Forget Rajat Gupta -- Feds Should Train Fire on Wall Street

Last Updated Oct 26, 2011 5:22 PM EDT

Just say no to insider trading. While we're at it, say no to drugs, braining someone with a hammer and jay-walking. Point is, why all the fuss over Rajat Gupta?

Yes, the former McKinsey boss may have fed secrets to convicted hedge fund baron Raj Rajaratnam. If so, under the law there's a good chance Gupta will join his pal in the clink. The end. What lessons should we draw?

An obvious one might be that -- contra Milton Friedman and other true-believers who argue that insider trading benefits financial markets -- such activity saps investor confidence, which theory suggests is a bad thing. Another is that it probably raises trading costs (because market-makers have to widen their spreads to keep up with all those corporate insiders trading on secrets). Nobody likes a front-runner.

Feds on patrol?
More fancifully, the NYT thinks Gupta's arrest highlights the "government's multiyear crackdown on illegal activity on Wall Street." The paper also says he is the "first executive to be implicated from the upper echelons of corporate America" as part of this campaign.

Wrong on both counts. In fact, the proliferation of insider trading cases since the housing crash underlines the feds' multiyear campaign to avoid taking legal action against bankers for their part in the financial crisis.

The Justice Department has filed criminal charges against exactly zero Wall Street executives. Just this August, the SEC dropped an administrative proceeding against Gupta over his alleged leaking to Rajaratnam. Why? To protect the "public interest" (which segment of the public it was protecting the agency didn't say). So-called deferred prosecution agreements, under which corporations accused of all manner of wrongdoing are allowed to pay fines without admitting guilt, are the norm.

So much for said crackdown. Federal prosecutors like going after insider trading because it is easier to prove. Gupta's fate hinges on a fairly straightforward question -- whether he illegally passed on material, nonpublic information to Rajaratnam.

What prosecutors don't like is going after big financial firms with squadrons of ace lawyers and deep connections in Washington. Especially when those cases turn on things like the inner workings of synthetic derivatives, collateralized debt obligations and other financial arcana sure to make jurors yawn. Oh, and where's a dedicated public servant supposed to work when it's time to grow up and make some real dough in the private sector?

Idea: Treat banker like insider traders
The problem with pursuing hedgies and style mavens while steering a wide berth around Wall Street CEOs is that insider trading has never threatened our financial system. But mortgage fraud has. Yet one of these malicious activities is a crime and the other isn't. An investor scores big by trading on confidential corporate information. Guilty. A bank scores bigger by trading on confidential information regarding the worthless loans underlying mortgage securities (securities the bank itself designed to fail). Guilty? Not under criminal law.

It doesn't have to be this way, write financial journalist Jeff Madrick and corporate law professor Frank Partnoy, a leading expert on derivatives:
A strong argument can be made that the U.S. should treat more financial activities as it does insider trading, making clear that investment firms have broad responsibilities that go well beyond mere market-making. It would require courageous prosecutors to advocate such an approach today, and any defendant would strongly protest the approach as making conduct criminal after the fact. But there are plenty of precedents and arguments for judges to find that bankers have broader responsibilities.
Then again, it's always possible the case against Gupta does signal a hardening of government resolve to prosecute top bankers. It will be interesting to see if the former Goldman Sachs (GS) director has any tales to tell about Goldman chief Lloyd Blankfein in exchange for federal leniency.

Government also isn't monolithic. Different parts of it have different agendas and interests. It is notable that the FBI -- which warned financial regulators about subprime loans blowing up years before the meltdown -- collared Gupta and not Attorney General Eric Holder.
Scalping party
Here's my bet: The government's focus on insider trading is chiefly a show of force. It's akin to the police busting street-level drug-dealers, a way to clear cases and pad arrest records that avoids the more difficult (and career-threatening) mission of trying to nail the bespoke-suited kingpin.

After all, despite his characterization in the Times and elsewhere as a big shot, Gupta is a small fry in the larger financial cosmos. He wasn't a decision-maker at Goldman -- he sat on the company's board, where the primary duty is taking dictation from Blankfein. As for his work fronting McKinsey, as with other management consultants his job was to abet institutions much higher up the corporate food chain. Even within the pantheon of insider traders, Gupta is closer to Martha Stewart than to Ivan Boesky.

Gupta may well have occupied the "upper echelons of corporate America" (whatever that means), as the Times puts it. But that's different than calling the shots. And in that context the reason for his downfall -- and that of Rajaratnam, and most of the other wiseguys and gals who have been caught gaming the market -- is clear: He doesn't matter.

Image from Flickr user World Economic Forum via Wikimedia Commons, CC 2.0
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  • Alain Sherter On Twitter»

    Alain Sherter is an award-winning business journalist who has written for The Deal, MarketWatch and Thomson Financial Media.

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