THE BLOG
02/15/2011 12:06 pm ET Updated May 25, 2011

The Tipster Calls: Do You Take the Money and Run?

Your friend who works at ABC Company tells you that the company is about to be acquired for more than it's worth by XYZ Company, and that the stock price of ABC is likely to double. You trust your friend's tip because he's an executive at ABC and he or she is doubling down on the buyout.

Question: As a retail investor, what would you do based on your friend's tip? Do you call your broker and buy up as much ABC as you can afford? Or do you betray your friend, contact the Securities and Exchange Commission and volunteer to be a wire-wearing whistle blower hoping to bag a big, fat reward?

Like many Wall Street operators -- especially if you're a hedge fund manager -- you have been given inside information, which translates into money and power. But now you're faced with an ethical dilemma. You read the newspapers and financial blogs and you are well aware of two things: insider trading is illegal, and yet it is an often-used business model with a long and inglorious history.

What exactly is insider trading? Basically, it is the practice of buying or selling stock or other assets by corporate officers, other insiders or ordinary investors on the basis of information that is not public and is supposed to remain confidential. Insiders can buy or sell stock based on information they report to the Securities and Exchange Commission, thus making the public aware of the good, bad or perhaps the ugly data on a company's balance sheet.

Reporting this information to the SEC presumably gives the average investor a break, a level playing field upon which to make informed decisions. Fair enough. But if you are a major player or a hedge fund magnet, giving ordinary investors a break isn't your concern. To pull down those hefty hedge fund fees you need to offer an edge, and that edge often amounts to inside knowledge played close to the chest and out of public view.

So if the "whales" of Wall Street constantly are in search of inside tips, despite the legal and ethical pitfalls, why shouldn't you cash in on your friend's possibly profitable tip?

The February 13 edition of the Washington Post business section features a story by David S. Hilzenrath and Jea Lynn Yang headlined "The federal dragnet on Wall Street's inside game" which explores the insider trading business model and the government's all-out push to put a stop to it.

Insider trading has grown in recent years, the reporters conclude. But is this a growing epidemic enhanced by digital technology and unique ways of tracing cons? Or has technology merely exposed a practice that has been at work for generations?

My experience brings me down on the side of the latter. Wall Street is not the Land of the Fair Deal. Indeed, insider trading is a means of taking advantage of ordinary investors and making a killing in the dark. For example, those insiders privy to special, non-public knowledge can -- and often do -- sell investors stock that is teetering on the edge of the cliff. The insiders sell you on the upside while betting the farm on the inevitable collapse. For example, hedge fund billionaire John Paulson recently worked with Goldman Sachs to produce a derivative made up of bad mortgage loans. Paulson bet against this so-called Abacus package, knowing in advance that it was built to crash, while Goldman sold it to clients as a bullish move. Paulson made out big-time, as did Goldman, while unsuspecting investors took the fall.

The Abacus scam made headlines in the wake of populist outrage directed at the 2008 market meltdown. It was a sexy example of greed and insiders feeding at the public trough. The Street shrugged it off. It was by all accounts business as usual.

It now appears that the Obama Administration is determined to crack down on such insider deals. The Department of Justice (DOJ) is focusing on a wide circle of expert network firms which feed inside information to financial management companies, matching various company insiders to stock traders. Wall Street argues there's nothing wrong with this practice, that it is part of due diligence. The trouble with this argument is that the public isn't connected to the process and is often enough victimized by it.

DOJ is now trolling for insiders willing to wear wires to help build cases against billionaire hedge funds and those who feed them insider information.

If there is honor among thieves, DOJ is proving the opposite is true. If stock and bond traders can't cash in using legal practices, they can always snitch and pick up whistle blower awards granted by regulators that are often equal to, and at times exceed, the bonuses given to top financial executives.

So where do you come down on my initial question? Do you call DOJ or do you take your insider tip and run straight to your broker?

Critics of insider trading say the "integrity" of the market depends on your answer. Yet these same critics are challenged to find -- let alone protect -- the integrity they are so eager to preserve.