SKARBECK: Even more investigations increase market cynicism

November 28, 2009

As if Wall Street needs another black eye, an expanding probe into insider trading threatens to elevate public cynicism over whether there’s a level playing field in public markets and raise skepticism about the ability of regulators to police them.

The shock is, the problem is so widespread that Securities and Exchange Commission enforcement director Robert Khuzami bluntly stated that insider trading has become “systemic” behavior in the hedge fund industry. The SEC has indicated that the cheating is not limited to the stock market, and is present in the derivatives market, too.

The current probe began with the arrest last month of Galleon hedge fund manager Raj Rajaratnam. Also arrested were executives at IBM, Intel and McKinsey & Co. The investigation has continued to snare more than 20 other people and firms.

Earlier this year, the SEC reopened an insider trading investigation of Pequot Capital, one of the country’s largest hedge funds. The fund announced in May that it would shut down as a result of the case.

In London, the Financial Services Authority now conducts an annual analysis of trading behavior. The FSA’s 2008 report concluded that nearly a third of takeover deals transacted on London markets could have been preceded by insider trading.

Students of markets will often observe “unusual” behavior in securities before mergers and other market-moving announcements. The overwhelming chore for the market watchdogs is to assess whether the information was illegally tipped to other participants or just a matter of the rampant rumors and innuendo that regularly circulate Wall Street.

In a recent example, option trading in 3Com exploded this month to more than 17 times the average trading volume just before Hewlett Packard’s announced purchase of the company. The trades earned the buyers 300-percent returns, leading one professional trader to remark, “Somebody knew this was coming.”

One significant problem for regulators is that insider trading cases are notoriously hard to prosecute. A recent failed insider trading case against billionaire Mark Cuban alleged that he traded on confidential information. In his defense, Cuban argued that, although he sold his shares while possessing confidential information, he was not under any fiduciary duty. The SEC has appealed the decision.

The SEC’s case against Galleon hedge fund was brought based on wiretaps and years of data mining, and alleges traders obtained tips in exchange for payments that generated over $50 million in illegal profits.

One can only surmise that greed and hubris must be the factors driving these people to cheat the system. Art Samburg of Pequot was a regular on Barron’s annual roundtable and Rajaratnam is a billionaire ranking No. 236 on the Forbes 400 Richest Americans list.

The current market tumult has exposed numerous examples of abhorrent behavior. As a result, authorities have a unique opportunity to impose meaningful reform to a financial system that by some measures has lost its moral compass.

The SEC’s push to prosecute insider trading is a good start. Market integrity is a necessary element the general public should demand from our capitalistic system.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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