Insider Trading Compromises the Level Playing Field for Average Investors

I previously blogged about the role of Raj Rajaratnam in the Goldman Sachs insider trading scandal. Last week Rajaratnam was convicted on all 14 counts of securities fraud and conspiracy in the biggest insider-trading case ever. The case centered on how the founder of the hedge fund Galleon Group trafficked in inside information obtained from corporate executives, bankers, consultants, traders, and directors of public companies including Goldman Sachs. Raj gained $64 million from his sale of insider tips and now faces 19 1/2 years in prison at a sentencing scheduled for July 29.

There has been an unprecedented growth in the number of insider trading scandals over the past several months, many due to activities of hedge fund traders. The government has had a hard time convicting the culprits because there is no clearly defined federal statute on just what constitutes insider trading. Most of us know it the use of private information for personal gain, but that doesn't cover passing it along to others for their personal gain or other forms of trading on the information.

Other insider trading cases that are pending include:

1.      Trades made in an account overseen by hedge-fund titan Steven Cohen that were suggested by two of his former fund managers who have pled guilty to securities-fraud charges for trading on inside information. The case involves trading in a $3 billion stock portfolio personally overseen by Cohen at SAC Capital Advisors and referred to by the government in the filings as "Cohen Account" and internally at SAC as "The Big Book." SAC portfolio managers allegedly funneled their best trading ideas to Cohen for this account and were paid a bonus if they generate big returns for Cohen.

2.      The feds have charged longtime New York stock trader Garrett D. Bauer, an unnamed co-conspirator and Matthew H. Kluger, with at least $32 million in illicit profits on investments of more than $109 million. Working on corporate merger and acquisition deals, Bauer was privy to insider information regarding big companies that were merging or being acquired and he started buying stocks in the companies before the deals happened.

3.      On the same day the feds claimed victory in the Rajaratnam case, they arrested Don Chu, an executive at Primary Global Research, a so-called expert-network firm that provides “market intelligence” to hedge funds and other money-management outfits. The government accused Chu of participating in an insider-trading conspiracy by arranging for his hedge fund clients to get illegal tips on technology companies including Broadcom, Sierra Wireless and Atheros Communications.

So, what's wrong with insider trading from an ethical perspective?  Just this: Investors must have confidence in the integrity of the markets, and that they are on an equal footing with those in the know and are protected against the improper use of inside information. If people fear that insiders will regularly profit at their expense, they will not be nearly as willing to invest. The argument is that efficient markets require a “level informational playing field” to avoid scaring away speculators, who contribute to securities market liquidity, and investors, who could invest their savings in markets with less risk of predation.

The question that must be asked is why so many insider trading cases now? I believe it is the response of federal regulators  to failing to heed the warning signs of the massive Ponzi scheme by Bernie Madoff. The SEC literally got caught with its pants down and thousands of investors paid the price of Madoff's hubris and self-dealing. A vigorous oversight mechanism with embedded warnings signals are necessary steps in fighting off insider trading crimes that are motivated by the greed is good culture on Wall Street that has persisted for almost thirty years following the release of the iconic film, Wall Street.

Blog by Steven Mintz, aka Ethics Sage, May 18, 2011

Cartoon reproduced with permission