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Generational Dynamics Web Log for 17-Dec-2010
17-Dec-10 News -- Insider trading charges target 'expert networks'

Web Log - December, 2010

17-Dec-10 News -- Insider trading charges target 'expert networks'

South Korea plans artillery exercises in waters near Yeonpyeong island

Insider trading charges target 'expert networks'

A year ago, Walter Shimoon, who had secret information about Apple's iPhone and iPad plans because his company supplied parts to Apple, was talking to a hedge fund manager, according to CNN.

He described to the hedge fund manager what features the next iPhone would have, and he said that Apple has a code name for something new. "It's totally ... It's a new category altogether... It doesn't have a camera, what I figured out. So I speculated that it's probably a reader. ... Something like that. Um, let me tell you, it's a very secretive program ... It's called K, K48. That's the internal name. So, you can get, at Apple you can get fired for saying K48." The iPad -- code named K48 -- was unveiled four months later.

Shimoon was an employee of Flextronics, which supplies camera and battery parts to Apple. He knew what Apple was planning, but he would have signed a non-disclosure agreement forbidding him to talk about what he knows. But when an "expert network" company, Primary Global Research, reached out to him and offered to pay him a large sum of money to reveal Apple's plans to a hedge fund, he decided to ignore his non-disclosure agreement.

The expert network company brought the two parties together. Shimoon would speak to the hedge fund manager. Shimoon would receive a large sum of money, and the hedge fund would use the inside information to gain a big advantage trading in Apple and competing stocks.

Unfortunately for Shimoon and the the expert network company, the hedge fund manager was a cooperating witness, and the phone conversation was being recorded. So now, Shimoon and an employee of Primary Global Research are among a number of people who were arrested on Wednesday, charged with conspiring to provide inside information to hedge funds and other investors.

An 'expert network' scam involves three parties:

An "expert" who has inside information about a company because he's an employee or a customer or a client or a supplier.

A hedge fund or investor that stands to make a great deal of money by using the inside information in the stock market.

An "expert network" consultant who links the above two people together. He collects a great deal of money from the hedge fund and passes some of it on to the expert.

Many people believe that this is a victimless crime. All three of these parties make money, and nobody loses any money.

But that isn't true. If a hedge fund gains by using insider knowledge, then some other (unknown) investors loses.

What we're seeing is the fulfillment of something that I've been talking about for six or seven years.

Massive fraud occurred during the real estate and credit bubbles because there was so much money around that no one was paying attention. But once the financial crisis began to bite, regulators went back and looked at what happened.

This is the same thing that happened in the 1930s. There was a great deal of embezzlement leading up to the last generational financial crisis. I've posted this passage several years ago, and it's worth posting it again. John Kenneth Galbraith described what happened -- and what will happen again -- in his 1954 book, The Great Crash - 1929, as follows:

"In many ways the effect of the crash on embezzlement was more significant than on suicide. To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in -- or more precisely not in -- the country's businesses and banks. This inventory -- it should perhaps be called the bezzle -- amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.
The stock market boom and the ensuing crash caused a traumatic exaggeration of these normal relationships. To the normal needs for money, for home, family and dissipation, was added, during the boom, the new and overwhelming requirement for funds to play the market or to meet margin calls. Money was exceptionally plentiful. People were also exceptionally trusting. A bank president who was himself trusting Kreuger, Hopson, and Insull was obviously unlikely to suspect his lifelong friend the cashier. In the late twenties the bezzle grew apace.
Just as the boom accelerated the rate of growth, so the crash enormously advanced the rate of discovery. Within a few days, something close to universal trust turned into something akin to universal suspicion. Audits were ordered. Strained or preoccupied behavior was noticed. Most important, the collapse in stock values made irredeemable the position of the employee who had embezzled to play the market. He now confessed.
After the first week or so of the crash, reports of defaulting employees were a daily occurrence. They were far more common than the suicides. On some days comparatively brief accounts occupied a column or more in the Times. The amounts were large and small, and they were reported from far and wide. ...
Each week during the autumn more such unfortunates were reveled in their misery. Most of them were small men who had taken a flier in the market and then become more deeply involved. Later they had more impressive companions. It was the crash, and the subsequent ruthless contraction of values which, in the end, exposed the speculation by Kreuger, Hopson, and Insull with the moey of other people. Should the American economy ever achieve permanent full employment and prosperity, firms should look well to their auditors. One of the uses of depression is the exposure of what auditors fail to find. Bagehot once observed: "Every great crisis reveals the excessive speculations of many houses which no one before suspected." [pp. 132-35]

Galbraith's point was that there were many criminal activities going on before the 1929 crash, but nobody cared, as long as everyone was making money. But once the crash occurred, any irregularity was viewed with suspicion and led to an investigation. These investigations turned up many cases of embezzlement -- people who had "temporarily borrowed" money that wasn't theirs to invest in the stock market, and then got caught in the crash.

Once the crash occurred, crime continued into the 1930s, including investor fraud and insider trading. The same thing is happening today.

One financial pundit reacted to Wednesday's insider trading charges by writing the following for Fortune:

"It's the same conclusion one can draw from Bethany McLean and Joe Nocera's excellent new book about the mortgage crisis, All the Devils Are Here: the real surprise isn't that there's a new scam being run, but that there are so many willing participants. For those of us who try to give people the benefit of the doubt—even those who choose to work on Wall Street—this is nothing but demoralizing news."

As I've pointed out many times, the credit bubble in the mid 2000s decade involved massive fraud perpetrated by almost every financial institution in the world. The same people are still working in these organizations, still committing crimes on a massive scale. These criminal prosecutions have barely begun.

Additional links

Starting on Friday, South Korea is planning new artillery exercises in waters near Yeonpyeong island. Similar exercises last month caused the North Koreans to shell and kill civilians on Yeonpyeong island. VOA

The euro crisis is still worsening. Spain had an incomplete bond sale on Wednesday because yields (interest rates) demanded by investors surged to 5.5% on 10 year bonds. It was below 5% in November. Bloomberg

At an EU financial summit in Brussels on Thursday, Germany led the way, supported by the Netherlands and Finland, to vetoing any substantial attempt to make Germany pay any money to bail out debtor EU nations. Economist

A new whaling season is about to begin, and once again there will be a big showdown between Japanese whaling ships and fanatical anti-whaling militants. Diplomat

In Germany, as in other countries, volunteers write back each year to tens of thousands of children who write to Santa Clause. But unlike the US and France, Father Christmas in Germany does not respond to e-mail requests. Spiegel

(Comments: For reader comments, questions and discussion, see the 17-Dec-10 News -- Insider trading charges target 'expert networks' thread of the Generational Dynamics forum. Comments may be posted anonymously.) (17-Dec-2010) Permanent Link
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Generational Dynamics Web Log for 17-Dec-2010 17-Dec-10 News -- Insider trading charges target 'expert networks'

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Generational Dynamics Web Log for 17-Dec-2010
17-Dec-10 News -- Insider trading charges target 'expert networks'