In the end, billionaire Steven Cohen, one of the most successful hedge-fund managers of his generation, could end up getting banned from the business he dominated for an error of omission, not commission.

In an administrative action that constitutes its first formal salvo against Cohen, the U.S. Securities and Exchange Commission alleged he failed to supervise two wayward portfolio managers and ignored “red flags.” The agency stops short of accusing the owner of SAC Capital Advisors LP of insider trading. While the proceeding may result in his being barred from managing other people’s money, it won’t carry the potential penalties available if the SEC had sued him. It also pales in comparison to a grand jury indictment for securities fraud, and the 20 year prison term a conviction could bring.

Instead, the SEC claim that Cohen should have known two of his subordinates were using material, non-public information to rack up hundreds of millions of dollars in trading profits will be easier to prove. The regulator will have a lesser burden of proof and won’t have to deal with all of the protections afforded a defendant in a lawsuit, let alone a prosecution.

“They are using an Al Capone-style tactic,” said John Coffee of Columbia Law School, referring to the prosecution of the Chicago gangster in 1931 on charges of tax evasion. “The SEC is aiming at his kneecaps, not his jugular,” he said. “This is a little like catching John Dillinger entering a bank with a submachine gun and charging him with double parking.”

‘Highly Suspicious’

The SEC, which seeks to ban Cohen from the financial industry for life in the non-court action, alleged he received “highly suspicious” information that should have caused any reasonable hedge-fund manager to investigate the basis for trades by subordinates Mathew Martoma and Michael Steinberg.

Cohen may find some guidance in how to respond to the agency from Rajat Gupta, the former Goldman Sachs Group Inc. director charged in the Galleon Group LLC insider trading probe.

Gupta sued the SEC after it filed an administrative action against him, saying he wanted the SEC to sue him so he could fairly defend himself. After both sides dropped their actions, agreeing any SEC matter would be in a federal court, Gupta was indicted by a federal grand jury. The SEC sued him, too.

An SEC administrative proceeding is held before an administrative law judge, not a U.S. district judge or federal jury. The administrative law judge, in Washington, will hear testimony and issue a determination, without a jury present, said Tom Gorman, a former lawyer with the SEC’s Enforcement Division who is now in private practice.

Administrative Judge

After the administrative judge issues a ruling, the SEC makes the final determination, evaluating the facts supporting the allegations. Cohen may appeal to the federal appeals court in Washington, which handles such regulatory matters.

But unlike if he were sued by the agency, Cohen won’t be entitled to evidence collected by the government, a distinct advantage if its only goal is to put him out of business.

SAC spokesman Jonathan Gasthalter has said the agency’s action against Cohen “has no merit.” Kevin Callahan, a spokesman for the SEC, didn’t return a call seeking comment.

SAC oversees $15 billion, about 60 percent of which is money from Cohen and employees. Cohen, whose net worth is estimated at about $9 billion by the Bloomberg Billionaires Index, has returned 25 percent a year in his funds since founding his firm in 1992, after taking half of the profits in fees, a record unsurpassed by other equity hedge-fund managers.

Martoma, Steinberg

SAC portfolio manager Mathew Martoma, 39, was charged by the U.S. in November with insider trading. Prosecutors accused him of helping Cohen’s Stamford, Connecticut-based hedge fund reap at least $276 million by trading on illicit tips about an Alzheimer’s drug. SAC’s Michael Steinberg, 41, was indicted in March by a federal grand jury in Manhattan for allegedly earning

more than $1.4 million by trading on illegal tips about Dell Inc. and Nvidia Corp.

Both men, who were also sued by the SEC for insider trading, have pleaded not guilty in the criminal cases brought by Manhattan U.S. Attorney Preet Bharara, and are scheduled to go to trial separately in November.

Regulators alleged Cohen, 57, ignored the suspicious actions of his subordinates and signs that pointed to malfeasance, in a failure to properly supervise that allowed the alleged illegal trades to take place.

In the administrative action, the agency for the first time described Cohen’s alleged personal involvement in trading activities with the two subordinates, including a claim that Cohen sold off hundreds of thousands of shares of Dell in August 2008. The SEC said the sale came after Steinberg sent Cohen an e-mail that the U.S. alleged included nonpublic information about the company’s disappointing earnings set to be reported days later.

Insider Trading

The agency doesn’t allege that Cohen knew that the information was illegal, a prerequisite to any prosecution of Cohen for insider trading. Instead, the SEC said he failed to supervise the men after receiving information that should have caused a “reasonable” hedge fund manager to investigate the basis for the trades.

The nature of the agency’s action against Cohen, in effect a disciplinary action that occurs internally, caught many by surprise, since it comes after years of scrutiny by federal authorities, both civil and criminal.

“If they put Steve Cohen out of business, it’s not normally something you would see from a failure to supervise case,” said Hillary Sale, a law professor at Washington University in St. Louis. “You see failure to supervise cases in the broker-dealer world, but not with a fish this big.”

Days Before

The SEC proceeding against Cohen was brought July 19, just days before the agency faced a five-year statute-of-limitations deadline stemming from trades sparked by Martoma’s tips made in late July 2008.

The agency action now puts the regulator at the forefront of the U.S. investigation of Cohen and his hedge fund.

The government’s six-year insider-trading crackdown on fund managers, analysts and insiders at technology companies has resulted in charges against more than 80 people and convictions against 73 people.

Prior to last week’s filing, the government’s major actions against alleged inside traders and their associates have largely been tandem federal enforcement efforts -- pairing simultaneous charges by Bharara’s office with a lawsuit by the SEC.

Earlier this month, the Wall Street Journal, citing unidentified sources, claimed federal prosecutors had concluded they didn’t have enough evidence to charge Cohen by the end of this month for crimes related to Martoma’s tips.

Not Enough

“This matter has been investigated for months,” said Tom Gorman, a former lawyer with the SEC’s enforcement division, now a partner at Dorsey & Whitney LLP in Washington. “Clearly the SEC does not have the facts to bring an insider trading case or they would have brought it.”

Gorman said the SEC’s action was based on two criminal insider-trading cases that have yet to go to trial. Should either Martoma or Steinberg be acquitted, it could damage the SEC’s proceeding, he said.

While he wouldn’t address the Cohen case specifically, Bharara took the unusual step in a speech last week of pointing out that prosecutors have other statutes, including conspiracy, that can push back any statute of limitations deadlines.

Rajat Gupta

The Commission’s solo action against Cohen is rare, however. One of the most recent administrative actions tied to insider-trading came in March 2011, and is perhaps the most prominent use of this less-than-lawsuit tool.

In that matter, the SEC filed an administrative proceeding against one-time Goldman Sachs director Gupta, accusing him of giving inside information to Galleon Group co-founder Raj Rajaratnam. Rajaratnam, 56, was convicted of masterminding the biggest hedge fund insider trading scheme in U.S. history and is serving an 11-year sentence.

Gupta, 64, countered by suing the agency in Manhattan federal court, arguing the SEC’s proceeding was a violation of his rights. He said the process wouldn’t give him access to evidence collected by the regulator -- evidence which must be turned over when a defendant is sued.

He also argued the administrative tactic, placing his fate in the hands of the agency making the allegations and a judge less independent than a federal jurist, was stacked against him.

Evidentiary Advantages

Gupta’s lawyer, Gary Naftalis, said such SEC actions also give unfair evidentiary advantages to the government because the administrative law judge was allowed to consider hearsay -- evidence that may only be indirect or speculative and would rarely be allowed in a formal court setting.

U.S. District Judge Jed Rakoff in Manhattan, who presided over Gupta’s lawsuit against the SEC, noted that more than a dozen people tied to the Rajaratnam case had been sued by the SEC in federal court in New York, and called the SEC’s administrative action against Gupta “bizarre.”

The SEC and Gupta later agreed to drop their respective legal actions and stipulated that Rakoff would preside over an SEC lawsuit if it was filed. Two months later, in October 2011, Gupta was instead charged with insider trading by prosecutors, as well as sued by the SEC. He was convicted and sentenced to two years in prison, and is free while he appeals. Rakoff last week ordered him to pay $13.9 million in the SEC case.

Bolster Success

The SEC chose to move against Cohen in an administrative proceeding to bolster its chances of success, lawyers said.

“They are doing that to get the home court advantage, as in an administrative proceeding there is more procedural informality and the federal rules of evidence do not apply,” Columbia’s John Coffee said. “They are also more comfortable with who the judge will be.”

Bypassing the courtroom has built-in advantages for the SEC, said Sale of Washington University.

“Administrative proceedings are on the SEC’s own territory,” she said. “Cohen can always appeal it to court down the road, but this gives the SEC the opportunity to manage this in-house.”

The downside of an administrative proceeding for the SEC is the lack of any stiff financial penalties that would ensue from a successful lawsuit.

Since Cohen agreed in March to pay $616 million to end allegations tied to the July 2008 drug company trades, financial penalties are less of a priority for the regulator in this matter, said a person familiar with the matter who requested anonymity because the matter isn’t public. As part of the March agreement, Cohen’s funds would neither admit nor deny the allegations of wrongdoing.

Criminal Case

As for any criminal case, the SEC’s administrative action described how the U.S. has amassed more information about Cohen’s behavior and interactions with both Martoma and Steinberg, and described how Cohen received and traded on what the U.S. has said was an e-mail that contained nonpublic information.

The U.S. attorney may also avoid the immediate constraints of the statute of limitations by levying a conspiracy charge alleging a continuing pattern of misconduct. And while prosecutors normally have a five-year deadline to bring mail fraud and wire fraud charges, that deadline can be pushed to 10 years if the crimes affect a financial institution, Bharara said.

The investigation by his office, and by the Federal Bureau of Investigation, said a person with knowledge of the probe, is continuing.