Inside Tracks

August 28, 2008, was a bad day for Dell Computer. The company reported earnings well short of analysts’ estimates, and said that its gross profit margin (a popular benchmark for performance) had fallen sharply. Investors dumped Dell shares, and the stock price fell fourteen per cent the next day. But to a small cabal of hedge-fund managers and analysts the numbers came as no surprise, because a source at Dell had tipped them off. These funds had shorted Dell’s stock, and cleared more than fifty million dollars in profit in a matter of days. It was, all things considered, a nice little trade.

It was also, of course, illegal. But that wasn’t unusual on Wall Street in 2008: there’s a host of evidence that insider trading has become widespread. The scope of something so clandestine is inherently difficult to pin down, but the number of insider-trading referrals to the S.E.C. from FINRA, the financial industry’s self-regulatory body, keeps going up. The S.E.C.’s enforcement actions have been on the rise as well, and the past three years saw more of them than any other three-year period in its history. Andrew Ceresney, the co-director of enforcement at the S.E.C., told me, “We’ve gotten better at detecting illegal activity, and at using technology that allows us to draw connections and see patterns.” But this isn’t just a case of vigilant policing giving the impression of a rise in crime; a number of studies of market-moving events have documented a boom in “suspicious activity” (that is, more trading than usual) around those events.

The consequences of being caught have never been higher—Raj Rajaratnam, the founder of the hedge fund Galleon Group, was sent to prison for eleven years—but hard-pressed fund managers continue to be tempted. Competition in the investing world is fierce: there are now nearly eight thousand hedge funds, and on average they have underperformed the stock market for nine of the past ten years. Whatever your supposed market-beating strategy is, someone else is probably duplicating it, and everyone is desperate to find an informational edge. There was a time when big investors could come by that edge quasi-legally, as companies leaked information to select investors and analysts. But in 2000 the S.E.C. passed a rule called Regulation F.D., which required companies to disclose material information publicly or not at all. As a 2004 study documented, the advantage of well-connected investors was thereby diminished. Unsurprisingly, some of them responded by trolling for inside tips.

Such tips are easier to come by these days, because there are more insiders than ever. In the case of mergers and acquisitions, most deals are now routinely syndicated among many banks, and, as a 2007 study found, there is a tight correlation between the number of firms participating in a deal and the amount of suspicious trading before it is announced. Similarly, the proliferation of consultants has created more opportunities for information to leak. Galleon made a lot of money shorting Google, after an employee of an investor-relations firm that was working with Google said that the company was going to miss its numbers. Then, there’s the rise of the so-called “expert networks” industry—which, for a fee, connects money managers with experts in a given industry or company. In theory, these experts are banned from disclosing confidential information. In practice, it hasn’t always worked that way: the SAC Capital portfolio manager Mathew Martoma is being prosecuted for allegedly trading on a tip from an expert-network participant that an experimental Alzheimer’s drug had failed to perform as expected.

The rewards for having inside information are enormous. Technological advances mean that companies have a much better real-time sense of how they are doing than they once did. Yet many companies have reacted to economic uncertainty by disclosing less information; fewer of them offer even quarterly-earnings guidance to investors, for instance. Insider information these days is therefore both better and more valuable than ever. What’s more, in the past two decades the market’s reaction to earnings surprises has intensified, so the payoff when you bet correctly has increased, and things like derivatives make it easier than it once was to place big bets without arousing suspicion.

Is there any way to make insider trading less attractive? The government’s willingness to prosecute high-profile traders is a start. Still, we need a more fundamental approach. In a world where companies increasingly know about their business in real time, it makes no sense that public reporting mostly follows the old quarterly schedule. Companies sit on vital information until reporting day, at which point the market goes crazy. Because investors are kept in the dark, the value of inside information is artificially inflated. “Insider trading is, by definition, based on information that is not known to investors,” Baruch Lev, a professor of accounting and finance at N.Y.U. and an expert on corporate disclosure, told me. “If you increase transparency, the gains for insider trading must go down.” Back in 2002, Harvey Pitt, who was then the head of the S.E.C., told Congress that companies should be providing investors with regular updates about their performance, rather than just making quarterly disclosures. More consistent, if not real-time, data about revenue, new orders, and major investments would help investors make more informed decisions and, into the bargain, would diminish the value of insider information. If companies tell us more, insider trading will be worth less.

Original Article
Source: newyorker.com
Author: James Surowiecki