Knowledge may be power, according to 16th century British philosopher Francis Bacon, but these days, information is equity. At least it was for a circle of friends employed as hedge fund portfolio managers and analysts in the United States. The seven buddies are on trial for swapping "inside information" about Dell (NSQ: DELL) and other technology companies. One of these tips generated $57 million - potentially the largest profit ever made on a single stock tip.
What is insider trading?
Insider trading is when someone who has not-yet-public information about a corporation trades that company's shares, bonds or stock options. He or she knows in advance if the company's shares will rise or fall once the information becomes public news. When employees, officers and directors trade their company's shares, they must report the trades so it becomes public information. If an insider shares material information (info that could have a significant impact on share price) with you and you buy or sell the company's shares because of it, you will be guilty of illegal insider trading. Insider trading tips have been gleaned by overhearing conversations at restaurants, bars, sports clubs, hair salons...and of course, there's always pillow talk.
A fictional example
In the 1987 film Wall Street, directed by Oliver Stone, Bud Fox (Charlie Sheen) is a junior stockbroker who learns some inside information about the airline company where his father (Martin Sheen) works. He relays the information to investment banker Gordon Gekko (Michael Douglas) who makes a lot of money trading the airline shares. Bud then learns to spy and pick up inside information by any means, becoming wealthy and successful, until he is finally caught by the SEC and arrested.
Why is insider trading illegal?
The stock markets operate on the premise that all investors should have access to the same information at the same time - a level playing field. When some people have access to secret information and use it for their own profit, they have an unfair advantage and the whole integrity of the system is compromised. (A classic case of a few bad apples spoiling it for the rest of us!) Regulators use market surveillance systems to monitor trading patterns and unusual trades. Those found guilty of illegal insider trading (or tipping off others) are subject to criminal prosecution.
The not-so-perfect Martha
In 2001, domestic doyenne Martha Stewart sold about $230,000 in shares of ImClone Systems, a pharmaceutical company that makes cancer medicines. The very next day it was announced that ImClone failed to get FDA approval for one of its experimental drugs. ImClone's shares plummeted on the news but Martha's profits were neatly saved. Until of course, she was questioned about her timely stock dump. She served five months in prison, five months of home confinement and two years of probation. Not a good thing!
Operation Perfect Hedge
According to the US government prosecutor, the men charged with insider trading of Dell shares are "a stunning portrait of organized corruption on a broad scale." Allegedly, they had access to information about the 2008 quarterly earnings reports of Dell before those reports were public and traded on that information. In doing so, they made profits of $62 million. Investigators called it "a criminal club whose purpose was profit and whose members regularly bartered lucrative inside information". The FBI gave it the code name of "Operation Perfect Hedge". Shown is Jon Horvath, an analyst at Sigma Capital, leaving a US federal courthouse.
Why are hedge funds often associated with insider trading?
Hedge funds are traditionally sold only to "sophisticated investors" - typically institutions, pension funds, foundations or uber-wealthy individuals. As a result, for many years hedge funds were not held to the same level of regulation and reporting as those sold to regular, retail investors, such as mutual funds. They simply weren't being watched. In 2010, the Dodd-Frank Wall Street Reform Act was passed requiring hedge fund advisors with $150 million or more in assets to register with the Securities and Exchange Commission (headed by Mary Schapiro, shown). In Europe, the Alternative Investment Fund Managers Directive provides monitoring and control of the hedge fund industry.
The biggest case in US history
On October 13th, 2011, billionaire hedge fund manager, Raj Rajaratnam, was convicted of insider trading and sentenced to an 11-year prison term. His crimes produced about $75 million in profit through dozens of trades over several years. Rajaratnam was the founder of Galleon Group, one of the largest hedge fund management firms in the world, which has been shut down. His sentence is the longest prison term yet for someone convicted of insider trading.
Does it happen in Canada?
The laws against insider trading do not vary much between the US and Canada, however some analysts have estimated that US authorities prosecute 20 times as many insider trading violations as we do in Canada (a given, considering the disparate populations). In the US, the SEC has national jurisdiction of securities regulation, while in Canada we have provincial securities regulators. The largest of these, the Ontario Securities Commission (OSC), launched 24 proceedings of securities law violations in 2010. A total of $36 million in fines were issued by the OSC in 2010, versus $2.8 billion in fines by the SEC in the US.
A Canadian example
In 2005, former investment banker Andrew Rankin was convicted of giving his school chum, Daniel Duic, inside information about some corporate takeovers he was working on. Rankin argued that Duic stole the information from his home computer. Regardless, Duic bought shares in 10 companies poised for takeover. When the acquisitions were announced and share prices shot up, he sold the shares and profited about $4.5 million. Once the OSC got involved, Rankin was convicted of tipping, paid $250,000 in fines and was banned from trading for 10 years. Duic agreed to testify against Rankin, paid $1.9 million to the OSC and was banned from trading in Canada for the rest of his life.
An illegal kind of greed
When you're privy to some fat, juicy, corporate secrets, it can be tough to sit on the sidelines, knowing you could earn a lifetime's worth of earnings in just one trade. This is the temptation that many people, especially those in the financial industry, face nearly every day. Greed - and that idea of getting rich quick - often makes people blind and obscures their judgment. Testimony of convicted inside traders often includes the phrases "I didn't think it could be traced to me" and "everybody is doing this, right?" However they should have known that the markets are like mothers...eventually, they always find out.