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Michael R. Milken, center, earned $550 million in a single year in the 1980s, an astonishing sum at the time.
Ivan F. Boesky admitted to insider trading after preaching to students that "Greed is all right, by the way," and had to pay $100 million in fines and restitution.
In a New Era of Insider Trading, It’s Risk vs. Reward Squared
By JAMES B. STEWART
In March 1991, Michael R. Milken, once the richest and most powerful financier of his generation, entered prison, signaling the end of an era of junk bond-financed hostile takeovers and high-visibility prosecutions that law enforcement officials hoped would deter insider trading for generations.
But now, less than one generation later, federal prosecutors and enforcement lawyers at the Securities and Exchange Commission have exposed a vast network of insider trading that in its sophistication, breadth and profits dwarfs that of the earlier era. And with the emergence of Steven A. Cohen, the founder of the hedge fund SAC Capital Advisors, as a subject of interest, the government has identified a financier whose power and wealth surpasses even that of Mr. Milken in his heyday.
Why has insider trading proved so persistent, even in the face of prosecutions and popular Hollywood films like “Wall Street”?
The risk-versus-reward equation that has always been a factor in financial markets has changed drastically in the last 20 years. Ivan F. Boesky, the once-celebrated arbitrageur who admitted to insider trading after preaching to graduates of the University of California, Berkeley in 1986 that “Greed is all right, by the way,” had to pay fines and restitution then considered a milestone: $100 million.
When the government revealed that Mr. Milken earned $550 million in a single year in the 1980s, the sum astonished Wall Street and even his fellow traders at his now-defunct firm, Drexel Burnham Lambert. The Wall Street Journal calculated that $550 million was more than it cost to launch the space shuttle, build a B-1 bomber or, adjusted for inflation, pay for the Louisiana Purchase. (Mr. Milken’s take would be $1.07 billion in 2011 dollars.)
By contrast, the average hedge fund manager in the top 25 performers today makes that in a good year, and a few have earned more than $4 billion in a single year. Mr. Cohen reportedly earned $1.4 billion in 2009, and Forbes estimated his net worth in 2012 at $8.8 billion. (Mr. Milken’s fortune, by comparison, is estimated by Forbes at $2 billion, which puts him in the middle of the magazine’s list of the richest 400 Americans.)
At the same time, the tactics and technologies available to inside traders today are more sophisticated and more difficult both to detect and to prove.
A large majority of hedge funds have not been tainted by any wrongdoing, just as most junk bond traders were never accused of any crime. Mr. Cohen hasn’t been accused of any wrongdoing nor has his firm, although the S.E.C. has said it may face civil charges.
This week, I stopped by St. Andrews Plaza in Lower Manhattan to see Preet Bharara, the United States attorney for the Southern District of New York, and his deputy, Richard Zabel, the former head of the criminal division. Both said they couldn’t discuss any pending cases. But many people who work in financial markets “are highly skilled at cost-benefit analysis,” Mr. Bharara told me. “They’re highly intelligent. They’ve been to the best schools. They weigh the risk of getting caught against the potential reward, and they decide it’s worth the risk. We’re trying to tilt that equation.”
There’s no doubt that the potential for gain “has soared,” Robert S. Khuzami, head of enforcement at the S.E.C., told me, and not because there are more takeovers and other market-moving events to trade on. “That’s a big change from the 1980s and ’90s. Hedge funds can take massive positions, use short-selling and derivatives, and employ trading techniques that aren’t transparent, and make huge amounts of money on small fluctuations on price. They don’t need to hit a home run on a $20 pop on a takeover announcement. These bets may be bunts and singles, but they get to the same place.”
Even at lower rungs of the hedge fund world, the potential gains have shot up. Mathew Martoma, a former SAC trader who was accused last month of using secret information to help SAC gain profits, was paid a $9.4 million bonus in 2008, when he was just 34. At the same time, the cost of failure can be catastrophic. When he failed to replicate that kind of information, he was fired a little more than a year later. (Mr. Martoma pleaded not guilty to the charge, and, through his lawyer, has denied any wrongdoing.)
The pressure to get an “edge,” as hedge fund traders often put it, has never been greater. “There’s a cruciblelike intensity of competition now that didn’t exist at the time of Boesky,” Mr. Zabel told me. “With hedge funds, there’s a lot of capital, and they’re competing ruthlessly. You have to be better every quarter or you’re not going to exist. Add the tremendous incentive of great wealth, and it’s not surprising that some people lack the moral fiber to resist that kind of pressure.”
Even as the potential rewards have soared, the nature of today’s trading — the bunts and singles, as Mr. Khuzami put it — has made enforcement more difficult, leading to what seems to have been a perception of less risk of getting caught. In the wake of the Milken-Boesky era, the government has become sophisticated at monitoring major market-moving events like takeover announcements, to the point that insider trading on major corporate news has become relatively rare (though just this week the S.E.C. charged an old-fashioned insider trading ring based on leaks about proposed mergers and acquisitions).
Modern technology has also rendered obsolete the use of suitcases of cash, secret passwords and other subterfuges I described in “Den of Thieves,” my 1991 book about Mr. Milken, Mr. Boesky and insider trading in the 1980s. “In the 1980s, you had to meet someone, or have lunch or exchange information in ways that were slower and more visible,” Mr. Zabel said. “Now, you can have only the glow of your computer screen on your face and you can scoop up all sorts of valuable information from all over the country or even the world. If you get even little bits, you can trade on a daily or hourly basis on micromovements.”
But technology has cut both ways. Although some critics say the S.E.C.’s expertise has lagged advances in areas like high-frequency trading, the enforcement division has made progress in monitoring suspicious trading. “We’ve created databases to see who is trading in tandem, even if you know nothing about an event,” Mr. Khuzami said. “It’s a trader-based approach, not an issuer-based approach. These trading patterns are the first clue to what might be insider trading rings. You then have to do the real detective work, pulling phone records and e-mails and using other techniques to uncover the links. ”
There’s no doubt that the new techniques have been yielding results. Since Mr. Bharara became a United States attorney in 2009, his office has charged 75 people with insider trading, including such now-household names as Raj Rajaratnam, the founder of the Galleon Group hedge fund, and Rajat K. Gupta, a former McKinsey chief and Goldman Sachs director. His office has secured 69 convictions or guilty pleas without losing a case (six are pending and more are said to be in the pipeline). Many of those cases were developed in conjunction with the S.E.C., which has brought over 200 enforcement actions since 2009. “These have been cases of hard-core insider trading, and they’ve done a marvelous job,” said Harvey Pitt, the former S.E.C. chairman who previously represented Mr. Boesky (and has lectured SAC employees on compliance with securities law).
It’s still too soon to measure the deterrent effect of the latest wave of cases, but it’s surely substantial. For the most part, inside traders aren’t hardened criminals but rational decision-makers. When confronted by an F.B.I. agent in his front yard, Mr. Martoma fainted. “What we’re trying to accomplish is deterrence,” Mr. Bharara said. He mentioned that the jurors in the Gupta case openly wept as they rendered their guilty verdict, which they must have known meant the ruin of a once-illustrious career and reputation. “I want smart people to see that and say, ‘I never want that to happen to me.’ ”
One thing that apparently hasn’t changed is motive, and a question hovering over insider trading prosecutions then and now is why people who are already so rich and successful would resort to criminal activity. “Sometimes, it’s about the money or a bigger house in the Hamptons or wanting to climb the social ladder,” Mr. Khuzami said. “But for the already-rich, it’s mostly about ego and being a player. A winning tip impresses others and makes them part of the club.”
Mr. Pitt added: “My bottom line is that not a lot has really changed. Cheating is still cheating. Insider trading is cheating. It’s an effort to get an edge and give yourself an advantage you know you’re not supposed to have.”
“Far too many people are questioning whether the markets give you a fair shake or whether inside traders are taking advantage of them,” Mr. Pitt said. “That’s bad for capitalism, bad for capital formation and very bad for the country.”
http://www.nytimes.com/2012/12/08/bu...gewanted=print
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