Cheating or Investing?

How being in the know might get to be illegal

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Hedge fund giant Raj Rajaratnam, who ran Galleon Group, is now on trial in lower Manhattan.

For the past couple of years, Preet Bharara, U.S. Attorney for the Southern District of New York, has been shaking the trees on Wall Street. Since October 2009, Bharara has charged 46 people in his investigation of insider trading tied to "expert networks." The biggest case is against hedge-fund giant Raj Rajaratnam, who ran Galleon Group and is now on trial in lower Manhattan. Expert networks are firms that broker information by connecting corporate insiders with hedge funds and traders looking for an edge. It's that hedge edge that's being called into legal question — what Bharara has described as "blatantly trafficking in material, nonpublic information." Any information that could potentially change a stock price is considered material.

Material, nonpublic information goes by another name in the financial world: smart investing research. That's how you make real money on Wall Street, by digging up stuff nobody else has. (It works in journalism too, actually.) Getting exclusive info about a company — say, Google, as Rajaratnam allegedly did — that may help predict the direction of its stock price is the meat of the Street.

But it's a meal that's not often shared with average investors. After the tech-stock crash of 2000, changes were made in securities regulations that were designed to make investing fairer by opening the closed loop of information flowing among companies, Wall Street investment banks, their equity analysts and their best customers. Investing, however, is never fair, and the inside-dope business immediately reconstituted itself outside Wall Street in the guise of expert networks.

Funny thing is, cops like Bharara use expert networks too. Only they're known as "informants." In an expert network, the informant could be someone working inside a company that you're interested in, so you pay for access. Just like the cops. But of course, the lawmen have an advantage: once Bharara got a confession, he flipped an informant working for an expert network into an informant working for him. That led to a series of wiretaps, and he and his team just sat back and listened while choirs of hedgies sang themselves into trouble.

Bharara alleges that the wiretaps confirm that Rajaratnam got information that most investors couldn't possibly access and traded on it. But what if all this information on the wiretaps is simply part of the market chatter that helps establish stock prices? Rajaratnam's defense will probably claim that whatever inside information he gleaned was just part of the mosaic of data to which he applied his skill as a trader. "There is lots of language in insider-trading cases suggesting that hedge funds and portfolio managers do a public service by investigating companies," says Georgetown University Law Center professor Don Langevoort. "And if the law is too open-ended and sends people to jail for doing legitimate research, you put a chill on economic activity." In other words, guys like Rajaratnam argue that they're doing us a favor because their information ultimately filters into the market. He shorted Akamai, for instance, and information about shorted positions is available daily.

The definition of insider trading remains fuzzy. Just because you got the scoop from the CEO's secretary doesn't mean it's illegal. The real question is whether there's harm to the shareholders or the market. In the U.S., insider trading is illegal only to the extent that it is fraudulent. So Bharara will likely mount a case based on misappropriation, arguing that the corporate secrets the experts provided were essentially stolen property and that the recipient, Rajaratnam, knew the merchandise was hot. The verdict will come down to whether a jury believes Rajaratnam was trying to cheat.

Prosecutors love to yank Wall Street's chain after periods of excess, as in the 1980s (junk bonds), the 1990s (savings-and-loan fraud) and the early 2000s (dotcom bust). We've just had another one, and the lawmen are back in business. The U.S. Attorney may be the only agency actively practicing financial reform, keeping markets safe for us. The jury has to figure out when being in the know becomes illegal. Hedgies like Rajaratnam are the best investors around because they are willing to spend so much time, money and energy obtaining vital information about stocks. Unless you have a spare $1 million, you can't benefit, because hedge funds like Galleon are open only to people who already have a lot to invest. Maybe that's the real crime.