Insider to Inmate

Billionaire hedge fund manager Raj Rajaratnam’s jail term has drawn attention to arguments for and against insider trading. He is trying to overturn his conviction, arguing that the wire taps that revealed embarrassing details of his insider trading were illegal and that the criteria for judgement was too broad.

By Echelon.

Published on June 10, 2013 with No Comments

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Eleven years! Convicted in 2011 on 14 counts of insider trading and conspiracy, Raj Rajaratnam was sentenced to eleven years behind bars, not to mention a $10 million criminal fine. He was also ordered to disgorge $53 million in illegal profits and pay $93 million in civil penalties, bringing his total outlay to three times what he made through illegal trades. Rajaratnam, currently serving his sentence, has recently filed an appeal. Meanwhile, his younger brother, Rengan, was indicted in March for assisting his inside trading scheme. Insider trading arises where a corporation’s managers or officials come into important knowledge about the firm’s performance or prospects that has yet to reach the public. They can use this information themselves and they can convey it to ‘tippees’ like Rajaratnam, who then become insiders themselves. Insiders can make money by buying shares that will rise in value when the good news comes out or cut losses by selling shares for more than they will be worth when bad news comes out. Such trading is illegal in most countries, though enforcement levels and sanctions vary widely.
Rajaratnam used no violence and his crime is described by his attorneys and some others as essentially ‘victimless’. Granted, his criminal trading – as revealed by wiretaps – was massive, systematic and gleeful. But does the harshness of his penalty reflect frustration over unpunished financial misdeeds elsewhere on Wall Street? The sentencing judge commented that Rajaratnam’s crimes reflect a “virus in our business culture that needs to be eradicated.”
Rajaratnam’s attorneys tried to point out that some of what he thought was inside information was actually public, that some of his inside information was vague or trivial, that some of his advantageous trades occurred before the phone conversation proving his inside knowledge, and that he sometimes failed to trade on his inside news or traded the other way. The jury nevertheless slammed him on each and every count. Again, one can wonder whether rage at rule-flouting fatcats got out of control in the trial, combined perhaps with resentment that this particular fatcat was an obvious immigrant when so many native-born Americans could not even find a job. Some experts wonder whether insider trading should be illegal at all.
Conventional wisdom deems insider trading ‘unfair’ as well as scary to lay investors who will shun markets where it prevails for fear of losing a rigged game. By chilling investment and capital supply, insider trading raises capital costs. Evidence for this chilling effect is weak it turns out, but the subject is difficult to study because the inside nature of the trades is secret, making it hard to say how much is going on and where. To whom in particular would insider trading be ‘unfair’? Long-term shareholders lose nothing on their investments from insider trading, which affects only gain-loss allocations among active traders. Some say insider trading might actually produce higher stock prices because firms could pay lower salaries to managers who can profit on secret information.
Nor is it clear that outsiders as a whole lose from trading with insiders. Outsiders poised to trade may even benefit secondhand from inside information. Insiders with positive secret information will pay a premium for the stock over what other buyers would pay, thereby conferring a bonus on the seller. Of course, that seller might complain that his bonus was too small when he sees the high price the stock reaches when the positive secret comes out. But since he wanted to sell when he wanted to sell and actually hauled in a bonus, what’s his beef? Similarly with negative secrets leading insiders to sell at a discount: buyers get a better price from them than from sellers who don’t know the bad news yet. Lucky the investor who trades with an insider!
So who loses? Consider two groups among both sellers and buyers: those who have decided to make a trade and those who are considering it but hesitating in hopes of a better price. As we have just seen, the already-decideds may unwittingly snag a windfall if lucky enough to trade with an insider. We don’t want to hear any whining that you would have done even better if you had waited to do what you had already decided to do at once. More sympathetic is your hesitant friend there who says she was waiting for a better price and jumped in when the insider offered her one. If that had not happened, she would have waited and made a great deal when the secret news went public. She was lured into buying a beautiful bracelet with fake rubies or into selling one with gold in it, as only her buyer knew. So, some of the whiners are actually winners while others are right to cry. On what basis do we decide that concern for the latter, prompting us to ban insider trading, outweighs concern for the former, who actually lose out from a ban? Perhaps the best answer is that no one can tell who the winners and losers really are and everyone feels after the fact that they fall among the losers. Once the secret news goes public, no one will admit even to himself that he was committed to trading in any case.
Strong objections to insider trading can be made on grounds of corporate governance. When managers delay publication, their own boards of directors may be kept in the dark along with the markets. Directors cannot guide corporate decision-making effectively without access to critical information. Equally problematic, inside-trading managers can easily profit on negative developments, thereby pulling their own incentives out of alignment with their company’s. They may even make moves disconsonant with company interests just to generate inside news on which they can profitably trade.
It seems then that corporate governance concerns alone amply justify laws against insider trading. Add to that an observation that money seems to flow more richly and fluidly in markets where corporate governance standards are generally high. Aside from his insider trading, Rajaratnam made tonnes of perfectly legal money in robust markets made possible by a web of U.S. regulation and investor confidence. He should have had more respect for the rules of a system that made him very, very rich. Critics of insider trading laws nevertheless add several final arguments: restrictions have little real impact; they are costly to enforce; and there is great danger of selective enforcement. On all this, Rajaratnam just might be their perfect poster boy, but none of it will get him out of jail. In his appeal, however, Rajaratnam contends there were two key legal errors at his trial. If he convinces an appellate court on either count, his conviction will be reversed.
First, the trial judge instructed the jury that they must find a violation if insider information was a ‘factor, however small’ in a decision to trade. This essentially means that holders of inside information must abstain from trading the security in question. Though that seems sound, courts elsewhere have maintained that no violation should be found unless insider information was the ‘basis’ for the trading decision. If Rajaratnam persuades the appeals court that ‘basis’ is the right legal rule and that ‘factor’ is too broad, he wins reversal based on erroneous application of the law.
Second, Rajaratnam claims legal error in allowing the jury to hear phone-tapped conversations because, as he contends, warrants for the taps were wrongfully authorized. Wiretap authorization requirements protect citizens from privacy-invading police surveillance. Since damning evidence came from phone taps, Rajaratnam’s conviction must be overturned if they were not properly authorized. Such is the controversial American ‘exclusionary rule,’ which forbids using illegally-obtained evidence against criminal defendants.
Wiretap authorization requires prosecutors to show ‘necessity’: that normal investigative techniques would fail to turn up evidence of likely crimes. Prosecutors in Rajaratnam’s case claimed that methods like interviews, depositions, subpoenas and search warrants would prove futile, despite knowing that securities regulators had used those very techniques to build a substantial civil case against Mr. Rajaratnam. If circumstances like these can be called ‘necessity,’ it differs little from ‘convenience.’

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