What is insider trading?
It’s the trading of a company’s stock by people privy to confidential information about the company, such as merger talks, new products, and earnings reports. This information enables insiders to buy stock just before it rises, or sell it before it crashes. Trading by insiders is not necessarily illegal—company officials and advisors are allowed to buy or sell their company’s stock as long as those trades are not based on information unavailable to the general public, and their trades are disclosed to the Securities and Exchange Commission. But if insiders trade on information that is available only to them, they could be fined up to three times their trading profits and jailed for five years per violation. The penalties are relatively harsh because insider trading undermines the integrity of the markets. “If you knew insider trading was widespread,” says securities lawyer John Olson, “would you advise your aged mother to put her life savings in the stock market?”
Can only company officials get into trouble?
No. It’s illegal for anyone to act on insider information. The highest-profile insider-trading defendant in recent years—domestic diva Martha Stewart—was not accused of trading her own company’s stock but rather that of pharmaceutical maker ImClone. In 2003, Stewart learned through her broker that ImClone CEO Samuel Waksal was selling his shares because the Food and Drug Administration was about to block the company’s cancer drug from going to market. Stewart sold her shares, too. Ultimately, she was convicted of lying about the stock sale, and served a 10-month sentence. Waksal served five and a half years.
Is insider trading hard to prove?
Yes. Prosecutors must show not only that the accused possessed nonpublic information, but also that they traded on the basis of that information. In 2006, former Enron CEO Jeffrey Skilling was acquitted of several insider-trading counts for selling 500,000 shares of Enron stock in late 2001. Prosecutors contended that he sold his stock because, as CEO, he knew something the public didn’t—that the company’s profits were a sham. Skilling’s lawyers argued that he sold only because he thought Enron’s business would suffer in the wake of the 9/11 attacks. Prosecutors may face a similar challenge in their case against hedge-fund manager Raj Rajaratnam (see below), who’s known for doing extensive research into every stock he trades. The feds will have to show that his trades were specifically based on privileged inside info he got from his corporate sources. “The more you dig in, the less certain it is where the lines are,” says former Salomon Brothers CEO John Gutfreund. “Is a rumor inside information?” Former SEC Chairman David Ruder has no patience for such complaints. “If you have strong reason to believe a tip is coming from an insider,” he says, “you’re in trouble.”
How common are such trades?
More common than Wall Street would care to admit. For every high-profile prosecution, countless other lawbreakers escape unscathed, market observers say. They point to the suspicious surges in trading that preceded almost every takeover announcement during the takeover boom of 2002–07. The frequent run-up in share prices before a takeover announcement are “statistically impossible unless people were talking,” one investment banker told The New York Times. “It was like free sex. There were so many deals being done that people figured there was cover for what they were doing.”
Are the most blatant offenders caught, at least?
Almost certainly not. These days, say market watchers, much insider trading takes place in so-called “dark pools’’—private networks where investment banks, hedge funds, and other large investors trade securities among themselves, far from the scrutiny of the SEC. But the real clearinghouse for inside information trading may be in the rarefied social circles where the corporate elite swap tips like party favors. At dinner parties and charity balls, says New York high society writer Jane Stanton Hitchcock, corporate secrets are an accepted form of table talk. “One would certainly hope so,” she says, “or why else would you go?”
Can prosecutions stop insider trading?
High-profile arrests undoubtedly have a chilling effect, but only a temporary one. As long as Wall Street insiders talk to one another, they will always enjoy an advantage in the game of buying and selling stocks. Under the Obama administration, the pace of prosecutions has picked up, but the SEC has fewer than 4,000 employees overseeing 35,000 companies and tens of thousands of investment advisors. “The agency’s rank-and-file personnel are struggling to keep up with the more sophisticated actors in the market,” says New York Sen. Charles Schumer, who is pushing to double the SEC’s budget. Doubling an agency’s budget might be a hard sell at a time of soaring federal deficits, but the lack of sufficient oversight, says New York University ethicist Larry Zicklin, reinforces the popular suspicion that “the markets are rigged in favor of the rich.”
A web of whispers
Prosecutors unveiled the biggest insider-trading case in years in October, when authorities arrested billionaire hedge-fund manager Raj Rajaratnam in a dawn raid at his Manhattan home. They accuse Rajaratnam, who ran the $7 billion Galleon fund, of trading on tips from a network of insiders at companies such as Intel, Google, and IBM. The insiders, prosecutors say, slipped him advance word on earnings announcements, takeovers, and other inside dope that he parlayed into $20 million in profits. Rajaratnam and the other defendants say they’re not guilty, but transcripts of their conversations are damning. At one point, one of the accused declares, “You put me in jail if you talk.” At another point, Rajaratnam discusses finding a new job for a high-ranking IBM executive. “Put him in another company where we can trade well,” Rajaratnam says. It remains to be seen whether Rajaratnam and the other defendants will be convicted, but damage has already been done. Days after he was arrested, with investors clamoring for their money back, Galleon went out of business.