The Implications of Insider Trading in Hedge Fund Land

 |  Includes: AMD, GOOG, HLT-OLD, PLCM
by: Market Folly

Raj Rajaratnam, founder of hedge fund Galleon Group has been charged with insider trading in a $20 million case as he and five other people were allegedly involved, including a former Bear Stearns executive and an IBM executive. The charges say that the six accused used insider information in two schemes where they traded shares of Google (NASDAQ:GOOG), Polycom (NASDAQ:PLCM), Hilton Hotels (HLT-OLD), and Advanced Micro Devices (NYSE:AMD).

This case is interesting in that it is the first time wiretaps have been used to target insider trading. The insider information apparently came from numerous sources, including other hedge funds, investor relations firms, and the companies listed above whose shares they traded. Rajaratnam faces 12 total fraud and conspiracy counts, many of which have up to a 20-year maximum sentence. Prosecutors had been investigating this case ever since 2007 when a non-named person began complying with the FBI. That person apparently had been using insider information and tipping off Rajaratnam since 2006.

The Wall Street Journal has dug into one particular case of the insider trading events regarding shares of now private Hilton Hotels. The Journal writes,

The deal is the early July LBO of Hilton Hotels. According to the regulator, on July 2 at 2:20 p.m., Hilton executives called the lead analyst covering the hotel for Moody’s. The purpose of the 7-minute call isn’t detailed. The SEC does say that at some point in the call the Hilton executives informed Moody’s that their company was being taken private by Blackstone Group and that the deal likely would be announced sometime before the Fourth of July.

There are two Moody’s analysts mentioned in the complaint, a vice president and senior analyst that was the credit rater’s lead analyst on Hilton and an associate analyst “involved” in rating Hilton. The lead analyst took the Hilton call. One analyst then told someone identified as “the cooperating witness” of the pending deal. The SEC says it reviewed phone records for the Moody’s analyst’s cellphone that show the analyst made three phone calls to the cooperating witness from 3 p.m. to 3:15 p.m. that same day. The cooperating witness provided the Hilton information to Rajaratnam, saying that it was “a sure thing.” The SEC says trading records show that Galleon Technology Funds on the following day, July 3, bought 400,000 shares of Hilton at an average price of $35.13 a share.

After the market closed that day, Hilton announced it had agreed to be acquired by Blackstone for $20.1 billion, or $47.50 a share. On July 5 and July 16, Galleon sold all 400,000 shares at prices ranging from $45.25 to $45.63. The SEC says the trades reaped Galleon a profit of $4 million. For passing along the tip, the Moody’s analyst received $10,000."

Very interesting stuff as this will undoubtedly lead to further questions as to possible other instances of insider trading across hedge fund land. In the past, insider trading cases had caught 'small' culprits, but this one is quite the opposite. Rajaratnam is the head of a major hedge fund that had $7 billion in assets under management at its peak. Galleon Group will certainly have quite the overhang of dark clouds now as its founder undergoes charges. We recently saw another large hedge fund shut down due to such a cloud of negativity as Art Samberg's Pequot Capital could not shake the bad image that had been bestowed upon them for past allegations. It will be interesting to see if Galleon suffers the same fate.

We haven't covered Galleon's holdings for some time, but those interested can view its portfolio from Q1 2009. Galleon was founded by Raj Rajaratnam in 1997 and currently manages in excess of $5 billion. Raj previously worked for Needham & Company and when he left was responsible for a compounded rate of return of 37% over 4 years while overseeing $250 million. Raj received a Bsc in Engineering and then an MBA in Finance from the University of Pennsylvania. Raj's work had also recently landed him on Forbes' billionaire list. His firm's track record landed two of its funds on Barron's top 100 hedge funds rankings list. But obviously with all of this news being uncovered, his success and track record will certainly be called into question.

You can see Galleon's positions as of June 30th as filed with the SEC here. For more on the insider trading case, head to articles from the WSJ here and here.