The Wall Street firms that do business with SAC Capital are right to be privately worried about possible legal contamination from the criminal indictment against the hedge fund.
Publicly, Wall Street is standing behind SAC Capital. It's "business as usual," according to reports. Gary Cohn of Goldman Sachs recently praised SAC as "a great counter party" in an interview with my colleague Kate Kelly.
But behind the scenes, Wall Street executives are worried, according to people familiar with the matter. All the biggest Wall Street firms have extensive ties to SAC Capital—ties that could put them in legal jeopardy, particularly under much larger exposure spelled out in the Dodd-Frank banking reform regulations..
It would be hard to over-estimate the significance of SAC Capital to Wall Street. The hedge fund employs what has been described as "significant leverage" in its trading strategies, borrowing money so that the firm is able to take trading positions that aggregate to much more than the roughly $15 billion of assets it has under management. The firm lists its regulatory assets as $50 billion in a recent regulatory filing, for example. Much of that leverage comes from loans from Wall Street banks.
Even that understates how much business SAC does through the top Wall Street firms. That $50 billion is a snapshot in time, not a cumulative count of all of the assets that SAC acquires and disposes of throughout the year. No one outside of SAC—and very few inside of SAC—knows the total volume of trading SAC is responsible for across all the markets it trades, but it's a safe bet that the number is in hundreds of billions.
That kind of volume makes handling SAC's trades very big business for its prime brokers. Over the years, SAC Capital has paid billion in fees to its prime brokers, people in the sector estimate. According to a recent regulatory filing, those on the receiving end of SAC's prime brokerage fees include all the big prime brokers—Bank of America's Merrill Lynch, Barclays, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Morgan Stanley and UBS. In short, there's SAC money flowing all over Wall Street.
At many of these firms, there are people whose entire careers are built around their relationship with the hedge fund. They work for SAC almost as much as they work for their nominal employers—and certainly their paychecks depend on robust SAC trading.
"These folks may be eating crumbs that fall from the table of SAC—but those crumbs are made of gold," one person at a prime broker used by SAC said (he does not work directly with SAC).
(Read more: SAC trader had been fired in bonus scheme: Report)
So the news that the Justice Department is not seeking to freeze SAC's assets is welcome on Wall Street. The fees also explain why Goldman's Gary Cohn uses the phrase "great counter-party" to describe a hedge fund under criminal indictment. If the Justice Department's investigation were to somehow put a halt to "business as usual," the big Wall Street firms would lose hundreds of millions of dollars in revenue.
But the loss of revenue may not be the worst of it. Wall Street may face an even greater—if less probable—danger if SAC were to be convicted of criminal charges. Some prime brokers and their employees could find themselves targeted by regulators for "aiding and abetting" the alleged securities law violations of SAC.
Ever since the mid-nineties, Securities and Exchange Commission has had the ability to bring aiding and abetting claims against those who assist in securities fraud. Bringing a claim under this act, however, was complicated because it required that the SEC prove that accused "knowingly" provide assistance to the fraud. In practice, this meant that few aiding and abetting cases were actually brought by the SEC.
The Dodd-Frank financial reforms loosened this standard considerably, allowing the SEC to bring cases against third parties who "recklessly" provide aid to securities fraudsters. This means the SEC no longer has to prove that a third-party knew about the fraud only that it failed to take reasonable measures to detect or prevent it.
For Wall Street firms that have long-standing relationships with SAC, this could mean trouble. Up until Dodd-Frank, they would have enjoyed a certain level of immunity from being contaminated by allegations of insider trading by even a very large client. Under the current law, however, they could potentially be found liable for not taking steps to detect or prevent insider trading. Both executing trades for SAC and lending money to provide leverage for allegedly illicit trades could land prime brokers in hot water.
(Read more: SAC's Cohen throws a party, despite indictment)
For most insider trading cases, it would be a stretch to blame the broker for not detecting insider trading. But with SAC, things are different. For starters, the hedge fund has a close relationship with its prime brokers—creating both the incentive to turn a blind eye to illicit trading and the opportunity for brokers to detect it. Regulators could argue that the pattern of trading at SAC should have raised "red flags" to the brokers—much as the Justice Department has argued that SAC turned a blind eye to "red flags" with respect to its traders.
"If there was some kind of notice—a 'red flag'—that a broker should have picked up on, the SEC would have an easier time [bringing an aiding and abetting case] under Dodd-Frank," says Gregory J. Wallance, a former assistant U.S. attorney now working in the white collar litigation department of Kaye Scholer.
In all likelihood the prime brokers have probably already received subpoenas demanding information about the allegedly illicit trades, according to Wallance.
"In the course of an investigation, the grand jury subpoenas go out to so many people. Then they have all this information that they got. It's not that difficult to start going through the secondary actors and see if there are suspicious patterns," Wallance says.
Several of the prime brokers are already conducting internal investigations, according to people familiar with the matter.
"The prime brokers are aware now of the SEC indictment. They're likely thinking: 'We'd better investigate whether we had such red flags.' If they turn anything up, they could end up going to the Department of Justice or the SEC with the information in hopes of obtaining leniency," Wallance says.
Once factor that may matter in terms of attracting attention of regulators would be whether the execution or leverage for allegedly illicit trades tended to come from a single prime broker. In addition, if a prime broker provided service for a number of illicit trades that created a clear pattern that would have been reasonably detectable, the SEC might be prompted to take action.
The worst fact pattern for a prime brokerage would be the existence of an email raising concerns that were then ignored or dismissed by the firm.
No such evidence is in the public record at this time.
Ironically, the huge volume of trading done by SAC might help the fund's brokers stay out of trouble. Only a small number of trades are alleged to have been illicit, a tiny fraction of the volume SAC conducts through its prime brokers. This could make it very difficult for a counter-party to detect any pattern of unlawful trading.
This would be a novel case for the SEC—and one not without perils for the agency. The SEC probably doesn't want to risk an early loss on a relatively untested legal authority. It's also unclear if courts would allow the Dodd-Frank change to be applied retroactively, a necessary concession if SAC's prime brokers were to be held liable for trades made several years ago. The SEC could also decide that it is just unfair to hold prime brokers liable for reckless conduct that occurred before the legal changes.
The Justice Department and the SEC declined to comment. Spokes folks for Bank of America's Merrill Lynch, Barclays, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Morgan Stanley and UBS either declined to comment or could not be reached for comment.
—By CNBC's John Carney. Follow me on Twitter @Carney