How The World's Most Leveraged Hedge Fund Got Away With Insider Trading

While everyone is aware by now that the biggest component of SAC's abnormal outperformance over the years was its recourse to "information arbitrage" and its reliance on "expert networks", both of which managed to send the SAC logo to Federal Purgatory, if not the hedge fund's infamous art-collecting founder, one player in the massive hedge fund insider trading ring which was busted over the past few years, involves the one hedge fund, which as we have shown in the past, has the highest leverage in the US if not the world: Citadel, with $142 billion in regulatory assets.


Today, we learn just how Ken Griffin's conglomerate also got its hands clean, and more importantly, how it managed to avoid any legal consequences.

As Bloomberg reported overnight, "the FBI files spell it out: An analyst at Citadel LLC, the hedge fund with $23 billion in capital invested globally, told agents he made millions of dollars trading on information from a company insider."

Normally, this would have been enough for the FBI to raid said hedge fund and at least settle for a fine, if not pursue outright prison time for those involved. This time, however, it did not.

Here are the details:

It was December 2011, and the Justice Department was deep into a seven-year investigation into illegal stock tips. As authorities homed in on people at several other hedge funds over leaks from a Dell Inc. employee, agents at the Federal Bureau of Investigation began questioning the Citadel analyst about the friendship he formed with the same Dell insider.


In confidential FBI reports summarizing those interviews, agents recounted how the Citadel analyst received market-sensitive information from the Dell employee in 2008 and 2009. In one trade he told agents he made, the analyst bet against Dell after learning it would announce disappointing earnings, bringing in $5 million to $6 million when the company’s shares fell by more than 10 percent. He told agents he later discarded records. 


The analyst discussed helping the Dell employee hunt for a Wall Street job, the agents wrote. “It became an ‘I’ll scratch your back if you scratch mine’” relationship, they wrote in a summary of a Jan. 4, 2012, interview with the Citadel analyst. 


Neither the analyst, Richard Farmer, nor the Dell employee, Rob Ray, was sued by regulators or prosecuted. Chicago-based Citadel hasn’t been accused of wrongdoing.

It would be worse if the Feds had turned a blind eye from the very beginning, blaming a heavy workload or insufficient budgets (as the CFTC did every time someone mentioned gold manipulation). In this case, however, they investigated.

Four people familiar with the probe said U.S. authorities investigated Farmer. Those people, who spoke confidentially because the matter isn’t public, said authorities didn’t have evidence to charge him. They declined to elaborate.

It would appear the US authorities have a rather stretched definition of evidence then, especially as none other than Steve Cohen was about to find out:

The Chicago fund’s name surfaced once in connection with Bharara’s probe. The July 2013 indictment of SAC Capital said Cohen received a warning about someone he wanted to hire. An unnamed employee of an unidentified hedge fund told Cohen that the prospective hire was part of an “insider trading group” where he worked. That fund was Citadel, people familiar with the prosecution said.


Citadel, in a statement at the time, called the claim baseless. SAC hired the person, who had worked in a different part of Citadel than Farmer, as a portfolio manager. He was later convicted of insider trading at SAC.

Farmer's lawyer, just like Bill Dudley, had some advice for any inquires: leave it alone: “Farmer, approached at his home in July when he was still working for Citadel, declined to comment. He has since left the firm “on amicable terms,” according to his lawyer, David Stetler.  When contacted by the government, my client truthfully and candidly answered any and all questions, allowing the U.S. Attorney to conclude that no charges were warranted,” Stetler wrote in a statement. “In fairness, that should be the end of the story.”

What follows is what the real end of the story should have been. Bloomberg detours into a quick summary of the Dell insider trading probe that snagged among others Galleon, Level Global and SAC. But not Citadel.

Ray’s Dell tips had also been reaching someone at Citadel, Goyal told agents during his own FBI interviews.


Goyal said Ray had spoken of being contacted by a Citadel employee, Farmer, who “was very aggressive” and “trying to get numbers and data points from Ray,” FBI agents wrote in summarizing the interviews with Goyal.


On Dec. 8, 2011, two FBI agents approached Ray, who was no longer working at Dell, near his new offices... On Dec. 30, 2011, the last day of a slack holiday trading week, an FBI agent and two assistant U.S. attorneys met with Farmer and his lawyer.


Farmer, a Colorado native with a Dartmouth College psychology degree and a University of Chicago MBA, covered technology stocks at Merrill Lynch until 2007. Citadel then hired him as an analyst, an agent wrote.


Farmer began calling Ray with questions about the industry shortly after the two met at the Dell dinner, agents cited both men as saying. Farmer told the FBI he eventually acted as a mentor, editing Ray’s resume and talking about job leads.

There is much more on the nuances of the investigation, but the punchline was all too clear: Farmer, and Citadel, ended up making millions in dollars in profits on what is at this point (because Citadel hasn't even been forced to admit or deny guilt) still allegely non-public information.

At Citadel, analysts such as Farmer could trade portions of a portfolio and share in the gains and losses stemming from their picks. Farmer said a superior had berated him for his performance and urged him to take some “swings” trading stocks, the agents wrote. Agents described trades that Farmer said he made, starting in 2008, using the Dell tips. It wasn’t clear whether he was working from memory during the interviews.


Farmer recalled that he used Ray’s tips in the summer of 2008, according to the FBI memos. In July, agents wrote, Farmer held a short position in Dell, a bet that the shares’ value would fall. Ray helped Farmer to confirm his view about Dell’s weakness, the agents wrote. Farmer told the agents that he brought in $5 million to $6 million, they wrote, when the shares dropped 15 to 18 percent.


It was the next month -- after markets closed on Aug. 28, 2008 -- that Dell announced its gross margin, and profit, had missed analysts’ projections. Shares fell 13.8 percent the next day and Dell lost $7 billion market value as roughly 100 million shares changed hands, more than twice the trading in the days before and after. Prosecutors characterized trades that Chiasson, Newman and Steinberg made on the gross-margin miss, based on information that came through Goyal, as “the big shorts.”


Farmer also told the agents that before Dell’s 2009 meeting with analysts, Ray -- who had by then moved from his job in investor-relations to corporate development -- had “volunteered that there was margin pressure.” Farmer reversed his small bet that Dell shares would rise and shorted them instead, agents wrote in the interview summary. The trade brought a six-figure profit when the news became public, they wrote.


When Dell publicly released its worse-than-projected figures after markets closed on July 13, 2009 -- the eve of Dell’s analyst day -- the company’s shares fell 8.1 percent.  Farmer had another conversation with Ray after analyst day in which Ray advised Farmer that margins were even worse than reported, the agents wrote. Farmer made his short position larger, they wrote.

So with all this information how did the world's most levered hedge fund get away with insider trading? Simple: "wiping the slate clean."

Shortly after returning from a trip in late 2009, Farmer erased electronic notes, in Microsoft Word format, that were stored on thumb drives, Zip drives and a shared drive at Citadel, agents wrote in a summary of one of the interviews with him. Farmer also threw away his handwritten notes because that was his normal practice and because they were incriminating, agents wrote.


Farmer got rid of e-mails as well, according to their summary.


“This,” they wrote, “wiped the slate clean.”

So all it took to get the Feds (and SEC) to throw away a case against an insider trader at Citadel was... erasing all the evidence? How did nobody else think of that. One person who clearly didn't was the US Attorney for the Southern District of New York, Preet Bharara, despite his pompous rhetoric.

“Part of our job is to make sure that the world understands,” Bharara said in a Jan. 7, 2014, interview on PBS’s Frontline, “that it doesn’t matter who you are, how much money you have, who you’re connected to, that you have to play by the same rules as everyone else.”

Everyone else... except Citadel.

Which begs two questions: the world knows about Too Big To Prosecut banks, but have we reached a point where a $100 billion +, massively levered, hedge fund is also untouchable in the US?

Or is the reason far more prosaic: as we have long stated, the one entity that the NY Fed engages in intraday, momentum-breaking market interventions, elsewhere known by a familiar three-leter acronym, is none other than Citadel. Has it now become the rule of law that any hedge fund that facilitates the Fed in its illegal manipulation of equity markets is henceforth above the law?

We don't anticipate to ever get the answer.