FORTUNE — Hedge fund powerhouse SAC Capital Advisors, indicted Thursday for wire and securities fraud violations after six of its employees pleaded guilty to those charges, appears to have close to no legal defense to the charges it faces.
That’s not a subjective statement on my part about the ethics of that company or its owner, Stephen A. Cohen, or the strength of the case against either of them. It’s a simple observation about an extraordinary and longstanding anomaly in American law. (In a statement, SAC says, “The handful of men who admit they broke the law does not reflect the honesty, integrity and character of the thousands of men and women who have worked at SAC over the past 21 years. SAC will continue to operate as we work through these matters.”)
In a 32,000-word law review article published in 2007, one eminent legal commentator explained the problem: “A multinational corporation may theoretically be indicted, convicted, and perhaps put out of business based on the alleged criminal activity of a single, low-level, rogue employee who was acting without the knowledge of any executive or director, in violation of well-publicized procedures, practices, and instructions of the company.”
This highly non-intuitive state of the law — one that “has been decried by virtually every commentator who has thought to study it,” the article notes — goes back to a 1909 U.S. Supreme Court case in which the Court affirmed the criminal conviction of the whole New York Central railroad company on the basis of actions committed by one assistant traffic manager. That ruling was “a legal earthquake whose tremors are still being felt today,” the article continues. “It forever changed the complexion of business crime prosecution and ushered in an age when government prosecutors would assume the role of regulators of commerce, manufacturing, and markets.”
The article’s author was Preet Bharara, who was then chief counsel for Senator Charles Schumer and who, since August 2009, has been the U.S. Attorney for the Southern District of New York (i.e., Manhattan). His office’s indictment of SAC may become the crowning achievement of his term in office. (Bharara’s thoughtful article, “Corporations Cry Uncle and Their Employees Cry Foul,” in the Winter 2007 issue of the American Criminal Law Review, can be purchased here.)
There is no hypocrisy whatsoever on Bharara’s part in bringing this indictment against SAC notwithstanding his qualms, voiced in the article, about the breathtaking breadth of the applicable law. His indictment against SAC is hardly based on the transgressions of a single “rogue, low-level employee.” Yet his qualms about the law, and about the enormous power it gives to federal prosecutors in deciding whether to punish a large corporation (SAC has about 1,000 employees) for the acts of a handful, may help explain why Bharara has gone to such lengths in the indictment to explain to the public why this particular indictment is warranted.
He makes a good case. The indictment lists six guilty pleas already entered by high-level SAC employees (portfolio managers and research analysts); it lists indictments pending against two more SAC portfolio managers (Mathew Martoma and Michael Steinberg); it cites a number of emails alluding to at least prima facie suspect information that was passed along to CEO Cohen himself and, in some cases, responded to by him, without triggering referrals to compliance officials; it alleges that SAC gave hiring preference to individuals with reputations for obtaining information of suspicious origin (portfolio manager Richard Lee, who pleaded guilty this week, was allegedly hired by SAC over its legal department’s objections, for instance); it alleges that SAC’s institutional structure and compensation incentives effectively encouraged and rewarded insider trading; and it alleges that SAC’s compliance program was feeble and ineffective in the face of all the huge enticements to transgress. The government alleges that “SAC’s compliance department contemporaneously identified only a single instance of suspected insider trading by its employees in its history,” for instance, and that the trader in question was punished with a mere fine. Meanwhile, the firm’s employees managed, according to admissions its portfolio managers have made in guilty pleas, to use inside information to trade in the stocks of Elan, Wyeth, Dell, Nvidia, Intel, AMD, RIMM, Yahoo, 3Com, Altera, Taiwan Semiconductor, Cisco, Broadcom, eBay, Cypress Semiconductor, Polycom, QLogic, Cirrus Log, Marvell Technology, Avent, and Fairchild Semiconductor.
With the exception of the fact that the guilty pleas and the as yet unproven indictments have occurred (Martoma and Steinberg have pleaded not guilty), all the government’s accusations are sharply disputed. SAC’s lawyers, led by Martin Klotz at Willkie Farr & Gallagher and Daniel J. Kramer at Paul, Weiss, Rifkind, Wharton & Garrison, have given a sneak peek of what their responses will look like in a 46-page White Paper disseminated to SAC’s employees on Monday. It responds to the Securities and Exchange Commission’s civil administrative charges against Cohen, whom the commission accuses of having failed to adequately supervise two portfolio managers in connection with their trading in three stocks — Wyeth, Elan, and Dell.
The paper — not yet rebutted, of course, by the government — succeeds in raising on its face plenty of doubts about any impropriety by Cohen in connection with those particular trades, and it also plausibly touts SAC’s compliance program — which now has 38 full-time employees — as being one of the earliest, most sophisticated, most expensive, and most far-reaching in the industry. It allegedly includes “daily reviews” of email and IMs; a 100% electronic retention policy; restrictions on the use of expert networks; and even surveillance of employee communications. It is true that most of these key compliance measures were instituted after the trades that are the focus of the indictments, but it also appears to be true that they were instituted before SAC became aware of the current investigation.
But regardless of whatever holes SAC’s lawyers can shoot in Bhrara’s peripheral allegations, the guilty pleas of the six portfolio managers are all Bharara seems to need under the current law, and they’ve already happened. (In fact, under existing law, you can convict a corporation based on an employee’s alleged wrongdoing even if the employee is ultimately acquitted!) All that remains to be determined — and probably negotiated — are the penalties and whether SAC will be permitted to survive in some form, perhaps through the mechanism of the government agreeing to dismiss the indictment in exchange for SAC’s execution of a non-prosecution agreement. (The Milberg class-action law firm survives to this day, for instance, notwithstanding having been indicted on racketeering charges in 2006. After its three indicted partners left the firm, Milberg was allowed to enter a non-prosecution agreement in exchange for a $75 million fine.)
Though Cohen himself, judging from his lawyers’ White Paper, might have a triable case in the SEC’s administrative action, where the commission seeks to ban him for life from the securities industry, Cohen may have to trade away whatever fighting chance he has there to avert catastrophe to his firm in the criminal case.