Insider trading: Brought to court

Mark Anthony Longoria was busy fielding calls from Wall Street. As a supply chain manager with Advanced Micro Devices, he had broad responsibilities – but this was not part of his day job at the chipmaker. “Tony” Longoria also moonlighted as a consultant for Primary Global Research, a firm that matches industry experts with money managers seeking corporate information.

AMD was due to report earnings and Mr Longoria was in high demand. Paid $300 an hour, he participated in 40 calls with 15 clients over a 60-day period, according to court documents. On July 21 2009, prosecutors allege, he provided exact revenue numbers and other financial data to a securities analyst and a hedge fund consultant.

All three have been charged with insider trading. The other two have pleaded guilty. Mr Longoria is in plea negotiations with prosecutors, says his lawyer. The case is part of an expansive five-year US investigation into the misuse of secret company information that has ensnared more than 40 individuals from across Wall Street and corporate America.

The probe targets the myriad sources of information through which professional traders gain an edge in fast-moving global markets. Just this week, the US Securities and Exchange Commission filed civil charges against Rajat Gupta, former head of McKinsey, the management consultancy, alleging he passed on information he learnt as a board member of Goldman Sachs. He denies wrongdoing.

Not since the groundbreaking 1980s investigation that led to the jailing of arbitrageur Ivan Boesky has Wall Street been so shaken. The US probe comes, moreover, at a time when authorities around the world – most dramatically in the UK and Hong Kong – are also attacking insider dealing with unprecedented fervour. Seeking to restore investor confidence shaken by the financial crisis, government enforcers are targeting professional traders and their close-knit and personally beneficial relationships.

“Insider trading corrodes that investor confidence. It undermines the integrity of the markets by tilting, unacceptably, the playing field in favour of those whose greed drives them to betray the duties and confidences they owe others,” Robert Khuzami, SEC enforcement director, said recently. “It short-changes every other investor who executes trades, with all the attendant risks, on the basis of trading decisions made by dint of hard work and genuine analysis.”

Prosecutors have charged a wide range of professionals: hedge fund managers, employees of listed companies, a credit rating analyst and two lawyers. The first big test comes next week when Raj Rajaratnam goes on trial. The billionaire co-founder of the Galleon Group hedge fund has pleaded not guilty to allegations that he traded in more than 30 stocks based on inside information.

The investigation has prompted some hedge funds to close. According to corporate security and investigation executives, some investment managers are also having their offices and homes swept rigorously for listening devices. The probe has also highlighted a potential downside of the exponential growth of the hedge fund industry, which meant thousands of investment firms were seeking to attract investors. With so many traders looking for some kind of edge, “expert network” firms such as Primary Global grew up to service them.

At the same time, institutional memories of the 1980s insider dealing probes began to fade, and many hedge funds lacked the elaborate compliance departments that big banks use to deter improper trading. Prosecutors allege some information providers then began peddling non-public information in exchange for fees to a cadre of all too willing buyers.

Across the Atlantic, the UK Financial Services Authority is flexing both its criminal and regulatory muscles against the suspicious trading that routinely floods its markets. The watchdog recently began using real-time monitoring and intelligence gathering to catch insider dealers in the act. Years behind their US colleagues in terms of bringing criminal cases, the UK authorities have nonetheless shocked traders with high-profile raids on City of London institutions last year and a series of warnings and civil cases that target leaks and rumour-mongering. In January, the authority won its longest criminal sentence to date in its first successful prosecution of an employed banker.

“A little enforcement goes a long way. If we can stigmatise this activity as criminal, the large majority of people will not want to engage in it,” says Jamie Symington, an FSA enforcement department head.

Hong Kong’s Securities and Futures Commission, too, has brought a slew of insider trading cases over the past couple of years, including the 2009 prosecution of a former Morgan Stanley senior banker, who was jailed for seven years.

Authorities have also ramped up their cross-border information sharing and they are starting to bring joint cases. US and UK prosecutors are currently co-operating on a case in which UK spread betters allegedly traded ahead of technology mergers based on information leaked from the US. US prosecutors also convicted a London-based, Greek-born investment banker at Switzerland’s UBS for tipping off family members and a US-based portfolio manager at Jefferies, a New York investment bank.

The increased attention to professionals arises out of previous – sometimes failed – efforts to investigate and deter widespread trading ahead of corporate announcements. US authorities have previously investigated expert network firms but dropped the probes after failing to develop evidence of wrongdoing.

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Insider dealing has been around for about as long as markets have existed. The FSA’s own statistics reveal unusual trading ahead of nearly 30 per cent of UK mergers in recent years; academic research suggests similar trends hold true in the US.

In the past, many cases involved one-off situations, where an assistant at a company obtained internal information and shared it with a family member or friend. But the recent cases purport to show a more sophisticated machine at work. Traders have allegedly peddled inside information as a cost of doing business, taking a calculated risk that they would not be caught. Insider trading has become “more professionalised” and “institutionalised among large networks of market professionals”, Daniel Hawke, chief of the SEC’s market abuse unit, said recently.

Court documents allege traders use pay-as-you-go mobile phones to hide their tracks and store tips on flash drives rather than company computers that may be subject to compliance programs. Some also buy and sell stocks repeatedly to create false patterns, and print out research reports as apparent justification for their trades, prosecutors maintain.

In one instance, prosecutors allege, a hedge fund manager called Samir Barai told Jason Pflaum, an analyst, not to worry about the federal investigation because they could rely on the “mosaic theory” as a defence, according to a note sent using BlackBerry Messenger and cited in a court document. Mr Barai denies wrongdoing, while Mr Pflaum has pleaded guilty and is co-operating with the government. Under the mosaic theory, traders can defend themselves against insider trading charges by showing that they based their decisions on large quantities of information rather than a single element.

“Disturbingly, many of the people who are going to such lengths to obtain inside information for a trading advantage are already among the most advantaged, privileged and wealthy insiders in modern finance,” said Preet Bharara, the US attorney in Manhattan, in a speech last year about what he called a “corrupt network” of insiders.

As traders have grown more sophisticated, enforcers too have had to become smarter. Insider trading cases are generally difficult to prove, because they are based on circumstantial evidence and juries have often been reluctant to convict. The SEC has recently lost two civil insider trading cases.

Both US and UK authorities are looking for relationships among bankers and traders rather than just unusual stock movements. US officials are also tapping phones to record conversations and wiring co-operators to build up more direct evidence.

US and UK law enforcement officers are also calling for longer prison sentences for insider trading, and the FSA is moving to publicise its civil cases more quickly – before the appeals process is complete. “We want to change the way people behave. The sooner we make the decision public, the sooner [people] can change their behaviour,” says Tracey McDermott, of the FSA’s enforcement department.

Defence lawyers argue, however, that insider trading is a victimless crime: the person on the other side of the trade always has their own reasons for buying or selling. They also complain that US enforcers are going too far, attacking legitimate research techniques.

“An essential element in the deployment of enforcement resources is getting your priorities right,” says Tony Woodcock, a UK partner with Stephenson Harwood, a law firm. “I question whether putting individuals or entities, who are in most cases doing their best to navigate unclear and moving standards in a complex industry, through aggressive and lengthy enforcement adds anything to what could more efficiently be achieved through better supervision.”

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Concern about professional insider trading has developed alongside the exponential growth of both independent research firms and hedge funds and other rapid-fire traders, say many observers.

Until a decade ago, banks were the main providers of corporate research on companies. But a 2002 analyst scandal changed the landscape. Ten US investment banks agreed to separate their research from investment banking operations and set aside money for independent research. At the same time, Regulation Fair Disclosure, an SEC rule forbidding companies from sharing confidential data with favoured analysts and investors, removed an important source of information about companies.

“It’s not like you can turn off the information spigot,” says Peter Henning, a law professor at Wayne State University in Michigan. Instead, “it got channelled in a way that I don’t think anybody ever expected”.

Some on Wall Street and in the City say the authorities are changing the rules of the game through criminal charges rather than writing new regulations. They argue that not all the information that is learnt from company insiders is material, which the US Supreme Court defines as information a reasonable investor would want to know when trading. Some of the data that were allegedly passed on by company insiders, such as the volume of semiconductor wafer shipments, might be important to someone specialised in technology companies, defence lawyers argue, but may not matter to an average investor.

The farther away the authorities get from pursuing traditional inside information, such as on corporate takeovers, the more difficult it could be to win cases, says Prof Henning. “That will be the challenge for the SEC if they start bringing cases more on the edge” of materiality.

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THE GALLEON CASE

A test of how evidence of rings plays before the jury

In a legal showdown set to start next week, US prosecutors will go head to head with hedge fund billionaire Raj Rajaratnam to try to prove he violated securities law by trading on inside information, writes Kara Scannell.

The battle, in a lower Manhattan courtroom, will pit a team of federal prosecutors who have been investigating the case for more than two years against John Dowd, a veteran Washington defence lawyer with a reputation for not pulling punches.

The stakes are high for the government. Though more than 20 people have pleaded guilty in its assault on alleged insider-trading rings of professionals, the trial will be the first test of how their evidence and legal theories play before a jury of New Yorkers.

For Mr Rajaratnam, whose Galleon Group hedge funds were liquidated after his 2009 arrest, the stakes are equally high. If convicted, the Sri Lankan-born American faces up to 15 to 20 years in prison. The former fund manager has denied doing anything wrong and is fighting for his reputation.

Mr Dowd, through a spokesman, declined to comment. The US attorney’s office in Manhattan, which is prosecuting the case, also declined to comment.

Prosecutors have alleged Mr Rajaratnam’s funds made more than $45m from trading nine stocks based on tips he received from various sources. According to the indictment, the tips came from four associates in several professions: Roomy Khan, a former Galleon trader; Rajiv Goel, a former finance executive at Intel, the technology group; Anil Kumar, a former partner at McKinsey, the management consultancy; and Danielle Chiesi, a former Bear Stearns hedge fund manager. Each pleaded guilty.

While neither side will reveal, even to the other, how it plans to present its arguments, lawyers following the case expect the government to rely heavily on Mr Rajaratnam’s secretly recorded phone conversations. The aim is to present the jury with Mr Rajaratnam discussing tips inappropriately, in his own words, with alleged co-conspirators.

To be successful, prosecutors will have to prove that the information Mr Rajaratnam obtained was material, or meaningful to an average investor, and that he received it from an insider who was prohibited from sharing it.

The defence is expected to attack the government allegations on many fronts. In a court filing, the lawyers argued that Mr Rajaratnam’s duty to his investors was to research stocks and that he did not necessarily know the source of the information.

Lawyers say that the evidence appears to be stacked against Mr Rajaratnam but his fate will boil down to which side does a better job of convincing the jury.