Insider-Trading Bust: Rajaratnam, Hedge Funds in Spotlight

Insider-Trading Bust: Rajaratnam, Hedge Funds in Spotlight

On July 19, 2007, Google reported earnings that were lower than what analysts had expected, and the tech company’s stock price dropped 5% — but Raj Rajaratnam made $9 million. Allegedly, the New York hedge-fund manager had gotten a tip that Google’s earnings would be below expectations, so he was prepared with short positions and put options that would become more valuable as the stock price fell. The alleged source of the tip: an employee at an investor-relations firm that helped Google announce its earnings who wanted to be paid for similar informational gems in the future.

If you didn’t already feel like a financial ingenue in the wake of last year’s Wall Street meltdown and Bernie Madoff’s massive Ponzi scheme, maybe the government’s latest insider-trading case will help put you over the top. Federal prosecutors have charged six people with conspiracy and securities fraud in a series of insider trades that allegedly netted more than $25 million in illegal profits. The defendants include higher-ups at two hedge funds as well as executives at Intel, IBM and the consulting firm McKinsey. Rajaratnam was arrested with the others on Oct. 16, but he promptly paid the $100 million bail so that he could return to work on Monday.

The case is being billed as the largest hedge fund insider-trading case in history — its importance underscored by the fact that the feds got a wiretap to collect evidence, a technique normally reserved for drug busts and organized crime. “This is a monumental step for the government,” says Stetson University law professor Ellen Podgor. “This is not the typical way you do a white-collar case.”

At issue are a number of purported information leaks, which — if the allegations are proven true — fall into a truly special category of brazenness. For example: a Moody’s bond-rating analyst sharing privileged information that the private-equity firm Blackstone was about to buy Hilton Hotels. A senior vice president at IBM handing over details of Sun Microsystems’s financials, which he had access to only because IBM was contemplating buying Sun. A managing director of Intel passing along the company’s revenue and profit numbers before they were publicly released and later asking his hedge-fund consort for a job with one of his “powerful friends.”

Thanks to the FBI’s wiretap, the complaints — filed by the U.S. Attorney’s Office and the Securities and Exchange Commission — contain some amazingly sordid snippets. In one, Rajaratnam and Danielle Chiesi, a portfolio manager at another hedge fund, apparently discuss how to avoid attracting the attention of regulators. In another, the two contemplate whether the senior vice president at IBM would be more valuable to them at a different firm. In a third, Chiesi, upon sharing non-public details about an upcoming reorganization of the microchip maker AMD, tells an alleged co-conspirator: “You put me in jail if you talk … I’m dead if this leaks. I really am … and my career is over. I’ll be like Martha f______ Stewart.” Both Rajaratnam and Chiesi have proclaimed their innocence.

The case is sending ripples throughout the world of hedge funds, a stratum of high finance that has thus far been largely untouched by the post-meltdown regulatory scrutiny and populist outrage directed at mainstream banks. “This case should be a wake-up call for Wall Street,” U.S. Attorney Preet Bharara said in announcing the charges. Indeed. While many hedge funds wouldn’t know what to do with inside information if they tripped over it — the strategy at quantitatively oriented shops often fixates on building better computer models — plenty of others ply their trade by working the phones and calling up companies as well as competitors, suppliers, customers and former employees in an attempt to find out more than the next guy.

That’s not to say that illegal insider trading is necessarily rampant among hedge funds. Considering that the typical fund was down by double digits in 2008 — a year in which hundreds went belly up — there’s reason to believe that cheating isn’t standard operating procedure.

The line, though, between legitimate information-gathering and illegal insider trading is hardly a clear one. Technically, no laws ban trading on non-public information; prosecutions are based on legal theories that were developed in earlier court cases. “It’s one of those areas where the courts say, ‘I know it when I see it,’ ” says Gerald Lefcourt, a white-collar criminal defense lawyer in New York and past president of the National Association of Criminal Defense Lawyers.

The case law maintains that two main things must be established for an act to be illegal insider trading. First, the information in question must be material and non-public. Second, revealing or trading on the information must entail knowingly breaching a duty of “trust or confidence.” This can be a fiduciary duty, which an officer of a company would have to a firm’s shareholders , or — as the Supreme Court has more recently found — a lower-level employee who has a broader duty to not share, or personally benefit from, his firm’s proprietary information .

To successfully prosecute a person who receives insider information and then trades on it , the government must show that the person knew the information came from a breach of duty. In the case of Rajaratnam’s alleged Google stock tip, he didn’t talk to the source of the information directly but rather to a middleman informant. That middleman purportedly told Rajaratnam who the tipster was — thus revealing the breach of duty. For that particular charge, that communication is key.

But the current case involves many charges — all told, six defendants, nine companies whose securities were allegedly illegally traded and many more than that number of actual trades. And while one alleged instance of illegality conveniently included Chiesi comparing her situation to the most famous insider-trading case in recent memory , many of the other instances could be more open to interpretation. This is a big case, and it will take a long time to untangle it in court.

In the meantime, based on what prosecutors have said, there might be more on the way.

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