Steven Cohen of SAC CAPITAL

SAC Capital  has been dragged through the courts in recently. One of the company’s former portfolio managers is accused of involvement in what’s been called the most lucrative insider trading scheme of all time. The manager, Matthew Martoma, was granted bail on a bond of $5 million today after his first appearance in court on the charges.

Martoma’s alleged offense was the use of insider tips from a doctor, in trades dealing with Elan Corporation plc (NYSE:ELN), and Wyeth Limited (NYSE:WYETH). According to prosecutors, the insider trading tips allowed SAC capital to avoid losses and gain profits of $276 million.The alleged offense took place in the summer of 2008.

According to Reuters, Martoma is the fifth person associated with SAC Capital to be charged with insider trading. Martoma worked for CR Intrinsic, a division of SAC Capital. The hedge fund was founded by Stephen A. Cohen. Martoma allegedly received information about a clinical trial result relating to an Alzheimer’s drug jointly developed by Elan plc (NYSE:ELN) and Wyeth Limited (NYSE:WYETH).

This is but the latest example of an accusation of insider trading being perpetrated using expert networks, specialized information supplied by a body of people inside an industry. The pharmaceutical industry is the most obvious arena for such types of insider trading.

Because of the nature of the pharmaceutical industry’s be all or end all clinical trials, information available to a few experts before public announcements are made is incredibly valuable. A single piece of information can make or break a company in the pharmaceutical industry. It is clear prey for insider traders.

This case, when it goes to court, will be decided on its own merits, but it is clear that illicit information movements have been a part of the industry for some time. In 2005 a Seattle Times investigation discovered 26 cases in which doctors had leaked confidential information about clinical trials to investment managers.

In 24 out of those 26 cases firms issues special reports to privileged clients, detailing at least some of the results of the clinical trials before they were made public. That investigation found that go-betweens matched doctors with information to hedge funds that would pay them for a meeting. One such firm claimed to have access to 60,000 such doctors.

Whether or not SAC Capital was involved in the practice is not the issue, particularly if it is known to be a daily occurrence. In such a secretive industry, and one in which information is paramount, it is almost impossible to track the perpetrators.

Assuming due precautions are taken, electronic communication dispensed with in favor of in person meetings and so on, the evidence to make such a case would be nigh impossible to put together. The law is almost impossible to enforce in this area.

The only option left to prosecutors, and judges, is to make sure that those who are caught face the harshest punishments available. Investment managers, experts in risk management, are unlikely to be awed by even the harshest sentences that could be imposed.

Removing all morality from the situation: If there was, for example, a 5% chance of being caught and prosecuted, but the alternative was a net loss of $276 million, only the most risk averse would forgo the opportunity. The punishment in question would have to be worth in dollar figures, a loss of twenty times that to compel a reasonable man to do without.

Given the scale of the industry uncovered by the Seattle Times, it seems unlikely that the chances of getting caught are as high as 5%. Lower chances of punishment result in much higher necessary punishment costs.

Given the mathematics, it seems barely plausible that any dealing in low-mid cap pharmaceutical stocks would avoid receiving information improperly, unless it was on purely moral grounds.

The SAC case will take some time to conclude. Whatever its outcome, it seems that the bane of expert networks in the financial industry will not go away until the penalties exceed the expected outcome. It is either that, or expect everybody in the financial industry to hold themselves to a high moral standard in the face of huge material gain for the opposite.