What is Insider Trading and Does it Hurt?

By Derek On October 15, 2011 Under Stock Broking 101


Raj Rat Goes to Jail

Sybil Fawlty: [about Manuel's rat] Perhaps it would be best to have it put
                        to S-L-E-E-P.

Basil Fawlty: Who, him or the rat? Might get a discount if we have them both
                        done.

Manuel:         ‘Spleep’?

Today Raj Rajaratnam was sentenced in New York to 11 years to be spent in a cage without a wheel after being found totally guilty on 14 counts of conspiracy and securities fraud. You may remember him as the self-made billionaire founder of hedge fund Galleon Group and whom prosecutors now refer to as “the modern face of illegal insider trading.” Raj, Sri Lankan by birth, studied engineering in the UK before moving to the US to get his Wharton MBA. He started out 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, focusing 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 bought it out from the bank and went independent calling his outfit Galleon. Performance was great with annualized returns of over 22% per annum – of course it was! Raj rat was trading 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 corrupt little paws extended all the way up to the Goldman Sachs Boardroom, revelations of which caused the immediate fall from grace of another rat, Rajat Gupta, member of Goldman’s board and previous CEO of McKinsey & Company. Formerly admired and respected, the faux success of Raj rat and Rajat rat has been exposed to the bright sunlight of public opinion and they are now reviled by decent 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 trading involves approved buying and selling of securities by corporate insiders; officers, directors and employees who buy and sell the stock of their own company with certain restrictions. Corporate insiders must notify and file with the SEC all of their trades to prevent them from buying, or selling, stock before news or developments about the company become public information. They are also restricted from buying or selling before results announcements, etc. These rules are to ensure a level playing field for all investors and maintain the integrity of fair and functioning markets.

If you study for the CFA or CAIA designation, you will have to learn 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 obtain “material and non-public information” about a company and then buy or sell securities, derivatives, bonds, etc. based on that inside knowledge. This is a breach of fiduciary trust and is an abuse of the system. The SEC has made insider trading “a priority area for enforcement” and the US is considered to have the strictest laws against such practice. Hong Kong, by contrast, has just made insider trading an illegal offense. It may be surprising that in France they let dogs poop on the sidewalks but they do and likewise it may surprise that in emerging markets insider trading is a common, albeit equally unattractive and unsanitary activity.

Noodle Slurping

You won’t get nailed for insider trading if you come across “material, non-public information” about a company. Say you are slurping noodles at some dingy café (in a Hong Kong context) and the guys in the booth behind you are whispering in Cantonese about a merger between their respective firms. (Actually, Cantonese can’t be whispered so this example might not work). Just because you overheard “inside information” does not put you in danger – only if you act upon it will you cross the line. “Acting” upon it can mean buying or selling based on that information or, and this is important, telling someone else about it. If they act upon it, you 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 screws up and lets something slip that can be considered non-public information and is material in nature, they must immediately 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 from time to time as part of the normal course of business. If your firm is involved in a deal, such as an IPO, you may be “brought over the wall.” The “wall” is called a “Chinese Wall” behind which inside information within a bank or law firm 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 your mouth shut.” Bankers need this information to properly advise companies on prospective courses of action. However, they cannot pass it along to their families, friends or post it on Facebook. You cannot ever pass it along to other clients either.

Raj rat is going to prison because he knowingly paid for and traded upon inside information for years to boost his investment gains and defraud his clients and the markets. Only by sending rattus rattus like this to jail with a stiff sentence will confidence be restored to investors and markets alike. Yes, insider trading hurts. Know what it is and don’t do it.

 

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