"Insider Trading Arrests - Too Often, Prosecutors Benefit & Investors Get Hurt"

Sydney M. Williams

Thought of the Day

“Insider Trading Arrests – Too Often, Prosecutors Benefit & Investors Get Hurt”

November 29, 2010

Trading on “inside information” has long constituted a crime. Regulation FD (Fair Disclosure), adopted by the SEC in August 2000, was an attempt to refine exactly what constituted inside information – material non-public information disclosed to one investor must be publically disseminated. Regardless, what constitutes “material information” remains a matter of interpretation. The real consequence of the rule has been to broaden the grey area between what’s legal and what is not. With a regularity that seems contrived, government agents have once again determined that this crime demands an aggressive full court press.

Both the U.S. Attorney’s Office for the Southern District of New York (appointed by the President) and the New York Attorney General’s Office (elected by citizens of New York) have been stepping stones for successful careers. Rudy Giuliani used the office of U.S Attorney to be elected Mayor of New York in 1994. Eliot Spitzer used the office of New York Attorney General to elevate himself to the governorship of New York in January 2007, a position he held until his personal predilection for peccadilloes caused him to resign a little more than a year later.

In February 1987, Rudy Giuliani, then U.S. Attorney, charged Richard Wigton of Kidder Peabody with insider trading, had him handcuffed and marched out of his office. Three months later the charges were dropped. Two years later, in an attempt to prosecute Mr. Milken, Giuliani stormed into the offices of the $3 billion-in-assets firm Princeton/Newport. The charges were later overturned on appeal on the grounds that what the principals had done did not constitute a crime. Nevertheless, the damage had been done. Mr. Wigton’s career had been destroyed, Princeton/Newport and Drexel Burnham closed. In 2003 Eliot Spitzer sued Dick Grasso, President of the NYSE, accusing him of keeping some of the board in the dark as to $140 million deferred compensation package. On July 1, 2008, the New York State Court of Appeals dismissed all claims against Mr. Grasso. Mr. Spitzer infamously charged Maurice “Hank” Greenberg, chairman and CEO of AIG for fraud, forcing the board of the company he had founded to fire him in March 2005. Following a subsequent investigation all criminal charges were dropped against Mr. Greenberg.

Both men, in their quest to trap a “name” (one recognizable to millions of voters) damaged the names and reputations of a number of innocent people and cost hundreds of others, if not thousands, to lose millions of dollars – including tax payers who funded these quixotic attempts at justice.

Preet Bharara, the U.S. Attorney for the Southern District of New York, is leading the current charge against what he has termed “the largest hedge fund insider trading case in history.” He, too, one can feel certain, has his eye on a bigger prize. In the meantime his actions have already had consequences. According to Friday’s Financial Times: “Investors have sought to withdraw about $3 billion from FrontPoint Partners, a hedge fund with $7 billion in assets.” Other hedge funds named will likely face similar disruptions. Funds will be closed. Jobs will be lost and investors will likely lose hundreds of millions of dollars. Fiduciaries, generally responsible for the bulk of assets in hedge funds, have little choice but to pull money at the first hint of trouble. Whether it is the U.S Attorney, the SEC or the Attorney General, the consequences of their charges are that a lot of innocent people – employees and investors – get hurt. It behooves them to proceed with caution However; in their view, the prospect of a political victory takes precedence over jurisprudence.

Information is at the heart of what makes Wall Street research function and though rules such as FD are designed to level the playing field, the truth is the field will always be rutted. In large part that is because people in this business have varying talents and differing work ethics. Analysts are not now and never will be equal. Some have good gut instincts, a quality that cannot be taught. Others are able to analyze numbers more proficiently than their competitors. Some are willing to walk that extra mile, stay later at their desks or spend more time on the road. And lastly, some are better at making judgments. A good analyst, whose job is to determine the value of a business, ferrets out information in differentiated ways – going through all the publically available numbers, doing channel checks, talking to customers or suppliers and then imposing his or her own interpretation of the data.

In his story of the supernatural, The Gap in the Curtain, John Buchan writes (in a different context), “Success, he had argued, depended upon looking a little farther into the future than other people.” Similarly, successful analysts attempt to predict the future for the companies followed – sales, cash flows and earnings – more accurately than their peers. In an op-ed in last Wednesday’s Wall Street Journal, Holman Jenkins wrote: “In the SEC’s ideal world any information originating inside a company will be reflected in stock prices only after the company has publically announced it to the world’s investors simultaneously.” But the real world is not so sanitized. Mr. Jenkins goes on: “A company cannot do business without revealing itself to its customers, its suppliers, the guy who drives by and sees a parking lot more full (or empty) than the day before.” That is what a good analyst does.

The passing on of true inside information can never be the fault of just one party. An analyst or portfolio manager, should he or her be guilty of trading on inside information must have received that information deliberately from someone of consequence within the company, almost always for compensation.

This is not meant to suggest that illegal activity and corruption do not exist in corporations or on Wall Street. They certainly do, but it is not rampant. The proprietary desks of sell-side firms’ and high frequency trading platforms deal within a far murkier environment than do conventional, customer-driven sell-side research analysts. Most research is perfectly legitimate – even those that employ outside consultants – with analysts and investors using their brains and their instincts to get an edge on the competition. However, neither do I agree with the concept that trading on inside information is a “victim-less” crime. There are always victims. Someone who buys or sells on privileged information, by definition, engages a counter-party. That person, for either buying too high or selling too low, is a victim, in my opinion.

The biggest problem with Wall Street continues to be the persistence of banks too big to fail – a situation not only left in place with Dodd-Frank but, in reality, enhanced. In private companies and partnerships, returns to labor and to capital are one and the same. The capital deployed is that of the partners, or owner-operators. In public companies there is a distinct difference; labor employs capital provided by outsiders. On Wall Street, within these large publically owned banks, labor takes the lion’s share of profits and does not, to any real extent, participate in the losses. Capital receives de minimis returns, yet assumes the bulk of the risk, as shareholders in Citigroup in 2008 can well attest.

Complaints about the money made by the owners of private hedge funds are without basis. Those firms were founded by entrepreneurs; no investor was coerced into investing with them. The formula on which their compensation is based is known to all. On the other hand, the employee of a public owned firm is dependent upon financing from public shareholders. It is the rare lack of failure of publically-held banks that permits Wall Street to persist in acting as the prodigal son – and when failure occurs, it is capital, not labor, that suffers the most grievously; as we have learned over the past two years, with stock prices’ still dramatically below their pre-crisis levels and Wall Street bonuses at record levels. The system of banks too big to fail owes its charmed life to the establishment that exists between them – the large banks – and Capital Hill. Capitalism should permit those enterprises that have run aground to fail, not be bailed out.

But it makes better headlines to go after “evil” and “greedy” hedge fund managers. That they are based in places like New York and Greenwich, Connecticut only enhances their appeal to politicians looking for a score. For a government rooted in populism, arresting and prosecuting hedge fund managers serves to distract voters from what President Obama deemed a “shellacking” at the polls three weeks ago and from the far more important problem of “too big to fail”. Whether it is the Attorney General for the Southern District of New York, the New York Attorney General or the SEC, their history of arrests being nullified and convictions being overturned is such that caution should be their byword. In acting rashly, the wrong people are made to suffer and the most significant consequence is that the fox that has been put in charge of the hen house who goes on to higher elected office.