By Mark Hager
Eleven years! Convicted earlier this year on 14 counts of insider trading and conspiracy, Raj Rajaratnam was sentenced in October to eleven years behind bars, not to mention a $10 million fine and disgorgement of some $53 million in illegal profits. In November, the court added $ 93 million in civil penalties, designed to bring his total outlay to three times what he made through illegal trades. Mr. Rajaratnam plans to appeal his conviction.
Would five years imprisonment not have been amply severe? Mr. Rajarantam used no violence and his crime is described by his attorneys and some others as essentially ‘victimless’. Granted, his criminal trading--as revealed by wiretaps--was massive, systematic and gleeful. But does the harshness of his penalty reflect frustration over unpunished financial misdeeds elsewhere on Wall Street? The sentencing judge commented that Mr. Rajaratnam’s crimes reflect a “virus in our business culture that needs to be eradicated.”
Insider trading arises where a corporation’s managers or officials come into important knowledge about the firm’s performance or prospects that has yet to reach the public. They can use this information themselves and they can sell it to ‘tippees’ like Mr. Rajaratnam, who then become insiders themselves. Insiders can make money by buying shares that will rise in value when the good news comes out or cut losses by selling shares for more than they will be worth when bad news comes out. Such trading is illegal in most countries, though enforcement levels and sanctions vary widely. Some experts wonder, however, whether it should be illegal at all.
Mr. Rajaratnam’s attorneys tried to point out that some of what he thought was inside information was actually public, that some of his inside information was vague or trivial, that some of his advantageous trades occurred before the phone conversation proving his inside knowledge, and that he sometimes failed to trade on his inside news or traded the other way. The jury nevertheless slammed him on each and every count. Again, one can wonder whether rage at rule-flouting fatcats got out of control in the trial, combined perhaps with resentment that this particular fatcat is an obvious immigrant when so many native-born Americans cannot even find a job.
Conventional wisdom holds insider trading to be ‘unfair’ as well as scary to lay investors who will shun markets where it prevails for fear of losing a rigged game. By chilling investment and capital supply, insider trading raises capital costs. Evidence for this chilling effect is weak it turns out, but the subject is difficult to study because the inside nature of the trades is secret, making it hard to say how much is going on and where.
To whom would insider trading be ‘unfair’? Long-term shareholders lose nothing on their investments from insider trading, which affects only gain-loss allocations among active traders. Insider trading might actually produce higher stock prices because firms could pay lower salaries to managers who can profit on secret information.
Nor is it clear that outsiders as a whole lose from trading with insiders. Outsiders poised to trade may even benefit secondhand from inside information. Insiders with positive secret information will pay a premium for the stock over what other buyers would pay, thereby conferring a bonus on the seller. Of course, that seller might complain that his bonus was too small when he sees the high price the stock reaches when the positive secret comes out. But since he wanted to sell when he wanted to sell and hauled in a bonus, what’s his beef? Similarly with negative secrets leading insiders to sell at a discount: buyers get a better price from them than from sellers who don’t know the bad news yet. Lucky the investor who trades with an insider!
So who loses? Consider two groups among both sellers and buyers: those who have decided to make a trade and those who are considering it but hesitating in hopes of a better price. As we have just seen, the already-decideds may unwittingly snag a windfall if lucky enough to trade with an insider. We don’t want to hear any whining that you would have done even better if you had waited to do what you had already decided to do at once. More sympathetic is your hesitant friend there who says she was waiting for a better price and jumped in when the insider offered her one. If that had not happened, she would have waited and made a great deal when the secret news went public. She was lured into buying a beautiful bracelet with fake rubies or into selling one with gold in it, as only her buyer knew.
So, some of the whiners are actually winners while others are right to cry. On what basis do we decide that concern for the latter, prompting us to ban insider trading, outweighs concern for the former, who actually lose out from a ban? Perhaps the best answer is that no one can tell who the winners and losers really are and everyone feels after the fact that they fall among the losers. Once the secret news goes public, no one will admit even to himself that he was committed to trading in any case.
The other losers from insider trading are market professionals--broker-dealers, analysts, floor traders, arbitrageurs and institutional investors--those who live by real or supposed superiority in processing public information. Insider trading shrinks their pond by pushing prices up or down before news goes public, leaving less space for movement afterward. Our hearts should bleed? True, market professionals may serve the wider public through expert processing but it is not clear how much good they do or how well they should be rewarded.
Defenders of insider trading contend that it quickly bids prices up and down to reflect true values. Critics respond that any such effect is fleeting as the secret information goes public within hours or days anyway. Moreover, insider trading creates a perverse incentive to delay publication of news so as to prolong the informational advantage. Which is more conducive to quick accurate pricing: insider trading or prompt publication?
Sound objections to insider trading can be made on grounds of corporate governance. When managers delay publication, their own boards of directors may be kept in the dark along with the markets. Directors cannot guide corporate decisionmaking effectively without access to critical information. Equally problematic, inside-trading managers can easily profit on negative developments, thereby pulling their own incentives out of alignment with their company’s. They may even make moves disconsonant with company interests just to generate inside news on which they can profitably trade.
But perhaps such governance considerations should be left to firms themselves? In the absence of legal prohibition, firms would remain perfectly free to ban or restrict insider trading by their managers. Why not let markets decide between firms that forbid insider trading and those that allow it?
This probably would not work because markets would not trust company policies against insider trading. It would be management policing itself. Moreover, markets would have difficulty processing different company policies. Imagine traders trying to keep track not only of full-ban and full-tolerance companies but those in between: ‘no insider trading, except in scenarios A through K as set out in Appendix Q’. And what happens when companies want to change their policies? Robust trade probably benefits from a regime where all equities fall under the same insider trading rule, at least officially.
It seems then that corporate governance concerns alone amply justify laws against insider trading. Add to that an observation that money seems to flow more richly and fluidly in markets where corporate governance standards are generally high. Aside from his insider trading, Mr. Rajaratnam made tons of perfectly legal money in robust equity markets made possible by a web of U.S. regulation and investor confidence. He should have had more respect for the rules of a system that made him very, very rich.
Critics of insider trading laws nevertheless add several final arguments: restrictions have little real impact; they are costly to enforce; and there is great danger of selective enforcement. On all this, Mr. Rajaratnam just might be their perfect poster boy.
Mark Hager is an American lawyer living in Pelawatte. A graduate of Harvard Law School, he consults on negotiation skills with Sea-Change Partners and on legal problems. firstname.lastname@example.org