Earlier this year, a federal judge issued a stinging dismissal of an insider trading case the SEC brought against Mark Cuban.
It’s rare that the SEC loses these cases, so no doubt Raj Rajaratnam’s lawyers are studying up on it. Unfortunately, it might not provide as much comfort as they hope.
Cuban sold stock in Mamma.com after he learned from an executive that the company was planning a private placement of shares that would dilute existing shareholders. The executive told Cuban about the private placement in hopes that Cuban would buy some of the shares but Cuban did exactly the opposite.
The SEC claimed that Cuban’s trade was illegal insider trading. But the judge in the case ruled that because Cuban wasn’t an insider at the company himself, he could only be held liable if he had agreed not to trade on the information. Because the SEC never even argued that Cuban had promised not to trade, the judge threw the case out.
Rajaratnam’s case differs in significant ways from Cuban’s. In the first place, it’s taking place in New York. The Second Circuit has far more experience with insider trading cases than the Texas court where Cuban was sued. And it has adopted a relatively broad interpretation of insider trading based on tips. The Texas trial court’s decision won’t be binding on the federal court in New York. It probably won’t even be very influential.
More importantly, Rajaratnam’s insider tip about Google is tainted with skullduggery. Where Cuban received his information from a loose lipped executive who openly disclosed the private placement, Rajaratnam received it through a shadowy network that was betraying the confidence of Google by conveying the information. This is the key difference: Cuban got his information without any betrayal of confidence, while Rajaratnam’s information was rooted in a betrayal.
In particular, the information that Google was set to report an earning’s shortfall came from an employee at a public relations firm hired by Google. This firm was under a duty of confidentiality to Google and prohibited from trading in its stock based on the information. When the tipster passed on the information, he was violating his duties—and that violation of duties is what triggers insider trading liability.
What’s more, the employee knew that he was engaged in wrong-doing that would generate profits from the inside information. He even went so far as to demand payment for delivering the information about earnings.
It certainly helps Rajaratnam’s case that the demand for payment was rejected and no more information was received. At this point, Rajaratnam might want to argue that he received the information innocently, without any overt act on his part to garner insider information. Unfortunately for this argument, the court may very well rule that once Rajaratnam was in possession of the information and knew of its source, he was barred from trading on it.
So what could Rajaratnam have done once he received inside information from a wrong-doer? What if his company was planning on shorting Google anyway, based on analysis that had nothing to do with the PR leak? The safest move would have been to create a firewall between the people with the inside information and the decision to trade. Because once you have the inside information, you are courting trouble.
Rajaratnam’s strongest defence will probably be to argue that he didn’t know the origins of the information. He did not get the information from the employee at the PR firm. He got it from another person who was also trading. If he didn’t know and didn’t have any reason to know that the information came from a tainted source, the government’s case against Rajaratnam is much weaker.
So this case may well turn on whether or not the evidence gathered by the government through wiretaps and confessions indicates whether Rajaratnam knew the information he was receiving came from someone who was violating a duty of confidentialty toward Google. If he did have this knowledge and didn’t recuse himself from trading decisions about Google, he is most likely toast.
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