The government’s risky SAC wager

June 6, 2011, 11:25 PM UTC

After falling down hard in the run-up to the financial crisis, regulators are hoping to stage a comeback with a wide-ranging insider trading probe. But as investigators circle Steve Cohen and SAC Capital, the government risks losing what little crime-fighting credibility it has gained.

FORTUNE — The public’s desire to see someone, anyone, come down hard on Wall Street has been answered, not by Dodd Frank, but by U.S. attorney Preet Bharara and his crackdown on insider trading. Hedge fund titan Raj Rajaratnam was convicted on 14 counts of insider trading and conspiracy. The jury is still out in the trial of traders Zvi Goffer, Emanuel Goffer, and Michael Kimelman. And the trial of Winifred Jiau, who was a consultant at the expert network firm Primary Global, has just begun. Now the government risks losing its newly-minted watchdog credibility if it can’t nail Steve Cohen, the head of $14 billion hedge fund SAC Capital.

While the government hasn’t accused SAC or its founder of any wrongdoing, the inquiries and probes into the firm, so flagrantly leaked to the media, show that investigators have planted a flag in the lawn of Stamford, CT’s 72 Cummings Point Road, as if to say, “Cohen, you’re next.”

To see why Cohen means so much, let’s take a quick look at why investigators are eyeing SAC in the first place. The firm, which has been described as a “super powerful information machine,” has turned out alums busted for insider trading after leaving the fold, and one man who testified that he also used illegal tips while working at SAC. SAC used expert networks that are at the heart of the government’s broad insider trading probe – Primary Global and Broadband Research – and Senator Charles Grassley has asked regulators to get to the bottom of “the potential scope of suspicious trading activity at SAC Capital.” Grassley also wrote: “While SAC Capital itself has not been charged, these allegations raise serious questions about the corporate culture at SAC Capital and undercut investor confidence in a fair and balanced playing field.”

“The downside of a case this high profile that fails is big,” says Michael Robinson, a former spokesperson for the SEC who is now a senior vice president at Levick Strategic Communications. “An overreach and a miss will set the government back. In law enforcement, you get credit for even small wins because it demonstrates that you’re alert. But if you try to convict and lose, then you’ve failed.” If the government can’t build an open and shut case against Cohen, if there are no wire taps and if cooperating witnesses can’t back up claims that Cohen condoned breaking the law, or if Cohen is just plain innocent, then he becomes a very unappealing target after being a really big suspect in the court of public opinion.

It is possible that the sweep will turn up lower level employees who plead guilty to insider trading, but SAC’s structure could make Cohen himself hard to nab. Much of his $3 billion trading book is comprised of investing ideas given to him by the layer of traders toiling lower down the org chart. Unless there’s a way to prove that Cohen knew about, authorized, or encouraged using inside information to get those investing ideas, it’s going to be hard to get a jury to believe that he’s guilty of breaking the law, according to several white collar attorneys I’ve spoken with over the past few weeks.

Cohen asks his portfolio managers and analysts every Sunday for their best ideas, according to a detailed Wall Street Journal story about the government’s investigation of Cohen’s trading activity. In an ideal world for the government, these Sunday fireside chats would have been caught on tape. They would include remarks like, “I really like MedImmune because I have heard through my grapevine of informants bearing illegal inside tips that it will soon be bought by AstraZeneca.” In a less great (but still pretty good) development for the government, several managers would agree to testify that the order to use inside information came straight from the big guy himself.

Lawyers think that capturing lower level SAC employees who have broken the law, even if they never get Cohen, is a win for the government. After all, it will show that wrongdoers get punished in the end. But I have to disagree to some extent. If the government loses in court, it fails because it can’t prove something that it has told us it publicly believes. The many leaks to reporters and insinuations by Grassley’s office that a culture of insider trading at SAC comes from the top have created an expectation that the government believes the firm is rotten to the core, even without an indictment or court case.

If Cohen, the guy from whom the corporate culture flows, is never tried, it will look like investigators either spent months casting a pall on an innocent man, or found a guilty man but never figured out how to get him. Either way, the glow of the Galleon win fades, and once again there’s egg on the government’s face.