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.
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.