Federal investigators continue to tighten ranks around hedge fund manager Steven Cohen, arresting one of his former portfolio managers in what the US Attorney for New York has called “the most lucrative insider trading scheme ever charged.”

Marc Powers, head of the securities litigation and enforcement practice at BakerHostetler, has been watching the case against Matthew Martoma, accused of tipping off associates at SAC Capital about poor clinical trial results of an experimental Alzheimer’s drug jointly developed by Wyeth and Elan.

Martoma’s alleged use of material inside information is reported to have netted an SAC subsidiary more than USD276m in illegal profits.

Powers is a former staff attorney in the SEC’s enforcement division with considerable experience insider trading cases – he represented a key cooperating witness in the Martha Stewart inside trade prosecution, also involving a failed clinical drug trial for ImClone. In the current matter, he points to a 2008 “smoking gun” phone conversation between Martoma and Cohen – it occurred shortly after Martoma learned of disappointing trials of the drug and immediately before SAC unwound its entire position in the two drug companies.

“That 20-minute phone call between Martoma and Cohen that occurred on the Sunday night before SAC began dumping its shares in Wyeth and Elan will be extremely problematic for both Martoma and Cohen to explain,” says Powers.

While other SAC employees have previously been charged of securities violations, Martoma’s arrest is the first time that Cohen has been directly linked to an alleged instance of insider trading. SAC avoided nearly USD200m in losses by selling its shares and then made USD83m more by shorting the shares of the companies involved.

Speculation is rampant that prosecutors are trying to “flip” Martoma to provide damaging evidence against his former boss – and recent history shows that traders who strike cooperative deals often receive little or no jail time, whereas going to trial could net Martoma a sentence of up to 20 years.

Powers says: “He needs to be completely forthcoming and tell everything he knows about Cohen’s alleged participation. Even then, there is no guarantee the US Attorney’s office will be lenient with him if he cooperates. If there is any discrepancy or omission, it could break any deal that prosecutors make to go easy on him.

“Prosecutors will make their recommendations to the court based upon the value of the information Martoma provides and whether it further advances their investigation up the hedge fund chain of command."

More generally, the SAC case illustrates the growing concern over insider trading among hedge funds.

“Since passage of Dodd-Frank, you have more than 1,000 newly registered funds acting as investment advisers,” Powers says. “Not only are there potential 10b-5 violations but advisers are required to have proper policies and procedures in place to prevent misuse of material non-public information. Failure to have these in place exposes hedge funds to separate charges that can bring substantial penalties and create steep reputational damage among institutional investors, who are notoriously wary of money managers with regulatory problems.”