Who Are the Real Victims of Insider Trading?

Last week, the prosecution and the defense filed their sentencing memoranda in the Rajaratnam case.  Raj was convicted of 14 counts in all — 9 counts of securities fraud, and 5 conspiracy counts.  So what do the parties think that’s worth?  The feds asked Judge Holwell to sentence Raj in the range of 19.5 to 24.5 years.  The defense didn’t make a specific request, just said it ought to be “well below” what the feds want.

So 20 years, huh?  Wow, he must have been an awful bad guy.  Must have hurt a whole lot of people, right?

After all, a mugger in a dark alley only takes one person’s wallet.  A “white-collar criminal” can steal from thousands of people — and takes not just their wallet, but their life savings!  Right?

Well, hang on.  Did Raj actually steal from anyone?  How many investors did he really harm?  And did any of them really lose enough money to warrant locking someone up till we all have flying cars and jetpacks?

Judging from the feds’ sentencing memo, you bet.  Just look at this, from the introduction:

Raj Rajaratnam’s criminal conduct was brazen, arrogant, harmful, and pervasive.  He corrupted old friends.  He corrupted subordinates.  He corrupted entire markets.  Day after day, month after month, year after year, Rajaratnam operated as a billion-dollar force of deception and corruption on Wall Street.

Wow, that sounds awful.  So the victims are… who again?

But wait, there’s more:

Rajaratnam repeatedly leveraged the power of money and his position as the head of a 7-billion dollar hedge fund to induce friends, employees, and associates to participate in his criminal activities.  Although already rich, Rajaratnam did this to drive up his personal wealth through profitable trading in his hedge fund.  He did it to make sure that investors did not pull their money out of Galleon and to attract new money to his fund.  And he did it because of his egomaniacal drive to triumph over his competitors on Wall Street.

Again, wow.  (The feds sure like their adjectives, don’t they?  Comes off a tad over-the-top, if not insulting to the intelligence.)  So he was trying to increase his wealth, gotcha.  But at whose expense?  Guess we have to read more:

That was what he cared about: money and success.  What he did not care about, at all, was the extensive harm he left in his wake: harm to the capital markets; harm to the average, ordinary investors who played by the rules; harm to the companies whose secret information was misappropriated; and harm to the lives of those he corrupted.

Well, that sounds a little more like it… but again, who was harmed, and how?

Although particular investors on the other side of Rajaratnam’s illegal trades are not easily identifiable, there should be no question that ordinary investors paid the price for Rajaratnam’s crimes and that public companies were harmed by Rajaratnam’s repeated theft of corporate secrets.

Oh for crying out loud.  Are they joking?  Stripped of its demagogical rhetoric, this translates to “We have not identified any actual victims.  But we shouldn’t have to.  It’s obvious that lots of people must have been harmed, even if we don’t know who they were.”

If they don’t know who — or even whether — anyone was actually harmed here, how in blazes do the feds justify asking for 19.5 to 24.5 years of imprisonment?  Here’s how:

[The feds want that much time because they feel it is] proportionate to the historic nature of his crimes.  He is arguably the most egregious violator of the laws against insider trading ever to be caught.  He is the modern face of illegal insider trading.

That’s it.  That’s all.  “Because this is the first time we’ve ever caught someone so red-handed,” and “because this case got so much press.”  Those are the sole reasons why they are looking to put this guy away until he dies of old age.

Really?

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For the record, we’re predicting something around 180 months — 15 years or so.  We base that prediction on other sentences by this judge that we’re aware of, and a bit of that amorphous experience we call our gut.

But is even that what this case is really worth?  When all is said and done, who really are the victims of insider trading?

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It depends on how the crime was committed, really.  There’s more than one way to skin a cat, and there’s more than one way to commit securities fraud.  Some kinds of insider trading have more obvious victims than others.

For example, let’s say you break into the offices of 3M, and read a secret file that shows they are about to announce the release of a phenomenal new kind of sticky note that will revolutionize office work forever.  You max out your leverage and buy all the 3M call options you can afford.  When the news is announced a week later, you’re an instant millionaire.

Now, did your actions change the profit or loss of any other people?  Nobody else’s stock price went up or down a penny because of your actions.  3M’s shareholders are just as wealthy as they otherwise would have been.

What about the counterparties to your trades?  Didn’t you defraud them by buying at their price when you knew the price would be higher?  Not really.  Fraud implies misrepresentation.  The only thing you represented was that you thought the price was going to go up, which was true.  They did the deal not because of any representation you made, but because they calculated it to be worth it.  So nobody in the market seems to be a victim here.

But you stole.  You out-and-out stole secret information that you weren’t entitled to.  The value of that theft can be calculated a few different ways, but the simplest way is to look at how much you yourself profited from the theft.

It’s not really insider trading, then, so much as a simple act of burglary.  Applying the securities laws doesn’t seem to be called for.  But it is still considered security fraud and insider trading at the moment, and there is certainly an identifiable victim: 3M.  And an easily calculable loss: either your gain, or some other book valuation of the info you stole.

Another example where there is a clear victim and a clear loss is when a short seller gets wind of some confidential information that’s bad for Company X, and the short seller starts shorting Company X all over the place, further driving down the stock price.  Company X’s shareholders are tangibly harmed by this, because their assets just lost a lot of value they probably wouldn’t have but for this trading on inside information.  (If the trader was someone who actually owed a duty to Company X — an executive or other fiduciary — there’s an added sense of disloyalty, but the harm is still the same.)

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But apart from those examples and maybe one or two more, there just aren’t situations where insider trading really has any victims.

So why is it a crime?

“Because it undermines consumer confidence in the markets,” is the official line.  That’s hogwash, of course.  Consumer confidence would only increase if there were more insider trading.  Share prices would be determined, not by guesswork and conjecture, but by actual solid data.  Heck, it ought to be mandatory.  If the information is material, and it’s a publicly traded company, then the information ought to be public.  Theft of trade secrets should be the only law on the books here.

Not only is it beneficial to the markets, to have pricing based on accurate information, but there is no element of fraud involved.  It really isn’t securities fraud.  Nobody is being deceived; everyone is engaged in arms-length trades, buying and selling for precisely what they think the stock is worth.

It’s no different than if I buy a rare book from you for $10.  You think it’s worth maybe a buck on a good day, and you’re happy to sell it to me for what I offered.  I, on the other hand, know it’s worth at least $1000 to a collector I happen to know.  So what?  My purchase isn’t fraudulent or criminal in any way.  (Presuming you hadn’t hired me to assess the value of the book, of course.)  How is this different from insider trading in the stock market?

The simple answer is that, absent outright theft or misappropriation of secrets that don’t belong to you, insider trading doesn’t have any victims.  It doesn’t hurt anyone.  In many cases, it’s probably actually a good thing.

The only reason it’s against the law is because it’s politically fashionable for it to be so.  People love railing against “corporate greed” and “Wall Street crooks,” those amorphous evils of the populist psyche.  When the economy takes a hit, for good and basic economic reasons that have nothing to do with any criminal activity, there’s an outcry for punishment of the financial wizards doing things with money that we don’t understand.  Folks on the left pass more laws and regulations outlawing efficient market behavior.  Folks on the right pass stiffer sentences.  Prosecutors break their legs tripping over each other to indict the next big press case.  And so it goes.

Who are the real victims of insider trading?  In some cases, maybe it’s the people who get charged with it.

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Even so… 20 years?

Really?

Really?