R.I.P. for SAC?

It’s not clear what real value hedge funds add to the economy, but the apparent abuses of Steven Cohen’s SAC Capital Advisors have made one significant though unintentional contribution: They have breathed new life into the concept of a corporate death penalty.

The criminal and civil charges just filed against SAC by the U.S. Attorney’s Office in Manhattan for insider trading could very well lead to the demise of the firm, given that prosecutors are reportedly seeking forfeiture of some $10 billion. In fact, some analysts believe that forcing SAC out of business is the primary goal of the feds.

In recent years, federal prosecutors have appeared to do everything possible to avoid prosecutions of even the most egregious companies if the case threatened their viability. This has allowed many of the big banks to avoid major criminal charges for their role in the financial meltdown, money laundering or LIBOR interest rate manipulation.

Those that have faced charges have never been in danger of going under, given their ability to negotiate deferred prosecution agreements or the application of criminal charges to a minor subsidiary. Some of the penalties have been sizable (e.g. $1.9 billion for HSBC and $1.5 billion for UBS) but not big enough to sink them.

SAC is a different story. A $10 billion penalty would cripple the firm, which has already been experiencing a rapid outflow of assets since the insider trading charges first surfaced and SAC paid $616 million last March to settle civil charges brought by the Securities and Exchange Commission.

Prosecutors don’t have to worry about broad economic consequences of an SAC collapse. Some negative ripple effects might be felt in Stamford, Connecticut, where the firm is headquartered, but there are plenty of other wealthy firms and individuals there to generate business for luxury car dealers and the high-end service sector.

The fact that a firm such as SAC could disappear without causing any significant disruption raises the question of what purpose it serves in the first place.

Hedge funds have been around for decades, but they used to be low-profile firms serving a limited clientele of wealthy individuals. During the 1990s hedge funds came out of the shadows. Hordes of young investment professionals like Steven Cohen left the stodgy confines of Wall Street and opened their own hedge funds. No longer satisfied with the prospect of becoming a mere millionaire at a brokerage firm, these hotshots saw the chance to become multimillionaires through esoteric investment techniques beyond the comprehension of mere mortals.

The dream of unlimited wealth was shaken in 1998, when a hedge fund called Long-Term Capital Management—which had used $2.2 billion in assets to acquire financial positions with a value of more than $1 trillion—was on the verge of collapse. Concerned that a failure of this magnitude would weaken the entire financial market, the Federal Reserve intervened by putting together a group of investment banks that bailed out the hedge fund and its rich investors.

Events such as this tarnished the reputation of hedge funds but did not result in a stampede among their clients, which included a growing number of pension funds. In fact, the sluggish performance of the stock market in the wake of the dot.com collapse made affluent investors even more interested in the extraordinary returns that hedge funds seemed to offer.

Despite the hype in the business press about funds pulling in annual returns of 40 percent or more, many hedge funds struggled to outperform the stock market. Looking for the big score, some turned back the clock to the financial maneuvers of the 1980s. Rather than simply engaging in financial plays, they used their holdings in companies to press for corporate restructuring to pump up the stock price or in some cases bought out the firm entirely in order to reshape it. Hedge fund managers began to behave like the corporate raiders of the 1980s, and some of those raiders, such as Carl Icahn, transformed themselves into hedge fund managers.

Yet even these approaches could not provide levels of return high enough to meet the inflated expectations of hedge fund investors. All the evidence suggests that firms such as SAC decided that the only way to beat the market was to obtain information that no one else had; in other words, by resorting to insider trading.

That was the message of the successful prosecution of Galleon Group founder Raj Rajaratnam in 2011 and is also at the heart of the SAC indictment, which alleges not just some isolated instances of insider trading. Instead, it charges that such behavior was inherent in the way SAC has operated:

The relentless pursuit of an information “edge” fostered a business culture within SAC in which there was no meaningful commitment to ensure that such “edge” came from legitimate research and not Inside Information. The predictable and foreseeable result, as charged herein, was systematic insider trading.

If SAC’s goose is indeed cooked, the next issue is what happens to its competitors. There’s no reason to believe that any of the other big hedge funds have been any more scrupulous in their pursuit of an information edge. Perhaps what we should be talking about here is not just the death penalty for a single company but for an entire industry.