Insider trading or outside the box?

Some hedge funds undoubtedly try to get an illegal edge by bribing company insiders, but digging out facts that companies do not want investors to know is not illegal in itself and should be encouraged.

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The news of Federal Bureau of Investigation raids on US hedge funds in a sweeping investigation into alleged insider trading is welcome. The authorities are clearly alert to a financial blight, although the funds deny wrongdoing and no charges have been brought.

Whatever the substance, Preet Bharara, US attorney for the New York southern district – the court close to Wall Street where Bernie Madoff was tried – is probably right when he argues that "illegal insider trading is rampant”. He is also correct that some of the miscreants are "among the most advantaged, privileged and wealthy insiders in modern finance”.

The financial blog Zero Hedge complained bitterly this week of: "a quid pro quo world in which insider information ... is bartered among the informational arbitrage elite on Wall Street, and which the retail investor has zero chance of competing on a fair basis.”

A dozen people, including Robert Moffat, a former senior executive at IBM, have already pleaded guilty in an earlier case – an inquiry into an alleged insider trading ring involving Galleon Group, a technology hedge fund. Raj Rajaratnam, Galleon’s founder, has denied charges of fraud and conspiracy, and is due to face trial early next year.

There is little question that some investors have tried to get an illegal edge by bribing company insiders – or lawyers or bankers – to divulge inside information on forthcoming deals or products. The number of incidents of share prices moving ahead of stock exchange announcements shows that.

But there is an important caveat, which lies at the heart of the latest inquiry. The fact that some investors dig out facts that companies do not want them to know – and thus gain an advantage over the rest of the investing public – is not illegal nor unethical in itself. To the contrary, it is to be encouraged.

In the 1997 O’Hagan case, the Supreme Court pointed out that "informational disparity is inevitable in securities markets” and described insider trading as "contrivance, not luck; it is a disadvantage that cannot be overcome with research or skill.” In other words, there is insider trading and then there is finding things out for yourself.

"That is what analysts do – they try to be first to find information,” says Stephen Bainbridge, a professor at the University of California, Los Angeles. "If the Securities and Exchange Commission is aggressive not only in investigating insider trading but in defining it, that could be enormously chilling.”

The inquiry is focused not only on hedge funds but research firms. Some are "channel checkers” that estimate the sales of retailers and consumer companies. Others are "expert networks” that introduce people – including executives and former executives – who tell investors about companies, products and technologies.

It is not hard to imagine cases where hedge funds get hold of inside information in this manner. "If you cross traders who are anxious to get any edges they can with experts who are as close to the action as possible, it is easy to cross the line,” says Richard Swanson, a securities lawyer at Arnold & Porter. Don Ching Trang Chu, an executive of one expert network, has been arrested and charged with securities fraud.

Any investor that pays a current executive, or even a junior employee, of a company for information on how that company is doing is probably inducing a breach of confidence. That is clearly true when a senior executive talks about forthcoming financial results, and is very likely true of a local store manager who reveals sales figures, even if the latter does not realise it.

Big Lots, an Ohio retailer, this week sued Retail Intelligence, a research group, for discovering that its sales growth was sagging by surveying 72 of its store managers without its permission. Enterprising as this was, the managers clearly gave away information that their employer wanted to remain secret.

But what if research firms find out things about a company not by talking to employees but to others with no duty of confidentiality? People in the same industry, or experts in the field, often have an informed sense of whether a product is likely to be successful or a new technology will work.

If Company X tells investors it has made a significant discovery of shale oil in Mongolia, why should they just take its word for it? A hedge fund that talks to its own shale oil experts, hires someone to go to Mongolia and talk to local geologists about the discovery, and then shorts Company X’s shares, is doing a legitimate job for its investors.

Companies routinely claim to be doing well and do not like being contradicted, but that is the task of investors, analysts and the media. "You want investors to challenge companies so that everything is not just spin. It would be an insuperable task for regulators to do it all themselves,” says Robert Silver, a partner of the law firm Boies, Schiller & Flexner.

During the dotcom boom of the 1990s, investment bank analysts often failed to question companies’ stories because of conflicts of interest. The fact that investment analysts and hedge funds now do so, armed with independent sources of information, is preferable.

Mr Bharara and the SEC are right to combat insider trading but an effort utterly to level the information playing field for all investors, no matter how passive or active, would be misguided. As long as expert networks and channel checkers obey the securities laws, they should remain in business.

Copyright The Financial Times Limited 2010.