11.22.10

The Bogus Insider-Trading Case

With the raids on three hedge funds yesterday, the Feds are robustly taking on insider trading. Charlie Gasparino on why this won’t do anything to rid Wall Street of miscreants.

The Justice Department is saying that it's getting ready to nail a slew of insider traders in a massive case that will, once and for all, clean the crud from the securities markets, with yesterday's FBI raids of three large hedge funds serving as an exclamation point.

This is an extraordinary statement, not just because the Feds are supposed to keep mum about cases of this alleged magnitude (at least until the perp walks begin), but also because rarely has so much been promised that will ultimately deliver so little value to the average investor.

That doesn't mean there won't eventually be criminal charges filed, perp walks staged, and grand juries empanelled, all in an effort to root out the crime known as "insider trading"—the illegal practice of trading and profiting off non-public information (i.e. stealing).

People with knowledge of the investigation tell me that the Justice Department, which is spearheading this probe, believes this is the biggest insider-trading investigation ever, targeting as many as a dozen hedge funds. Sources say more raids beyond yesterday's troika are likely in the coming days and weeks.

The raids are being orchestrated by the U.S. attorney based in Manhattan, Preet Bharara, an unusually chatty fellow who seems to be pushing the level of grandstanding well beyond anything established by an early predecessor, Rudy Giuliani, who pioneered the public lynching of Wall Street miscreants in the 1980s, or Eliot Spitzer, the former New York attorney general who took Giuliani's tactics further, making public statements about targets even before the investigations were complete. Both Giuliani and Spitzer had some success—and also had their fair share of cases that didn't pan out, or were eventually overturned.

It didn't matter, at least as far as they were concerned: Both used their reps as Wall Street's top cops as a springboard to higher office, with Giuliani becoming a pretty decent mayor of New York City, and Spitzer becoming a pretty disgraced governor of New York state.

The bigger outrage may be that two years after the financial crisis upended all of the major banks, the Feds haven't brought a single substantial case.

Bharara seems to have learned a thing or two from both men. Last month, he gave a speech to a group of lawyers, in which he promised a massive crackdown on insider trading, and the use of every tool at his disposal to find the crooks: "Inside information is a form of financial steroid. It is unfair; it is offensive; it is unlawful; and it puts a black mark on the entire enterprise."

This weekend, he signaled that his offensive is bearing fruit. Leaks from his office that a massive insider-trading scandal is about to bust open caused massive losses to the overall stock market yesterday morning before prices eventually recovered—though financial shares remained weak, particularly Goldman Sachs, amid speculation that the banks' traders may be involved. And what will this all yield? In the end, I believe, very little.

Like most things coming from the Obama administration's Justice Department involving Wall Street, the insider-trading inquisition has a serious class-warfare element to it. Sources with knowledge of the investigation tell me that the emphasis among G-men, beyond rooting out crime, is fundamentally changing the hedge-fund business, a business that caters to the wealthy and has enjoyed strong returns in recent years even as the rest of the markets suffered.

In other words, the probe is intended, at least in part, to "level the playing field," the catchphrase used when regulators believe one class of people have earned too much to the detriment of society. It's a bogus argument, even if it sounds good to say that every investor deserves to trade off the same information. Markets, of course, don't work that way; they reward those who have better insights and better access to information than those who don't.

Investigators are specifically homing in on how hedge funds use consultants to gain detailed market information not normally available to general market participants. And while you can't put someone in jail for simple research, you can make it difficult for hedge funds to obtain even legal information not generally available to the public, and that appears to be where the Justice Department is heading in yet another round of income redistribution.

Keep in mind, if hedge funds can't get access to even legal information that isn't public, who in their right mind will pay the high fees these investments demand? So why would we need hedge funds?

Yet even worse, the Justice Department is wasting its limited resources, employing tools often reserved to investigate terrorists, such as wiretaps, to investigate what is mostly a victimless crime. The Feds will tell you that cracking down on insider trades protects the rights of all investors. Someone who receives information illegally on a stock, and trades on it, is basically screwing investors who didn't have access to that information.

Most investors shouldn't be screwed because they're not flipping individual stocks day in and day out. They're making broad market bets through mutual funds and by holding individual shares. As such, they should be more worried about the Fed printing money, why it is doing so, than whether some guy at a hedge fund obtained information on a stock in what's deemed an illegal manner.

In the long run, why does it matter to the markets how information is obtained? The trade itself leads to price discovery, which is good for everybody. Information that isn't known is now being reflected in stock prices broadly and immediately even if it was obtained in a fashion that violates established law.

And that law isn't clear-cut. Aside from the outright theft of inside information ala Bud Fox who took a job as a janitor to copy documents in the first Wall Street movie, the vast majority of these cases don't involve physical stealing. They involved people who know stuff, some of it confidential, some just not available to the general public, about events that move markets, and either trade of it, or pass that knowledge on to others to trade on it.

The laws governing such trades are murky because there is no one law—there's just a set of court precedent that prescribes what is the proper dissemination of such information and what isn't. Recall the famous Martha Stewart insider-trading case. Well guess what: She didn't go to jail for getting an inside tip from her broker. She went to jail for lying about that tip. The Justice Department said charging her with insider trading would have pushed the boundaries of the law.

The bigger outrage may be that two years after the financial crisis upended all of the major banks, and destroyed the economy, the Justice Department and the Securities and Exchange Commission, haven't brought a single substantial case. Not one against Lehman Brothers or its senior executives, who told the world the bank was fine just months before it imploded and caused the greatest financial tsunami the world has ever seen. But we can take comfort that Preet Bharara is on the case and a bunch of hedge-fund managers won't be able to get "inside information" from consultants any longer. No wonder people are buying gold.

Charlie Gasparino is a senior correspondent for Fox Business Network. He is a columnist for The Daily Beast and a frequent contributor to the New York Post, Forbes, and other publications. His latest book, Bought and Paid For, is about the Obama administration and Wall Street.