[The Detection Series] Insider Trading: Challenging, Yet Not Impossible To Detect

Insider trading, the act of trading shares on the stock exchange to give you a financial advantage based on confidential information that you have acquired, may be the most popular form of market abuse. Or, at least the most well-known. And it’s been going on for a long time: the first examples date back to the roaring ‘20s.

Even celebrities can get caught

The homemaker maven, Martha Stewart was guilty of insider trading in the ImClone scandal. The debacle abruptly halted her then soaring eponymous enterprise and career: it also wreaked havoc on her brand. She was imprisoned in 2004 for five months because she avoided a mere $45,673 loss by selling her shares two days prior to ImClone’s 2001 announcement of an FDA rejection. Despite its “popularity,” insider trading represents a particularly challenging form of market abuse to detect and prosecute.

How do you know when someone learned something about a company to inform a financial transaction? It’s as if you need a prying eye on every mobile phone – and burner phone – which is a daunting endeavor given the proliferation of eCommunications today. But then you would also need hidden cameras and audio recording devices (i.e. “bugs”) in every boardroom, office, café, restaurant, and other places that people might meet in person to divulge confidential information. And that’s hardly realistic.

The golf course is another ideal backdrop for insider trading. Case in point, the insider trading scandal with the Dean Foods stock which netted golf pro, Phil Mickelson, with over $931,000 in gains. Insufficient evidence was available to charge Mickelson, but he was forced to give up his profits – plus interest.

Is wire-tapping the only way to gain proof?

There are numerous other ways to detect insider trading despite the challenge of doing so, even with respect to eComms. Fraudsters are always scheming on how to work the system so that they are not flagged for insider trading; and, if they are, there won’t be sufficient evidence for the charges to stick. In 2007, the Securities & Exchange Commission (SEC) became suspicious of Raj Rajaratnam, a hedge-fund founder who seemed to be in the habit of making noticeably large trades just prior to a major corporate announcement or event. With enough evidence in hand, including $53 Million in gains, they began eavesdropping on his phone lines.

Some of the insider trading schemes are downright elaborate. In October 2019, an international insider trading ring was exposed. At its core, a prominent London investment banking couple, a trader in Monaco, a VP at Goldman Sachs, and a Grecian man who owned a chain of restaurants in NYC which was often the site of the illegal tip exchanges. The group allegedly acquired tens of millions of dollars with their insider trading scheme by bouncing trades back and forth across the Atlantic Ocean through an assembled group of unrelated middlemen. The illicit tips were rewarded with untraceable perks like luxury watches, vacations, and cash. Burner phones were the communication mode of choice to impede detection. The fraudsters would also tip off the media, including Bloomberg News, immediately following the trades to affect stock prices and further boost their gains.

Small talk, when associated with a potentially suspicious text or instant message is increasingly being flagged as camouflage for illicit activity. All brokers at financial institutions sign stringent contracts that permit monitoring of their calls, texts, and trading activity. Any interaction with an external party is monitored especially closely. A seemingly innocent phrase such as, “I need to call you tonight.” immediately gets flagged because there is some urgency in communication with an external party. But it’s tricky to get right 100% of the time. That said, today, algorithms are constantly improving through refinements made as machine learning uncovers new associations via repeated analysis over ever-increasing volumes of texts exchanged.

Fraudsters are clever – but so is technology and the SEC

Stephen Metro, a clerk at a law firm in NYC, cleverly passed tips along to his acquaintance, Frank Tamayo, who worked at a café in Grand Central Terminal. Metro would write the ticker symbol on a napkin or note which Tamayo would then pass on to the broker, Vladimir Eydelman, formerly of Morgan Stanley. Tamayo would then eat the napkin or note. and engaged in insider trading repeatedly over the period 2015-16. Eydelman is still serving a three-year prison term.

While burner cell phones present a new tier in detection avoidance, technology does exist today to decode SMS text messages. For example, late last year, the SEC pressed charges against five friends in Silicon Valley. The lead instigator, Janardhan Nellore, used his IT credentials to hack confidential information regarding his employer’s (Networks Inc.) earnings. Through text messaging, where “baby” referenced his company’s stock, the group of friends would then make buy or sell trades. The friends used some of their profits as cash gifts in small increments back to Nellore. Immediately following an interview with the FBI, Nellore purchased one-way tickets for himself and his family to India but was apprehended at the airport.

Avoid the legal fallout from insider trading

You may be in a vulnerable position, and the question is how do you protect yourself? For example, you may be an officer of a publicly-traded company and be aware of a pending negative or positive announcement that could affect the company’s market value. If you opt to make a trade prior to that announcement but report your intention to the SEC, you may be granted Safe Harbor protection. And, if you tell the truth to law enforcement, you avoid the penalty for a felony.

There are numerous examples of people being charged with insider trading – even though they never executed a stock transaction. Market abusers cunningly use a spouse’s or relative’s accounts to do the trade, thinking it won’t be detected. Others are charged because they divulged confidential information to a third party who benefited financially from that information. In 2017, a therapist was charged by the SEC with insider trading because he shared confidential information disclosed to him by his patient during a treatment session. It is noteworthy that the therapist was also charged with violating patient confidentiality and ethics violations.

As challenging as it is to monitor, detect and report suspected market abuse like insider trading as it’s being transacted via eComms, technology solutions are available. I personally know of one…