Fraud and Insider Trading: The Differences
In the past week, the business headlines have been rife with charges, settlements, and convictions for fraud and insider trading. You’re might be wondering if there are any honest traders or portfolios. Actually, the vast majority of these folks are honest and are merely chasing the goal, however illusive, of adding value to their clients’ portfolios. Nonetheless, we’re seeing a spate of bad behavior, which is particularly troubling when it occurs at our most powerful financial institutions and among some of the most influential professionals in money management.
|Going on tour (1995)|
Yesterday, Bill Hwang of Tiger Asia settled criminal charges for insider trading. Mr. Hwang received information that certain Chinese companies were going to issue stock. He shorted the stocks, anticipating that their prices would fall when the news was announced. When the securities were eventually issued, he purchased shares to cover his shorts. Mr. Hwang is a protégé of Julian Robertson, one of the most successful hedge fund managers of the 1980s and 1990s. When I was a research analyst, I called on Mr. Robertson. It was an intimidating experience because he asked penetrating questions. Mr. Hwang, on the hand, had it easy, because he already had the answers.
Next Monday, UBS, the Swiss bank, is expected to settle fraud charges. UBS is one of several banks that made up the price for LIBOR (the basic lending rate off of which many loans are priced). The fake prices enabled UBS to make trades on their books appear to be profitable. The bank is expected to pay about $1 billion to settle the charges. Barclay’s has already settled with regulators after agreeing to a $450 million penalty.
While insider trading and fraud are both illegal, it’s important to think about the difference between these two activities. Insider trading is a crime that involves improper timing. The information is true (e.g., a pending merger, an earnings release, critical test results). The problem is that the person trading knows that he’s received and acted on information that has not yet been released to the market. The inside trader prepositions his capital, so he will profit when company makes the formal announcement. It’s like seeing your opponent’s cards in a game of poker before they’re laid face up on the table.
Fraud is the act of intentionally putting false information into the market, representing that it is legitimate, and having the victim rely on the falsehood. Going back to the poker table, it’s like injecting fake cards into the game. Without getting into a legal treatise, fraud is more difficult to prove than insider trading, and its necessary elements vary by jurisdiction.
In both cases, the trader has to knowingly commit the act. You’ve got to know that you’re in possession of inside information, and the prosecutor has to prove it. In a fraud you have to know and intend that information is false, and the burden is, as it must be, on the district attorney. Moreover, in a fraud the victims have to rely on the false information. In short, these crimes can be hard to prove. Hence, prosecutors are often willing to settle.
When a case goes to trial and a trader is acquitted of insider trading or fraud, he will often release a statement that says he has been vindicated. And indeed, as a legal matter, he has been vindicated. This does not necessarily mean that he didn’t do something bad. Investors can be harmed by schemes that don’t fully meet the legal tests, or for which there’s insufficient evidence. Most of the folks trafficking in insider information and fraud are pretty smart. Many people received legal advice on how to structure their business affairs, so that it is hard to prove all the necessary elements of a crime. The legal structures created in the sub-prime mortgage debacle made the regulator’s and prosecutor’s task very difficult.
While many of these cases may be difficult to prove, it is still important for regulators and prosecutors to pursue them. Financial markets rely on the confidence of its participants. Our confidence is shaken if the markets aren’t properly policed.