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Stocks & Bonds

Feds Cracking Down On Insider Trading

A wave of fraud cases is hitting Wall Street. Here's what it means to you.

Editor's Note: This story is scheduled to appear in the July 2011 issue of Kiplinger's Personal Finance magazine. Kiplinger.com readers are getting a sneak peek.

A billionaire hedge fund manager is found guilty of 14 federal charges stemming from a massive insider trading scheme that prosecutors said netted $63 million. Galleon Group founder Raj Rajaratnam, who will appeal the verdict, was one of 26 criminal defendants in the case, 21 of whom have pleaded guilty.

Not even the Oracle of Omaha can escape the taint of insider dealings. A Berkshire Hathaway exec (who has not been charged with insider trading) resigned after he raised eyebrows by purchasing shares of Lubrizol Corp. right before Warren Buffett bought in.

Investors may be forgiven for feeling outmaneuvered. More than 50 people have faced criminal charges of insider trading since the summer of 2009. The Securities and Exchange Commission, which brings civil-law versions of the cases, has announced 30-plus cases in fiscal 2011, beginning last October, on top of 53 cases in fiscal 2010 and 37 the year before that. But it’s the kinds of cases and how they’re brought that’s significant. Instead of the one-off friends-and-family shenanigans that typify insider-trading cases, the focus is on organized secret-swapping among a new generation of market pros.

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A modestly funded SEC, still stinging from criticism that it missed Bernard Madoff’s Ponzi scheme, is swamped with carrying out provisions of the financial reform law. But an overhaul of the enforcement division shows promise, with five new units that have defined areas of expertise.

New technology allows investigators to search and filter vast amounts of data, revealing relationships among traders. “It’s somewhat similar to progress in DNA evidence 20 or 30 years ago,” says Daniel Hawke, chief of the SEC’s Market Abuse unit. “We didn’t have the technology to connect a person to a potential crime then. Now we do.” Collaborations with criminal prosecutors start earlier, and criminal investigations are right out of The Sopranos or Scarface, relying on extensive wiretaps.

Catching crooks is one thing. Convicting them is another, given sometimes murky legal theories on what constitutes insider trading. (Test your understanding of these laws with our quiz Are You Guilty of Insider Trading?)

Compensating -- or even identifying -- victims is another challenge. Buy-and-holders who favor exchange-traded funds or index funds have little to fear from insider trading in any particular stock. The long-term effect on someone’s portfolio would likely be negligible, says law professor Peter Henning at Wayne State University.

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The SEC orders inside traders to disgorge profits (or losses avoided), but it’s rare in stock cases that such seizures reach levels at which it’s economical to distribute the money to investors. The biggest threat insider trading poses is to the market overall. Ultimately, investors won’t play if they think the game is rigged.