Galleon's Defense: Insightful vs. Insider Information

If the insider trading case against Galleon Management co-founder Raj Rajaratnam ever gets to trial, expect a vigorous defense strategy built around the difference between information that’s considered insightful “market color” versus top secret, market-moving, trading tips.

The hedge fund manager’s lawyer will probably argue that the handful of trades that prosecutors say were the result of illegal tips were cherry-picked from the tens of thousands of clearly legitimate trades Galleon’s funds made over the last three years.

And the lawyers can note that the questionable transactions often were part of a complex trading strategy that can look more incriminating when taken in isolation.

Rajaratnam’s defense team may contend a tip about a company’s upcoming earnings report is nothing more than helpful insight, especially if the executive passing on the information fails to provide specific details like figures for revenues and net profits.

To buttress this point, the lawyers will no doubt point to things like yesterday’s article in The New York Times, which notes that Galleon lost $30 million on the allegedly illegal trades.

But the problem for Rajaratnam is that by the time this case comes to trial a year or two from now, the charges against him could be even more serious. There’s a good chance that new allegations of insider trading could be lodged against Rajaratnam as other potential co-conspirators come forward in the coming weeks to cut deals with federal prosecutors.

The criminal complaint against Rajaratnam and his co-defendants is just the opening salvo — even though the investigation began two years ago.

One white-collar defense lawyer called the complaint a “warning shot” to other traders not yet identified who may have benefited from the same trading tips Galleon got.

Lawyers say a number of hedge fund traders not named in the criminal complaint are already “lawyering up,” largely out of fear they may be the next ones to fall within the gun-sights of federal prosecutors.

There’s an expectation among lawyers and those in hedge funds that prosecutors will quickly secure guilty pleas from several other traders who may have made similar bets with inside information.

None of this, of course, is good news for Rajaratnam and his co-defendants.

And some of the evidence the federal government has unearthed looks pretty damaging for Rajaratnam. It will be hard for Rajaratnam to explain away recorded conversations in which he is trying to give advice to others on how to trade on information without raising suspicions.

Especially troubling is the evidence Rajaratnam, who says he is innocent, directed his fund to make a big upside bet on Hilton Hotels (HLT) in July 2007 after he is said to have received information from a Moody’s Investors Service (MCO) analyst that Blackstone Group (BX) was on the verge of buying out the hotel chain.

Prosecutors say that the Moody’s analyst was paid $10,000 for his helpful tip. Now that’s not a lot of money for a trade that generated a $4 million profit for Galleon, according to prosecutors. But that speaks more to the poor negotiating skills of the former Moody’s analyst than anything else.

Any time someone is willing to pay cold cash for confidential market-moving information, it’s a safe bet the person buying the information knows it’s something they shouldn’t have in the first place.

So bring on the trial. If nothing else it will help shed light on the often shadowy ways in which hedge fund managers wheel and deal to get a trading edge.

Comments

[Kinabalu]

The defense will be the Mosaic Theory. You put together an investment theme from a lot of separate pieces of information, none of them material on their own. Rajaratnam has already been quoted as saying he gets thousands of calls from people with investment ideas.

2009 Oct 22 12:40 PM

[Jim P. Smith]

Kinab-

Perhaps the reason Raj gets thousands of call from people is because they know once in a while Raj will shell out the dough for some good 'juice'

Juuuust a thought.

2009 Oct 22 01:15 PM

[Monty Agarwal]

The recent Galleon Insider trading scandal that broke on October 16th is nothing new for Wall Street or Main Street. There have been umpteen cases of investors trading on non-public news to turn a profit.
And why shouldn’t they? The temptation of gaining access to information that can result in guaranteed profits is just too large, even when measured against the prospects of getting caught.
The solution is not to increase the policing, as the criminal mind will always find ways to beat the system.
The solution is to increase transparency, such that news at publicly traded companies becomes public ASAP. Soon as company executives make strategiec decisions that could affect its earnings outlook and thereby the stock price, they should immediately release that information to the public. After all the public has a right to that information, as soon as it is available. This will take away any advantage that an insider would have to non-public information and thereby rid the system of illegal insider trading profits.

2009 Oct 22 02:07 PM

[Vladimir Senkov]

Matthew,

Have you had a chance to read the complaint itself? It sounds like you've been getting your information from the media instead. I'm not 100% sure but I get this impression from the general tone of your article.
Please correct me if I'm wrong.

2009 Oct 22 08:48 PM

[Moon Kil Woong]

I'm sure Paulson Inc. doesn't needed to buy inside information since they got it from themselves for free. Not to defend Raj, but most hedge funds are premised around the concept that the guys running it have a market edge legal or illegal. That is the only way they can justify their outrageous fees.

I have yet to have heard compelling proof by a hedge fund about how they can maintain a consistent market edge over other sophisticated investors. Past history usually only proves they were on 1 side or the other in the standard deviation of returns or that they boughtr a lot of volatility. Market timing as we now know by them is mostly a bunch of hot air given how terribly they fared during the downturn or the up cycle before (if they were mainly short). And the Bernie maddoff, insider theory, and criminal element has proven that unethical behavior can burn the hedge fund investors just as much as hedge funds can theoretically burn other market participants. Last, if you invest because of a star performers, realize they come and go from these firms like so many flies to dung.

Like Maddoff, those often seeking hedge funds often don't ask questions or don't want to know the particulars under the hood because often but not always, they feel that what they are doing is not quite kosher. They tend to think there is a premium for illegality and an insider's edge. I it's called 2 + 20%.

We need better disclosure and better oversight into hedge funds and how they peddle their funds. This is not because their strategies or business methods are so bad, but to dispel the appearance and appeal for illegality in this market even if it costs them by wringing lower fees from investors. Marketing food as miracle drugs or packed with vitamins when they are not is illegal. Shouldn't marketing financial products this way be too? It certainly can be fatal to your financial health.

I have a suspicion in such a world of hedge funds market their funds fairly would revert them into financial cults, consisting of a mad following of some people believing that one or a group of people are magically endowed with supernatural financial powers. In many ways it is already like this. Really, most hedge fund investors need to go back to reading Harry Potter and start reading Graham and Dodds when it comes to investing.

2009 Oct 22 10:17 PM

[2018dr3amer]

This article brings to mind the name: Jim Cramer

2009 Oct 23 02:08 AM

[fishluvrain]

With all of the media attention , allegations of wiretap evidence, will we really ever know the truth? One would believe as is often the case when the Media runs wild with a story, No. The defendant(s) were guilty when the ink hit the paper. I don't want to defend someone I don't know and am unlikely to meet. I would like to defend the right to defense. I am disturbed by the conviction of individuals before the trial has even begun. What would be repaired if the individuals in this upcoming case were exonerated. The investments shown legal and prudent. Who will replace the loss it will cause the individuals and the investors. The course of Justice is usually fair The course of trial by Media attack packs is not. Will these media sites, writers and others make restitution, I think not.

2009 Oct 23 07:40 AM

[Vladimir Senkov]

Let's imagine for a second that the defendants in this case are found not guilty and are released.
You are arguing that in this case they are entitled to restitution? I think not. When they engaged in the business they engaged in they made choices. When you make choices you take risks. Risks are not limited to just breaking the law or not. Some business practices that may be legal could still create plenty of trouble for you down the road.
Yes, media attention can be bad for business, but it can also be good for business. Even "bad" attention can be good for business. Didn't the defendant in this case get bombarded with new insider tips as a result of these charges?

On Oct 23 07:40 AM fishluvrain wrote:

> With all of the media attention , allegations of wiretap evidence,
> will we really ever know the truth? One would believe as is often
> the case when the Media runs wild with a story, No. The defendant(s)
> were guilty when the ink hit the paper. I don't want to defend someone
> I don't know and am unlikely to meet. I would like to defend the
> right to defense. I am disturbed by the conviction of individuals
> before the trial has even begun. What would be repaired if the
> individuals in this upcoming case were exonerated. The investments
> shown legal and prudent. Who will replace the loss it will cause
> the individuals and the investors. The course of Justice is usually
> fair The course of trial by Media attack packs is not. Will these
> media sites, writers and others make restitution, I think not.

2009 Oct 25 01:26 AM