Circle of Friends (3 page)

Slaine never forced the person on the other side of the trade to buy or sell his stock. The person on the other side was going to buy or sell the same shares anyway, because the inside information available to Slaine and his circle of friends hadn't been made public.

They were in a sense “victims” of their own lousy investment decisions. The only difference is that David Slaine and his cohorts made money.

Another question to consider: Do average investors really care? Viscerally most would say yes. Anything that gives an unfair advantage to one party over the other should be eradicated from the markets. This gut reaction has been interpreted for decades now by market regulators, and increasingly by federal prosecutors, to mean that the average investor would have less confidence in buying stocks and investing for retirement if they knew the game was rigged by well-connected players making a quick buck based on their exclusive access to market-moving information.

But that doesn't mean the market-confidence argument that regulators embrace holds up. Professor Cox, for one, says there's little in the way of academic research to suggest that insider trading—which has existed as long as there's been a stock market—actually makes people wary of putting their money into the markets.

“There's little in terms of quantitative evidence to prove that investors care” about insider trading when making decisions about whether to buy stocks, Cox says. With that, Cox questions whether insider trading deserves more attention than other white-collar crimes. Higher on his list was mindless risk-taking that brought down the financial system in 2008, causing
trillions of dollars
in losses or the outright market manipulation where traders collude to push prices lower depending on their need, or Ponzi schemes of the Bernie Madoff variety, where people lost altogether tens of billions of dollars.

Regulators would say they focus on these crimes as well, but the facts suggest otherwise. Not a single major financial executive faces jail time for crisis-related crimes. Bernie Madoff was caught, but only after he turned himself in and after regulators were warned of his activities. And yet the news of the day is the dramatic rise in cases of insider trading, a practice deemed by a vast and growing federal regulatory apparatus to be something on the scale of terrorism, when in reality it is not, at least when compared to other more damaging market-based frauds.

Cox explains the difference this way: “When you look around you don't see many bleeding bodies after insider trading takes place. You do see those bleeding bodies with Ponzi schemes and market manipulation in terms of people losing lots of money and never being able to recover that money.”

This critical view, as I will show in
Circle of Friends
, isn't widely accepted by the federal law enforcement bureaucracy (or most people in the media). People like David Chaves and his team at the FBI, not to mention the entire enforcement staff at the SEC, believe that trading on insider information is tantamount to robbing a bank because it is stolen information that is being used to help a privileged few to profit.

And nothing good ever comes from stealing.

Or does it? What makes markets function at their best is the free flow of information (related to what financial academics call the “Efficient Markets Theory).” One could argue that when David Slaine obtained information that was not public (and not his) and traded on it, he helped the public know something: The information is being used to price the stock. Most scholars as well as practitioners who study financial markets believe deeply that markets function best when stock prices (or the prices of bonds, commodities, derivatives, options, mortgages, currencies, interest rates, and the whole massive slew of financial instruments we have managed to cook up) reflect
all
the available information. So in that sense, David Slaine helped the markets run more efficiently, not less.

Circle of Friends
is not a defense of insider trading—far from it. But it is an attempt to provide some perspective on what our regulators view as the white-collar crime of the century, one that they're now trying to convince the general public would be running rampant were it not for their heroic law enforcement efforts.

And some of these efforts
are
heroic. People like Chaves and his team, as well as agent B. J. Kang, brilliantly turned witnesses like Roomy Khan to convict Rajaratnam. And maybe most of all, the enforcement agents at the Securities and Exchange Commission, led by an understated but determined investigator named Sanjay Wadhwa, are dedicated professionals who believe they are doing the right thing in setting the stage for the most successful insider trading crackdown in history.

During numerous interviews, they've all provided the same defense of their actions: Ridding the markets of insider trading will send a message to the public that government will do all it can to make the markets fair. With ensured fairness comes confidence and with that increased confidence a new investor class will be born (while those who lost faith in the markets following the financial crisis will, perhaps slowly, return).

Yet consider the following, as many academics I have interviewed for this book point out, and a few government officials involved in the crackdown concede:

In the years where people like David Slaine traded on illegal information freely, market confidence, particularly among small investors, was at its height. Boatloads of money flowed into the stock markets from average investors, either directly through the purchase of individual stocks or indirectly as small investors plowed trillions of dollars into equity mutual funds and ETFs (exchange-traded funds, which for the purposes of this discussion function essentially as mutual funds—mechanisms that let small investors buy into much bigger baskets of stocks than they could affordably do otherwise).

So when did confidence begin to dry out? It goes back to 2008, when the financial crisis and persistent worries about the direction of the U.S. economy hit individual investors and small business people hardest. That crisis, caused by greedy bankers who took on too much risk, coupled with weak regulations and poor government oversight, has had more to do with the erosion of investor confidence than anything David Slaine and his cohorts did or are still doing.

The stock markets have recovered their losses from the financial crisis, and yet small investors remain fretful. They've been yanking money out of stock mutual funds since the 2008 crisis, a process that's continued largely unabated even as the Federal Reserve has taken short-term interest rates down to zero, and only recently began purchasing stocks in modest amounts. The Fed's interest rate policy was designed to create what's known as the
wealth effect.
With interest rates so low, the Fed's logic went, investors would flee low-yielding bonds for investments that offered higher returns, like stocks.

But this wealth effect was largely a Wall Street phenomenon. It's interesting to note that this mass migration out of stocks and into bonds, money-market funds, and gold by small investors occurred just as our government launched its crackdown on insider trading. Thus, just as the government was making the investing world safe, investors felt less safe. Small investors have remained in bond funds and gold—but not because they think insider traders are ripping them off. Rather, it's because they believe the markets are vulnerable to a precipitous fall, whether it's because of the burgeoning European banking and economic crisis, the unsustainable deficits that are devaluing the currency (the reason for the gold purchases), the dysfunction in Washington over economic policy (the reason for the purchases of super-safe bonds), a flash crash that sent stocks falling for no other reason than a computer malfunction, or all of the above.

And maybe average investors simply accept the “unfairness” of insider trading as a minor obstacle in their financial lives. It is no secret among average investors that the big players, namely large institutional investors, and Wall Street trading houses have monopolized information flows illegally
and
legally for years. Consider the controversial Facebook initial public offering. In the weeks prior to the stock's IPO, underwriters gave (perfectly legal) private briefings to large investors about Facebook's dimming prospects but gave no such hand-holding to small investors who bought what turned out to be inflated shares through the retail networks of firms like Morgan Stanley. As I write this, months after the IPO, Facebook is still trading below its initial price. Those big investors who got out immediately or didn't play at all are doing much better relative to the legions of small investors who made what in hindsight is a pretty bad bet.

Or maybe they have a better, less idealized understanding of the markets and how they work than our regulators do. Read Friedrich Hayek, or Milton Friedman, or any of the great free-market thinkers and you will come away with one undeniable conclusion: Markets are by their very nature unfair; the smartest traders, those with the
best information
, are
supposed
to pick stocks better and make more money than anyone else.

Now, Americans
hate
cheaters, and they don't like those who have an unfair advantage, which is why when you ask most people about insider trading, they'll usually say that the perpetrators belong in jail.

To that end, the biggest coup of the ongoing insider-trading crackdown at least so far has been the conviction of Galleon Group founder Raj Rajaratnam, who was found guilty of insider trading and securities fraud and sentenced to eleven years in the same federal prison that houses Madoff and mob kingpin Carmine “the Snake” Persico. During the course of his career Rajaratnam made a lot of money trading, accumulating a net worth of nearly $2 billion. Wiretaps, government witnesses, and telephone recordings from informants with inside tips paint a wide pattern of abuse, leading to a well-deserved conviction.

Yet even government prosecutors would concede that most of the money he made for himself and for his clients did
not
come from breaking the law. Largely overlooked by the media was the cost of Raj's illegal dealings. Before his arrest in 2009 (and Galleon's subsequent demise) the fund had accumulated around $7 billion in assets.

To build a fund of that size, Raj and his team conducted many tens of billions of dollars' worth of trades to produce overwhelmingly positive annual returns averaging around 25 percent since 1992 and amounting to
billions of dollars
in winnings for his clients. Yet the feds say he stole only some $70 million by trading on insider information. That figure, even if it is accurate (Raj lawyers claim the amount is closer to $7 million), would mean that the vast majority of his trades, billions upon billions in winnings, were perfectly legal.

It would also mean that the government spent tens of millions of dollars to prosecute a crime that pales in comparison to many other shady practices that have cost the financial markets and American taxpayers untold billions and possibly trillions of dollars in losses. The shadiest of those practices, of course, led to the 2008 financial crisis, one of the world's great economic tragedies.

The financial crisis and its continued lack of identifiable culprits is key to understanding why insider trading is all the rage these days with the federal law enforcement bureaucracy, and why men who run hedge funds, like Raj Rajaratnam and Steve Cohen, have become more recognizable household names than those of our banking titans. Of course, bubbles like the one that caused the risk-taking that led to the 2008 collapse are often more about irrational exuberance than the more rational act of fraud. In other words, they are difficult cases to make, and upon taking office in 2009, and with the after effect of the financial crisis causing massive unemployment, regulatory officials in the Obama administration barely explained those nuances to a skeptical and hurting American public.

What it needed was a white-collar scandal that it could tout as having successfully prosecuted to satisfy the public's demand for Wall Street scalps, even though insider trading had nothing to do with the practices that led to the banking debacle.

At least that's what many of the career prosecutors have told me in their more candid moments while being interviewed for this book. Did they make up the crimes of Raj Rajaratnam, David Slaine, and their circle of friends? Of course not; these cases were based on good detective work, informants, and wiretaps that produced overwhelming evidence that the culprits didn't merely step over the line of what is acceptable behavior—they often drew new boundaries.

But consider the following: The investigations were launched during the waning years of the Bush administration and had been developed by career law enforcement officials from the SEC, the FBI, and the Justice Department. They were developed at a time when Bernie Madoff still roamed free, with some in law enforcement ignoring warnings about his activities, and when risk-taking by the banks grew to enormous heights.

Unlike the minutiae involved in mortgage fraud or Wall Street risk-taking, insider trading cases are, as one prosecutor called them, “sexy,” in that they include wiretapped evidence of tipsters getting not just cash but lobsters and real sex in exchange for their services, as
Circle of Friends
will point out. The hedge fund moguls on the other end of the telephone were caught on tape eagerly paying for the information, while bragging about their exploits.

All of this was tailor-made for the Obama administration's white-collar crime point man, Preet Bharara, the U.S. attorney from Manhattan. Bharara is a smart, capable, and ambitious prosecutor. His critics inside the Justice Department and in the legal community have also described him as a Rudy Giuliani on steroids when it comes to using the media to burnish his image and turn the crime of trading on “material nonpublic information” into the Wall Street crime of the century.