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Who's Hurt by Insider Trading

Who's Hurt by Insider Trading

A court recently issued Raj Rajaratnam the harshest sentence to date for insider trading: 11 years in prison. Insider trading is far from a victimless crime. It erodes our very economic foundation. However, it seems that every time I read about someone being convicted, the government is the only one offering high-fives to fellow prosecutors. I've rarely seen the public rejoice in a conviction for insider trading.

By Theodore F. di Stefano
11/04/11 8:00 AM PT

One would think that after all of the publicity in recent years about insider trading and its illegality, that such a phenomenon would be a thing of the past. Not so.

On Oct. 13, 2011, the hedge fund billionaire Raj Rajaratnam, received the longest prison sentence to date for insider trading. A judge for the Federal District Court of Manhattan, Richard J. Howell, sentenced Rajaratnam to 11 years in prison.

What's Wrong With Insider Trading?

I have no doubt that there are still people who wonder what the big deal is about insider trading. It seems to be a victimless crime, right?

The fact is that such trading erodes our very economic foundation. Why is that? Because such trading creates a trading field that is not level -- meaning only certain "special" people on this trading field possess valuable information about specific securities. Such information has the effect of oversized gains for a certain few and losses to the masses. This is patently unfair on its face.

Our economic system and stock exchanges need to be efficient and honest. This means that everyone involved in trading securities has access to the same information as everyone else. It doesn't necessarily mean that someone involved in the stock market will take advantage of the available information. It does mean, however, that no information is hidden from any participants in our markets.

Rajaratnam has paid dearly for his moral lapses. Besides being sentenced to 11 years in prison, he must pay a US$10 million fine and forfeit $53.8 million of his illegal profits from insider trading. The interesting (and wonderful) thing about this sentence is that the profits Rajaratnam made from information that wasn't available to the entire market must be returned. This sentence specifically quantifies the illegal gains derived by a person who had information that the general market did not. It clearly shows that nature abhors a vacuum -- the vacuum created by all of the information possessed by Rajaratnam and not possessed by the rest of the market.

How Do We Define Insiders?

An insider would be a majority stockholder, the directors of a corporation, management, the company's lawyers and accountants. Additionally, an insider is anyone who has a fiduciary relationship with the organization -- a relationship of trust. Additionally, if anyone is privy to information that is not available to the general public, he or she is an insider.

One must keep in mind, therefore, the so-called level playing field when confronted with a situation that could give a person more access to information than the general public has. Markets must be efficient in order for our economy to function properly. They become inefficient when information is held only by a "chosen" few and not by the general public.

If you are confronted with a situation where someone offers you a tip about a particular stock, you must ask yourself, does the general public have access to the information that I'm being offered? If the answer is no, then I would decline the perceived opportunity to make a quick buck.

Why Aren't Investors More Upset About Insider Trading?

It seems that every time I read a case about someone being convicted of insider trading, the government is the only one offering high-fives to fellow prosecutors. I rarely have seen a case where the public rejoices in a conviction for insider trading.

The fact is that most investors don't seem to realize that by someone's greed, vis-a-vis his/her making use of information that is not generally available to the investing public, the investors are being hurt. Investors don't normally feel the pinch in their pocket from illicit trading. The pain is spread among all of the investors in a particular stock and usually a person doesn't even realize that he/she has suffered in some fashion due to insider trading.

Bernard Madoff, the now infamous former head of Bernard L. Madoff Investment Securities, was not actually convicted of insider trading. He was convicted and sentenced for securities fraud, theft, money laundering and perjury. He is now on an extended "vacation" in a federal prison, having been sentenced to 150 years.

In his case, his crimes had a direct impact on people's lives. He substantially affected individual investors' financial wellbeing. They were justifiably outraged at him because they personally felt the pain of his misdeeds.

Additionally, there were many charities that had placed their trust and their money in Madoff's company. They also were directly affected by what he did.

In the case of insider trading, individuals usually don't directly feel the impact of someone else's greed. This is because of the insidious nature of such a crime. It's often too subtle to have a noticeable impact on most investors.

Hedge Fund's Under the Insider Microscope

Rajaratnam was at the head of a hedge fund, Galleon Group, which was the largest hedge fund insider case discovered and prosecuted to date. I personally feel that the vast majority of the investors in Galleon had no clue about what was going on. They were probably content with the profits being made by the Galleon Group. No doubt, Rajaratnam was equally content. Forbes magazine estimated Mr. Rajaratnam's net worth at $1.5 billion in 2009. He easily could have done without the $53.8 million of illegal profits that he was ordered to pay back due to his insider trading conviction.

There is no doubt in my mind that hedge funds have now gotten the attention of prosecutors and they will be watching for oversized profits by head fund managers and traders.

Will we still see insider-trading prosecutions in the future? Because there are times when greed seems to trump morals and logic, I have no doubt that we will!

Good luck!


Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at Ted@capitalsourcepartners.com.


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