Insider Trading Victims

by: Ira Stoll

Jeff Madrick writes:

"Nothing surprises me much more than when I read that trading on insider information is a victimless crime ... In fact, it is entirely untrue. The victims are all those who sold Raj a stock or other security at a lower price than they might have if they had the same information he had."

This doesn't make much sense to me. First, it's not clear that those who sold Raj, or someone like him, a stock are necessarily "victims." They may have been at a disadvantage in the trade for a host of other reasons unrelated to the material nonpublic information. Raj may have all day to devote to security analysis, while the seller may be doing it on the side. Raj may subscribe to expensive databases or trade publications, while the seller may not. Raj may have a degree from a top business school, while the seller may not. Raj may have knowledge as a result of being a regular customer of a company that the seller may not have. And while the material nonpublic information may be an advantage, it may be dwarfed by other events that Raj may have no way of knowing about.

Here's an illustrative example: Suppose Raj knows that on May 3 BP (NYSE:BP) will announce better-than-expected earnings. On May 1 Raj buys some BP stock at 10, betting it will rise to 12 on the earnings announcement. The seller takes the proceeds from the sale and puts it a money market account. On May 2, BP suffers a big oil spill, and the stock goes to 5. Is the person who sold to Raj, in this case, a "victim"?

Second, the seller may have other information about whatever the seller is going to redeploy his assets into from the stock that is sold. Suppose the seller needs to sell on May 1 to invest in his child's business, or to buy the lot of land next door to his own house. One's own child or the land next door are two things one has excellent information about, better than even an insider trader has about most publicly traded stocks. Is the seller still a "victim" if he is redeploying his money into an asset in which he has even better information?

Third, let's stick with this scenario in which what's going on isn't a price-sensitive sale but a time-sensitive sale. Remember, what the prosecutors and regulators are after isn't so much the wide dispersal of the information Raj had, but for companies to do a better job of keeping the information secret, or for those with the information to abstain from trading on it. If the regulators and prosecutors get what they want, Raj isn't buying BP at 10, either because he doesn't know about the May 3 earnings announcement or won't trade on the knowledge. So the seller has to lower his price and unload the stock at $9.50 to attract a willing buyer other than Raj. With less money from the sale, the seller may not even be able to afford the lot next door. Who is the "victim" now — and who is the perpetrator? For this seller, the presence of a buyer like Raj acting on "inside information" meant not a lower price, but a higher one. Or suppose it is a price-sensitive sale rather than a time-sensitive sale, and the price the seller has set for an exit is $10. The presence of Raj as a buyer at $10 makes such a sale possible sooner, while if the prosecutors and regulators get what they want, the seller doesn't get his exit price until later, or maybe not at all. Again, who is the "victim"?

The Madrick piece, which is up at the Roosevelt Institute site and on the Huffington Post home page, goes on:

One of the more interesting facts about hedge funds is that, according to those who measure risk statistically by deriving 'betas' and 'alphas,' they do better on average than the amount of risk they take suggests they should. Mutual funds on average do not.

Some interpret this as proof of how astute the hedge funds are compared to other investors. The data could also be interpreted another way. That given their size and wealth, they have more information about company strategies and results, takeovers, and the trading patterns of the market. They may even be able to push prices their way and bail out before others catch on. Cornering markets can be against the law. How often does "mini-cornering" — momentary attempts to buy enough supply to determine a quick price change — go on? That's perhaps the main reason why they do better than the risk they take suggests they should.

It doesn't make much sense to me that hedge funds would have an information edge over mutual funds merely because of their "size and wealth." The biggest mutual funds, like Pimco's $240 billion Total Return Institutional Fund, or Fidelity's $65 billion Contrafund, are bigger than the biggest hedge funds.

I'm not defending Rajaratnam's behavior or the behavior of those who gave him the information upon which he traded. I do think it tends to erode confidence and trust in the markets. But identifying the victims is more complicated than Mr. Madrick would have us believe.