R.I.P. for SAC?

SAC indictmentIt’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.

China’s Familiar Charges Against Glaxo

big-pharma-pills-and-moneyGlobal corporations piously claim to adhere to the laws of the countries in which they do business, knowing full well that those laws in many places are weak or are not rigorously enforced.

It’s thus amusing to see British drug giant GlaxoSmithKline squirm in the face of corruption charges unexpectedly brought by the Chinese government. GSK purports to be shocked by allegations that its Chinese executives used funds laundered through travel agencies to bribe doctors, hospitals and public officials to purchase more of its products. The company insists that it has zero tolerance for such behavior and that a recent internal investigation had found no evidence of corruption  in its Chinese operations.

These protestations are as unconvincing as the Chinese government’s claims that it is simply enforcing the law—as opposed to giving its emerging pharmaceutical  industry a leg up. GSK’s alleged transgressions are little different from the practices that it and the rest of Big Pharma employ around the world.

Take the United States. In recent years, GSK has become known as the company that pays massive amounts to resolve wide-ranging allegations brought by regulators and prosecutors.

Some of those charges involved payments very much like the ones it is being accused of making in China. GSK was charged with giving kickbacks to doctors and other health professionals to prescribe drugs such as the anti-depressants Paxil and Wellbutrin for unapproved (and possibly dangerous) purposes.  Payments also went to figures such as radio personality Drew Pinsky, who was given $275,000 by the company to promote Wellbutrin on his program.

The kickback allegations were among the charges covered by a $3 billion settlement GSK reached with the U.S. Justice Department in 2012. Also included in the deal were accusations that GSK withheld crucial safety data on its diabetes medication Avandia from the Food & Drug Administration and that it defrauded government healthcare programs in its pricing practices.

These safety and pricing matters were the culmination of years of controversy surrounding GSK and its predecessor companies. The safety issues dated back at least to the 1950s, when Smith, Kline & French was among the firms linked to Thalidomide and its horrible legacy of birth defects.

Until it was sold off in the late 1980s, Glaxo’s infant formula business, like that of Nestle, was accused of undermining public health in the third world by marketing the powder to women who were so poor that they tended to dilute the formula to the point that it lost its nutritional potency.

In the 1980s, SmithKline Beckman was the target of a rare criminal case brought under U.S. drug laws for failing to warn regulators and the public about the potentially lethal side effects of its blood pressure medication Selacryn.

Later years saw frequent charges that GSK suppressed evidence about the dangers of Paxil, especially in children. There were also many cases involving pricing abuses, including one in which GSK paid $150 million to resolve allegations of violating the federal False Claims Act in its dealings with Medicare and Medicaid.

Unlike many corporate settlements, GSK’s $3 billion deal with the feds required it to plead guilty to several criminal counts. It also had to sign a Corporate Integrity Agreement with the Department of Health and Human Services.

In other words, the company is in effect on parole and subject to heightened scrutiny. The Chinese accusations seem to point to a big, fat violation of the U.S. Foreign Corrupt Practices Act. That would jeopardize GSK’s settlement and subject it to new penalties and sanctions.

Foreign corporations have long taken advantage of China’s lax regulatory system. Now that the People’s Republic is (selectively) cracking down, a company such as GSK deserves no sympathy.

Deregulation Crashes and Burns

Canada’s Transportation Safety Board is far from reaching a conclusion on what caused an unattended train with 72 tanker cars filled with crude oil to roll downhill and crash into the Quebec town of Lac-Megantic, setting off a huge explosion that killed at least 15 people. But that hasn’t stopped Edward Burkhardt, the chief executive of the railroad, from pointing the finger at everyone in sight — except himself.

Burkhardt first tried to blame local firefighters who had extinguished a small blaze in the train before the larger accident, and now he is accusing his own employee — the person who was operating the train all by himself — for failing to apply all the hand brakes when he parked the train for the night and went to a hotel for some rest after his 12-hour shift.

Whatever were the immediate causes of the accident, Burkhardt and his company — Montreal, Maine & Atlantic (MMA) Railway and its parent Rail World Inc. — bear much of the responsibility.

Burkhardt is a living symbol of the pitfalls of deregulation, deunionization, privatization and the other features of laissez-faire capitalism. He first made his mark in the late 1980s, when his Wisconsin Central Railroad took advantage of federal railroad deregulation, via the 1980 Staggers Rail Act, to purchase 2,700 miles of track from the Soo Line and remake it into a supposedly dynamic and efficient carrier. That efficiency came largely from operating non-union and thus eliminating work rules that had promoted safety.

Wisconsin Central — which also took advantage of privatization to acquire rail operations in countries such as Britain, Australia and New Zealand — racked up a questionable safety record. Burkhardt was forced out of Wisconsin Central in a boardroom dispute in 2001, but he continued his risky practices after his new company, Rail World, took over the Bangor and Aroostook line in 2003 and renamed it MMA.

Faced with operating losses, Burkhardt and his colleague Robert Grindrod targeted labor costs with little concern about the safety consequences. In 2010 the Bangor Daily News reported that MMA was planning to reduce its crews to one person in Maine, which, amazingly, was allowed by state officials. Grindrod blithely told the newspaper: “Obviously, if you are running two men on a crew and switch to one man, you’re saving 50 percent of your labor component.” The company also succeeded in getting permission for one-man crews in Canada.

Inadequate staffing may have also played a role in a 2009 incident at an MMA maintenance facility in Maine in which more than 100,000 gallons of oil were spilled during a transfer in the facility’s boiler room. In 2011 the EPA fined the company $30,000 for Clean Water Act violations.

MMA continued to have safety problems even before the Lac-Megantic disaster. The Wall Street Journal reported that MMA had 23 accidents, injuries or other reportable mishaps from 2010 to 2012 and that on a per-mile basis the company’s rate was much higher than the U.S. national average.

The Lac-Megantic accident is prompting calls in Canada for a reconsideration of the policy of allowing a high degree of self-regulation on the part of the railroads. A review of lax regulation, including the elimination of work rules, should also occur in the United States. There’s also a scandal in the fact that railroads like MMA are still allowed to use outdated and unsafe tanker cars.

Yet some observers are seeking to exploit the deaths in Quebec by making the bizarre argument that the real lesson of the accident is the need to rely more on pipelines rather than railroads to carry the crude oil gushing out of the North Dakota Bakken fields (the content of the MMA tankers) and the tar sands of Canada. North Dakota Senator John Hoeven, for instance, is using the incident to argue the need for the controversial XL Pipeline.

How quickly these people forget that the safety record of pipelines is far from unblemished. Hoeven’s neighbors in Montana are still recovering from the 2011 rupture of an Exxon Mobil pipeline that spilled some 40,000 gallons of crude oil into the Yellowstone River.

The problem is not the particular delivery system by which hazardous substances are transported but the fact that too many of those systems are under the control of executives such as Burkhardt who put their profits before the safety of the public.