Which came first: the crime or the investigation?
With insider trading, the answer until now was always simple: the crime came first. But the case against Raj Rajaratnam, the hedge fund manager who was convicted by a federal court jury on Wednesday, stemmed from an investigation that began well before the crimes were committed.
And that made all the difference.
In normal insider trading cases, whether the ones involving someone?s brother-in-law or the celebrated one that brought down Ivan F Boesky a generation ago, the investigation started only after someone noticed suspicious trading, like the purchase of a stock just before a takeover offer was announced or the short sale of the stock just before bad earnings news was released.
Once the investigation began, the Securities and Exchange Commission could find out who made the trades, and could ask why they chose to make the trades in question. It could also search for a source who might have leaked the ?material nonpublic information?, to use the legal term for inside information.
That investigative technique often failed to find proof, even if the investigators were convinced the law had been broken. It was more likely to work with small fish than with whales. If the trader in question had never bought options before and then made a killing by purchasing call options just before a merger was announced, the investigators would be virtually certain there had been a leak.
If it turned out that the chief financial officer of the company being acquired was also a neighbour of the lucky investor, and that phone records showed they had talked just before the trade was made, the case was clear. In many cases, either leaker or leakee would admit what had happened, and often identify others who had shared in the tip. But that technique is all but useless if the suspect is a hedge fund manager like Rajaratnam. His firm made dozens, if not hundreds, of trades every day. It had a bevy of analysts and access to all the research by Wall Street firms.
If a trade were somehow questioned, the firm could come up with any number of reasonable-sounding explanations, as Rajaratnam?s lawyer did in the case that ended in his conviction. But those explanations sounded pretty lame when stacked up against the recordings of conversations in which corporate insiders gave confidential information to Rajaratnam.
Those tapes exist only because the Justice Department got involved in the investigation at the beginning. Presumably, it had reason to believe that insider trading was happening, and that persuaded a federal judge to approve wiretaps.
As a result, the FBI could listen in as the information was provided just before trades were made. And they could hear Rajaratnam discuss ways to throw off a normal insider trading probe. He suggested sending choreographed emails with fake reasons for a trade. He recommended trading in and out of a stock that was being accumulated because of inside information.
It seems likely that Rajaratnam had used just such tactics in the past to explain away trades that had aroused suspicion. But hearing him describe them turned a defence into a virtual confession.
In providing clear evidence that the stock market playing field was tilted in favour of those with few scruples and lots of money, the government may have helped to level the field. At a minimum, other fund managers will be much more careful during telephone conversations.