Insider Trading: A Dirty Business

One of the major tactics of hedge funds is to “arbitrage reality”, operating with a better understanding of a company and its stock price than other participants in the market. In a legitimate operation, that means lots of research. On the wrong side it means getting inside information about a company’s earnings, upcoming deals, and other inside information.

The hedge fund most notably found to be operating on the wrong side was the Galleon Group run by Raj Rajaratnam. On May 11th he was found guilty on all fourteen counts of securities fraud and conspiracy to commit securities fraud. His sentencing is scheduled for July 29th. His appeals will go on for years.

George Packer puts together an insightful look at the Rajaratnam as a lens to explore the difficulties in getting a guilty verdict for insider trading and for prosecutions coming out of the financial crisis in a long article in The New Yorker: A Dirty Business.

I don’t think Rajaratnam’s guilty verdict was a surprise to anyone. Maybe it was a surprise to him and his lawyer. The feds had wiretaps and what appeared to me to be very solid evidence. One of the biggest difficulties is showing the flow of information to show that the trade happened based on material, non-public information. For a company insider or company adviser that is more straightforward than finding that information with a third-party trader. Without the flow of information you can’t show that the use of the information was in breach of a duty.

The death blow in the Rajaratnam trail was Rajat Gupta, a member of the Goldman Sachs’ board of directors. At a board meeting they discussed Warren Buffett’s proposed investment of five billion dollars in Goldman Sachs. The meeting ended at 3:54 P.M. Sixteen seconds later, Gupta called Rajaratnam’s office. At 3:58, just two minutes before the markets closed, Rajaratnam gave an order to buy three hundred and fifty thousand shares of Goldman stock. Fit him for a pinstripe jumpsuit.

Goldman Sachs chairman and chief executive, Lloyd Blankfein was in the witness stand at the Rajaratnam trial. But he was merely there to say that Rajat Gupta had violated the company’s confidentiality rules.

Did insider trading cause the 2008 financial crisis? Did it even play a role?

I’m in the camp with Charles Ferguson, the director of Inside Job, that the financial crisis was caused primarily by shoddy mortgages and trading of those bad loans. But unlike Ferguson, I think the ultimate crisis was caused by greed and stupidity.

The top executives of financial institutions were likely unaware or perhaps willfully ignorant of the low-level players who were originating the toxic mortgages and the packaging of the toxic mortgages into even more toxic mortgage-back securities. Delusion, stupidity and greed are not illegal.

Going back to insider trading, the push for information arbitrage is really a push to the edges of ethical and legal operation. Pushing back from the edge is a person’s morality, their sense of right and wrong. The hammer to that morality is potential prosecution for going past the edge. Packer refers to a 2007 of twenty-five hundred Wall Street professionals.

They were asked if they would use inside information to make ten million dollars if the chances of getting caught were fifty per cent. Seven per cent said yes. But, if there was zero chance of getting caught, fifty-eight per cent said that they would break the law.

That is the real problem with under-funding of the SEC. Without sufficient resources, their hammer of prosecution seems like a negligible risk. If traders see their peers trading on inside information and not getting caught, they are more likely to push past that legal edge. The  Rajaratnam is an important signal that you can get caught.

To be effective the SEC needs more cases, not just bigger cases.