The Feds’ Insider-Trading Gamble


The feds are really ramping up their insider-trading enforcement.  But instead of going after real insiders, they’re going after consultants and investors who use them.  This is a big risk for the feds, and they could lose big.

It started a year ago, when the feds indicted a bunch of people in what we collectively refer to as the “Galleon” case.  For the first time ever, the feds had used wiretaps in a white-collar investigation.  It looked like the gloves were coming off, and the feds were going to start getting down and dirty, using street-crime law enforcement techniques to go after Wall Streeters.

Then in May, Lanny Breuer announced a “new era of heightened white-collar crime enforcement — an era marked by increased resources, increased information-sharing, increased cooperation and coordination, and tough penalties for corporations and individuals alike.”  In the wake of an economic bubble bursting, they were gunning for the suits who had profited.  And unlike the last time they tried, in the wake of the dot-com bubble, now there was no 9-11 to divert their resources.

To some extent, such a strategy is like shooting fish in a barrel.  Real frauds like Ponzi schemes and the like, which can hide amidst a rising market, come to light pretty easily when the market collapses.  And we saw a lot of those prosecutions in the past couple of years.

But to a larger extent, it’s a political strategy.  Going after those who make money by moving it around, instead of creating something of value, is always going to be a populist move.  It wins brownie points for the DOJ and the president.

And now comes the takedown.

On Saturday, the Wall Street Journal reported that the feds had been conducting a 3-year investigation into possible insider trading.  They had been approaching people out of the blue, telling them they were in trouble, and suggesting that they wear a wire (with at least a couple people refusing to do so, and then emailing all their clients to tell them what had just happened).  The feds had been subpoenaing records for a while.  The targets seemed to be Goldman Sachs and consultants who matched knowledgeable industry leaders with hedge fund managers looking for an edge.

That seems to have forced the feds’ hand, and on Monday they started executing search warrants at Diamondback Capital Management and Level Global Investors, which had been identified in the Saturday story.  Then they raided Loch Capital Management later in the day.  We hear that more raids are coming, and as we speak a lot of investment firms are doing some heavy internal reviews, to figure out if they might be on the list.

Because nobody knows what kind of behavior the feds are going after.  And if past performance is any indicator of present results, the feds may just well be going after perfectly innocent behavior.


The reason is that the feds don’t seem to understand the difference between illegal insider trading and lawful sharing of information.  In a conference yesterday, while the raids were going on, an associate director of the SEC’s enforcement division said that “there’s a lot more patterns and serial insider trading than we previously thought had occurred.”

Translated, this means that the feds are suddenly taking note of all the consultants and analysts out there, who give hedge fund managers insights into where an industry or company is going.  As one would expect, plenty of those consultants used to be high-ups at such companies.  Hence their ability to provide insights.

But that’s not insider trading.

Insider trading is a fairly new crime, one of the countless new federal crimes created in the last decade.  One commits the crime of insider trading by first, knowing some secret, non-public information.  Second, one must have a fiduciary duty to the owner of that secret information, a duty not to disclose it.  Third, one must divulge that secret in violation of that duty.  And fourth, the person who uses that secret information had to know that it had been shared in violation of that duty.

That last step is bloody hard to prove.  You have to be able to prove actual subjective knowledge on the part of the recipient of the information, that it was a secret.  “Knowledge” is not the same as “this sounds like a secret” or “this is probably a secret.”  “Knowledge” is “I know this really is a secret.”

And even if the information being divulged to hedge fund managers was secret at one point, it’s not as if the information is coming directly from the executive with the fiduciary duty.  He spilled the beans to someone else, who shared that info with a consultant, who mentioned it to one of these firms that matches consultants with investors, and eventually the information got shared with the hedge fund manager.

In that case, the executive sure committed a crime.  But that’s not who the feds are targeting!  They’re going after the consultants, the hedge funds, and the firms that match them up.  None of them breached a fiduciary duty, the end user had zero privity with the one who did breach the duty, and it’s going to be hard to prove any actual knowledge by any intermediary or investor.

That’s a lot of room for reasonable doubt.  A good defense lawyer will have a heyday with this kind of case.


And don’t forget, a hedge fund manager (or any other trader)’s primary function is to gather information.  You keep your ear to the ground, listen to rumors, and try to predict what’s going on.  A good trader has a network of sources to rely on, and everyone and their mother has a tip.  Most of the “sure thing” tips one hears are utter bullshit, but every now and then one is worthwhile.  The trick is being able to spot the gold.

This “relentless pursuit of data,” as it has been characterized, is completely normal and perfectly legal.  It is what the market is supposed to do.  It is precisely what the law is supposed to encourage.

It’s not the same thing as an insider profiting from his own knowledge at the expense of the market.  It is the market trying to make the best judgment call from the available data.  If a real insider happens to seed the market’s data with secret information, it is not the market’s fault, and it’s not a crime to use it if one learns it from a third party, without knowing it was a secret.

There’s all kinds of room for reasonable doubt here.  And don’t even get us started on the way the feds are all of a sudden using wiretaps and body wires to gather evidence.  Forget the suppression issues we keep seeing — a good defense lawyer with experience with these things can often fight such evidence successfully at trial.  It’s not always as strong as you might think.  But that’s a topic for a whole nother post.

Suffice it to say, for now, that the feds are taking a huge risk here.  A very expensive, three-year investigation, could very well go down the toilet, because they’re going after the wrong people, for the wrong activity, with the wrong tools.

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