Raj Rajaratnam and Insider Trading

Summary

In October 2009, the Justice Department charged Raj Rajaratnam, a New York hedge fund manager, with fourteen counts of securities fraud and conspiracy. Rajaratnam, who was found guilty on all fourteen counts on May 11, 2011, had allegedly cultivated a network of executives at, among others, Intel, McKinsey, IBM, and Goldman Sachs.  These insiders provided him with material nonpublic information.[1] Preet Bharara, the government’s attorney, argued in the case that Raj Rajaratnam had made approximately $60 million in illicit profits from inside information.[2] Rajaratnam’s conviction in fact falls into a larger post-recession crackdown on insider trading undertaken by the SEC and the US Justice Department, led by Preet Bharara.[3]

Raj Rajaratnam was the 35^th person to be convicted of insider trading of 47 people charged since 2010.[4] This effort to prosecute insider trading has been marked by more aggressive tactics such as wiretapping to prosecute insider-trading cases, which might otherwise be difficult to prove.[5] This case study will use a specific instance of insider trading from the Rajaratnam trial to examine more general claims that insider trading ought to be legal. It will focus on Rajaratnam’s trading immediately before and after Warren Buffet’s infusion of $5 billion into Goldman Sachs on September 23, 2008.

The Players

Raj Rajaratnam was the Sri-Lankan manager of the hedge fund Galleon Group, which managed $6.5 billion at its height.[6]

Rajat Gupta is a former director at Goldman Sachs and head of McKinsey consulting. He also served on the board of Procter & Gamble.[7]

Warren Buffet is the CEO of Berkshire Hathaway, an investment company.

Preet Bharara is the United States Attorney for the Southern District of New York.[8]

Facts and Claims

Facts

–      On September 23, 2008, Warren Buffet agreed to pay $5 billion for preferred shares of Goldman Sachs.[9]

–      This information was not announced until 6 p.m., after the NYSE closed on that day.[10]

–      Before the announcement, Raj Rajaratnam bought 175,000 shares of Goldman Sachs.[11]

–      The next day, by which time the infusion was public knowledge, Rajaratnam sold his shares, for a profit of $900,000.[12]

–      In the same period of time financial stocks as a whole fell.[13]

Claims

–      Rajat Gupta had called Rajaratnam immediately after the board meeting at which Warren Buffet’s infusion had been announced, and told him of the money Goldman expected to receive. [14]

–      This information was material to the price of Goldman stock, thus inciting Rajaratnam to make the trade, something he would otherwise not have done.

Background

Insider trading may be defined as any form of trading based on nonpublic information relevant for the fundamental value of a company (and thus the stock price).[15] Thus, it is an activity founded in asymmetrical information. Section 10b of the Securities and Exchange Act of 1934 governs U.S. insider trading rules. According to Engelen and Liederkerke, “Based on this authority, the SEC enacted Rules 10b-5 and 14e-3. […] Insiders are only liable if they breach a fiduciary duty to the source of the information.”  Similarly, recipients of insider tips (tippees) must breach the tipper’s fiduciary duty before the tippee becomes liable.[16]

Furthermore, most European countries enacted insider-trading regulations in the early 1990s, and in 2003, the European Union introduced the Market Abuse Directive (MAD).  The Directive excludes primary and secondary insiders to engage in trading based on inside information, disclosing the information to third parties, and recommending a transaction to a third party.[17]

Ethical Analysis

Several academics, including Milton Friedman, have argued that insider trading ought to be legal.[18] Several other commentators have renewed that argument in articles over the past year, often citing the Rajaratnam case.[19] Their arguments are as follows:

1. It is difficult to prosecute.[20]
2. It is a victimless crime.[21]
3. It increases the information in the market, thus increasing market efficiency. This argument requires a bit more explanation. Essentially the idea is that if an insider knows that stock X is severely over-valued, and sells his or her holdings in X, then the price of X will drop, thus more accurately reflecting its value.[22]
4. It increases incentives for company officers to make profits.[23]

We will use the Rajaratnam case, specifically the instance of alleged insider trading on September 23 and 24, 2008, to examine these four claims made by proponents of legalizing insider trading:

Insider trading is difficult to prosecute.

This is an empty argument that does not address the ethics of insider trading and could be used to justify any unethical behavior. Recent empirical evidence demolishes this argument. The government’s new aggressive investigative techniques have made insider trading easier to successfully prosecute. Although Rajaratnam’s defense lawyers resorted to the mosaic argument, contending that Galleon’s trades were made not on the basis of illicitly obtained information, but hours of diligent research, the jury nonetheless found him guilty.[24] This case leads one to believe that insider trading is not as difficult to prosecute as some proponents might assert.

Insider trading is a victimless crime.

Let us consider the imaginary case of Jane Smith, an investor in Goldman Sachs stock who puts in a sell order for 100 shares of Goldman Sachs three minutes before closing time on September 23, 2008. Now let us suppose Rajaratnam’s Galleon Group buys her shares at $119.53. The share price then spikes when markets open the following morning, leaving Galleon with a virtually risk-free $900,000 profit. Had Rajaratnam not bought those shares, then Jane would have sold her hundred shares for a substantially higher price the next morning. Given that any reasonable investor would not have sold their shares, were they in possession of the information in question, it seems that Rajaratnam’s actions would have harmed our imaginary Jane Smith, and did harm the investors from whom he bought 175,000 shares of Goldman Sachs stock. While nobody forced these investors to sell, it was near to impossible for them to acquire the same information on which Rajaratnam was trading. Thus, while trades are almost always made on asymmetrical information, because not all investors have equal time and money to devote to market research, there is a significant difference between information that Jane Smith could find out but did not and that which she could not have discovered. Insider trading is therefore not a victimless crime, but rather one in which certain investors lose money by virtue of their inability to access certain information.

Insider trading increases the amount of information in the market, thus increasing market efficiency.

By buying 175,000 shares of Goldman stock immediately before the market closed on September 23, 2008, Rajaratnam inflated its price, making this reflect the then-unknown fact that Berkshire Hathaway would invest $5 billion in the bank. In the short term, the argument is seems sound.  It is clear that Rajaratnam’s actions caused Goldman Sachs stock to more accurately reflect its true value.

However, we must question if insider trading may have negative consequences that outweigh short-term market efficiency. Upon even a cursory consideration, it appears such consequences do exist.

Frequent insider trading decreases overall trust in the markets. Insider trading allows a small group of insiders (consisting mainly of corporate executives and hungry hedge fund managers) to profit from non-public information. If done on a large scale over significant periods of time, legalized insider-trading leads to a market in which the common investor feels she is always at a disadvantage. She gives up investing in the market.  Instead legalized insider trading may force this investor to use and pay fees for, a professional money manager, thereby incurring more costs.  Indeed, she may avoid the market altogether and invest in Treasuries. In the long term, insider trading privileges a small group of corporate officials, destabilizing the public’s trust in the fairness of the markets.

If non-privileged investors lose faith in the markets and stop investing, the liquidity and thus efficiency of the market will fall. Thus, instead of making the markets more efficient as insider trading proponents argue, insider trading makes markets LESS efficient in the long term. Legalizing insider trading has a deleterious effect on market efficiency.

Insider trading increases the incentives for company employees to make a profit, thus increasing productivity.

If we again consider the Galleon case it seems this argument is feeble. The only employees at Goldman who knew of the deal with Berkshire Hathaway were apparently the directors; thus the great majority of Goldman employees did not even have the information on which to trade, let alone the incentive to do so. Employees at financial firms are often paid in company stock, thereby giving the employees an incentive to do well and increase company profits. Legalizing insider trading would not induce employees to higher production, it would merely allow them (and only senior management in most cases) to trade their company’s stock to increase personal wealth.

Insider Trading is Illegal and Unethical

Insider trading is an unethical practice for two reasons:

(1) It is unfair.  Insiders have access to information that is not given to the public.              Unequal possession of information is an advantage that cannot be competed away

because this advantage depends on a lawful privilege to which an outsider cannot acquire access.[25]

(2) On a utilitarian basis, the greatest good for society is not achieved in the long term. It is true that insider trading may increase market efficiency in the short-term.  Yet, insider trading may in fact, decrease efficiency in the long term. How can this decline in market efficiency happen?

Experiments in behavioral finance show economic actors do not appreciate unequal and unfair behavior. When participants in an experiment see others in the experiment benefiting monetarily due to what is perceived as unfair behavior, these participants forsake profits to punish the other participant who behaves unfairly.  According to the (current) rational model of economics, this result cannot occur because the participant who is unfairly treated prefers to maximize profits, even if treated unfairly.  However, unfairness offends human sensibilities and people may either punish those who treat them unfairly, or opt out of the game.  Thus, investors may stay out of the market if they see rampant insider trading.  If enough investors stay out of the market and instead, say, buy government bonds only, market efficiency will be harmed.

Indeed insider trading has negative consequences for investors and markets. Analyzing the Rajaratnam case uncovers these negative consequences.  Proponents of legalizing insider trading hold up the Rajaratnam trial as an example of the inefficacies of insider trading charges. The four main arguments advanced in favor of legalizing insider trading do not stand up under scrutiny. Raj Rajaratnam did act unethically by trading shares of Goldman Sachs on September 23 and 24, 2008, and demonstrated why insider trading ought to continue to be illegal.

Contributed by: Samuel Clowes Huneke