Why Insider Trading Is Hard to Define, Prove and PreventPublished: November 11, 2009 in Knowledge@Wharton
When federal prosecutors charged one of America's wealthiest people with insider trading in October, the case against Raj Rajaratnam and his firm, Galleon Group hedge fund, seemed notable for the types of evidence gathering investigators claimed to have used on the six defendants: bugged conversations and inside informants. Many allegations of insider trading are hobbled by weak evidence like suspicious stock trades just before key corporate announcements.
Since the case broke in mid-October, it has widened. On November 5, 14 additional people were charged. Prosecutors described a network of conspirators who earned at least $60 million. They predicted even more arrests in coming weeks.
Aside from being the most sensational insider trading case of recent years, and the biggest ever to involve a hedge fund, the Galleon case raises questions about what exactly constitutes insider trading at a time when so many market participants, such as hedge funds and other opaque investment pools, live or die on their ability to gather information that competitors don't have. Regulations on insider trading have gradually tightened over the years in the U.S. and many other countries, but some economists argue for a complete course reversal, making insider trading legal.
"I think there are some libertarians who think we should allow it," says Wharton finance professor Jeremy J. Siegel. "But I think insider trading is not a good thing. It makes it more risky to buy securities. When someone is offering to buy or sell, it might be that he or she has some inside information and you are going to get duped. So you cannot trust that you are going to get a fair price." Put simply, insider trading means other investors pay more than they should when they buy and get less than they should when they sell.
Although studies indicate there are a good deal more insider trades than insider trading prosecutions, Siegel does not believe it's a major force in the financial markets. "When we consider the trillions and trillions of dollars that we trade up and down, I think most of that is on the up and up," he says.
Nonetheless, it's important to prosecute insider trading cases because the practice can hurt individual investors and undermine the public confidence that allows firms to raise money in the capital markets, says Eric W. Orts, professor of legal studies and business ethics at Wharton. "The danger is you lose a broad public faith in the markets, and people take their money out."
While insider trading cases come along fairly frequently, their volume is minor compared to crimes like murder, rape and robbery. But that doesn't mean insider trading is rare. Orts says numerous academic studies indicate quite the opposite by uncovering indicators like spikes in a stock's trading volume just before key information, such as quarterly earnings, is made public. "There are a number of studies that indicate a lot of insider trading is occurring," he says, adding: "Usually there is a radical increase [in trading] before the public announcement of the event. So the question is: What is explaining that increase...? And the best explanation is that somebody is getting the information ahead of the news."
Insider trading does not leave clear tracks, like a bloody victim or empty safe, so cases can go undetected. "It's hard to know how much criminal conduct goes on in the world, especially in the white collar world where there's a lot of protection of secrets," says Alan Strudler, professor of legal studies and business ethics at Wharton.
Also, an anti-regulation policy during the Bush and Clinton years left the Securities and Exchange Commission and other enforcers with thin resources for investigating insider trading. These crimes are getting more enforcement emphasis under the Obama administration. Finally, insider trading is tough to prove, with a conviction often pivoting on a judge's or jury's view of whether a defendant really knew that information was not yet public.
Generally, insider trading means profiting on "material, non-public information." It can be committed by an insider, such as a company executive, or an outsider who gets information from an insider. Merely obtaining inside information is not illegal. A journalist, for example, can use inside sources to glean earnings data before it is disclosed and legally use it for a story. But the reporter would be breaking the law if he used that knowledge to buy the firm's stock before an announcement drove the price up.
In the textbook case, it is not illegal to trade on information that one overhears on a train or at the ballpark, so long as you don't know it is material, non-public information. But an investment banker or lawyer helping a firm prepare a merger would clearly be breaking the law by trading on the information. "If something like that happens, it's really shocking in terms of corporate ethics," says Wharton finance professor Richard Marston.
Similarly, he notes that corporate insiders violate their ethical responsibilities to their own shareholders by profiting on information the shareholders don't have. Corporate information belongs to the shareholders, and they should all get it at the same time, he says.
While textbook cases are clear, in real life the distinction between legal and illegal use of information can be difficult. In principle, all investors should have access to the same information. That doesn't mean they actually all have the same information, just that anyone could get it by working hard enough. An example, says Orts, would be a trader who tracks a chief executive's movements, discovers he's meeting with merger-and-acquisition lawyers and trades on the assumption a merger is in the works. That would be legal. Getting an insider to tell you about the merger, and then trading on it, would break the law.
Marston notes that "a fine line" separates legitimate information from insider information, and that professional traders are inevitably going to have an advantage over everyone else. Letting them have a minor edge by, for example, allowing them to see other investors' trading orders a second or two before everyone else, a practice called "flash trading," probably doesn't present much of a problem, and may even make the markets more efficient, Marston argues. "But it's different when you get to the point where you're actually bribing people.... I think it would be a major problem if a hedge fund manager is corrupting someone at McKinsey or Intel," he says, referring to firms' defendants probed for alleged inside information.
Insider trading rules were tightened by Regulation Fair Disclosure adopted by the SEC in 2000. That rule, meant to curb the practice of company executives giving securities analysts an inside track, requires that anything disclosed to any outsider must be disclosed to the general public.
Siegel notes that much insider trading is curbed by rules restricting trading by insiders. Executives and many other employees, for example, are barred from trading during sensitive periods like earnings announcements. High-level insiders have to report all of their trading, not just trades in their own company's shares. "The rules are so strict about when you can buy or sell," Siegel says. "All information has to be out.... I think they have very tough enforcement of that."
The Galleon case stands out because prosecutors claim to have clear evidence the defendants knew they were breaking the law. They accuse those charged with making about $60 million on illegal trades, and said it was the first time court-authorized wiretaps had been used in an insider trading case. One court document says authorities developed an inside source who wore a wire to record conversations with defendants.
Rajaratnam, said by Forbes magazine to be worth $1.3 billion, has denied any wrongdoing, and is free on a $100 million bond. The federal complaint accuses him of obtaining inside information to execute trades that earned Galleon $12.7 million between January 2006 and July 2007. Other illegal trading produced millions more in profits, according to law enforcement officials, who said the inside information involved earnings and acquisitions, among other data.
The initial arrests included executives at Intel Capital, an investment wing of Intel Corp.; a director at McKinsey; and an executive at International Business Machines.
In one wiretap conversation cited in court documents, Rajaratnam and another defendant debate whether to have one of their sources continue working at IBM, or move the source to another company. In another conversation, Rajaratnam and another person appear to be aware that what they are doing could get them into trouble, according to court documents. "I'll never call you on my cell phone," Rajaratnam says, according to the filing. Other defendants made similar statements, and some used pre-paid cell phones to avoid wiretaps, according to court papers.
So far, 20 people have been charged with a variety of offenses, and five have pleaded guilty. The picture that emerges is of a kind of wide-ranging mutual back-scratching society, with members gathering and passing on information. Trading tips and favors is not, in itself, illegal -- in fact, trading information is a big part of a hedge fund manager's job. But it's illegal to do that with inside information.
Some experts worry that the rise of hedge funds and similar, lightly regulated trading pools, could make insider trading more common. "The more opacity there is, the more you can get away with," Strudler says of hedge funds. "And they are plenty opaque." Marston, for his part, thinks insider trading can be a serious problem in individual cases,butdoes not believe it has a major effect on the financial markets. "It's an irritation," he says.
But how strong is the Galleon case? Orts notes that evidence frequently sounds solid when prosecutors summarize it, but that cases often crumble. "You really have to be careful before making a judgment on this. The presumption of innocence has to be recognized." Adds Strudler: "It looks pretty bad, but the prosecutor's office is pretty good at making people look bad.... To get somebody on a crime you need pretty strong evidence." From press reports of the prosecution's case, he is not yet convinced the evidence is strong enough for convictions. "The line between information that's public and information that's not public, in lots of cases, is difficult [to define]."
Insider trading has not always been illegal everywhere. U.S. law has tightened considerably over the years, and it was not until relatively recently that Germany and Japan outlawed it. A 2002 study titled "The World Price of Insider Trading," published in the Journal of Finance, found that prior to 1990 only 34 of 103 countries studied had anti-insider trading laws, and just 9 countries had actually prosecuted cases. The figures rose to 87 and 38 by 2002.
The study's authors, Utpal Bhattacharya and Hazem Daouk of the Kelley School of Business at Indiana University, concluded that prosecutions reduced the prevalence of insider trading. Evidence was seen in a reduced cost of equity after prosecutions began, allowing companies to raise money more cheaply.
"The legal ban on insider trading is a relatively new thing," Strudler says. "The United States has been a leader in its prohibition of insider trading. It still has not spread completely over the world, but I think the perception of the wrongness of insider trading is something that has been evolving over the decades."
Still, some economists say insider trading should be legal. Some argue it's too expensive to enforce the law. Others, including Nobel Prize winner Milton Friedman, have argued that insider trading is actually a good thing, allowing market prices to more quickly reflect information about a company.
George Mason University economics professor Donald J. Boudreaux made this argument in an October 24 opinion piece in The Wall Street Journal: "Far from being so injurious to the economy that its practice must be criminalized, insiders buying and selling stocks based on their knowledge play a critical role in keeping asset prices honest -- in keeping prices from lying to the public about corporate realities."
But that perspective is not widespread, according to Orts. "The way the law is moving internationally is clearly against that [view]," he says. "The only reason you make a lot of money [on insider trades] is that you are hurting other people." Insider trading prohibitions, he adds, are covered in a basic law class that Wharton MBA students are required to take.
In many cases, the damage from insider trading is more theoretical than observable, but not always. "Look at Enron," says Strudler, referring to the Texas energy company that collapsed in scandal early in the decade. The Enron case illustrates one of the most pernicious effects of insider trading: It gives executives a reason to distort reports on corporate performance and find other ways to manipulate markets to their own benefit, he notes. "There was insider trading there, and that was pretty damaging to the firm in the long term. It destroyed it."