Views on improving the integrity of global capital markets
14 October 2011

Insider Trading: Big Time for “Victimless Crime”

The prison sentences handed down to Galleon founder Raj Rajaratnam — which, at 11 years, is the longest-ever sentence in an insider-trading case — and Incremental Capital and Galleon trader Zvi Gofer (10 years), should send a clear message to Wall Street that insider trading will not be tolerated.

According to a Wall Street Journal article, with insider-trading sentences averaging two and a half years, Raj and Zvi’s stiff sentences far exceed that average as well as the penalties levied at others charged alongside them: Emanuel Goffer, Zvi’s brother, received 36 months while Danielle Chiesi, a Galleon trader, was given 30 months. The longer prison terms likely reflect the fact that both were perceived as leaders of the insider-trading activities at their respective companies.

The argument from Raj’s lawyers that it was a victimless crime because “Insider trading does not cause the kinds of measurable losses to identifiable victims that conventional fraud causes [do],” probably didn’t earn Raj any points at sentencing. While insider trading may not inflict a direct financial hit, it does directly impact investor trust, which is a necessary component of an efficient capital market structure.

Indeed, sound ethics and investor trust are fundamental to the success of capital markets and the investment profession. Trust must exist between clients and the investment professionals with whom they work. And investment professionals, in turn, must have confidence that their peers will abide by, and that the regulators will enforce, the laws of the land. When one party trades on inside information, this trust is broken. And the industry has witnessed over the past few years just how difficult it is to regain lost trust.

The CFA Institute mission is to lead the investment profession globally by setting the highest standards of ethics, education, and professional excellence is grounded in the principles of our Code of Ethics and Standards of Professional Conduct. Several aspects of the Code of Ethics embrace the concept of acting with, maintaining, and promoting professional integrity for yourself and the capital markets as a whole. The Standards of Professional Conduct, meanwhile, explicitly prohibit trading on material nonpublic information.

When viewing these insider-trading actions through our ethical lenses, we see a wide range of victims: The average investor who has lost confidence that the financial markets are not rigged against his success, leading to a reduction in invested assets and, even worse, the prospect of insufficient resources for retirement. While Raj and Zvi may not have taken money directly from investors, they have likely kept those investors from earning the returns and profits expected from a fair and efficient market.

We offer our continued support to regulators and the legal system for their ongoing battle to remove this element from the investment industry. The prospect of sentences of 10-plus years should prompt investment professionals to carefully weigh the risks — and whether the reward of trading on inside information is really worth it.

About the Author(s)
Glenn Doggett, CFA

Glenn Doggett, CFA, is a director of professional standards for CFA Institute. His responsibilities include providing member guidance in applying the ethics and standards of practice policies, supporting related educational and public awareness activities, and working with the Standards of Practice Council of CFA Institute on its initiatives. He is co-host of the free, live, interactive webinars used by CFA Institute to promote ethical decision making and global best practices. Previously, Mr. Doggett, as a member of the CFA Institute Financial Reporting Policy Group, represented membership interests regarding reporting and disclosures initiatives, including XBRL. Prior to joining CFA Institute, he worked in the financial information sector with SNL Financial, where he focused on the real estate and energy industries, directing the development and maintenance of a financial data storage system. Mr. Doggett holds a BA in economics from the University of Virginia. He was awarded the CFA charter in 2006 and is a member of CFA Society Virginia.

2 thoughts on “Insider Trading: Big Time for “Victimless Crime””

  1. Michal Zapendowski says:

    Is there any study backing up the theory that insider trading is detrimental to capital markets? For instance, is there any instance in human history where insider trading was legalized, and the effect on a capital market measured?

    I am curious. It seems to me pretty significant to admit that there is no “direct financial hit” when an investor trades with an inside trader, as opposed to someone else in the same market. Indeed, studies have shown that inside traders give their unwitting counter-parties BETTER market prices than other investors in the same market — because the inside trader is understandably more interested in closing the trade, and less concerned with small price differences.

    In light of this fact, it seems at least possible (and worth investigating) that insider trading may harm nobody, in which case it probably shouldn’t land people in jail for 10-11 years. There also probably shouldn’t be an entire federal agency dedicated to prosecuting insider trading if the whole thing turns out to be, from a factual standpoint, an enormous witch hunt.

    I have an open mind but would like to see some hard data to back up the abstract theories that are landing people in jail. The answer may be different, for instance, for the options market than it is for other markets. You would think that the SEC would publish such a study before turning to Congress with a $1.3 Billion budget request.

  2. Glenn Doggett, CFA says:

    Thank you for your comments, Mr. Zapendowski.

    One example of a market where insider trading was not specifically illegal was India some time ago (see http://timesofindia.indiatimes.com/business/india-business/Insider-trading-still-flourishes-on-Dalal-Street/articleshow/14218269.cms). To your larger point, there has been academic debate over whether insider trading damages market integrity by giving unfair information advantages to privileged market participants, or whether use of insider information contributes to beneficial market efficiency by speeding incorporation of all available information in prices (the renowned economist Milton Friedman is one prominent example of a proponent of the latter argument.)

    CFA Institute is clear in our position that any benefit to market efficiency is outweighed significantly by the potential damage insider trading inflicts on investor confidence in their fair opportunities for profit and loss in the markets. The CFA Institute Code of Ethics and Standards of Professional Conduct require that members and candidates not use material nonpublic information that could affect the value of an investment, nor may they cause others to act on that information.

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