Wiretaps, a fallen hedge-fund titan, and the line between research and a tip

In 2009 the FBI arrested Raj Rajaratnam, founder of the $7 billion Galleon hedge fund, in the first insider-trading case ever built on wiretaps. Agents had recorded thousands of his phone calls, capturing tips that traced back to insiders at Intel, Goldman Sachs, McKinsey, and more. In 2011 a jury convicted him on all 14 counts. He was sentenced to 11 years — at the time the longest insider-trading sentence in US history — and ordered to forfeit tens of millions.

The line Rajaratnam crossed, between legitimate research and trading on material non-public information, is the exact line CFA Level I Ethics makes you find. MNPI is one of its most-tested traps, and the vignettes are written to sit in the grey. Candidates who decide from surface details get them wrong with remarkable consistency. The fix is a test you apply the same way every time.

The two-prong test

Information is MNPI only if both prongs are true:

• Material — a reasonable investor would consider it important to a buy, sell, or hold decision, and its release would likely move the price.
• Non-public — it has not been broadly disseminated to the market and given time to be absorbed.

Material but public is fair game. Non-public but immaterial is fair game. The prohibition applies only when both prongs are met.

What tends to be material: earnings results or guidance revisions, mergers and acquisitions, dividend changes, major management changes, regulatory approvals or rejections, big litigation outcomes, major contract wins or losses.

What counts as public is narrower than people assume. A regulatory filing, a press release over a standard wire, or a disclosure on an open earnings call is public. A remark at a private dinner, a figure on a password-protected investor page, or a tip whispered over the phone (as in the Galleon calls) is not.

Mosaic theory: allowed, and frequently tested

The exam keeps probing this distinction. An analyst combines public shipping data, a paid-but-broadly-available satellite feed of retail parking lots, and quarterly filings, and concludes a retailer's inventory is unsustainable. She recommends shorting. No violation. Assembling many public and non-material pieces into a material conclusion is the mosaic theory, which is exactly what diligent research is supposed to do. Non-material, non-public scraps added to public data are yours to use.

Rajaratnam was the opposite case. He was not building a mosaic; he was being handed finished, material, non-public facts (an unannounced earnings number, a deal not yet public) and trading on them. That is a tip, and acting on a tip is a violation of Standard II(A).

What to do when you receive MNPI

The required sequence is short and non-negotiable:

• Do not trade on it, for yourself or for clients.
• Do not tip it to anyone who might.
• Notify your supervisor or compliance, and encourage the company to disseminate the information publicly.

The cost of getting this wrong goes well beyond an exam point. Improper handling of inside information has ended careers and produced multi-year prison sentences. What CFA Institute requires lines up closely with what regulators in the US, EU, and UK actually enforce, so the standard is worth knowing cold rather than guessing.

When a vignette feels designed to make you guess, stop and run the two prongs, then ask whether the chain of information is a mosaic or a tip. That discipline is what turns the grey-area questions into reliable points.