DealBook: How Serious a Crime Is Insider Trading?

Peter Foley/Bloomberg NewsRaj Rajaratnam leaving federal court during his trial in the spring.

As could be expected, the sentencing memos submitted by Raj Rajaratnam, the hedge fund manager convicted of insider trading charges, and by federal prosecutors paint very different pictures of the defendant.

At their core, the two filings put forth dueling views about just how serious the crime of insider trading is and what is an appropriate punishment for an offense that often involves successful individuals who can argue they did not mean to cause any real harm.

The defense filing asserts that “[w]ith the sole, and significant, exception of his criminal conviction in this case, the evidence shows that Mr. Rajaratnam lived a life that was not just blameless, but exemplary.”

Prosecutors, on the other hand, maintain in their filing that Mr. Rajaratnam “operated as a billion-dollar force of deception and corruption on Wall Street.”

The truth most likely lies somewhere in between. It will be up to Judge Richard J. Holwell to decide in Federal District Court in Manhattan on Sept. 27 when he sentences Mr. Rajaratnam, who was convicted of 14 counts of conspiracy and securities fraud.

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Although it does not recommend a particular sentence, Mr. Rajaratnam’s memorandum asks Judge Holwell to sentence him to a term of imprisonment well below what is called for by the federal sentencing guidelines, which the government asserts provides for a recommended term of 19 and a half to 24 and a half years in prison.

Mr. Rajaratnam’s lawyers point out that other defendants tied to his firm who entered guilty pleas received comparatively light sentences, like the 30-month sentence given to Danielle Chiesi, a co-defendant of Mr. Rajaratnam, and the 27-month sentence imposed on the hedge fund manager Mark Kurland. They argue that a sentence for Mr. Rajaratnam even close to that recommended by the sentencing guidelines would be wildly disproportionate to the punishments given to Ms. Chiesi and Mr. Kurland for essentially the same conduct.

Beyond just the facts of his case, Mr. Rajaratnam’s memo offers a deeper justification for a lighter sentence: his crime did not involve any identifiable victims, nor did it cause the kind of harm inflicted on investors by the likes of Bernard L. Madoff or such corporate chieftains as Jeffrey K. Skilling of Enron or Bernard Ebbers of WorldCom.

The defense memorandum portrays insider trading as a less pernicious offense than other types of securities fraud, in which individual investors can be identified as particular victims, because no one individual can be shown to have suffered identifiable losses. Even though Mr. Rajaratnam made money from the tips he received, “a defendant tippee who profits from illegal trading does not engage in conduct that is as culpable as a defendant who affirmatively steals the same amount from an identifiable victim,” the defense memorandum states.

Mr. Rajaratnam’s argument that insider trading involves unidentifiable victims, and therefore is less harmful, raises the fundamental question of how a court should view the harm caused by the violation. He is essentially arguing that this is a victimless crime, at least as compared to a case like Mr. Madoff’s vast Ponzi scheme, and therefore violators are less deserving of the kind of significant punishments imposed on those who actually steal from individual investors.

This argument reflects the fact that there are unlikely to be any letters submitted to the court in advance of the sentencing from so-called victims of his crimes, as we saw before the sentencing of Mr. Madoff, when there were poignant reminders of the enormous damage he caused. The trading by Mr. Rajaratnam’s firm, the Galleon Group, was in the stocks of large companies on highly liquid markets. Those who were on the other side of his purchases and sales are in all likelihood unaware of their connection to him and would not perceive themselves as victims.

Federal prosecutors have tried to counter this view by arguing that a substantial sentence is needed “to send a strong and clear message that the time for illegal insider trading to end is now.” Without a lengthy prison sentence, they argue:

“There is a significant danger that these executives and money managers may view a light sentence as an insufficient deterrent to insider trading, secure in the knowledge that if they are ever caught, they would be able to go to trial and argue at sentencing after conviction that whatever their conduct was, it had to have been less extensive than the crimes committed by Rajaratnam, and therefore worthy of a shorter sentence than him.”

This is similar to the Justice Department’s argument in the sentencing of Lee B. Farkas, a former mortgage company executive who received a 30-year term of imprisonment for his role in a fraud the government estimated at $2.9 billion. Insider trading is different from mortgage fraud, however, because the harm is much more difficult to measure, even if it is clear what a defendant gained from the trading.

The sentencing of Mr. Rajaratnam can almost be seen as a referendum on how insider trading should be viewed: a lighter sentence means that it is not a crime that causes significant social harm because its impact is dissipated, while a heavier sentence sends a message of deterrence in order to maintain the integrity of the markets.

An interesting question is whether the message of deterrence, what prosecutors called the desire to end insider trading, is one that will be heard. For a crime that does not involve an identifiable victim beyond the disembodied securities markets, defendants seem to be able to convince themselves that they really are not doing anything wrong, or at least not nearly as wrong as someone like Mr. Madoff and the corporate executives who destroyed their companies through accounting fraud.

Three insider trading cases announced last week involved prominent defendants who traded on and tipped confidential information used for trading that resulted in comparatively small gains. These cases lend some support to the view that those who engage in this type of conduct may not perceive themselves as violating the law because there is no immediate victim.

The two civil cases brought by the Securities and Exchange Commission involved William A. Marovitz, husband of Christie Hefner, the former chief executive of Playboy Enterprises, and a former major league baseball player, Douglas V. DeCinces. Both men were successful in other business ventures, and while Mr. DeCinces made more than $1 million from his trading, Mr. Marovitz’s case involved gains and avoided losses of about $100,000, a modest amount to break the law.

The criminal prosecution of a former director of Mariner Energy, H. Clayton Peterson, which will very likely result in his serving a prison term, involved about $150,000 in profits realized by his son Drew, who received the tips.

Is it worth risking your reputation, and perhaps even going to federal prison, for such paltry amounts? I doubt these men would participate in a grocery store robbery or help set up a Ponzi scheme, but they appear to have willingly engaged in insider trading.

In contrast, of course, the government contends Mr. Rajaratnam pulled in $63.8 million in profits through insider trading.

The length of Mr. Rajarantman’s term may not have much deterrent effect so long as insider trading is viewed as a victimless crime. The fact that the harm is to the trust in the market makes it easier to argue that there is little measurable impact from the violation when there is no victim who will stand up in court and explain what happened after the crime, as we saw at Mr. Madoff’s sentencing.

Whether that means insider trading should be treated as less serious, with a commensurately reduced punishment, will be reflected in Judge Holwell’s sentencing decision.

Defense’s Sentencing Memorandum

Prosecution’s Sentencing Memorandum

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