The Informant’s Incentive

This October, prosecutors announced a case of hedge fund insider trading with multiple arrests and perp walks amid great media fanfare. Revelations from court documents have become curiouser and curiouser.

The government’s key witness, Roomy Khan, comes across as a determined practitioner of insider trading going back more than a decade. She pleaded guilty to the crime in 2001. At that time or earlier, she became an informant for the FBI.

Subsequently she went on a brazen run, obtaining and trading on private information about company after company, acting as if she were protected from legal consequences. Her bizarre career highlights the ambiguity surrounding this issue. Legal scholar Richard Epstein has pointed out that enforcing insider trading law involves heavy costs and intrusion—see his Simple Rules for a Complex World. He argues that insider trading should be generally regarded as legal.

Consider the implications of the broad case based on Ms. Khan as informant and witness.

In 1998, she sought to sell non-public information about her employer, chip manufacturer Intel, to hedge fund manager Raj Rajaratnam. She was videotaped faxing information. The government apparently hoped to catch bigger fish with her help.

In this early run-in with insider trading law, Ms. Khan was given an unusually light sentence (she’s had other, unrelated, legal problems) and was merely confined to her home for six months.

Neither the FBI nor the Securities and Exchange Commission pursued Mr. Rajaratnam at the time—there was no evidence that he traded on the Intel information. Neither did he pay for it. It is no crime to receive non-public information if you don’t trade on it.

After she left Intel Ms. Khan went to work for Mr. Rajaratnam’s Galleon Group. In 2005, she asked him for a job again. She did not get one, but she collected information about public companies from various sources, traded on it to make large sums of money for herself, and passed the info on to Galleon, from 2005 through 2007.

Those activities are now the centerpiece of the insider trading charges against Mr. Rajaratnam and others. Ms. Khan figures repeatedly as “Tipper A” in the complaint against them and once more pleaded guilty herself to insider trading. She has been working with the authorities again since 2007.

Why did she go on a trading spree? Probably in part because she thought that in the worst case scenario she’d get another six months at home. She would receive leniency for informing in particular against Mr. Rajaratnam. After all, she’d already worked as an FBI informant and had the prior experience of getting off lightly.

As long as she passed on the goodies to others and got them on tape talking with her, she would not face the full penalties!

Professor Epstein argues that the benefits of insider trading may be larger than its costs. It is so hard to catch because its effects are unclear. If he’s right, this big government effort is a waste. If, on the other hand, you believe that the activity is undesirable and people should be punished for it – perhaps made an example of – you have the dilemma of encouraging informants who are themselves big–time insider traders.

In all likelihood the current case would not exist without Ms. Khan. Probably informants are necessary to gather evidence of insider trading in many instances. That means that the government provides a select group of spies with in effect a protected status to engage in insider trading and ensnare other people. Enforcement efforts create more of the supposed problem in the name of fighting it.

Photo: Business Insider

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