No Pain, No Gain: The Criminal Absence of the Efficient Capital Markets Theory from Insider Trading Sentencing

Article excerpt


Michael Douglas's notorious Wall Street character Gordon Gekko once proclaimed, "I don't throw darts at a board. I bet on sure things. . . . Every battle is won before it is ever fought."1 Mr. Gekko famously epitomized the greed of 1980s traders through his ability to trade stocks based on information he had exclusive access to, thereby allowing himself to place bets on events that were certain to occur.2 While traders of publicly traded securities are presumed to base their decisions on timely and accurate information,3 when that information is unknown to the public, the resulting gains or avoided losses are not legitimate.4 Knowledge of such information provides traders like Gekko with an unfair advantage in the fierce battle over profits. Known as insider trading, this conduct is contrary to the "justifiable expectation of the securities marketplace that all investors . . . have relatively equal access to material information."5 Arguably, the incentives and opportunities today to illegally profit from inside information have never been greater. Take the hedge fund industry and one of its giants, the Galleon Group, which had over $7 billion in assets.6 Galleon's CEO, Raj Rajaratnam, who Forbes Magazine labeled as a "Money Maverick" despite the difficult economy, attributed his success to "frequent visits with companies" and "conversations with execs who invest in his fund."7 Almost simultaneous with these accolades came Rajaratnam's arrest in connection with one of the "biggest criminal case[s] involving hedge fund insider trading."8 Allegedly, Rajaratnam, along with a network of others, including directors at high profile companies such as Intel and McKinsey, netted millions in illicit profits by passing inside information gleaned from their jobs to trade on publicly traded companies such as Google.9

The prevalence of insider trading at all levels of society is also alarming, as evidenced in a recent SEC investigation for possible criminal violations of securities laws. Following up on a tip of "suspicious activity," improprieties, and "trading on nonpublic information" it was revealed that the group at issue had "no compliance system in place to ensure that its employees did not engage in insider trading."10 The allegations centered not on a vast network of executives and directors but on longtime employees who were lawyers.11 Their employer-the SEC!12

To combat this epidemic, regulatory authorities have increased enforcement efforts through a variety of measures, making insider trading a top priority.13 In the Rajaratnam case, wiretapping was used for perhaps the first time to detect the passing of inside information, which "reflects that the government thinks this is serious conduct involving a significant amount of money."14 But with its limited resources, the SEC is forced to take creative measures to counteract criticisms of being soft on white-collar criminals and Wall Street.15 The SEC's aggressive approach and unfettered power, though, produces far more dangerous consequences when it comes to criminal prosecutions in which incarceration is at stake, unlike the mere threat of monetary damages and a loss of reputation in civil suits.

Criminally, insider trading-that is, trading public securities on the basis of inside, undisclosed information-is punished according to the gains received by the insider as a result of the trading.16 In other words, the greater the gains, the longer the sentence. The potential punishment is high, as the already harsh penalties under the Insider Trading and Securities Fraud Enforcement Act of 198817 were increased in 2002 to possible fines of up to $5 million for individuals and prison sentences of up to twenty years.18 Given its only mixed success in prosecuting criminal insider trading cases,19 the government has every incentive to make examples out of those insiders that it is actually able to convict by seeking longer sentences.

In pursuing longer sentences, however, the SEC has turned its back on the rationale and assumptions underlying the basis of many securities fraud regulations it previously embraced, a fact not gone unnoticed by courts. …