It seems every other week or so there is another news story about successful hedge fund insider trading convictions. The most famous rat trapped, Raj Rajaratnam, was sentenced in New York to 11 years to be confined in a cage without a wheel after being found guilty on 14 counts of conspiracy and securities fraud in October. You may recall him as the self-made billionaire founder of hedge fund Galleon Group and whomthe Feds now refer to as “the modern face of illegal insider trading.” Raj, Sri Lankan by birth, studied engineering in the United kingdom before moving to the US to get his Wharton MBA. Hebegan in the business as a loan officer at Chase Manhattan Bank where his clients were high tech companies and then moved to do research at boutique investment firm Needham & Co, concentrating on the IT industry. While there, Needham ‘needed more ham’ and asked him to start a hedge fund, which he did and then after a few years took the fund private from the bank and proceeded to go independent naming his outfit Galleon. Performance was great with annualized returns of over 22% per annum – of course it was! Raj rat was buying and selling on tips and inside information from his buddies – rodentia he knew from Wharton or that burrowed into the walls of the high tech industry. His defiling little paws extended all the way up to the Goldman Sachs Boardroom, revelations of which caused the rapid fall from grace of a different rat, Rajat Gupta, member of Goldman’s board and previous CEO of McKinsey & Company. Formerly admired and respected, thefaux success of Raj rat and Rajat rat has been exposed to the Vivid sunlight of public opinion and they are now despised by honest people everywhere.
What’s the Big Deal?
According to the Securities and Exchange Commission (SEC), there are two types of insider trading: the legal kind and the “meet your cellmate Bubba” kind. Legal insider tradinginvolves approved buying and selling of securities by corporate insiders; officers, directors and employees who buy and sell the shares of their own company within very clear restrictions. Corporate insiders have to notify and file with the SEC all of their trades to prevent them from buying, or selling, shares before news or developments about the companyenter the public domain . They are also prohibited from trading before results announcements, etc. Theserules are to assure a level playing field for all investors and retain the integrity of fair and functioning markets.
If you study for the CFA or CAIA financial designation, you will have to master inside and out the “Standards of Practice Handbook,” from which I quote:
“Trading on material nonpublic information erodes confidence in capital markets, institutions, and investment professionals by supporting the idea that those with inside information and special access can take unfair advantage of the general investing public……investors avoid capital markets perceived to be “rigged” in favor of the knowledgeable insider.”
The stuff you can go to jail for (like Raj rat) is when you receive “material and non-public information” about a company and then trade securities, derivatives, bonds, etc. based on that inside information. This is clear abuse of the system and a significant breach of fiduciary trust . The SEC has made insider trading “a priority area for enforcement” and the United States is considered to have the strictest laws against such activity.
Evesdropping
You won’t getaccused of insider trading if you accidentally find “material, non-public information” about a company. Say you are slurping noodles at some dingy café and the guys in the booth behind you are whispering about atie-up between their respective firms . Just because you overheard “inside information” does not put you in danger – only if you act upon this information will you cross the line . “Acting” upon it can mean buying or selling based on that information or, and this is vital, telling someone else about it. If others act upon it, you now run the risk of spending serious time in close quarters with Bubba.
In a corporate context, if a company in a meeting with an investor makes a mistake and lets something out that can be considered non-public information and is material in nature, the company mustquickly make a public disclosure in order to comply with the law and to level the investment playing field .
Over the Wall We Go
Working in finance you will be exposed to insider information occasionally as part of the normal course of your work . If your firm is involved in a deal, such as an IPO, youmay possibly be “brought over the wall.” The “wall” is called a “Chinese Wall” behind which inside information withina bank or securities firm or even a printer is kept strictly among those with a need to know basis. If someone says, “I will have to bring you over the wall on this one,” this means “I am about to tell you sensitive, non-public information so keep this confidential .” Bankers need this information to properly advise companies on prospective strategies . However, they are not allowed to communicate it along to their families, friends or God fobid, post it on Facebook. You cannot ever tell it to other clients either.
Raj rat is going to Sing Sing because he clearly paid for and traded upon inside information for a long time to boost his investment gains and defraud his clients and the markets. Only by sending rattus rattus like this toprison with astiff sentence will confidence be restored to investors and markets alike. Yes, insider tradinghurts. Know what it is and don’t engage in it.