The insider-trading dragnet that has rocked Wall Street this week appears likely to reinforce the feeling that the house always wins.
For average investors, a lack of trust in the markets is understandable, especially considering the latest probe comes on the heels of analyst scandals in the ‘80s and ‘90s, the scary financial crisis, the emergence of countless Ponzi schemes and the May 6 “Flash Crash.”
Pervasive investor mistrust is deeply troubling and here’s why: If that sentiment becomes cemented in the psyche of the average investor, it could drive them further away from the stock market and create another headwind for a marketplace already starving for greater participation from Main Street.
“While the rule isn’t that everyone has the same information, the rules do say it’s not a rigged deck,” said Tom Gorman, a former staff member at the Securities and Exchange Commission’s Enforcement Division. “How many times do you want to hear the deck is rigged before you decide you don’t want to play?”
The U.S. stepped up an investigation this week into insider trading that may end up being the biggest ever both in scope and magnitude. Insider trading occurs when someone buys or sells a stock or other security based on nonpublic, material information. If timed correctly, the trades can result in huge profits.
Earlier this week the U.S. requested more information from asset management giants Wellington Management and Janus Capital (NYSE:JNS) as well as hedge fund titans SAC Capital and Citadel Investment Group.
The government on Wednesday charged Don Ching Trang Chu, an executive at a so-called “expert-networking” firm, with conspiracy to commit securities fraud by arranging insiders provide material, nonpublic information to his firm’s hedge funds clients.
Cumulative Impact of Scandals
Threatening to ensnare consultants, hedge and mutual fund managers, investment bankers and analysts across the country, the probe has the potential to further undermine Americans’ confidence in the system. That could further hurt the stock market, which has seen average investors shy away in the wake of the Great Recession.
U.S. stock mutual funds, which are largely populated by retail investors, have seen a net $50 billion disappear so far in 2010, building on a three-year exodus.
“If you know people are cheating in the marketplace you’re not going to play -- at least you shouldn’t if you have a brain. That is a detriment to the markets,” Harvey Pitt, chairman of the SEC from 2001 to 2003, told FOX Business.
Market veterans worry about the cumulative effect the insider-trading probe will have on already-rattled small investors.
After all, the American investing public felt badly burned by revelations that analysts had trumped up tech stocks they actually disliked during the dotcom bubble. They were spooked by the discovery of massive Ponzi schemes, the 1,000-point plunge during the “Flash Crash” and the near collapse of Wall Street amid the financial crisis.
“In this business, your word is your bond. The cornerstone of the viability of this business is trust. It’s confidence,” said Peter Kenny, managing director at Knight Capital. “People are already skeptical. This is just one more log on the fire.”
But some believe insider trading is actually a “victimless crime” because those charged are rarely stealing from any one individual or company. They say these individuals are simply acting on information that will become public anyway.
However, proponents of clamping down on insider trading argue that the victims are the market itself due to a loss of confidence in the system as well as those on the other side of the trade.
This would constitute acting on material, nonpublic information and would likely result in a big profit. While the fund wouldn’t be stealing from any one person, it would have an unfair advantage against those playing by the rules.
“People think of the stock market as this impersonal entity. But every time you sell your stock there’s someone on the other side selling it to you,” said Gorman, currently a partner at Porter & Wright. “If you have inside info and I don’t, when I sell, I’m selling too cheap.”
Some worry that the insider-trading probe may unintentionally hurt investor confidence by having a chilling effect on the legitimate price-discovery activities by hedge funds and aggressive analysts hungry for information.
Hedge funds affect price discovery by “ferreting out information and doing the kind of diligence and research they’re capable of doing,” said Pitt. “As long as it’s legitimate, they actually make the markets more efficient."
During the credit crisis hedge fund manager David Einhorn helped lead the case against Lehman Brothers, arguing the now-defunct investment bank was undercapitalized and was hiding its exposure to toxic assets.
Jeffrey Little, author of Understanding Wall Street, believes the efforts made to level the playing field may have gone too far.
“Why even have analysts if the only information you’re going to get is the information that appears on the Internet 30 seconds” after a company’s earnings are released, said Little, a former analyst on Wall Street during the 1960s and 1970s.
Little said before insider-trading laws were enforced in their current fashion, “I would essentially be a walking, talking insider information box.” He added, “That was the nature of the business back in those days. That has changed.”
It remains to be seen just how many individuals and funds will be convicted or plead guilty in the government’s insider-trading probe. But even if the government’s charges are unable to stand up to scrutiny, the damage on Wall Street may already be done.
“Perception is everything. If the perception is that some people have been given an advantage over others, it is extremely destructive to the fabric of this market,” said Kenny.