realize profits and avoid losses totaling approximately $275 million. The firm may be willing to go to trial in hopes of winning on those trades. If prosecutors can’t show a violation by Mr. Martoma, then the likely punishment of the firm would be much lower.

The Potential Punishment

Because SAC is likely to be convicted for the trades by the six employees who have pleaded guilty, the issue of punishment may be the real fight in the case. The fine for a securities fraud violation is capped at $25 million for an organization, so SAC would be facing a maximum of $100 million for the four securities counts in the indictment if it is convicted.

For the wire fraud count, the maximum fine can be up to twice the gain from the violation, which makes the trading by Mr. Martoma crucial because the violations by the other SAC employees involved much smaller amounts.

In determining the fine, the Federal Sentencing Guidelines calculate a culpability score for a convicted company. An organization with 1,000 employees in which senior management condoned the violation or if “tolerance of the offense by substantial authority personnel was pervasive” can quickly see the recommended punishment increase up to the statutory maximum.

The indictment emphasizes the inadequacy of SAC’s internal controls, devoting five pages to the shortcomings of its compliance program. For example, the Justice Department pointed to only one instance in which the firm identified insider trading by its employees, and they were fined but permitted to keep their jobs and no report was made about the violations.

Although there have been proposals to limit corporate criminal liability by allowing companies to offer a compliance defense, that does not exist yet. So the only reason to include the information about SAC’s compliance is to build the case for a higher punishment of the firm while blunting public claims that prosecutors have ignored its extensive compliance measures in pursuing charges against the firm.

There is no corporate “death penalty” under federal law, and imposing the maximum fines would be unlikely to put SAC out of business because Mr. Cohen is reported to have at least $8 billion invested in the firm. The more likely outcome of this case is that investors will withdraw their funds, and some banks and brokerage firms doing business with it may terminate their relationships. Thus, SAC may well stop being an investment adviser, but its basic operations probably can continue.

Mr. Cohen will still have significant assets to invest if SAC is convicted and the Securities and Exchange Commission is successful in its administrative proceeding filed last week that accuses him of failing to supervise his employees who engaged in insider trading. And this is Wall Street, after all, so firms are likely to take his business in whatever future organization he uses once the dust settles from the charges.