Ironing out insider trading’s latest wrinkle

Yet another scandal is rocking Wall Street. This time, hedge funds — and possibly mutual funds — allegedly have engaged in insider trading, yet again shaking individual investors’ faith in the fairness of the stock market.

This latest in a series of scandals that stretches back to the 1980s surely will convince average investors that the stock market is stacked against them, that only an inner circle of large investors can win and that many in that inner circle are if not breaking the rules, at least bending them.

It is little wonder, then, that individual investors have been slow to return to investing in stocks after the market collapse of 2008, even though, on average, stocks have made a strong recovery. This latest black eye will do nothing to speed their return.

The Securities and Exchange Commission’s charges and subpoenas suggest that there may have been widespread rule bending and breaking by hedge funds, research firms and relatively new firms called expert-network firms, with some mutual funds among the possible beneficiaries. The investigations also involve the FBI and the U.S. Attorney’s Office for the Southern District of New York.

Some of the alleged behavior seems to straddle the line between legitimate research and collecting, and profiting from insider information.

The SEC must spare no effort in pursuing its investigations and prosecuting those it thinks have fallen on the wrong side of that line. But the SEC and the courts also must clarify the line between legitimate stock research and insider information.

This case arose out of an insider trading case brought against The Galleon Group hedge fund and its founder, Raj Rajaratnam. That case directed the SEC’s attention to the activities of the expert-network firms.

These firms put hedge funds and other investors into contact with people who might have valuable knowledge of the operations of public companies, including former and current employees.

The SEC’s case against Mr. Rajaratnam alleges that he received and used material non-public information from an employee of an expert network.

The use of expert networks is a relatively new wrinkle in securities research. Until its advent, fundamental securities analysis involved poring over the financial data released by a company, analyzing it to determine how the company was performing, and making projections about its future prospects. The analysts’ work theoretically provided an objective view of the company’s future prospects.

To flesh out their analyses and to provide context for the reported financial figures, analysts simply gathered public information that was available to anyone who sought it. Talking to companies’ suppliers and customers, and to former employees, to get a feel for what was going on inside the company no doubt seemed a logical extension of the research process.

The problem was finding those employees, and that is where expert-network firms provided help.

Talking to employees probably seemed logical, too, but the SEC apparently thinks that gathering information from those who have knowledge of a company’s activities crosses the line into insider trading.

The SEC investigations and the court cases resulting from them must clarify the line between research and insider information. And Wall Street must cooperate with the SEC, not only in the investigation of those suspected of wrongdoing in this case but in reporting others that may be pushing the limits.

So far, it appears that the mutual fund companies that have become embroiled in the mess are cooperating. That is an important step in easing some of the concerns of individual investors that Wall Street is corrupt and doesn’t play by the rules.

Related Topics: Securities and Exchange Commission