Raj Rajaratnam, founder of the Galleon Group hedge fund in New York, has just been found guilty on all counts in one of the largest insider trading cases in U.S history. Amid the discussions on that case and on insider trading generally, the role of technology in communicating information has often been overlooked. Social media networks and advancements in mobile technologies are now critical conduits not just of information but also important drivers of human behavior. Technological developments in how we access and communicate information will continue to factor heavily in the commission of insider trading as well as the enforcement challenges and opportunities, say David N. Lawrence, Steven M. Witzel and William F. Johnson in this opinion piece.
Technology has impacted more than the brick-sized mobile phone that Hollywood gave Michael Douglas’s character Gordon Gekko in the original Wall Street movie (1987) to facilitate his covert receipt of material nonpublic information. Technological innovations and growing social-media networks are now critical conduits of information and also important drivers of human behavior. They will factor heavily in the efforts that regulators make in the future to enforce insider trading laws.
Insider trading has always been the white-collar crime that creates headlines and grabs public attention (as it has done for several months in the Galleon case). The schemes and artifices are often Shakespearian in quality, revealing the nature of our temptations and the manifestations of our flaws. The subplots have involved abuse of trust, misuse of power, greed, corruption, bribery, theft, conspiracy, arrogance, stealth, deception, threats, the allure of drugs and sex, attempted cover-ups and obstruction of justice. Investigative techniques were immutably established long ago — subpoenas, search warrants, physical and electronic surveillance, witnesses, informants, cooperators, confessions and plea bargains.
The secretive nature of this crime mandates that detection is rarely contemporaneous with its commission. Trials are thus historical prisms through which longstanding activity is viewed and judged. Because even the most efficient enforcement efforts cannot catch all violations and violators, successful outcomes must deliver a highly-publicized message of general deterrence: “No one is above the law.”
What exactly is illegal insider trading? The person on the street would likely state they “know it when they see it.” As a matter of law and regulatory application, however, insider trading is far more complicated. Illegal insider trading occurs when a person uses material non-public information to trade securities of a publicly-held company, and where the insider obtains a personal benefit in exchange for breaching a fiduciary duty or other relationship of trust and confidence. The people trading on inside information are divided into two camps — the “tippers” and the “tippees.” A “tipper” is the individual who communicates material nonpublic information about a public company. A “tippee” is the individual who receives and trades, or passes on, this material nonpublic information. The “tippee” is liable if aware of the breach of duty or confidence by his “tipper.”
The reality surrounding the enforcement of laws and regulations involving insider trading is complex. Individuals and businesses typically desire precision in the rules and regulations that govern their conduct. In contrast, the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ) understandably prefer the other side of the trade — that the parameters of illegal conduct remain sufficiently flexible so that enforcement decisions can be made with the broadest possible discretion.
As a result, the precise conduct under the definition of insider trading has always been vague, and purposely so — ambiguous enough to allow enforcement efforts to adapt over time to changed circumstances and to the human instinct to innovate for personal advantage. Former SEC Chairman Arthur Levitt explained this time-honored enforcement approach in a March 2011 interview with Bloomberg News: “If the SEC had an option as to whether they wanted to have greater specificity and the Justice Department as well, they’d say ‘Absolutely not’ because greater specificity would give the legal fraternity various ways of getting around those specifics. They want these laws purposely vague to see to it they have the maximum leverage in terms of bringing cases.”
The ambiguity around insider trading continues to raise questions. Currently open for public review and debate is the question of whether it is legal for a corporate officer of a company to privately buy stock in a target corporation before making a recommendation that potentially leads to the target’s acquisition. This was the critical factor involved in the controversy involving David Sokol, who was widely reputed to be Warren Buffett’s successor at Berkshire Hathaway. Sokol reportedly invested in the stock of Lubrizol just before recommending that Berkshire Hathaway purchase the company.
While the parameters of insider trading may remain vague, the underlying rationales for its prohibition have been consistent and clear. Securities exchanges are the marketing platforms for attracting investment capital and creating liquidity needed to support innovation and economic expansion. Insider trading undermines investor confidence in the integrity and fairness of how investment risk and reward are allocated. As a matter of fundamental fairness to individual investors and fiduciary institutions entrusted with hard-earned savings and retirement funds, the disadvantage that flows from being at the short end of insider information resonates legally as fraud and theft — and, intuitively, as just plain wrong.
Information is power, and that power is controlled by a limited number of insiders. Material information is in relatively short and prized supply. Global stock markets are the open-source trading networks for monetizing knowledge and power that has not been fully shared. Unlike boilerplate warnings for investments in mutual funds, the past charts on the performance of material nonpublic information are highly predictive of the potential and allure for future yields and returns. The motivations also have remained the same over time. They extend beyond financial rewards, and include a wide range of commercial and personal “relationship currencies.” Whether as a matter of empirical proof or human instinct, the risk-reward equation for insider trading always has appeared to — and may, in fact — favor the risk.
Insider trading is an equal opportunity employer — recruiting without regard to age, race, religion, background, sexual orientation, educational background, occupation, social-standing, or monetary need. The perpetrators of these schemes have always claimed the money and reputations of the innocent individuals and institutions.
Recent events confirm these themes. The news of the day is replete with insider trading cases. A prominent hedge fund manager is on trial; a chemist at the Food and Drug Administration has been charged; the former head of a preeminent global consulting firm and independent director of large public companies stands accused; a trusted deputy of a reputable investor is reportedly under investigation; and a lawyer who advised companies on mergers and acquisitions is under arrest as the tipper of a multi-year insider trading ring, among others.
The trial dynamics also are being repeated in recent insider trading cases. Once again, the government takes its witnesses as it finds them. Former co-conspirators, now testifying as government witnesses, remain susceptible to cross examinations based on their motives to cooperate in exchange for reduced jail time, faulty recollections, and inconsistent statements. Third-party witnesses attest to the nonpublic and confidential nature of certain information and their duty not to disclose. The most compelling and incriminating proof comes in the form of the defendant’s own express and implied admissions — words, voice, hand and keystroke. Evidence emanates from a vast array of sources, including electronic recordings of meetings and telephone calls, records of trading activity, emails, text messages, offshore bank accounts and digital fingerprints left behind when systems and sites are accessed.
Levitt provides context and perspective: “It is pretty raw. It goes back [before] the days of Ivan Boesky and bags of cash. People are what people are and in an environment where money is the currency that fuels the system, there’s going to be insider trading … There always will be insider trading and a lot more that hasn’t come out, and never will come out. And I think the best the regulators can do is to find some of the most egregious cases involving some of the most prestigious people which gives us something of a lesson about human nature, where there are massive sums of money, where there are questions of power …
“It doesn’t seem to make sense. The amount of money involved in certain instances is peanuts. But there are other motivations that are more powerful than money, and those motivations are pride and power and part of that comes with the winks and whispers that really what they say and do is that I know something that nobody else knows.”
Nothing has changed about the motivations underlying insider trading. Technological advances, however, signal new conspiratorial horizons for insider trading, as well as challenges and opportunities for enforcement officials. The means by which we connect, communicate, coordinate, organize, associate, and disseminate is evolving in radical and unpredictably entrepreneurial trajectories. The impact has been profound in influencing commercial activity, consumer behavior, reporting of current events, leaking of governmental and corporate secrets, our social and intimate relationships, religious beliefs and even populist regime change. These are becoming embedded and reflected in the commission of our crimes.
What has changed insider trading is both access to material nonpublic information, the connectivity of individuals who are in position to pass along and act upon it, and the multitude of technological platforms for sending and receiving information. Once, the communication of insider information was confined to a direct meeting or a conversation over a landline. Stealth activity was essentially limited to the use of a pay phone, speaking on a third-party’s land-line, maintaining an off-shore bank account, and employing covert and euphemistic language. In 1987, Martin Siegel, former investment banker at Drexel Burnham Lambert, when discussing inside information with a co-conspirator about the then-rumored takeover of Beatrice Foods, coined the infamous phrase: “Your Bunny has a good nose.”
First, the vast and interlocking webs of alleged illegality reveal the greater ability of tippers and tippees to connect with each other. Media reports graphically show a “web” of overlapping interconnections. Unlike the relatively simpler and smaller groups of individuals implicated in the Michael Milken or Ivan Boesky insider trading cases, the web of connections in the Galleon-related cases is overwhelming. It may be that personal networks are larger today than 25 years ago, because of the Internet. Or, perhaps it was more difficult previously for the government to prove the connections between others because more conversations occurred in person, not everyone used a cellular telephone, and ‘social media’ was only a gleam in Gordon Gekko’s eye. Either way, although the concept of an ‘expert network’ may have loosely existed, it was not an established business model. This paradigm of web-based access to networks of individuals with information, with identities often purposely cloaked, was simply not available in Milken’s era.
To effectively understand and pursue insider trading, enforcement officials now have to go far beyond traditional investigative techniques and analyses. The Rajaratnam trial — whose “guilty” verdict has just been delivered on May 11 — and other current cases involving ‘expert networks’ are informative about the future of insider trading and law enforcement. These cases demonstrate how the evolution of technology and connectivity require law enforcement to enlist new twists on investigative techniques. Apart from some notable prosecutions of brokerage “boiler rooms” for stock manipulation in the 1990s, wiretaps were seldom used in white-collar cases. The wiretaps in Galleon and related cases have been critical in convincing various subjects to cooperate with investigations and testify, and provide insights into the network of relationships and communication channels. These results would have been difficult without the overwhelming persuasiveness of the recordings with electronic surveillance.
Government investigators are adopting other tools, too. The SEC last year unveiled a new Market Abuse Unit which aims to identify large-scale insider trading networks and rings. The unit aims “to be proactive by identifying patterns, connections and relationships among traders and institutions at the outset of investigations,” rather than waiting for tips from informants or referrals from stock exchanges about unusual trading. The government is also monitoring activities involving social media sites to determine whether criminals are perpetrating old crimes in new ways. The SEC last year obtained an emergency asset freeze against individuals alleged to be fraudulently touting penny stocks through Facebook and Twitter. The SEC says the individuals received millions of shares of the touted companies as compensation and then sold the shares on the open market while simultaneously using social media to predict massive price increases for the issuers.
The government is also collaborating more with other law enforcement agencies, including those abroad. In November 2010, the Justice Department said that it had collaborated on a lengthy joint insider trading investigation with the SEC and the U.K.’s Financial Services Authority.
Foreign governments too are cracking down on insider trading with more vigor. In December 2010, the European Commission suggested mandatory prison terms for insider trading, and Hong Kong’s Securities and Futures Commission sought to ban a defendant in an insider trading case from futures trading there. In January 2011, the China Securities Regulatory Commission announced that it is making a concerted effort to fight insider trading, and in July that year, Russia passed its first comprehensive insider trading law. Similarly, recent prosecutions in France and Brazil (which culminated in the first criminal convictions for insider trading in that country) have highlighted that insider trading enforcement has indeed gone global.
Yet another point illustrated by the Galleon trial concerns the inherent tensions that arise when information becomes more available and accessible. Efforts to police the markets are challenged by these same advances in technology, as well as competing privacy concerns. A central argument the defense offered in its opening statement in the Rajaratnam case was that the defendant was simply trading on a mosaic of public information and thus was not committing insider trading. Here, the proliferation of information accessible through social media provides a challenge to prosecutors. A defendant can put forth expert testimony that all trades were based on information circulated on a blog or website that was accessible to all investors.
Social media sites can provide important data to investigators as well. For example, the government can subpoena Twitter for who “tweeted” classified or other illegally-obtained information. Or it can review Facebook and LinkedIn-type profiles to establish relationships among co-conspirators. Nevertheless, some attempts by the government to mine social media sites for information have raised privacy concerns. For example, its attempt to force Twitter to turn over “customer or subscriber account information for each account registered to or associated with Wikileaks” prompted the American Civil Liberties Union and the Electronic Frontier Foundation to challenge the government’s rights without a search warrant. The government won that battle, at least for now. In March 2011, a federal magistrate judge re-affirmed a prior order requiring Twitter to produce the subpoenaed information about Wikileaks to the government. Presumably a government subpoena demanding to know the identities of who “tweeted” material nonpublic information or market rumors would likewise be permitted.
As the markets and their participants innovate around connectivity and speed of execution, more will be required for law enforcement to compete in a technological arms race against human nature’s desire to capitalize on information. Previously disparate and disconnected persons, ideas and relationships are now linked globally within seconds, and in 140 characters or less. Developed and developing markets are globally connected in real time with access to 24-7 electronic trading. ”Open” networks and accessible technology do not equate to transparency — Individuals can “surf” anonymously within social network sites and blogs, deploy digital “noms de plume”, utilize disposable cell phones and log into publicly accessible computers at internet cafes. Messages now disappear after proscribed intervals and can never be retrieved. Social networks are veritable independent islands hosting their own records of communication and some technologies appear to be partially impenetrable to effective electronic surveillance. The government will require the private sector’s help to understand and legitimately gain access to relevant records. Network information security will remain a predominant issue, as will the debate over privacy rights.
Finding the probative conversation or message (even with various electronic search technologies) that demonstrates action upon illegal information requires regulators to find the proverbial needle not in the haystack — but in the entire hay field. Many consumers, knowingly and unknowingly, waive their rights of privacy in exchange for digital access, connectivity and freedom of expression. In turn, companies monitor, plot and archive searches, viewings, purchases, travel, relationships, postings and offline activities. Corporate interests will generally seek to protect the sanctity of business models against costly regulatory burdens. Enforcement agencies will need more funding to support improved technological resources and expert personnel.
The government will increasingly be called upon to provide clear digital evidence and forensic compasses that point “true north” to guilt. And, in an age of “reality” entertainment, jurors can now have their post-verdict 15 minutes of non-sequestered fame. They grant interviews, post and tweet about the bases for their deliberations and conclusions, even when cautioned against doing so by judges. More than ever, jurors do not want to be “wrong”.
The past has always been prologue in the realm of insider trading. Access and connectivity have always been integral to this crime. Innovative technologies and social networks will play increasingly central roles in the commission and cover-up of this crime. As a matter of legal and practical precedence, the proliferation of technology and social media offers both obstacles and evidentiary opportunities for law enforcement in their efforts to preserve the integrity and fairness upon which our markets are predicated. The government, however, will require enhanced funding, technological resources and expertise to confront this evolving reality. Continued cooperation from the private sector will be critical to the enforcement effort. Ensuring investor trust and confidence — and, in turn, corporate access to capital — are among the high stakes that hang in the balance.
Editor’s Note: David N. Lawrence is associate general counsel and managing director at Goldman Sachs. Steven M. Witzel and William F. Johnson are partners at Fried, Frank, Harris, Shriver & Jacobson LLP, and along with Mr. Lawrence, are former Assistant United States Attorneys in the Southern District of New York. Samuel P. Groner, an associate at Fried Frank, and Matthew H. Lawrence, an undergraduate student at Brown University, assisted in the research and preparation of this article. The views expressed are entirely personal and not reflective of the institutions with which the authors are, or have been, affiliated.