Watchdogs tell hedge funds: we are on to your game

Alleged insider dealing by Raj Rajaratnam at Galleon may be only the tip of the iceberg, reports Stephen Foley from Wall Street

When the FBI arrested Raj Rajaratnam last week, a chill went down the spines of more than a few of his rival hedge fund managers. There but for the grace of the gods ...

Insiders at the Securities and Exchange Commission, the Wall Street watchdog, and at the Justice Department say that there are more civil charges and more criminal prosecutions in the offing. Hedge fund managers need to learn to spot the difference between scouring every possible source for trading ideas, and out-and-out insider dealing, and they had better learn fast.

The question now is whether the hedge fund industry is hooked on insider trading, whether the Galleon case is a singular one starring some really rotten apples – or whether, as Mr Rajaratnam was insisting to his staff and investors yesterday, he has been unfairly accused.

It was only a matter of time until Mr Rajaratnam or someone like him ended up in the dock. It is difficult to imagine he will be the last.

"It would be wise," the SEC's enforcement chief, Robert Khuzami, thundered after the Galleon arrests, "for investment advisers and corporate executives to closely look at today's case, their own internal operations, and the increasing focus and scrutiny on hedge fund trading activity by the SEC and others, and consider what lessons can be learned and applied to their own operations."

In other words – we are on to you.

Knowledge, of course, is power. On Wall Street, knowledge is profit. Large parts of the hedge fund industry are engaged in short-term trading, attempting to harvest a quick buck from a big share price move, perhaps one triggered by a profit warning or a takeover. Armies of traders and analysts are therefore employed to seek out any and all information that might allow them to guess what is coming. Many are employed specifically because they are well-connected in a particular industry, with a network of contacts that they can tap up for news, views and rumours of the latest developments.

Retail analysts spend a lot of time talking to store managers or suppliers, seeking out anecdotal evidence they can extrapolate into sales trends. Agricultural analysts will spend big on detailed weather forecasts, with which they might calculate likely crop yields. Technology analysts will forever be ringing their contacts in the industry for rumours about the next gadget to come out of Apple or its rivals.

And financial journalists with a scoop can expect to be bombarded with emails from obscure hedge fund managers across the world, each wanting that little bit of extra information about the story.

Galleon is hardly the only hedge fund where there was relentless pressure to turn up new scraps of information but, thanks to the scandal that has erupted there, we know a lot about how that pressure was applied.

Every morning at 8.35am, Mr Rajaratnam assembled his staff of 70 traders and analysts to discuss short-term trading ideas. Those who were late were fined $25. Those who didn't appear to have an edge, to have more information on their selected stocks than seemed to be available elsewhere, would quickly fall out of favour. It was an office where type-A personalities bawled each other out, and poor investment performance was not tolerated. Thanks to Mr Rajaratnam's background as a technology analyst for Needham & Co before he set up Galleon with partners in 1997, and to the well-connected staff he hired, it was seen as one of the smartest, best-informed funds working out of New York. But time and time again it was going over the line, soliciting and trading on inside information – scraps that Mr Rajaratnam and his traders knew should not have been thrown their way. Arrested and charged with him last Friday were executives from two of the world's most important technology firms, Intel and IBM.

Galleon is alleged to have made profits of $20m from illegally obtained information: from an investor relations firm that had been working on the press release of Google's 2007 profit warning, advance knowledge of the release passed through a third party informant; from Robert Moffatt, an IBM director so senior he was talked about as a future chief executive; advance information about an Arab investment in Advanced Micro Devices, the chip maker; and from a McKinsey consultant who also had knowledge of AMD.

What makes it insider trading? "Lots of people hear lots of things and lots of information," says Christopher Clark, a former US prosecutor who now works as a white-collar defence attorney. "Contrary to the impression given by the movie Wall Street, you can certainly have information that no one else has and trade on it. The problem is when you have obtained that information in contravention of someone's fiduciary duty or duty not to trade."

Mr Clark, now at the law firm Dewey & LeBoeuf, where he successfully defended the billionaire Mark Cuban against insider dealing charges this year, says hedge fund traders are often wise enough to get legal advice on whether they can trade on information. "Firms need to explain gently that it is greatly in their self-interest to understand the source of their information. Even if they are vindicated, and come whole out of the meat grinder, being accused of insider trading can cost millions of dollars, be terribly unpleasant and lead to very bad press."

The SEC brought a record 61 insider dealing cases in 2008, thanks to new software that can spot firms which are routinely on the right side of big share price moves. And there is another new tactic at work in the fight against this crime. The Galleon arrests show that the FBI has been using wiretaps on private phone lines to listen in on conversations between suspects and their contacts. The most cautious traders long ago decided to stop having their conversations with sources over email or over the firm's phone lines, both of which are recorded. So prosecutors are expected to lean heavily on transcripts of tapped calls in their case against Mr Rajaratnam, and a jury will have to comb through them to decide if the defendants knew that their sources were passing on information which they had a duty to keep secret.

For his part, Mr Rajaratnam is now fighting to save his fund. Reports yesterday suggested he will struggle, since investors have demanded back more than one-third of the $3.7bn in the pot. But in a letter to clients, he was defiant: "I am entirely innocent and will vigorously defend myself and our firm."

The world of insider trading: Exotic dancers and golden geese

The Securities and Exchange Commission said derisively that Raj Rajaratnam was not a master of the universe but a "master of the Rolodex". It is a description that could be applied even more so to Art Samberg, the veteran hedge fund manager who has also been warned to expect charges from the SEC in an unrelated enquiry.

Insider trading rumours dogged Mr Samberg for years, possibly because he is so well connected on Wall Street. Investigations into his Pequot Capital threatened to drag in John Mack, chief executive of Morgan Stanley, who is an old friend of Mr Samberg and briefly chaied the hedge fund. An SEC staff member thought he could be tipping off Mr Samberg, but in the end Mr Mack was never contacted. He denied wrongdoing. Mr Samberg has, however, been told to expect charges over contacts with a Microsoft employee in 2001, when Pequot was betting on its shares.

* Eugene Plotkin and David Pajcin, two low-level Goldman Sachs staff, were convicted in 2006 of operating what was then one of the broadest insider trading conspiracies, across two continents and involving a dozen people. They solicited tips from a Merrill Lynch banker and an employee at the printers that produced BusinessWeek magazine, and passed them on to friends and relatives, including a retired seamstress in Croatia and an exotic dancer. Profits totalled $6.7m; Plotkin got four years and nine months and Pajcin, who co-operated, almost half that.

* Most insider dealing cases are a simple bet on a share price using information gleaned in the course of work on an upcoming deal. The SEC filed charges against Reza Saleh, an employee of Ross Perot, within three days of his $8.6m trade around the takeover of Mr Perot's firm to Dell last month. Other cases have a twist. Last year, the public relations firm Brunswick sheepishly admitted that the husband of one of its staff, Nina Devlin, had been secretly reading the deals she was working on and trading on the insider information. Matthew Devlin called his unsuspecting wife "the golden goose".

* Prosecutors and the SEC do not always get it right. Mark Cuban, the dot.com billionaire who now owns the Dallas Mavericks basketball team, was charged with insider dealing after having a conversation with the boss of Mamma.com about an upcoming share placement. The placement would dilute shareholders and send the stock plunging, so Mr Cuban sold. But a Texan judge dismissed the charges, saying the billionaire had breached no confidence and had never promised not to trade on the information.

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