What to Make of Insider Trading
As October 16 dawned, agents from the Federal Bureau of Investigation handcuffed billionaire Raj Rajaratnam at his Manhattan apartment, launching the largest insider trading case in a generation. The 52-year old Sri Lankan immigrant had been running Galleon Group since 1997, a hedge fund that oversaw $7 billion in assets at its peak.
Along with Rajaratnam, federal prosecutors and the Securities and Exchange Commission charged five other defendants that Friday. A few weeks later, on November 5, prosecutors swooped again, arresting another nine people for criminal conspiracy and illegal trades allegedly executed over three years, resulting in as much as $53 million in profits. Galleon's extensive, swirling network encompassed various companies, including Google, Hilton, AMD and IBM.
The scandal, which has rocked Wall Street, has far reaching implications: how widespread is insider trading abuse, among the hedge fund community, other financial institutions, and even deep in Corporate America? Is the Galleon cast of characters a barrel of exceptionally bad apples? Or did authorities choose it for an example, picked as a warning at large?
In the incestuous hedge fund community, information is constantly exchanged, as those engaged in so-called fast money discuss their activities. These conversations may consist of gossip or intentions, such as, "You should consider this or that stock, or let's both buy it!" The line between illegal and unethical can be thin. "Most sell side people inside the investment community firmly believe that a significant percentage of hedge fund activity is questionable," says Stanley Fortgang of LECG, who traded fixed income at Goldman Sachs from 1990 to 2000, and at Morgan Stanley from 2001 to 2008. He adds, "Another significant portion would argue many hedge funds are completely corrupt. They see the Galleon case and they snicker."
None less than Robert Khuzami, who is the SEC's enforcement director, labeled hedge funds' aggressive information gathering as "systemic". At the Bloomberg Washington Summit on November 13, Khuzami characterized that behaviour as "potentially more dangerous" than opportunistic trading.
"If you put a lot of sugar in one place you get ants," comments Vikas Agarwal, a finance professor at Georgia State University. He references the proliferation of good, bad and mediocre managers who have flooded the hedge fund industry in recent years, many migrating from the mutual fund space. Whereas earlier generations of hedge fund managers often represented the most talented and hardworking people, the phenomenal returns of that era drew in a new crowd of less stellar professionals. While these might not act in strict collusion, they behaved like a herd of sheep, Fortgang recalls. "At our trading desks, every hedge fund would call to buy the same popular security. We would laugh, and say, ‘we just got off the hedge fund conference call!'"
A core question is whether hedge funds have achieved better returns, or alpha, because they are more skillful, or because they are less regulated, and operate on the cusp of questionable activity. Agarwal estimates that about 4300 hedge funds were operating in 2001, growing to 7100 by 2005, and probably numbering close to 10,000 today. With so many players, there is pressure and temptation to seek even the smallest edge.
Agarwal reports that he has collected and analyzed data on hedge fund fraud, discovering only about 100 cases over a ten-year period through 2007. While it somewhat surprised him to find a relatively modest number, compared to corporate instances, he considers the possibility that some hedge fund fraud is underreported to the SEC by those investors who lose money.
Or perhaps insider trading activities in fact extend beyond the hedge fund universe, deep into the corporate world. The Galleon case in itself reveals a wide network of well placed individuals in high level corporate positions in publicly traded companies. The group of those charged included executives from Intel, McKinsey, Moody's, a former Bear Stearns fund and others. One Galleon employee, Zvi Goffer, had penetrated so many circles that fellow scammers nicknamed him "The Octopussy." John Hueston, currently an attorney at Irell & Manella, cross-examined Kenneth Lay in the Enron litigation in 2002 as co-lead prosecutor. He notes that the Galleon interconnections "show a network of alleged greed through layers of corporate America, highlighting the dangers of comprehensive trading of information."
Hueston argues that insider prosecutions serve at best as deterrents. "When corporate America relies on a criminal process to remedy the system, the system is already broken. Resources deployed almost always exceed monies recovered," he says. Consider how some motorists exceed the speed limit, sometimes zooming over 90 mph. There are never enough police to guard every corner. Police may leave a decoy, a patrol car with blinkers and a mannequin inside, to send speed demons a message. If the point of insider trading enforcement is to deter conduct, then catching smaller cases may even be most effective, as a warning that small fry cannot count on escaping attention.
With their limited resources, government authorities face two sets of challenges. It is difficult enough to identify sufficiently suspicious insider trading patterns; then comes the daunting task of prosecution. "Until five years ago, the government spent more on Marine Corps marching bands than own the whole SEC budget!" notes Jim Heinzman, managing director at Actimize, whose software regulators use to monitor trading.
The most straightforward cases develop when an insider comes forward to rat out a scheme. More typically, regulators start by combing their software to pinpoint a spike in trading volume or price of a security, especially surrounding business announcements, like mergers, drug approvals or mineral discoveries. Algorithms calculate price and volume fluctuations over a period, perhaps six months, and how they may deviate from a current price function. For example, a discrepancy of, say, two standard deviations, might signal an anomaly.
Once regulators spot an anomalous deviant, they must establish exactly who traded in front of a news event. "Unlike private firms, the SEC does not have access to customer information data, like names, identity numbers or historical trading records of customer positions," Heinzman explains. So the SEC must perform a labor intensive ‘Blue Sheet' request, asking the major firms who cleared and settled the suspect trades for information from their own control lists. It takes time for the firms to search many months through a ‘lookback period', and respond, possibly to several further rounds of questions. For instance, if someone consistently trades 1000 shares on the third Tuesday of each month, even a large transaction may not merit further investigation.
The next level involves an analysis of relationships and patterns. "The SEC, which is mostly composed of lawyers and accountants, may lack the street smart-type skill sets for forensic review," says Heinzman. Enter professionals, such as Steve Lee, who runs a forensic detective service from Los Angeles. Lee, who has conducted numerous high profile cases, looks for social networking date, such as old school ties, charitable contributions and connections between firms and individuals. The paper trail may encompass telephone contact records or personal emails unrelated to trading.
"Hedge fund managers are typically younger, less risk averse and less experienced with regulations than other investment institutions," Lee suggests. "They may be more flatfooted about protections like document retentions." He points out some of the naivete and "sheer silliness" in the reported Galleon activities, like disposable cell phones - was someone watching too much television? According to security experts, disposable phones, which narcotics traffickers use, tend to attract attention and encourage surveillance. Even secure land lines, with digitally encrypted voice communications would be safer. Lee doubts Galleon participants ever consulted their own attorneys, who would have recommended they "convey information face-to-face, or get a runner."
After having assembled multiple clues, drawn inferences and established plausible connections, authorities typically move in like a swat team clearing a building. They pick targets, moving swiftly from one witness to another, trying to induce cooperation in return for plea bargains.
Proving and winning an insider case now becomes a huge hurdle. The prosecution must be able to show knowledge and intent, the latter always the hardest element. The Galleon case is most notable for its use of wiretaps as an investigative technique, hitherto an unusual ploy outside of organized crime, narcotics distribution or counter terrorism. "It's time consuming to apply to a judge for a wiretap. Then you must commit resources to monitoring and interpreting it," says Andrew Hruska, an attorney with King & Spalding, who previously obtained and supervised wiretaps during his eight years in the state and federal justice systems. "But they are very effective, even more than written correspondence or emails, to show a jury what defendents were saying or thinking in unguarded moments," he explains.
More crimes are committed than prosecuted, so authorities must choose their battles carefully, and win them. Losing is a big black eye, like the recent verdicts in the Bear Stearns fund managers Cioffi and Tannin cases. "It's a momentum game," says Hueston. "If they succeed, that inspires more cases, but if not, will be seen as a waste of resources." Besides, there is value in law enforcement to getting recognition. Regulators can hire better candidates when they are perceived as being effective.
If nothing succeeds like success, did authorities initially decided to focus on Rajaratnam because his case seemed winnable? Hueston guesses that the FBI had "developed a terrific cooperating witness, which is how big cases inevitably start." Craig Lilly, an attorney with Squire, Sanders & Dempsey, agrees that a key to convictions is often a cooperating witness, an element missing from the Bear Stearns case, which depended only on email exchanges. He says the Galleon matter appears egregious, "because of the quantity of trades, number of corroborating witnesses, and pattern of a longterm course of conduct, rather than an isolated incident."
Some observers have suggested that Rajaratnam could serve as a whipping boy, or at least as a defendant less sympathetic to a jury. Was the heavy-set Sri Lankan billionaire, with his network of mostly Asian alleged co-conspirators, picked in part for its image as a group of outsiders?
Yet the complexity of the web, and the scope and scale of activity would indicate that was not a primary reason. Perhaps, though, "Connecticut Yankees" differ from the Galleon protagonists in style, Lee posits. Lilly, who clearly does not regard Rajaratnam as a scapegoat, nonetheless considers that "gambling can be more pervasive and acceptable in Eastern cultures, where stock trading is also perceived that way. It might even lead to some cultural disregard for Western rules."
It is one matter to take investment risks, but what would motivate anybody, from any culture, to jeopardize an entire livelihood, and even prison, for such comparatively meager sums? Recall that charges involve profits of about $53 million, a kind of hedge fund shoplifting in the context of a $7 billion empire.
On one hand, the pressure to perform in the hedge fund industry is immense, with status built around an ability to beat the market. So every dollar counts. "Money becomes more than money, but a means of keeping score against competitors," says Hruska. Besides, insider traders rarely get caught immediately. Like a child, who is not punished right away, it may seem tempting to keep pushing luck.
Alternatively, that $53 million could be the tip of an iceberg. "For all we know, it represented his whole business model and was, in fact, all he had," says Fortgang, who hypothesizes, "perhaps it was not just him and his employees, but other people who wanted to be paid for information and knocked on his door."
Greed knows no bounds. "It ultimately boils down to incentives," Agarwal contends. Hedge fund managers must be able to deliver superior performance in terms of risk-adjusted returns, to justify their hefty fees. He compares their positions with those of option holders: for an option, the nearer the money (close to break even on the exercise price), the higher the motivation to make additional efforts. "The hedge fund concept resembles that of CEO executive stock options, which may incent CEOs to take on additional risk, as a perverse outcome of the option structure."
That structure means it is possible "to zero in on those funds most likely to benefit from incentives and opportunities, by dividing the hedge fund universe among those which are in, out of, or near the money," Agarwal explains. He has done research on "returns management" in funds, whereby managers engaged in various accounting manipulations to achieve a temporary lift in December - such as stuffing the cookie jar, or borrowing from the future by eliciting early orders from best clients. Why December? Managers at or near the money are determined to make their bonuses, which can mean 20% of profits in the hedge arena. By a similar token, the temptation to cross the line into illicit activities can be more powerful for those who stand to gain the money in fees. "I wouldn't be surprised if that includes going into illegal territories. It's at least a way for regulators to think about the problem," Agawal proposes.
Authorities do indeed appear receptive to new approaches. When Hueston first heard the breaking news of the Galleon investigation, he wondered "what the big deal was." After all, insider trading cases have been around almost as long as Ponzi schemes. He soon concluded that "what is now different is the new focus of huge resources directed at these types of crimes, resulting in larger prosecutions."
The environment has altered drastically, especially the speed at which information travels and is disseminated. In the nineteenth century, the Rothschilds amassed fortunes by relaying news from the battlefield by carrier pigeon. Later, J.P.Morgan utilized the recently invented stock ticker to obtain faster quotes from the New York Stock Exchange, while competitors waited for closing prices from the Dow Jones Customers Afternoon Letter. Michael Mann, at attorney at Richards Kibbe & Orbe, describes the change in the ability to access and transmit in milliseconds what used to be valuable information. In past decades, clients wondered whether they were permitted to trade on judges' rulings in antitrust cases before the rest of the market, by sending somebody to sit in a court room with an open cell phone. Others, meanwhile, had to wait for Dow Jones to report. "The edge from good research has increasingly narrowed," says Mann. "There is constant pressure to improve that advantage, and insider trading represents the perfect edge."
Along with advances in communications, sophisticated technology has transformed the market surveillance conducted by exchanges, self regulatory organizations and financial firms themselves. Today, every brokerage firm tapes its employees, and is able to search electronically for key words. The capability to crunch a terabyte of email grows ever more refined. And as noted, the use of wiretaps in the Galleon case may be a harbinger of a future trend in white collar prosecutions.
Meanwhile, individuals appear increasingly lax about how they share information. Contrast today's behaviors to the insider scandals of the 1980's, when pieces of specific information could prove intensely valuable, causing a stock to double overnight. Mann compares that era to the Galleon actions, which center on everyday valuations of securities. While the Galleon information was clearly "over the line," it was also only incrementally valuable to the investments.
Investors, on the other hand, have shown they are not lax or casual about insider trading charges. This time they voted with their feet. After Rajaratnam's arrest on Friday October 16, the following Monday, Galleon proclaimed that the firm would continue to operate, business as usual. Twenty-four hours later, the message changed drastically. As investors scrambled to withdraw money, the fund was compelled to announce it was winding down.
Lilly predicts a surge in prosecutions, "not necessarily because the activity is becoming more prevalent, but because the SEC wants to show it can be aggressive." Nor has this fresh focus been prompted merely by the Bernard Madoff and Allen Stanford fraud revelations of the past year. Authorities were already hot on Rajaratnam's trail long before those scandals erupted. As the Galleon indictments have revealed, it may take several years to develop comprehensive white collar investigation. Only now we are beginning the see the fruits of the investment of resources from several years ago. Money managers across the industry are taking heed. Who will be next in line to face the music?
SIDEBAR: The Case for No Case
A minority of academics and legal experts contend that insider trading, a victimless crime, should be legalized, generally citing a cost benefit argument. "They maintain that if you have to spend more resources on catching the criminals than the benefits you gain, it's probably not worth it," Vikas Agarwal explains.
First, it is obviously impossible to police or enforce the law on a widespread scale, since most instances are undetectable. A few publicized cases must serve as deterrents. A more subtle thesis centers on market efficiency. Some facts usually seep from insiders to become incorporated into prices, moving them to correct levels - or at least economic realities. In theory, insiders should even be trading and arbitraging among themselves, acting as their own whistleblowers.
Any given piece of data can constitute a chunk of a final mosaic that renders the whole jigsaw puzzle understandable. "If courts were to treat the final jigsaw pieces as material, that would reduce the speed with which information is impounded and discounted into asset prices. Any chilling effect on impounding would interfere with a fundamental tenet of how securities markets operate," says Steve Lee. "We rely on outsiders' pursuit of self interest and extremely rapid price changes to produce efficiency."
A much more dubious proposition states that insider trading actually works as an incentive, an adjunct "way to compensate insiders," says Agarwal. During the internet boom in particular, advantageous information often enabled firms to attract talented employees less expensively.
Defenders of the status quo respond vigorously, that insider laws protect overall confidence. The SEC announces on its website that it enforces violations as a priority, because "insider trading undermines investor confidences in the fairness and integrity of securities markets."
