How insider trading becomes endemic

By Felix Salmon
June 22, 2011
George Packer's massive, 11,000-word article on Raj Rajaratnam, his prosecutor Preet Bharara, and financial prosecutions. Highly recommended. But there was one line in particular which jumped out at me:


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This week’s New Yorker has George Packer’s massive, 11,000-word article on Raj Rajaratnam, his prosecutor Preet Bharara, and financial prosecutions. Highly recommended. But there was one line in particular which jumped out at me:

If there are examples of people whom Rajaratnam unsuccessfully tried to corrupt, they have not surfaced in the voluminous public record on Galleon.

I asked Packer what he meant by this. Is it simply a narrow statement about “the voluminous public record on Galleon”? Is it possible that Rajaratnam never met someone he couldn’t corrupt? Or is it something in the middle, maybe that Rajaratnam had an extremely good nose for the kind of people who could be corrupted?

I wanted to know just how malign Packer considers Raj to be. If you or I had been approached by Raj in full flower, would he have corrupted us, too? I have an image of Raj as someone a bit like Javier Bardem in No Country for Old Men, only instead of killing the people who come across his path he just turns them into insider traders.

Packer replied:

From my work on this story, I’m certain there are people Raj tried to corrupt and couldn’t. And perhaps it’s not surprising that their names didn’t show up in the record, since we’re talking about a criminal investigation. It’s just striking that so many names of the corruptible do show up, how casually they show up, how easy it was for Raj to turn most of them. Also striking that not a single counter-instance happens to stumble into the record, with all the documents I’ve seen and wiretaps I’ve heard. You’d think that at least one example would appear. (And, to answer one of your questions, I’d to think that if you or I floated through this world, we’d have been that example.) And finally, it’s striking how many people who weren’t actively involved in the crimes must have known about them but apparently never raised a red flag, and certainly never went to regulators or other authorities. There’s a kind of code of silence on Wall Street that reminds me of omerta in the mob and the blue wall with the police, which obviously makes it all the harder for prosecutors to take on the vast scope of these crimes. Preet Bharara was cautious about what he would say to me, but one thing he did say was that insider trading is “everywhere you look.”

This is depressing, and rings true. I’m no expert on insider trading, but it does seem to me that prosecutions tend to come proactively as a result of deep investigations, rather than reactively as a result of companies or employees turning violators over to the authorities. Galleon employed about 70 analysts, fund managers and traders when Raj was arrested, as well as support staff; it’s reasonable to assume there were at least as many ex-employees too. It’s silly to believe that they were mostly ignorant of what Raj was looking for — and yet none of them said anything.

The key here, I think is the same slippery slope of complicity that I’ve written about before. Start with a job offer, and an office culture. And then slowly raise the money and the pressure, and bring as many people as you can inside the fold. Long before they do something illegal, they’re tainted, and won’t give up their colleagues.

I also wonder: hedge funds are famous for the barrage of interviews and personality tests that they put prospective employees through. Are some of those tests ferreting out precisely the sort of people who are the most corruptible? After all, corruption is a close relative of greed, which hedge funds are unabashed about prizing.

And remember too that all of Wall Street, even down to the level of individual investors, trafficks in exclusive information. Think of all those expensive newsletters offering an edge in the market, or the various subscription websites and boring conferences which promise to give people hugely valuable investment advice.

It’s a given, on Wall Street, that information can be prized and valuable. One time-tested way of making it big on Wall Street is to find information which others don’t have and then act on it: look at Muddy Waters for a prime example. Everybody’s looking for the information edge — and the point at which exclusive information crosses over into being inside information is maybe not always obvious from the point of view of an ambitious analyst. If I’m sitting on the Acela and overhear two businessmen talking about an upcoming deal, I can act on that knowledge perfectly legally. And the main problem with analysts’ information isn’t that it’s illegal, but rather just that it’s worthless.

All of which says to me that there’s a lot more insider trading going on than the number of prosecutions would imply, and that it’s going to be extremely difficult to crack down on. The very architecture of Wall Street is designed to encourage it, with only a thin layer of compliance people doing their best to warn people sternly about what they can’t do. They — along with prosecutors — are likely to remain mostly ineffectual, so long as everyone else continues to push for an edge wherever they can find one.

18 comments

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Great summary Felix.

I don’t believe HFs deliberately ferret out the most corruptible – being greedy/highly motivated by money is probably enough.
Just applying for a HF position marks you as far from Mother Teresa-like in your moral standing. Not evil, but highly ambivalent.
I mean, you have to be perfectly comfortable working every hour you can, with your impressive intellect, knowing that you are doing ABSOLUTELY nothing to improve the world.

I also believe that the mosaic theory absolutely absolves many (at least in their own minds) of what might be considered true/prosecutable insider trading.

I mean just how good is a given contact? Sure, Raj’s were the best. However, his junior analysts would be talking to worse contacts and they would need more than one to be able to corroborate and give a conviction call.

At this point they are probably well within the law.
Effectively chatting to a bunch of store managers for a company with 1,000s of stores perhaps.

But over time, their contacts might be promoted, and become regional or divisional managers. This improves the information and increases the conviction in the call.

At what point do you cease to use that contact?
It’s a VERY grey line.

Clearly the very best way to counter this is to make damn sure that the deterrent is HUGE and REAL.

It can’t just be Raj Raj or Stevie getting taken down. You need to nail a couple of minnows too. Which they appear to be doing.

Posted by TinyTim1 | Report as abusive

I believe that acting on information you overhear on the train is illegal if it is non-public information.

Impossible to prosecute, but illegal.

Posted by MattJW | Report as abusive

I’ll bet you a dollar that Raj’s conviction will be overturned on appeal. He has the best law (not legal services, but law) money can buy. Just sayin’.

Posted by Curmudgeon | Report as abusive

Many years ago (in the late 80s) I had a stock account with a highly regarded, though relatively small, Wall St. brokerage firm (later acquired by Lehman). I had recently transferred my account from a somnolent Boston firm. Shortly after the transfer, my excellent broker began to purchase stock in a variety of companies that, almost invariably were acquired a month or two afterwards. The value of my shares soared. My account was small. My broker was no genius. I have no reason to doubt his absolute probity — or that of his firm (which came out of the Lehman debacle smelling like a rose). But I did acquire great respect for the conversations that must have taken place around water coolers on Wall St. vis a vis State St.

Now that I think about it, he did sell my IBM at 46….

Posted by jbernar | Report as abusive

One of the interesting things is just how [relatively] tiny the sums the insider trader makes. Rajaratnam was worth 1.8bn USD at one point. The upper end of what he made was 60mn. If I told you I could increase your wealth by 3% over a number of years but you might spend a decade or so in federal jail would you take up the offer? At that time Rajaratnam could have made more than that sticking his money in the bank.

Also I think you have a very weird idea of how market mechanics work, the amount of truly market moving info that is out there is minimal and predicting how that info will impact the market is not as trivial as you seem to imply it is. Also alot of trading is designed to be more information insensitive for that reason. Hence the amount of “insider trading” is nowhere near as big as you think it is, again look at the Rajaratnam case.

TinyTim1, remind me again how exactly Mother Teresa “improved the world”?

Posted by Danny_Black | Report as abusive

When wrong-doing is pervasive, or perceived to be, then people tend to minimize both the odds that they will be caught and their estimation of the ‘wrongness’ of the act. The belief that ‘everybody is doing it’ also leads one to wonder how much you’re losing by not doing it.

Posted by JimInMissoula | Report as abusive

JimInMissoula, except it wasnt pervasive and even in this particular case the illicit gains were small beans. 60mn gain in a 7bn fund. Even if we assume every single penny when to Rajaratnam that would make him personally worth 1,860mn instead of 1,800mn. Frankly there is not enough private, clearly actionable information to allow “everyone” to do it.

Posted by Danny_Black | Report as abusive

Very interesting and welcome piece that certainly rings true for me. However I must point out that the media, particularly in the US, has been very much complicit in allowing this “code of silence” to persist.

First, influential American newspapers such as the NYT (and later, academia) had bought into the rather absurd message that Wall Street and City firms attract the “best and brightest” to perform the important task of, in effect, allocating global economic resources. This deference naturally offered a convenient smokescreen for such firms to engage in activities of highly dubious value, activities that all involved can pretend are beyond the grasp of such mere mortals as journalists and regulators to therefore avoid scrutiny.

Second, this omerta undoubtedly also applies to the entire deeply interconnected echo chamber of big money (VCs, PE, hedge funds, investment banks, etc), industry analysts, public relations, and the media. While there are indeed many participants in this ecosystem who are not conscious of the origin of these optimistic corporate messages nor of how they are transmitted and disseminated, social pressure and career goals often coax these participants along. At other times, the effects may be less subtle, much as reporters who portray the White House rather too negatively can find themselves without a seat on Air Force One’s next flight.

The lessons ostensibly learned during the dotcom bust, such how Silicon Valley VCs, underwriters, and analysts conspired to pump up companies they knew had few growth prospects–as reporters rushed over each other to praise the latest entrant and all other parties involved–were evidently forgotten, ignored, or considered unfit to print just a few years later as the twin credit and asset bubbles unfolded.

Financial markets exist to serve the public by allocating capital to its most productive uses. There is nothing more important that journalists can do than helping to ensure that they actually do so.

Posted by David4321 | Report as abusive

@Danny Black … Seriously?

For people like Rajaratnam, insider trading and corruption are what MAKES their riches and makes them who they are and wish to be. They have already risked everything to achieve their status the dirty way …

It is a culture that draws like minds. The culture is huge, it is the number who are caught that is small. The only reason why so few are prosecuted is it is difficult to prove. Do you really think Rajaratnam only made the dirty money that was proven? C’mon Danny!

One of the reasons why this is so, is that they use the “everyone is doing it” excuse to recruit and as Felix so aptly put it, once they are tainted, they are much more reluctant to give up their partners in crime and apt to continue and foster the culture of like minds.

The majority of traders may be pretty honest, but insider trading is rampant. There are a lot of immoral people who are in it for the gains at all costs … even a few years in a compound with horrors such as restricted cable TV access is not going to stop them.

I am questioning why you are adamantly in denial that insider trading is rampant. The number of people caught and tried remains small, but that has more to do with corrupted collusion providing less whistle-blowers, the cost of and perhaps even some lack of incentive to catch many, as there is less confidence in an obviously rigged market.

David4321, the banksters get off scotfree and the man who steals some meat to feed his family gets 2 years. Why? Greed creates a culture where money gives prestige, power and Teflon-like slipperiness to those who have it, however ill gotten.

Posted by hsvkitty | Report as abusive

hswkitty, numbers don’t back you up. The amount of money made in this insider trading scheme is tiny relative to the guys own wealth, even if we assume every single penny went directly in his pocket that is 3% over a number of years. He could have bought T-Bills and done better.

A couple of seconds thought shows it can’t be “endemic”. Companies have whole teams of people whose job it is to massage the figures exactly so investors are not surprised and when there is a shock, usually it is news to the executives just as much as to the outside world. Secondly, the amount of information that is truly market moving is small relative to the market. What percentage of the market is M&A activity? Lets assume you knew every single merger that was going to happen in advance, thats still a tiny percentage of the market. Company misses its quarterly figures? You can be sure it is as much a surprise to the CFO and CEO as it is to the investors.

David4321, rings true because it panders to your prejudices.

Posted by Danny_Black | Report as abusive

Well said Danny

Posted by Isaac_R | Report as abusive

@Danny

“You can be sure it is as much a surprise to the CFO and CEO as it is to the investors.”

I am not sure you mean to be this silly. You are in effect denying that inside information exists AT ALL which is clearly NOT the case.

Companies announce their quarterly figures around a month or so AFTER the end of the Q.
For a little while the numbers will be crunched but then the CEO and CFO (and other insiders) will know them.

WELL BEFORE THEY ANNOUNCE THEM TO THE PUBLIC.

This is sometimes known as quiet period or black out period. The insiders are prevented in that period from trading stock.

It is at exactly this time that the stock is vulnerable to insider trading. If someone knew RIMM’s numbers were a miss the week before the results were released (and you can be sure the CEO and CFO knew) they could have made a killing.

As for your claim that Raj would have made more money in T-Bills you are missing the point.

For all we know, Raj could have built his entire business on the back of insider trading.
His fantastic returns were only so good because he had insider knowledge.
So, his AUMs were much higher than they would have been if he were relying on non-insider research.
AUMs = better.
Performance = better.
On 2 and 20 that is a whole BUNCH more money for the big man.

Posted by TinyTim1 | Report as abusive

Raj probably deserves his punishment, but the faces of the few public scapegoats tossed to the masses in an attempt to placate them are ones easy to chew on but not necessarily the most deserving ones.

Posted by Greenspan2 | Report as abusive

The $60 million figure is just what the prosecution could build a case on over the period of investigation. It’s very unlikely that it reflects the full scope of the misdeeds at Galleon.

Posted by JimInMissoula | Report as abusive

JimInMissoula, actually the prosecution claimed up to 60 million so it is an upper bound during the time of investigation during which his funds make 1.5bn profit in just one of the years. Given the amount of time and effort that the prosecution put into this is safe to bet the vast majority of his earnings that year were legal.

TinyTim1, and for all we know Steve Jobs has a deal with Colgate that makes people who brush their teeth need to buy overpriced tat.

Ok engage BOTH brain cells. Public companies do not have a load of receipts pile up in the corner and then let the accountants lose on it at the end of every quarter. Nor during the time they are collating their figures do the IR teams go on holiday. I assume you think it is just a coincidence that the consensus figures for those companies come in so close to the actual figures and IR tell that to anyone. Yes if by public you mean people too lazy to do anything except look at CNBC but anyone who is a even vaguely serious investor is massaged by a team of people who job it is to make sure nobody is surprised.

Posted by Danny_Black | Report as abusive

Felix, I know someone that is closely related to this story and would love to tell someone his side of the story. If you are interested let me know at pdcw007@yahoo.com

Thanks

Patrick.

Posted by PDCWilliams | Report as abusive

@Danny Black, your prejudice as a former banker tends to shine even brighter than mine. Having read what his colleagues have said of him, the culture of dirty money is exactly what floated Raj’s boat. For some, the need for greed is a raison d’etre.

http://pragcap.com/how-long-was-galleon- trading-on-insider-information

From the article’s “Seeking integrity in business;”

“In March, 2007, the S.E.C. briefed the F.B.I. and the United States Attorney’s Office for the Southern District of New York, which opened a criminal case. That same month, an anonymous letter arrived at the S.E.C.’s offices, postmarked Queens, March 13, 2007.

“It is hedge funds like Galleon Group that create wealth for their shareholders and themselves at the expense of innocent investors,” the letter began. “Insider trading word in this fund should be changed to insider partnership and prostitution. . . . Prostitution is rampant for executives visiting Galleon. You will find that the Super Bowl parties for the executives, paid for by Galleon Group, include prostitutes and other forms of illegal entertainment.

In return, the executives provide Galleon the unfair edge that the fund leverages so well.” The letter was signed “Seeking integrity in business.” The writer sounded knowledgeable about Galleon and the industry, but it was impossible to track him down.

Posted by hsvkitty | Report as abusive

ah, PragCap, the website written by a guy who thinks 2 and 20 is the investment banking model….

Thank god no one needs to bother with facts anymore.

Posted by Danny_Black | Report as abusive