Before going any further, it's important to add the usual journalistic parachutes. Neither Steve Cohen nor SAC Capital have been officially accused of any wrongdoing, criminal or civil. People are entitled to a presumption of innocence even when accused. SAC says it has a strong culture of legal compliance, employs a small army of legal and compliance staffers, and says that "insider trading isn't acceptable in our culture of compliance, and we don't give a wink or nod to the contrary."
So perhaps all of the investors in SAC Capital are completely persuaded that, except for a rogue operator here or there, the firm and its founder are — as the Munchkins might put it — "legally, morally, ethically, spiritually, physically, positively, absolutely, undeniably and reliably" free of securities law-breaking wickedness.
But it's good to keep in mind that investors are highly incentivized to adopt such an attitude. The returns on wrongdoing are asymmetrical for them. If cheating were contributing to the long history of abnormal returns at SAC Capital, this would benefit the outside investors. Prosecution of insiders for lawbreaking would inflict no cost on the outsiders. It would be irrational — or, at least, contrary to their rational self-interest — for investors to care very much about the legality of SAC's gains.
It's easy to see this as a structural flaw in our system. With publicly held companies, we have short-sellers who have financial incentives to track down fraud and violations of securities laws by executives. No such market-mechanism exists for promoting the detection of fraud in private funds such as SAC Capital. We try to make up for this by creating whistle-blower programs that potentially grant windfall rewards to those help authorities uncover fraud. But the effectiveness of these whistle-blower awards is still an open question.
The flaw, however, might not be all that serious. The lack of a market incentive for detecting insider trading by hedge funds arises because the generally are no victims of insider trading. There's no market for protecting the investments of the public against predation by better informed traders because the predation is harmless. It enriches the informed but inflicts no harm on a diversified investor.
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