Why Is Insider Trading Wrong?
BY PETER J. HENNING
Rick Maiman/Bloomberg NewsRaj Rajaratnam, the Galleon Group’s co-founder, heading into federal court in Manhattan on Monday.Raj Rajaratnam, the head of the Galleon Group, is defending himself against charges of insider trading by arguing that his trades were based on the so-called “mosaic theory,” which means his firm gathered information from every nook and cranny of the market to put together a picture of a company.
Under this analysis, information received from a source inside a company would not be sufficiently important to be “material” to the ultimate investment decision because of all the other information available, so there was nothing illegal about his trading.
If successful, this defense effectively calls into question why insider trading is considered wrongful if it is possible that one could have traded while in possession of confidential information yet not engage in secu......
rities fraud.
rities fraud.
Judge Richard J. Holwell, in Federal District Court in Manhattan, is allowing Professor Gregg A. Jarrell, an economics and finance professor at the University of Rochester, to testify for the defense about the “economic materiality” of information to bolster the argument that anything confidential disclosed to Mr. Rajaratnam was already incorporated in the price of the stocks he later traded. Under this approach, if similar information was already available to the market, then any confidential information would not add anything of importance for investors.
The defense argument is that if everyone were already aware of the underlying information, then Mr. Rajaratnam’s purchases and sales would not constitute securities fraud. For basketball fans, this is known as “no harm, no foul
Unlike larceny, however, it is difficult to identify any particular victim of insider trading. If the transactions at issue involved common stock, then the trades occurred on impersonal securities markets like the New York Stock Exchange or the Nasdaq in which buyers and sellers never meet, instead making their transactions through intermediary brokers and the trades completed by a quick keystroke on a computer. To say that the person selling (or buying) the shares on the opposite side of the trader with inside information is a victim stretches that term far beyond its usual meaning in criminal law.Insider trading is illegal because it is a form of securities fraud, and fraud is viewed as a type of larceny or theft. That crime requires proof that a defendant took something from another person with the intent to steal it. This is one of the most common crimes committed, as most people have been victims at one time of petty thefts like having a purse or wallet stolen or an item taken from a car.
The broader market could be viewed as a victim when prices for securities are skewed because one party is trading on inside information unavailable to others. Professor Jarrell’s analysis is that information equivalent to what Mr. Rajaratnam received was already available, so that the market had largely factored in what was learned from sources inside various companies. It is difficult to see how the market would be harmed when there are numerous informational disparities that have nothing to do with insider trading, like good fundamental research.
The Justice Department and the Securities and Exchange Commission often cite the loss of confidence in the markets as a reason to pursue insider trading. In announcing the charges against Mr. Rajaratnam and his co-defendants in October 2009, a news release quoted an F.B.I. agent, Joseph Demarest Jr., as stating the charges were filed “to ensure integrity in the marketplace, to protect the average investor, and by extension, the economy.”
Insider trading does not appear to have any appreciable effect on the markets, at least as measured by the volume of trading that occurs. The Justice Department’s last witness presented evidence showing that Mr. Rajaratnam made approximately $63 million in profits or losses avoided from his trading over the course of four years in a dozen stocks. Given that billions of shares trade on a daily basis, it is hard to imagine that these trades had much impact on the markets.
The companies whose information was taken have a stronger claim to being victims of the fraud because it is their own information that is stolen and used for personal gain by someone else. While that might support a charge of mail or wire fraud against those who orchestrated the improper disclosure, it is more difficult to see how the company is a victim of securities fraud when it is the shareholders who are actually involved in the trading, not the corporate entity.
There is also the argument that insider trading is simply unfair when a corporate insider or outside adviser takes advantage of access to information to reap significant personal gains that are unavailable to other investors. Steven M. Bainbridge points out in his book “Insider Trading” that “given the draconian penalties associated with insider trading, however, vague and poorly articulated notions of fairness surely provide an insufficient justification for the prohibition.”
Perhaps the strongest argument about why insider trading is wrong is the simplest: because it is. While there is no clear definition of what “material” information is, there is no question that it is against the law and will be prosecuted if discovered. Congress has endorsed prohibiting insider trading by adding to the penalties the S.E.C. can assess for violations, and extending to private investors a right to pursue claims. As Professor Bainbridge notes, “the federal insider trading prohibition is doubtless here to stay.”
The clearest validation of this notion is the recent spate of insider trading prosecutions in which defendants went to great lengths to conceal their trading.Charges were filed last week against a corporate lawyer, Matthew H. Kluger, and a trader, Garrett D. Bauer, alleging that they used disposable cellphones and cash transactions to hide an insider trading scheme that stretched over 17 years while Mr. Kluger worked for a number of leading law firms.
On March 29, the Justice Department and S.E.C. accused a chemist at the Food and Drug Administration for trading in pharmaceutical companies after accessing a confidential agency database for information about pending drug applications. He is accused of using seven brokerage accounts in the names of others, including one for his 84-year old mother in China.
If proven, these cases show the defendants clearly understood their conduct violated the law; otherwise, why go to such lengths to cover it up? It will be difficult for them to offer Mr. Rajaratnam’s defense that the information they accessed was already available in the market when it was subject to protection by the attorney-client privilege and government regulation. Working that hard to avoid detection can be powerful proof of their intent to defraud and the materiality of the information.
The evidence at Mr. Rajaratnam’s trial hinted at efforts to cover up the sources of his information, but nothing indicates that he engaged in the types of subterfuge seen in other recent prosecutions. That lends at least some credence to the defense argument that the mosaic theory explains his trading and that he did not intend to violate the securities laws.
If Mr. Rajaratnam’s defense succeeds, it will be much more difficult for the Justice Department and the S.E.C. to pursue insider trading cases against outsider investors like hedge funds that work to pry information from various sources about companies to decide whether to invest. A “not guilty” verdict would weaken the prohibition on insider trading, but certainly not eliminate it entirely, at least in those cases where a defendant works hard to keep the trading a secret and abuses access to confidential information.
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