In 2009, the Securities and Exchange Commission (SEC) charged nine firms with insider trading, one of the highest in years.
According to the SEC, insider-trading profits netted more then $70 million in 2009 and those known are only the tip of the iceberg. Insider trading occurs when an investor or firm benefits illegally from nonpublic, confidential information.
“There are a number of studies that indicate a lot of insider trading is occurring,” said Eric W. Orts, a professor at the University of Pennsylvania, according to a recent Knowledge @ Wharton (KW) report.
“Usually there is a radical increase (in trading) before the public announcement of the event. So the question is: What is explaining that increase...? And the best explanation is that somebody is getting the information ahead of the news,” said Orts.
The latest insider-trading scheme—uncovered by the SEC in November—netted $20 million and the first in the link among the defendants was Arthur J. Cutillo, a lawyer at Ropes & Gray LLP.
A total of two attorneys, six securities traders, and two hedge fund portfolio managers were part of the conspiracy. Zvi Goffer, a trader at the Schottenfeld Group, tipped off his trading buddies via disposable cell phones, a clear indication that the group was well aware of the illegality of their activities.
“Goffer was known as ‘the Octopussy’ within the insider trading ring due to his reputation for having his arms in so many sources of inside information,” the SEC said.
The most infamous insider-trading charges this year were leveled against Raj Rajaratnam, owner of the New York-based Galleon Management LP. A total of 19 individuals were uncovered and others may be added to the list of defendants. The individuals were charged with earning $33 million in illicit profits.
“What we have uncovered in the trading activities of Raj Rajaratnam is that the secret of his success is not genius trading strategies. He is not the astute study of company fundamentals or marketplace trends that he is widely thought to be. Raj Rajaratnam is not a master of the universe, but rather a master of the rolodex,” said SEC investigators in a recent press release.
Until news of the insider-trading charges broke, Galleon was one of the most well-respected and successful securities firms in the industry.
A review of the 2009 SEC actions shows that individuals working in prestigious positions—with much to lose if discovered—often forgot their fiduciary responsibilities, ethical behavior and associated integrity, and took part in clandestine and underground insider-trading activities.
Insider Trading is Hard to Prove
Evidence from insider-trading market studies indicates that such practice is very common in Wall Street circles and that the SEC has only skimmed the tip of the iceberg in their effort to root out the practice.
“Many allegations of insider trading are hobbled by weak evidence like suspicious stock trades just before key corporate announcements,” University of Pennsylvania professors said in a recent KW study.
While some liberal reformists don’t see insider trading as having a large impact on the financial markets at large, others, such as Jeremy J. Siegel, a finance professor at the Wharton School of Business, believes otherwise.
Siegel’s research indicates that in the long run, when insider trading occurs, investors are the losers. The common investors will see their costs higher or their profits lower than what could have been in a true market situation.
Most importantly, allegations of insider trading impact an affected company’s ability to raise funds in capital markets and have a demoralizing effect on public confidence.
Research indicates that insider trading is often hard to distinguish from regular trading, unless a frenzied flurry of trading activity occurs before sensitive information is made public.
“The line between information that’s public and information that’s not public, in lots of cases, is difficult [to define],” said Alan Strudler, professor of legal studies and business ethics, in the KW article.
For example, insider trading contributed to the downfall of oil and gas-trading firm Enron Corp. in 2001. Former Enron executives Jeffrey Skilling and Paula Rieker, and Kenneth Lay, founder of Enron, were all charged with insider trading.
“The Enron case illustrates one of the most pernicious effects of insider trading: It gives executives a reason to distort reports on corporate performance and find other ways to manipulate markets to their own benefit,” Strudler notes. “There was insider trading there, and that was pretty damaging to the firm in the long term. It destroyed it.”
What is Insider Trading?
In the United States, laws that govern insider trading were first enacted after the stock market crash of 1929 in the Securities Exchange Act of 1934, with additional rulings and changes included in subsequent years.
In 1984, Congress enacted legislation that provided for a fine of three times the amount of any profit gained by all those caught for insider trading.
In 2000, the SEC adopted a requirement that any insider knowledge must be disclosed to the public before trading can occur. Furthermore, employees of a company may not trade in the market before any sensitive company information is made public.
“When Wall Street professionals or others exploit inside information for an illegal tip-and-trade binge, they undermine the level playing field that is fundamental to our capital markets,” said Robert Khuzami, Director of the Division of Enforcement at the SEC, in a statement.
“These defendants thought the rules that apply to all investors did not apply to them, but the one rule they cannot avoid is the rule of law. Now they face financial penalties, industry bars, and possible jail time for their indiscretions,” he said.
Sharing knowledge about impending mergers, sales, or any other confidential information is in itself not illegal. It becomes illegal when those “in-the-know,” or those who were given the information, buy or sell securities of the particular company to make money.
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