H. Nejat Seyhun, contributing writer to The BusinessThinker magazine, is the Jerome B. & Eilene M. York Professor of Business Administration and professor of finance, Ross School of Business, University of Michigan. He is an internationally recognized authority on financial issues and Derivatives.
The insider trading case of billionaire Raj Rajaratnam who has been charged with 14 counts of securities fraud and conspiracy in lower Manhattan federal court is now in the hands of a jury, which has been deliberating since Monday. Government claims that Mr. Rajaratnam made over $60 million in abnormal profits using illegally obtained inside information. To prosecute its case, the government indicted 26, obtained 21 guilty pleas, and taped over 1,000 private telephone calls.
The stakes are obviously high for both sides: If the jury convicts on any one of the fraud charges, Mr. Rajaratnam could be facing more than 10 years in prison. While losing his freedom after having his hedge fund business destroyed is obviously important to Mr. Rajaratnam, the stakes are also high for the government. The government invested massive resources to prepare and prosecute this case. If the government fails to obtain a single guilty verdict in any of the charges in spite of its massive effort and expense, this case will once again underscore the difficulty of obtaining convictions for insider trading cases and jeopardize government’s current and future efforts to limit insider trading.
The stakes are also high for everyday investors. Regardless of his true guilt or innocence, if Mr. Rajaratnam is found not-guilty, this may represent open invitation for other potential illegal traders. Meanwhile, everyday small investors may conclude that the markets are rigged and they have no fair chance and become disillusioned about investing. This can raise the cost of capital for all corporations and make it more difficult for innovative ideas to be developed into commercial products. If Mr. Rajaratnam is found guilty, we may actually see some decline in illegal insider trading for a change.
The central issue here is the fact that what constitutes insider information is complex. The law simply defines inside information to be material, non-public information. What exactly is material, non-public information is left to case law and for juries to decide. Often, understanding insider information requires specialization in finance or statistics, each case is complex, and each case has its own unique features. In practice, material information is defined as any information that would influence a rational investor’s decision to buy or sell securities. Thus, the jury needs to decide first if the information given to Mr. Rajaratnam was also publicly available. If the jury decides that this information was not publicly available, it then needs to decide if this information was material.
The defense presented evidence attacking both of these requirements. Using finance professors as experts, the defense attempted to demonstrate that the information given to Mr. Rajaratnam could be inferred from publicly available sources. To buttress this argument, the defense attempted to demonstrate from financial press and analysts reports that certain firms could be targets of takeovers or candidates for cash infusions. This is also called a leakage theory. The idea is that information does not come in zero or one bytes. Instead, it can be located anywhere along a uniform probability distribution of materiality and it can slowly evolve over time. To the extent any kind of speculation can be counted as publicly available information, this approach has the potential to undermine any insider trading prosecution.
Second, defense produced a theory of investing which it called a mosaic theory: An investor such as Mr. Rajaratnam does not rely on a single source for investing. Instead, it has access to numerous sources and it relies on dozens of pieces of information, none of which is material by itself. By putting these together, one can create a useful big picture to help buy or sell securities.
The finance literature addresses both of these issues. On the leakage theory, there are numerous academic articles that show that details about corporate takeovers are often discussed as rumors in the financial press. Hence, it is true that using publicly available information, the probability of a takeover can be inferred as a significant possibility. Moreover, stock prices do respond to these published rumors and they rise significantly prior to public announcement of the takeover. What is not obvious from the finance literature is who the original source of these rumors is. If someone illegally obtains information about a future takeover and takes a position, he or she will then have incentives to create rumors about the takeover to divert attention away from their own trading activity. Thus, the fact that there is a newspaper article about a takeover rumor does not preclude the possibility of illegally obtained material information.
Finance literature also addresses the mosaic theory. Finance literature states that while investors can observe and weigh different pieces of information, they will not view them as equally informative. Instead, investors will weigh each piece of information according to the precision of the information. Any information with a high precision will get a much higher weight in the trading decision. Thus, it is possible for an investor to consider many pieces of information, and yet at the same time, he or she may rely almost exclusively on a single piece of information which has the highest precision. Moreover, the size of the investment position would be directly related to the overall precision of the information. Since insider information by definition has extremely high precision, mosaic theory does not actually pose a challenge to the insider trading theory.
The task facing the jury now is to understand these issues and make these distinctions on probabilities and precision of information and the size of associated investments by Mr. Rajaratnam. This will be an awfully tough task for anyone, but especially so for any jury member without a Ph.D. in finance or statistics. We will watch for the outcome and see what it tells for the future of U.S. securities markets. The stakes are high for all of us everyday investors.
About the author
H. Nejat Seyhun is Professor of Finance and Jerome B. and Eilene M. York Professor of Business Administration at the Ross School of Business, University of Michigan, where he has twice served as the chairman of the finance department. He holds a Ph.D. in finance (1984) from University of Rochester, Rochester NY. Professor Seyhun is an internationally recognized authority on financial issues and Derivatives. His research has been quoted frequently in the financial press including the Wall Street Journal, New York Times, Washington Post, Newsweek, Business Week, Bloomberg Business News, and Los Angeles Times. Among his past consulting clients are Citigroup, Towneley Capital, Tweedy, Browne, and Vanguard.