Phone taps, FBI surveillance, confidential informants it’s the stuff of major mafia investigations and Law & Order reruns. But they’re also the tactics used by federal authorities against a slew of dark-suited desk jockeys accused in Wall Street’s largest insider-trading scandal in decades. Authorities say billionaire hedge-fund manager Raj Rajaratnam, founder of the Galleon Group, and 19 others illegally used secret information about public companies to inform investments that yielded some $60 million in profits over the past several years. The defendants, who also include traders, lawyers and executives at firms such as IBM and McKinsey & Co., now face hefty fines and years behind bars.
It requires only a kindergartner’s sense of justice to understand why insider trading is a Wall Street no-no: it’s unfair. Simply put, insider trading means buying or selling stocks, bonds or other securities based on significant information that’s not available to the general public. Besides creating an uneven playing field that disadvantages regular investors, insider trading by corporate officials also violates their responsibility to operate in the best interests of shareholders.
Insider trading hasn’t always been a crime. On the contrary, it was once considered logical and efficient to let any competitive advantage inform decision-making in the free market a position many economic libertarians continue to embrace today. What some consider to be America’s first insider-trading scandal took place shortly after the nation’s birth; a former Assistant Treasury Secretary named William Duer capitalized on his government connections to make bets on the country’s debt. His investments eventually soured, however, and Duer’s bankruptcy brought down much of New York’s economy in 1792; he died a few years later in debtors’ prison. Nineteenth century railroad magnate Jay Gould didn’t try to hide his flagrant insider trading; profits from buying and selling stock in his own companies helped make him one of the wealthiest men in U.S. history.
The first real crackdown against the practice came in 1909, when the U.S. Supreme Court ruled that that a director of the Philippine Sugar Estates Development Company committed fraud when he bought stock in his company without sharing information with the seller that soon boosted its value. But it wasn’t until after the 1929 stock-market crash that Congress passed laws to limit such trading
The 1980s were a monument to Wall Street excess, witnessing some of the most notorious insider-trading prosecutions in history. Corporate raider Ivan Boesky said to be an inspiration for the fictional Gordon Gekko, villain of the Oliver Stone film Wall Street was sentenced to 3 years in prison and fined $100 million in 1986 for insider trading. Financier Michael Milken, the “junk-bond king” who famously earned $550 million in 1987, avoided prosecution on similar charges by pleading guilty to other criminal counts. But the largest insider-trading conviction came two decades later, in 2007, when former Qwest Communications head Joseph Nacchio was convicted of selling $52 million in company stock while knowing the company was headed for trouble. He was sentenced to six years in prison, though an appeals court later ordered his sentence reduced.
These days, you don’t have to work on Wall Street to get entangled in an insider-trading scandal just ask Martha Stewart. The homemaking guru spent five months in prison in 2004 after a series of events triggered by her sale of $228,000 in shares of biomedical firm ImClone Systems, the day before its value plunged 15%. Thanks to a 1997 Supreme Court ruling, even those who lack a connection to a company cannot trade on inside information if they know it is meant to remain confidential.