The SEC's Risky Expansion of Insider-Trading Cases

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Securities and Exchange Commission crackdown on insider trading Many hedge funds prosper by taking outsize bets on companies based on their reading of the firm's future fortunes. Often, they employ experienced industry analysts and compile detailed information on the company to make those judgments.

But now, the federal government now appears to be trying to broaden the definition of insider trading to include the information-gathering of hedge funds as criminal activity. Which raises the interesting question: What's the difference between a good analyst and a criminal?

"They are widening the net," says Jay Dahya, an economic professor at the Zicklin School of Business at the City University of New York. "They are now focusing on information transmission -- how is it that some people seem to have an advantage over others, and how is this information getting to them?"

No Statuary Definition

This new level of insider-trading probe became evident when FBI agents raided three hedge funds on Monday: Level Global Investors in New York, Loch Capital Management in Boston and Diamondback Capital Management in Stamford, Conn. "We can confirm that agents from the Federal Bureau of Investigation visited our offices this morning as part of what we believe to be a broader investigation," a spokesman for Level Global told the Associated Press.

In essence, they're investigating outsiders -- the hedge funds -- for insured trading violations. This could be difficult to prove in court, because there's no statuary definition of insider trading. There's only a kind of fraud, known as the abstain or disclose rule, which maintains that if you have material nonpublic information and an obligation to keep it secret, then you're not allowed to trade on it until the information is disclosed to the public.

Peter Henning, a professor at the Wayne State University Law School, says this kind of case puts the government in a "very gray area" and is a departure form the usual practice at the Securities and Exchange Commission. These cases normally involve what Henning calls "the big hit," such as when a company is about to announce a merger and its stock price is likely to go up sharply, or when a pharmaceutical company is about to announce that a clinical trial has failed and the stock price is likely to fall sharply. Then the SEC looks at relatively isolated stock trades that are clearly suspicious and works backward to see if there was an information leak from the company.

"In this case, it's going to be: How much of this information did the hedge funds have, was it really inside information and did it affect their trading decisions?" Henning says. "That's why they are going to need wiretaps and recorded conversations, because you are not going to be able to make this case just on objective evidence."

Looking at All Links in the Chain


Very few such cases have worked their way through the courts. R. Foster Winans, who wrote the "Heard on the Street" column for The Wall Street Journal in the early 80s, was convicted of fraud for selling information before his columns were published. In another case, the Supreme Court ruled that a stock analyst who passed on a tip about a failing insurance company could not be held liable for insider trading.

Dahya says the government has been using what it calls misappropriation theory in civil cases to prove that anybody who is linked in the chain from selling the security to being involved in the company could be held liable for insider trading.

The SEC has already brought a case against Raj Rajaratnam, head of hedge fund Galleon Group. So far, 14 defendants have entered guilty pleas in that case, including an Intel executive who admitted to providing Rajaratnam with information on the company's earnings before they were released.

Focusing on SAC Capital

Such disclosures are now covered by the Sarbanes-Oxley rules that require companies to issue information simultaneously to all analysts and investors. Under the misappropriation theory, that could be construed as insider trading. But will a jury agree? That's why Rajaratnam's lawyer is fighting strenuously to keep wiretapped recordings of his conversations with tipsters out of the trial.

The current hedge fund case seems to be focusing on another firm, SAC Capital, which has an extraordinary record of an annual average return of 30% per year for the past 20 years. Level Global and Diamondback were both founded by former SAC Capital traders. In addition, Nicos Stephanou, former head of mergers and acquisitions at the Swiss bank UBS, testified at a federal trial that he leaked stock tips to a number of traders including an analyst at SAC Capital.

Dahya says it's common for the SEC to start a case with small characters and then use their testimony against bigger participants in the fraud. "I get the impression that they are going to set an example, a Hollywood-type example of someone," Dahya says.

He says hedge funds are now struggling in a down market to make decent returns and as a result, many are taking large risks, and "more people are crossing the line." If that's the case, the feds will have yet more suspects to flush out. Putting them away, however, could be a lot harder.

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54 Comments

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uralrider

why are the members of congress exempt from insider trading rules?

November 25 2010 at 6:24 AM Report abuse +3 rate up rate down Reply
frqflyr0

Good!

November 25 2010 at 5:18 AM Report abuse rate up rate down Reply
crimson00king

The Republicans are crying for tax breaks for these thieves and the Rich 2 percent of Americans. We would have to borrow 700 billion more from the Chinese so they can have tax breaks. This I believe is a security risk for our country. Please contact your congressmen your senators and the White House and tell them NO MORE TAX BREAKS FOR THE RICH AND NO EXTENTIONS EITHER>

November 24 2010 at 10:51 PM Report abuse -1 rate up rate down Reply
2 replies to crimson00king's comment
uralrider

why not it works for Hugo Chavez

November 25 2010 at 6:26 AM Report abuse +1 rate up rate down Reply
bggdg

If your family wants to spend more than they are able to generate, do you "borrow from the Chinese"? Or maybe you cut your spending to match your earnings? Then again, from the looks of your post, maybe you steal from your neighbor to continue your profilgate ways? The above represent three options for our government as well. Perhaps thinking people can imagine which is best, and let their elected representatives know their desires?

November 26 2010 at 9:54 AM Report abuse +1 rate up rate down Reply
rncranston

I'm confused. I thought insiders were Board members, employees, or suppliers with special information.

November 24 2010 at 10:21 PM Report abuse rate up rate down Reply
Dave Lewis

I wonder whether one or more hedge funds paid Charles Wallace to write that article? He never did disclaim.

November 24 2010 at 8:52 PM Report abuse +2 rate up rate down Reply
ckwords

Try statutory definition, not statuary.

November 24 2010 at 8:00 PM Report abuse +1 rate up rate down Reply
kdocjjk123

The Den of Thieves does not want anyone to investigate how corrupt they are. Infiltrating a drug smuggling ring is also risky but if you are going to try and slow the criminal behavior you do it. The criminal behavior on Wall Stree will never be stopped but it can be slowed or reduced by active policing. Republicans absolutely refuse to curb any illegal behavior and thus has put society thru the Great Depression and now the Great Recession that can still turn into another Great Depression if the European countries collapse. Check out GW Bush and his insider trading of Harken Energy when his Dad was President. That is why he could or would not stop any other illegal insider trading. Ken Lay was cooking the books at Enron and GW Bush ws trying to get Social Security ended so people would have to deal with Wall Street. Buy Enron! Buy Harken!

November 24 2010 at 7:36 PM Report abuse +3 rate up rate down Reply
2 replies to kdocjjk123's comment
warrenbent

Why do you think it should be illegal to sell drugs? Do you somehow imagine your sheepleherders know more about what you should ingest in your own body than do you? If so, how did you become so incapacitated?

November 24 2010 at 7:57 PM Report abuse +1 rate up rate down Reply
superdudedude

Kenny Boy Lay was in fact Bushes largest campaign contributor, along with the other boys at Enron. Bankers at Citi, MS and JP Morgan were also implicit in helping Enron keep the scam going for so long. It was years later before ANY charges were brought against ANYBODY from Enron. Further most folks across the USA probably don't realize California is STILL paying off $billions in loans that were required to keep the light on during the Enron attack on California. Enron had figured out how to charge $1,000 for power normally worth about $50. They had power plant operators shut down for a few hours when 100+ degree would kill elderly and weak persons.

November 27 2010 at 6:41 PM Report abuse rate up rate down Reply
lovbuton

Regulate the hell out of the greedy bastards!!!!

November 24 2010 at 6:57 PM Report abuse +4 rate up rate down Reply
3 replies to lovbuton's comment
ksmwtm

The Big Scary New Financial Regulation law our Courageous Congress assigned Regulators to decide what to enforce----Aren't REGULATORS RESPONSIBLE in part for this Financial Crisis? Congress Stabs Mainstreet in the back----again!

November 24 2010 at 6:16 PM Report abuse -3 rate up rate down Reply
1 reply to ksmwtm's comment
superdudedude

Not much has been regulated in at least the last 10 years. Remember specific info about Madoff's scams was given to the SEC, yet more than 9 years went by before they did ANYTHING! Oh, yes they were too busy snorting meth and downloading porno, same as the guys at MMC in charge of offshore drilling safety.

November 27 2010 at 6:32 PM Report abuse rate up rate down Reply
vrd071265

Everybody know how the wall street works? It is all about the greed. Nobody can get rich by staying honest.

November 24 2010 at 5:21 PM Report abuse +3 rate up rate down Reply