Turning Up the Heat on Insider Trading

Criminal and civil allegations of insider trading recently were filed against Brian Jorgenson, a senior portfolio manager at Microsoft. This news amazed me, because over the last few years there has been an abundance of published information about the hazards of insider trading, especially the criminal consequences.

Consider what happened to the hedge fund billionaire, Raj Rajaratnam. District Court Judge Richard J. Howell in 2011 sentenced Rajaratnam to 11 years in prison, the longest prison sentence to date for insider trading. Rajaratnam also had to pay a US$10 million fine and forfeit $53.8 million of his illegal profits from insider trading.

A Brief Primer on Insider Trading

What’s the big deal about insider trading, you may ask? The answer is that U.S. markets are designed so that there is a free flow of information, and every individual is permitted to have the same access to that information. This creates a level playing field in which competitors for a stock are all playing under the same rules.

The U.S.’ economic stability depends on this free flow of information. When the closing bell rings at the end of each day, it should be safe to assume that the trading that went on during that day did not favor one group or individual over others, especially when it comes to the availability of financial data on particular companies. No one individual or firm is allowed to have a head start in the competitive game of buying shares.

When every purchaser of a stock is potentially in the same position as every other purchaser, insofar as availability of information goes, then there is a so-called efficient stock market whose values can be assumed to be fairly and openly determined. If not, the U.S.’ entire financial structure could be brought down.

When Is Someone an Insider?

Insiders include majority stockholders, directors of a corporation, management, and company lawyers and accountants. Additionally, an insider can be anyone who has a fiduciary relationship with an organization — a relationship of trust. Anyone who is privy to information that is not available to the general public is an insider.

When confronted with a situation that could allow more access to information than the general public has, one must keep in mind the so-called level playing field. Markets must be efficient in order for the 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 someone offering 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 you should decline the perceived opportunity to make a quick buck.

Insider Trading Laws

There is nothing particularly new about the illegality of insider trading. Laws prohibiting it have been around since before the SEC Act of 1934. Their intent was, and still is, to make the purchase of securities an open and fair process.

When you are purchasing a security, you expect that you are paying a fair price and that no else had a headstart in purchasing the same security for a far cheaper price, assuming that both you and the prior purchaser had the same information. That’s the big assumption: the availability of identical information to both of you.

An illegal trade occurs when an insider has some pre-knowledge of an event that outsiders don’t have access to — and acts on that knowledge by purchasing a security.

When the information that the insider has finally goes public, the market responds accordingly by increasing the price of the stock. The insider can then dump the shares and make a tidy profit, all to the detriment of those who have played the game honestly.

What’s the Solution?

Unfortunately, there is no easy solution. The reason for this is that the SEC and other related entities do not have the manpower to police every suspicious transaction — or, for that matter, to even be aware of each time a suspicious transaction occurs.

The best alternative for law enforcement agencies may be to target an especially high-profile case, like the case of the billionaire Raj Rajaratnam, and make a severe example of him in order to deter future transgressions. When I initially read about the Rajaratnam case, I thought that the tremendous monetary and personal penalty he received would certainly deter future transgressors.

Unfortunately, human nature being what it is, we always will have a greedy person who tries to circumvent the law in order to make a quick profit. The best that we can hope for is increased vigilance on the part of the SEC and other authorities.

Of course, when a prominent person gets caught and is publicly exposed, fined and jailed, that usually serves as a warning to insider traders!

Theodore F. di Stefano

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 [email protected]. Follow Theodore F. di Stefano on Twitter.

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