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Insider Trading in the Post-Rajaratnam World

Hedge Fund billionaire Raj Rajaratnam has been found guilty of all 14 counts of securities fraud and conspiracy charges against him. The case now goes to 2nd Circuit Court of Appeals. If upheld, Mr. Rajaratnam is facing the possibility of a maximum 190 years in prison, though he is likely to receive about seven to eight years based on the precedents.

Raj Rajaratnam thinking

Based on press reports, Mr. Rajaratnam may have spent $40 million on his defense, while government has spent $30 million to prosecute Mr. Rajaratnam. Clearly, litigation required immense resources on both parties. Meanwhile, the government has charged almost 50 people ranging from traders, hedge fund managers, lawyers and experts with similar crimes over the past year and a half. What are the likely takeaways from these trials for investors, hedge fund managers and students of the market?

For some hedge fund managers and others trading on illegal inside information, one takeaway is loud and clear: do not discuss any investment business on the phone or via email exchanges that leave trails. A critical element in government’s case was the taped telephone conversations. The jury indicated that the taped conversations made the case compelling and without this evidence, the government would have had a much more difficult case.

Based on this takeaway, I expect future illegal insiders will adopt more covert methods for communication, such as verbal communication through layers of intermediaries, making use of cloud communications, or exchanging notes on pieces of paper. While bringing much success to the government in this case, wiretapping and use of telephones will be highly scrutinized in the future. This may make it more difficult for the government to be able to bring in future insider trading charges.

For everyday investors, one possible takeaway is that the markets are just rigged. They may conclude that market professionals trade on illegal inside information and there is no hope for the small investors to survive on their own, using only public information. This takeaway may discourage the small investors to trade on personal account and instead encourage them to seek the services of professionals.

This may actually be good news for financial intermediaries such as mutual funds and hedge funds, which may see an increased business. Hedge funds are already managing about $2 trillion and they are likely to further benefit from additional inflows.

For the defense, their strategy clearly did not work: Defense strategy was two-pronged. The defense argued that illegally acquired non-public information was also publicly available. You could read published rumors, innuendos, and speculations, and come to similar conclusions as having illegally obtained non-public inside information. The second part of defense strategy was the mosaic theory.

The defense argued that Mr. Rajaratnam possessed many small pieces of information, none of which is material by itself; yet when put together, it became material. The jury resoundingly rejected these make-believe defenses. The defense is also likely to second-guess other areas of their strategy such as aggressively attacking government’s witnesses, rejecting a possible plea-bargain for reduced charges, and not putting Mr. Rajaratnam on the witness stand.

For the SEC and Justice Department prosecutors, they will feel vindicated and emboldened. The government’s success is likely to result in additional charges of insider trading, more guilty pleas, and harsher penalties. Ultimately, whether insider trading will be reduced, we will wait and see.

This article is written by Nejat Seyhun and originally published at Benzinga.

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