The Implications of Insider Trading in Hedge Fund Land

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 (GOOG), Polycom (PLCM), Hilton Hotels (HLT), and Advanced Micro Devices (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.

Comments

[lower98th:]

Going after Rajaratnam is another example of "not to big" to pick on. This is window dressing for a system to compromised to take on the politically connected crooks.

Oct 18 07:57 AM

[logicalthought:]

Should we go after folks like Rajaratnam? Sure, but the reasons for it are purely psychological, in that the fear is that folks won't participate in the markets if the markets are perceived to be "rigged." In reality, Rajaratnam bought from willing and anonymous sellers and probably gave them a better price than they would've otherwise gotten, because if he hadn't had that info he wouldn't have been a buyer, and thus those willing and anonymous sellers wouldn't have had as many parties bidding for their shares.

Meanwhile, of course, while the government was spending three years and who knows how much money investigating this alleged crook over his $20 million profit, the large banks were costing us taxpayers TRILLIONS of dollars with the seemingly legal but completely non-commonsensical "investment instruments" they were creating and actively pushing upon each other and, even worse, upon our naive municipalities and pension funds.

This is a long-winded way of saying that in a cost-benefit analysis, government resources (as usual) were grotesquely misallocated.

Oct 18 09:29 AM

[talld:]

I am guessing that someone knew about googles earnings report a bit early, probably around 10/1. At that time Goog started showing a strong correlation to index spreads not noticable in prior earning reports.

Oct 18 12:03 PM

[talld:]

Actually the entire time period of 9/17 to 9/23 also looks funny with a correlation coefficient of 0.9 or better for the relationship between the index spread and goog, and the next days close.

As for the "too big to pick on" comment, I agree.

Oct 18 12:13 PM

[davidbdc:]

This isn't a waste of government resources, rather its one of the few legitimate actions our government actually undertakes.

Lets not pretend this is some isolated incident. There is an incredible "cozy" relationship between the firms that pay for Moody's, Standard & Poors reports/rating and the analysts at these firms. From help to structure products to get certain ratings to passing along information in this case. What is really sad is that the analyst is obviously not a very good negotiator - he/she got 10K for a $4MM tip? Good grief.

This is extremely important. How many times do you read an analyst at such and such bank is "upgrading" the company after meeting with company officials and being impressed with blah, blah blah......think his/her firm's funds haven't jumped in before you? Of course they have.

We need about another 50 of these type of arrests to start to clean up the joint.

Oct 18 02:15 PM

[talld:]

I think the comments goes to things more like how the folks behind mortgage backed securities made claims like "We didnt know a "no-doc" loan was going to be heavily defaulted on, when the new interest rate kicked in."

If you think not, imagine going to a car lot and saying you wanted to buy a car on a no-doc loan. You would be laughed out of the joint.

This incredible fraud was perpetuated on the world through all of those near worthless securites, and it was all insured by an "insurance company" with no reserves. (AIG)

So, yeah, they popped a guy for an analyst tip and four million in profit, while at the same time, other people who perpetuated a much larger fraud are being ignored by the courts.

Oct 18 03:30 PM

[logicalthought:]

Davidbdc:

I wish there were an "edit" function on the comments, because I didn't mean to imply that the SEC shouldn't go after these guys-- hell, it pisses me off as much as the next guy that they did this. I was really just pointing out that ironically, what this guy did (lol, make that ALLEGEDLY did-- I don't want to get sued by a billionaire!) actually probably BENEFITTED the people whose stock he bought, whereas the "big picture stuff" that went on cost us all TRILLIONS.


On Oct 18 02:15 PM davidbdc wrote:

> This isn't a waste of government resources, rather its one of the
> few legitimate actions our government actually undertakes.
>
> Lets not pretend this is some isolated incident. There is an incredible
> "cozy" relationship between the firms that pay for Moody's, Standard
> & Poors reports/rating and the analysts at these firms. From
> help to structure products to get certain ratings to passing along
> information in this case. What is really sad is that the analyst
> is obviously not a very good negotiator - he/she got 10K for a $4MM
> tip? Good grief.
>
> This is extremely important. How many times do you read an analyst
> at such and such bank is "upgrading" the company after meeting with
> company officials and being impressed with blah, blah blah......think
> his/her firm's funds haven't jumped in before you? Of course they
> have.
>
> We need about another 50 of these type of arrests to start to clean
> up the joint.

Oct 18 03:41 PM