The Inside Scoop on Insider Trading

The Inside Scoop on Insider Trading

You might have heard of a guy named Raj.

The big news toward the end of last week was that hedge fund manager Raj Rajaratnam was sentenced to 11 years in prison for insider trading, a record sentence for that kind of offense. In the wake of his sentencing, this week’s issue of The Market will focus on:

  1. How hedge funds work
  2. What insider trading entails

Aside from the Raj Ruination (as we’ve termed it), this week's headlines were mostly dominated by the same old turmoil: By midweek, the stock market was slumpy, the Occupy Wall Street movement was gaining speed and European officials still couldn’t reach an agreement on the debt crisis.

On the other hand, we’re still discussing Raj’s rise—and fall. The media has buzzed about the symbolic significance of this record sentence, but, as The Los Angeles Times asks, “Why do we even have these rules? How do you draw the line between smart research and illegal information? Why not let a free market run free?”

The World According to Hedge Funds

We will answer those questions, but let's start with a definition: A hedge fund is basically a pool of investor money—similar to a mutual fund—that’s controlled by portfolio managers. Presumably, those managers are hotshot investors with the knowledge and skills to earn more money than clients would be able to earn on their own.

Unlike mutual funds, hedge funds are usually open to a limited number of super-rich investors. For example, some don’t allow anyone without a net worth of at least $1 million. Hedge funds also differ from mutual funds because they are far less regulated by the authorities and can use different (and often riskier) investing strategies than their mutual fund cousins. For example, they can “short" stocks, which can be lucrative but also risky—personally and economically. For more on what that means, read this.

Where Raj Went Wrong

When super-rich investors pay a lot to have someone manage their fortunes for them, they want to see high returns. Hedge fund analysts do intense research to decide what to invest in, from interviewing sources to combing reports from the Securities and Exchange Commission. But, although there’s pressure to be psychic about the market, there’s a limit to how far you can go to get your information—and Raj Rajaratnam blew past that long ago.

U.S. investigators are calling this the largest hedge fund insider trading case in the nation’s history, with Rajaratnam earning more than $72 million from illegal trading tips on stocks like Google and Goldman Sachs. In the end, more than two dozen people were convicted in a huge investigation that involved FBI wiretaps.

That leads us to the key question: What exactly constitutes insider trading?

Insider Trading, Explained

In a nutshell, it’s when people buy and sell stocks based on tips that regular people couldn’t know—corporate information that hasn’t been made public.

For example, if you were a CEO who knew your corporation was about to tank: If you sold all of your stock before the news hit the media, you’d be acting in a way that hurts regular Joe Schmoe investors because you know something they couldn’t. That's why many financial companies have very strict rules about their employees' own personal finances, to make sure there aren't any conflicts of interest.

Of course, greed is part of human nature, and most companies have no way to 100% ensure that there's no insider trading going on. So, there's almost certainly more insider trading going on than is being prosecuted, but it's unclear how often it occurs or how big the trades have to be to catch the attention of the authorities.

Beyond simple fairness, insider trading is illegal because one of the underpinnings of a capital market is transparency of information. The idea is that investors should get ahead by being better at analyzing the available facts, not by obtaining privileged information. The theory holds that non-insider investors would lose confidence in their own investments if insider trading were allowed—and stop investing altogether. And that, in turn, would hurt both companies and the market as a whole.

So, who's an insider? Anyone who gains access to insider knowledge. So, for example, if you overheard a company exec saying something confidential on her cell phone at the grocery store and used that overheard information as a stock tip, you’d be guilty of insider trading, too.

And Raj Rajaratnam definitely didn’t just innocently overhear.

He tapped into a network of high-ranking execs at various prominent corporations, including two of his classmates from Wharton Business School (class of '83) : Rajiv Goel, an exec at Intel, and Anil Kumar, an exec at McKinsey & Company. Rajaratnam allegedly offered Kumar $500,000 a year for the tips, including a $1 million bonus in 2006. Other informants included IBM's former server chief Robert Moffat and Rajat Gupta, who was a director at Goldman Sachs until last year.

Government prosecutors had sought a sentence as long as 25 years for these crimes, but the judge pointed to Rajaratnam's health issues. Rajaratnam has diabetes, among other ailments, and, according to the judge, faces "imminent kidney failure." Judge Holwell assigned less than the 19.5-year minimum that prosecutors suggested because prison is a more intense punishment for someone who's critically ill. That said, he also noted that illness isn't a "get-out-of-jail-free card," either.

Although the sentence was less than what the government sought, most legal experts agree that the sentencing sends a clear message to Wall Street and should discourage these illegal activities in the future. As Judge Holwell said, “Insider trading is an assault upon our free markets.”

Other Items of Note

Like hedge funders, company CEOs are under pressure, too—here’s why corporations do what they do.

Occupy Wall Street is going strong: We got a Wall Street protester to explain why and what she’s protesting, here.


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