Financial Regulators Will Need a Very Solid Case to Sink Galleon's Founder

For Galleon Group, a hedge fund firm whose lead portfolio manager has been accused of insider trading, the water just kept rising too fast around the ship’s decks. But it is the regulators who are under pressure from an increasingly incensed public that ought to be careful how the game ultimately pans out.

Yesterday morning, media outlets reported that Raj Rajaratnam’s $3.7 billion healthcare and technology-focused hedge fund empire was pursuing “an orderly wind down” of its various funds. Rajaratnam, a fund manager who was accused last week by federal prosecutors of conspiring with five other senior executives in a Silicon Valley-linked insider trading ring, is currently out on $100 million bail.

It’s an odd case for regulators to bring with such fanfare, given the relatively paltry amount of money supposedly generated from the scheme and the time period in which it was operating.

The Securities & Exchange Commission (SEC), which is filing a separate civil action suit against Rajaratnam, estimates the fund manager made around half of the total profits earned from the scheme, or $12.7 million. The profits were earned between January 2006 and July 2007, according to the filing; at the same time, Galleon had more than $7 billion under management.

Nasdaq and many of the tech-related stocks which trade on its market have often generated similar scandals, so it’s not unlikely there is some kind of fire behind the smoke. Still, it is amazing that no one has pointed out how unlikely it is that a fund manager would risk breaking the law so flagrantly in order to generate less than a 0.2 percent profit. Even in hedge fund circles, that is peanuts in performance — it’s around a tenth of the funds’ overall management fees.

Reuters blogger Matthew Goldstein points out that if the case ever gets to trial, then the defense is likely to argue that the overall picture is much more complicated than prosecutors are letting on:

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.

In reality, it is common for very senior analysts at hedge funds to hear snippets of semi-public information from time to time. Whether to act on that information or not is more often a question of conscience and proper procedure than it is any sort of black-and-white legalese. For all the apparent simplicity of the crime, few working outside the finance industry realize how hard it is to prove someone guilty of insider trading. Regulators are aware of this, which is why so few cases are ever brought.

But regulators have been constantly accused this year of failing to act when they have received information from whistle-blowers about potential frauds. The most notable example was in the case of Bernard Madoff Investment Securities, where derivatives analyst Harry Markopolos warned the SEC several times to no avail about the potential that the firm was merely a shield for the world’s largest ponzi scheme.

Hopefully, regulators and prosecutors are not jumping the gun in this instance merely to save some face for their previous failures. Because on the surface of it, this looks like one case where they might actually end up having to concede defeat.

Comments

[Nettligent:]

SEC is incompetent, untouchable, only interested in quick settlements, and going mortal. We need to regain our market confident more prosecutions and put these crooks away as many as possible.
America has enough laws and regulations. It is a matter of using them. Never trust SEC.

Oct 23 04:28 AM

[Moon Kil Woong:]

Debates over him getting inside information but losing money because the market collapsed is completely irrelevant to the facts at hand. Criminal conduct is based on criminal intent and and actions seeking to carry through with that intent. It is like saying the guy robbing the bank should be let off because he got no money and his car was towed while he was commiting the deed. The fact that he lost money in the illegal exploit earns him no reprieve from the criminal act.

The market is filled with people misrepresenting their funds, trying to get insider information, hiding or aiding others to hide gains and losses overseas, frontrunning, manipulate the market through HFT or other mechanisms, splitting your company up so you can sell garbage on one end and short the garbage you are selling on the other, and all other sordid actions the SEC, Federal Reserve, and other regulators choose to ignore or used to extort paltry penalties on firms perpetrating actions detrimental to the customers, the public at large, and/or the free market system as a whole.

Personally, it is astounding that they would even dare to criminally charge the guy. After all, they could have just as easily have gotten a few million dollars in penalties from him instead like they want to do with Bank of America. Thankfully, the status quo might be getting broken for once. It's about time.

Oct 23 06:44 AM

[Daniel Harr...:]

"Debates over him getting inside information but losing money because the market collapsed is completely irrelevant to the facts at hand. Criminal conduct is based on criminal intent and and actions seeking to carry through with that intent."

Actually Moon, in order to be guilty of insider trading, one of the requirements is that you have to have made a profit. You cannot be guilty of insider trading if you show a loss.


On Oct 23 06:44 AM Moon Kil Woong wrote:

> Debates over him getting inside information but losing money because
> the market collapsed is completely irrelevant to the facts at hand.
> Criminal conduct is based on criminal intent and and actions seeking
> to carry through with that intent. It is like saying the guy robbing
> the bank should be let off because he got no money and his car was
> towed while he was commiting the deed. The fact that he lost money
> in the illegal exploit earns him no reprieve from the criminal act.
>
>
> The market is filled with people misrepresenting their funds, trying
> to get insider information, hiding or aiding others to hide gains
> and losses overseas, frontrunning, manipulate the market through
> HFT or other mechanisms, splitting your company up so you can sell
> garbage on one end and short the garbage you are selling on the other,
> and all other sordid actions the SEC, Federal Reserve, and other
> regulators choose to ignore or used to extort paltry penalties on
> firms perpetrating actions detrimental to the customers, the public
> at large, and/or the free market system as a whole.
>
> Personally, it is astounding that they would even dare to criminally
> charge the guy. After all, they could have just as easily have gotten
> a few million dollars in penalties from him instead like they want
> to do with Bank of America. Thankfully, the status quo might be getting
> broken for once. It's about time.

Oct 23 07:07 AM

[JohnDough454:]

He's already sunk. The only question is will he get jail time or how large his fine might be.

Losing $3.7 billion under management @2% is $750 million/year in fees. Not to mention reputation hit, difficulty keeping licenses etc.

Mr. Harr -- can you provide a cite? My reading of the regs says simply trading with insider information is illegal. The fine may be limited to profits, but the action is still criminal.

Oct 23 08:58 PM

[davidbdc:]

it is amazing that no one has pointed out how unlikely it is that a fund manager would risk breaking the law so flagrantly in order to generate less than a 0.2 percent profit
----------------------...

How about this type of information is responsible for a much much larger percentage of his profits......they just managed to catch him .2 percent of the time.
======================

In reality, it is common for very senior analysts at hedge funds to hear snippets of semi-public information from time to time. Whether to act on that information or not is more often a question of conscience and proper procedure than it is any sort of black-and-white legalese

------------------

Actual it is black and white. You can't trade on insider information, period.

The guy is toast. If he was truly innocent he wouldn't be winding down his entire fund. It appears to be setting him up for some type of attempt at a plea bargain that costs him a few million and bars him from trading, but keeps him out of jail.

I hope this is just the first action taken. Its time to level the playing field and this is a small first step of many required to begin the process.

Oct 24 05:45 PM

[E Nuff Sed:]

What will be interesting is what will come out of the case. RR may finger a lot of execs in the companies which supplied Galleon with inside information.

Oct 24 11:02 PM