How Prevalent Is Insider Trading? And What's to Be Done About It? A Freakonomics Quorum
As I type these words, the biggest insider-trading trial in years, that of Raj Rajaratnam, has just gone to the jury. I haven’t followed the trial too closely, but the gist is evident: the line between “insider trading” and the legitimate, if sharp-elbowed, acquisition of useful trading information is extremely blurry.
This is hardly the only insider case at the moment. Preet Bharara, U.S. Attorney for the Southern District of New York, famously said last fall that “illegal insider trading is rampant and may even be on the rise.” So it seemed a good time to put together a Freakonomics Quorum and ask a couple of straightforward questions:
Just how prevalent is insider trading? And what, if anything, should be done about it?
The folks we convened to answer these questions include: a couple of former federal prosecutors; a former SEC lawyer; a one-time banker who went to prison for securities fraud; a money manager and lifestyle revolutionary; and a man who runs a consulting speakers bureau that features convicted white-collar criminals. One of the most trenchant lines comes from Samuel Buell, a former prosecutor who now teaches law at Duke: “The expectation that insider trading is rare actually benefits the market, because it attracts investment and prevents a would-be race to the exits if people concluded that the market was rigged.”
But what happens if or when that expectation proves to be false? Watch out.
Thanks to all for participating in the quorum; it is stuffed with useful and sobering insights.
Stephen Miller is a member of the commercial litigation practice group at the law firm Cozen O’Connor, and a former prosecutor in the U.S. Attorney’s offices in the Southern District of New York and the Eastern District of Pennsylvania.
It’s hard to assess from the outside whether insider-trading is more prevalent now than at other times. I can think of two big reasons, though, why arrests and prosecutions are on the rise:
1. The Aircraft Carrier of Government Has Turned. In the years after 9/11, every federal agency’s priority was terrorism. The FBI reassigned scores of experienced white-collar fraud agents to terrorism investigations. Nearly ten years later, terrorism remains important, but the lack of another devastating attack combined with the recent financial meltdown have caused law enforcement agencies to rededicate themselves to addressing financial frauds. With more and more agents digging around suspicious financial transactions — all the while “flipping” individuals to provide information about even more transactions — it is not surprising that we are beginning to see the fruit of the Federal Government’s labors.
There is also a natural “moths to a flame” impulse within the law enforcement community that augments the agencies’ financial and manpower commitments. Put simply: success begets more success. Financial fraud prosecutions are “hot” right now; the positive press attention paid to those enforcement efforts shines a warm light on agency heads and DOJ bureaucrats in Washington. As a consequence, the most motivated prosecutors and agents may gravitate toward white-collar frauds in an effort to make their mark in an area that their bosses and the public have deemed so important.
2. Technology Has Improved Significantly. Technological changes will continue to fuel insider-trading arrests in a number of ways. For example, one must presume that regulatory agencies have improved the computerized algorithms by which they mine evidence of suspicious trades from the flow of daily transactions on the major stock exchanges. But the more impactful changes relate to the growing ease in discovering and proving insider-trading cases.
Just one generation ago, most insider-trading cases had to be proven through the circumstantial evidence surrounding a stock trade, such as records that two parties met in person or spoke on the phone around the time of the trade. In the new wave of prosecutions, however, prosecutors are marshaling direct evidence of fraudulent intent through wiretaps, e-mails, text messages, social-media contacts, etc. That high-quality evidence makes it easier to convince co-conspirators to turn on each other and provide even more high-quality evidence of fraud.
That trend should only continue. The generation in colleges and business schools today is filled with “digital natives” — they have come of age in an era in which friends more commonly communicate in writing (through e-mails or text messages) as opposed to actually conversing in person or by phone. When those conversations turn to insider trading, law enforcement officers will be the beneficiaries.
OMG! You whispered something to someone who whispered it to someone else on the subway, and a guy overheard and made a trade and now you are all going to jail! What the heck is happening? Every fund in the world is being raided, people are being threatened with prosecution, and all we want to do is just relax and get back to being scammed in this rigged market. My main question is: why are these billionaires even risking jail with what is at the very least a very gray area of the law? But first, should insider trading even be illegal?
The obvious answer is of course it should, else the average investor will get taken advantage of. If some players in a market have an advantage, then some have a disadvantage and that’s not fair. However, I’m not sure it’s so black and white. Here are the benefits of making insider trading legal:
The more information in a market, any market, the more efficient prices become. If informed investors start buying or selling based on privileged information, asset prices will rise to their “correct” level. For instance, if insiders traded on information that company XYZ was going to get acquired within a month (and note: no deal is ever done until its done) then the price of XYZ would smoothly go from point A (where it is now) to point B (the price it’s going to get acquired for) rather than in a one-second leap on the day the deal is announced. This will more properly reflect the fair value of the company as the deal gets closer to being accomplished.
Fraud will be exposed earlier. This is a key point. Enron is an example of a case in which tens of thousands of investors got burned because they were piling into a stock during the later stages of its fraud. If insiders were selling, we would’ve seen a much swifter move down, and probable fraud exposed. Now, when insiders sell, it would have much more meaning, because it wouldn’t just be during blackout periods where trades are invisible to the market, like when Kenneth Lay sold the bulk of his Enron shares. Insider selling could now indicate real information.
Companies will either become more transparent, to keep the retail investor happy, or will themselves enforce secrecy rather than being complacent with the idea that the law somehow protects their secrets. In other words, if a deal is being done, a company will be a lot more transparent and open with their investors about whether they are engaging in negotiations. Or: they will finish the negotiations a lot faster to avoid the risk of information getting out, since it would be legal to trade on that information. This speed and/or transparency is good for the retail investor.
One concern is that there will be a flight of liquidity because people will be concerned about the legitimacy of our markets. Rather, the opposite will occur. More enforcement dollars will be used to uncover actual frauds such as the next Enron or Worldcom. Billions are now being spent on insider trading cases. Better those billions be used to find the next Bernie Madoff. Arguably, these frauds are a thousand times more dangerous for the retail investor than what is probably a victimless crime such as insider trading.
Insider trading is almost impossible to prosecute and the government wastes countless dollars trying. Again, better to use those dollars to track down frauds where countless investors are being directly harmed in either Ponzi schemes or corporate frauds.
Samuel Buell is a Duke University law professor and a former federal prosecutor in New York, Boston, Washington, and Houston. In 2002, he was one of the lead prosecutors on the Arthur Andersen criminal trial, the first of the Enron-related trials, which led to a conviction of the company for obstruction of justice.
Consider two curious things about legal controls on insider trading. First, the law treats it as a type of fraud, fraud by concealment (or omission) — like selling a product with a known defect to a buyer who would be justified in expecting disclosure of such a defect. The idea is that the inside trader doesn’t tell his counter party that the trade is motivated by the sort of informational advantage that is improper and unfair (like getting a tip about a looming merger because one happens to move in the right circles). The counter party is deceived because they expect others, even in big liquid markets with impersonal transactions, not to make trades using that kind of information.
Why is their expectation justified, such that the law ought to protect it? Because there have been legal controls on insider trading for so long now that people expect it not to occur (or at least to be infrequent and punished). Sounds circular, to be sure. But fraud is always a function of buyer expectations, which vary with the norms of particular markets. The expectation that insider trading is rare actually benefits the market, because it attracts investment and prevents a would-be race to the exits if people concluded that the market was rigged. That is, of course, the great unknown fact that insider trading law can only assume: that a return to a state of no legal control on insider trading would lead, in economists’ terms, to a “lemons market.”
Second, the relationship between insider trading and law enforcement is opaque and possibly quite fragile. Deterrence is a function of people’s beliefs about (1) the severity of penalties and (2) the likelihood of getting caught. The perceived likelihood of getting caught is a function of the number of violations that people believe occur, and the number that end up being punished. People might have a somewhat accurate perception of the former, especially if the government tends to focus resources on press-worthy cases. But there is no good information about the latter. People likely take the number of prosecutions (and SEC enforcement cases) as a primary signal of how much insider trading there is.
This inference, though resting on empirically shaky ground, suggests a dilemma for enforcers. Not enough insider trading cases, and the audience might think that lots of people are getting away with insider trading. Too many cases, and the audience might think that insider trading is widespread. (A similar point has been made about the optimal level of prosecuting people for cheating on their taxes.) What to do if you are Preet Bharara, the most important prosecutor in the insider trading field? Hard to know, but at least don’t say publicly—as he recently did—that insider trading on Wall Street is “rampant and may be on the rise.”
Stephen Crimmins is a former SEC lawyer and current chairman of the Federal Bar Association’s securities law executive council. He spent 14 years at the SEC, the last 8 of them as deputy chief litigation counsel of the SEC’s enforcement division. Since 2001, he has defended a range of clients involved in securities cases, including public companies, senior corporate officers, financial services firms and Big Four accountants.
Information is what moves markets, and exploiting information ahead of others is what makes makes money for market participants. There will always be cheats who break the law by getting an informational edge, either through theft or by breaching a duty of confidentiality. For this reason, insider trading will be with us for as long as we have markets. Law enforcement’s goal must be to build in sufficient risk to the potential insider trader’s decision-making process to minimize this conduct to the greatest degree possible.
Over the last year, the Justice Department and the Securities and Exchange Commission have seriously ramped up their game in going after insider traders. Cases built only on “circumstantial” evidence — for example, a profitable trade by someone who happens to have a contact at the company — can be hard to prove. We’re now seeing the government using get-tough tactics like wire-taps and criminal plea bargaining to get “direct” evidence and build strong and winning cases that will deter others. The other big change has been the government’s pursuit of rings of insider traders who regularly swap inside information about multiple stocks. Once the government locks onto a portion of the ring, it can leverage cooperating witnesses to deliver the rest of the ring.
Much of the current action involves these so-called “expert networks,” which provide research to hedge funds and other sophisticated traders. This situation grew out of a piece of regulation the SEC adopted in 2000 called Regulation FD, which restricts public companies from selectively giving out information. Expert networks gradually became alternative sources for traders to get information about companies. However these venues are not always transparent and can thus pose new and different challenges for policing our markets.
There have been times when insider trading and other fraudulent practices have led investors to cynically conclude that Wall Street is not a place where a simple retail investor can make a buck. Such views are particularly dangerous today, with the need for capital formation and growth following the worst melt-down in 80 years. The challenge before Congress in the coming months will be to realize that adequate funding for Wall Street’s police is critical to restoring investor confidence and rebuilding our economy.
Dan Bubalo worked at the investment bank Drexel Burnham Lambert in the mid-1980s. He went on to co-found the investment firm Seneca Capital, before pleading guilty to securities fraud in 1999 and serving four years in federal prison. He is currently the GM of an HVAC company in Plano, Texas.
Insider trading has been rampant in the securities industry for decades. I ought to know. I plead guilty to its fraternal twin, securities fraud, and was sentenced to four years in a medium security federal prison in 1999. The only reason regulators are paying more attention to it today, I believe, is due to advancements in technology, which gives them a fighting chance for the first time in a while.
I worked at Drexel Burnham and got to know a lot of influential thinkers in the securities industry. I’ve also had the unfortunate privilege of meeting regulatory enforcement officials up close and personal, and believe me: the intellectual talent gap between the two groups is enormous, skewed in favor of industry sharks of course. Committing insider trading has traditionally come with such a low threat of getting caught, with the exception of the most overt and clumsy actions, that it has been far more prevalent than the handful of prosecutorial action would seem to indicate.
This is not to say that everyone in a position to commit insider trading does. Just the opposite is true. The majority of key players are aware of an absurd amount of propriety data and yet never cross the line to capitalize on it. In theory, only key people on the corporate or investment side are aware of sensitive information, while in reality it is impossible to exercise containment of such data due to the number of people directly or indirectly exposed to it, such as accountants, lawyers, executives and the inevitable cadre of administrative support staff. A compromise of security is, therefore, imminently predictable and can manifest itself in a number of different ways.
Certainly, there have been instances over the years of a cleaning person capitalizing on a merger due to information left carelessly on a desk, or that enterprising Kinko’s employee who took action after reading some merger documents he was entrusted to copy. But these are the exceptions as opposed to the rule.
Access to information for those intent upon using it for illegal gain is a timeless dilemma, and the Chinese Wall of Silence is nothing more than a myth that has been violated repeatedly by those motivated by illicit gain. The primary difference between today’s criminal and transgressors of the past is that today, there exists the belief that security lies in the enormous volume of transactions flooding the marketplace everyday, that this data overload provides them with cover. In a way, it’s not an incorrect calculation. But clearly, as recent events show, authorities have gotten significantly better at detecting trading anomalies amidst massive amounts of data.
Today’s young turks and mavericks are also providing authorities with new sources of evidence with all their tweets and texts. The secret and coded world they’ve created for themselves combined with a profound arrogance toward regulation has given them a false sense of security to the point that they’ve ignored the inevitable, and grown blind to the fact that all written communication is traceable.
Gary Zeune is an accountant with 35 years of experience in auditing, corporate finance, and investment banking; he also runs Pros and Cons, the only speakers’ bureau in the country that represents white-collar criminals.
Insider trading is cyclical. So why the big increase right now? When Congress adopted Sarbanes-Oxley, it failed to take into account that any time you change a system, people will always change their behavior to maximize the benefit to themselves. Happens over and over and neither lawmakers nor auditors take the change into account in establishing controls and oversight. Failing to figure out how people will react nearly always results in unintended, negative consequences.
The economic meltdown that started with subprime mortgages is an example of not thinking through the consequences of a “new system.” Thirty years ago if you wanted to buy a house you trotted down to your local bank, filled out the application, put 10 or 20 percent down. The bank vouched that you were a good citizen, confirmed you had a job and how much you made. Why? Because if you didn’t make payments, the bank got stuck. All the folks on the front end — mortgage broker, appraiser, title agent, etc. — were, for the most part, diligent. They depended on repeat business.
Then Congress decided it was a good idea to increase home ownership and let lenders sell mortgages to investment banks, which securitized them and sold them with AAA ratings. But the people who got paid on the front end of the transaction had no long term risk. They didn’t have to return their fees or commissions if the loan went bad. Any time you separate the pay from the risk you get a really bad result. To drive responsible behavior, you have to link rewards with behavior. For example, to ensure that loans would be paid back, lawmakers could have required that for any loan that was to be packaged and sold, the ‘front-end’ participants would get paid only as the borrower made loan payments. That system would have been “goal congruent.”
People engage in fraud when the three conditions of the triangle of fraud are met: need, opportunity, and rationalization. Need is the trigger. It can be financial or psychological. A bookkeeper whose house is in foreclosure steals to make payments. Or an employee who has valuable information and an expert will pay for it. Opportunity is simply thinking that you won’t get caught. People speed when driving because there aren’t many cops around. The current insider trading fraud in expert networks is because the ‘experts’ and their sources (company employees) are new to the system and don’t realize there are lots of ‘SEC cops’ on the beat. Third, rationalization is talking yourself into behaving outside your “moral code of conduct”, i.e., justifying breaking the law. Driving: “I’m a safe driver.”, “Everyone does it.”, “I’m only keeping up with traffic.” Employees and experts engage in insider trading: “Those hedge funds are making millions off my expertise.”, “I’m just taking a tiny amount. No one will miss it.”, “I work hard and I’m not paid what I’m worth.” So the next time you’re driving, ask yourself how you rationalize breaking the law. Insiders tell themselves the same thing. Why don’t speed limits work?
Here are some controls (adapted from Carlo di Florio, Director of SEC Office of Compliance Inspections and Examinations) that, if implemented with the “expert networks” required by SOX, would have reduced (not eliminated) the temptation to commit insider trading:
- A signed agreement with every party participating in the network or using the information derived therefrom.
- Every conversation has to be approved before it occurs. After the conversations are much too easy to rationalize.
- Independent monitoring of all conversations.
- Absolute prohibition of using public company employees as experts (di Florio listed extra controls over public company employees acting as ‘experts’ but that allows people to rationalize illegal behavior).
- Each trade must be certified as ‘non-insider trading free’ with automatic dismissal, disgorgement of 5 times the illegal profits and referral to law enforcement.
- All parties in the system are required to provide access to their trading records and stock holdings. Any failure is automatic dismissal, etc.
Congress failed to mandate new controls and compensation systems to minimize the risk of fraud when it required ‘expert networks’ under SOX. The predictable result? Insider trading fraud. Only then do we “see the light” and attempt to punish the fraudsters and implement controls. For example, experts told the FAA for years that if the security system at airports were ever seriously challenged, it would fail miserably. Why did 3,000 people have to die before the FAA got a backbone and did something about it? Why don’t we ever learn our lesson?