The ins and outs of insider trading

Hedge-fund founder on wrong side of borderline between information gathering and insider trading.

One of the most famous insider-trading scandals occurred in 1905, when a US Department of Agriculture employee was found to be surreptitiously signaling the level of cotton production to trader Louis Van Riper through the use of a window blind. All observers agreed that this was a clear case of insider trading, though the laws in those days were not as strict as today. Van Riper ultimately got off with a small fine.
But surreptitious does not seem to describe the character of hedgefund nabob Raj Rajaratnam, founder of the Galleon Group.
Rajaratnam was not at all secretive about the huge and far-ranging list of contacts in his Rolodex. What after all is the value added of a great trader if not his advantage over others in the ability to collect and assimilate the mountains of bits of information that move markets? So Rajaratnam’s conviction Wednesday on 14 counts of security fraud raises interesting question regarding the narrow line, in law and in ethics, between a superior ability to process public information and illegal and unethical use of private information.
The New York Times editorial summed up the unique approach of Rajaratnam: “The classic insider case involves one person tipping another in individual transactions.
Mr. Rajaratnam created a network of tipping networks that seemed cynically designed to go to the edges of the law on obtaining insider information without breaking it. By providing him with a mosaic of information from many sources, his defense contended, no single source or piece of information was material to a decision to invest even though, added up, they gave him a vital edge as an investor.”
The description makes Rajaratnam sound like someone who made a cynical and ultimately unsuccessful attempt to tiptoe around the boundaries of the law in order to violate its spirit but not its letter. The problem is that it could equally make him sound like someone who is doing successfully what traders are supposed to be doing, and getting paid for: making sure asset prices accurately reflect asset values. Why aren’t the people who are keeping inside information secret the ones being prosecuted? The problem is in many ways the same as that of intellectual property.
If I know how to cure a disease, or make a better mousetrap, or play a better symphony, why should I be able to keep that knowledge to myself? The information should be made public so that everyone can benefit, at no cost to me.
The problem is that without intellectual-property protection, far fewer people will invest money and effort in innovating new cures, devices and artistic creations.
Likewise, it costs money and effort to sniff out undervalued firms to buy out. If the information is leaked, then the target will no longer be undervalued and markets will be less, rather than more, efficient; the undervalued firm will never be properly evaluated.
Alternatively, the companies would invest huge, and ultimately wasteful, sums in enforcing security, much like the large, wasteful investments made in personal security by wealthy people in countries with weak law enforcement.
This is where the jury found that Rajaratnam crossed the line. He was paying people to disclose information that their employees were paying them to keep secret.
That is much different than paying people to unearth information that other people are not skilled at finding or interpreting.
It has been said that even though no one can say precisely when day ends and night begins, the two are nonetheless well-distinguished.
The same can be said about legitimate gathering of market information and insider trading. There is certainly a perplexing gray area, but some traders clearly cross the line.
Asher Meir is research director at the Business Ethics Center of Jerusalem, an independent institute in the Jerusalem College of Technology (Machon Lev).