Galleon charges shine harsh light on hedge-fund industry

Date: Tuesday, October 27, 2009
Author: Allistair Barr, Marketwatch.com

Insider-trading charges against hedge-fund billionaire Raj Rajaratnam are rippling through the $1.5 trillion industry, because being aggressive about obtaining information is an integral part of many firms' strategies.

Galleon Group founder Rajaratnam; Danielle Chiesi and Mark Kurland of hedge-fund firm New Castle Partners; and executives at International Business Machines Corp. (NYSE:IBM) , Intel Corp. (NASDAQ:INTC) and McKinsey & Co. were arrested earlier this month on charges they were part of a network that trafficked in private, market-moving information about upcoming earnings reports and acquisitions.

Whether or not the allegations are true, they have brought greater scrutiny into the industry's efforts to gain advantage by seeking out information.

"There are thousands of long-only managers and hedge funds out there, and everyone is trying to get an edge," said Bradley Alford of Alpha Capital Management, which invests in hedge funds. "Managers and analysts conduct channel checks, dig deep and use the information to put puzzles together. That's not insider trading, but sometimes the line is very blurry."

Hedge funds grew quickly from a cottage industry overseeing less than $40 billion in 1990 to one controlling more than $2 trillion before the financial crisis hit in 2008. As more managers entered the business and funds grew larger, competition for trading ideas and pressure to generate market-beating returns intensified.

With lucrative fees that offer managers the chance to collect roughly 20% of annual profits, there's a financial incentive to get ahead of rivals in the marketplace. Meanwhile, rapid trading by some hedge funds makes it harder for regulators to spot potentially suspicious activity.

Rajaratnam is alleged to have made roughly $20 million in profit from trading on insider information about companies including Akamai Technologies (NASDAQ:AKAM) , Google Inc. (NASDAQ:GOOG) , Hilton Hotels and Polycom Inc. (NASDAQ:PLCM)

Those alleged profits are small for a hedge-fund firm that oversaw more than $5 billion in at its peak, according to Bryan Routledge, associate professor of finance at the Tepper School of Business at Carnegie Mellon University, who is researching whether illegal activity can be spotted by analyzing hedge-fund returns.

"It's surprising that [those recently charged] would push so close to the line and risk going to jail for such small amounts," Routledge said, "or the implication is that this is the tip of the iceberg and it happens all the time."

Galleon is shutting down and Rajaratnam has said he's innocent. Kurland's attorney declined to comment. See story on Galleon's closure plans and Rajaratnam's comments.

Chiesi's lawyer, Alan Robert Kaufman, an attorney at Kelley Drye & Warren in New York, said his client is innocent. "She was doing what tens of thousands of people do on Wall Street, which is to get information out of people who have that information," Kaufman told MarketWatch.

'Dawn of time'

Jahan Raissi, a former SEC enforcement lawyer who's a partner at the law firm Shartsis Friese LLP, reports getting more calls in recent days asking about Galleon from hedge-fund managers, investment advisers, brokerage analysts and company executives.

"People are wondering whether the case means the rules of investment research have changed," he said in an interview. "Hedge funds, investment advisers and broker-dealer analysts all do the same thing: They try to find information about companies to help them make informed investment decisions."

Raissi has been telling clients that the rules probably haven't changed. "The conduct described in the Galleon case seems rather extreme," he added. "I don't think anyone is confused about what to do if they get information from a person at a company about a specific acquisition or earnings announcement. That's been insider trading since the dawn of time."

However, Raissi said it's always good to brush up on what's insider trading and what isn't. Asking an Apple store manager what are the hot-selling gadgets or going to Home Depot to find out what chainsaws shoppers prefer is perfectly legal research. Interviewing customers, competitors and suppliers of companies -- a common research technique in the technology sector -- also is usually fine.

"Of course, you can cross the line while doing your research," according to Raissi. "If someone at a company tells you 'Here's what our earnings announcement will be next week,' you shouldn't trade on that and you shouldn't be surprised if the government wants to hear about it."

Wiretaps

Federal prosecutors used wiretaps over a period of roughly two years to track the activities and conversations of Rajaratnam, Chiesi, Kurland and others. The official techniques employed in this case have been used successfully against the Mafia and drug cartels, but prosecutors plan on relying on them more to track down insider trading and other white-collar crime.

Representatives at the Justice Department and the Federal Bureau of Investigation declined to comment.

Chiesi spent a lot of time wooing company executives to get information, which she shared with Rajaratnam and Kurland, according to federal charges filed against her earlier this month.

On July 24, 2008, Chiesi called Rajaratnam and told him she was talking to an unidentified Akamai executive "about the family" and how "you're the only person in the family that helps me," the charges allege.

Chiesi then told Rajaratnam the Akamai executive had told her the company was going to "guide down a lot" when it reported quarterly results the following Wednesday. The executive also told her that the company's stock could fall as low as $25.

Rajaratnam said he would be "radio silent" and told Chiesi to keep shorting Akamai shares, which she allegedly did on behalf of New Castle.

After the stock market closed on July 30, Akamai released results and said it expected earnings per share for the following quarter to be below analysts' expectations. The stock opened the next day down roughly 20% at $25.06.

Rajaratnam called Chiesi to thank her for the information. New Castle unwound its negative bets on Akamai the next day, making a $2.4 million profit, according to federal prosecutors.

In September, Kurland told Chiesi to contact the Akamai executive again. She said it was a "scary thing to do."

"Call him ... let him talk," Kurland replied, according to federal prosecutors.

A week later, the Akamai executive called Chiesi and suggested that Akamai didn't drop its earnings guidance far enough when it reported quarterly results in July. Chiesi then advised the executive to buy shares of chip maker Advance Micro Devices Inc. (NYSE:AMD) , based on insider information prosecutors say she got from Robert Moffat, a senior executive at IBM.

Chiesi and Rajaratnam also talked about the value of her contact at IBM. They discussed the possibility of him moving to another company.

"Put him in some company where we can trade well," Rajaratnam allegedly said.

Chiesi also suggested Moffat would be more valuable if he stayed at IBM. "This guy is giving me more information. ... I'd like to keep him at IBM right now because that's a very powerful place for him. For us, too."

"Only if he becomes CEO," Rajaratnam replied.

Moffat ended up proving his worth in early 2009, prosecutors claim.

In January, Moffat was among nine IBM executives doing due diligence on Sun Microsystems Inc. (NASDAQ:JAVA) , because IBM was considering buying the company. Prosecutors say that Moffat told Chiesi that Sun would beat quarterly expectations before the company's results came out.

"The only way ... he would know is because I know they were doing due diligence," Chiesi told a cooperating witness in the government's case. "The only reason my guy would know that is because it's his deal. Like, he's in bed with them."

A day later, on Jan. 27, Sun reported quarterly revenue that topped analysts' forecasts. New Castle made a profit of more than $900,000 as Sun's shares rallied after the report, prosecutors say.

Net widening

The probe into Galleon is expanding; prosecutors reportedly are planning to charge 10 more people. The Wall Street Journal said Monday that federal investigators in the Galleon case have requested trading records from Richard Grodin, a hedge-fund manager who once worked for Steven Cohen's SAC Capital Advisors, one of the world's largest hedge-fund firms.

An SAC spokesman said Grodin left SAC in January 2004 and that Cohen didn't invest in Grodin's most recent fund. He declined to comment further.

Grodin closed his hedge fund, Quadrum Capital, in recent weeks, the Journal reported, citing unidentified people familiar with the situation.

In 2004, the SEC sent a so-called Wells notice to Michael Zimmerman, then a trader at SAC Capital, and his wife Holly Becker, an analyst at Lehman Brothers (OTHER:LEHMQ) . Such a notice warns recipients that the regulator is preparing to take legal action against them.

The SEC reportedly was investigating allegations that Becker tipped Zimmerman off about research reports she was preparing on Internet companies. However, the probe fizzled without any charges being filed. Zimmerman left SAC in 2004.

In January, the SEC reopened an investigation into Pequot Capital Management, run by Art Samberg.

Pequot was first reported to be under investigation in June 2006, after former SEC attorney Gary Aguirre complained that he was fired when his probe led him to John Mack, chief executive of Morgan Stanley (NYSE:MS) .

Aguirre told the Senate Judiciary Committee that he suspected Mack may have tipped Pequot to a pending acquisition. Pequot has denied receiving tips that resulted in insider trading, and Morgan Stanley has said that there was no evidence of wrongdoing by Mack. The SEC also denied giving anyone special treatment during the probe.

The renewed SEC investigation focuses on whether Pequot was involved in insider trading of Microsoft Corp. (NASDAQ:MSFT) stock, and whether David Zilkha -- a former Microsoft employee who joined Pequot in 2001 -- got information on the software giant's upcoming earnings report in April of that year. See full story.

Pequot said in May it was shutting down. Read more.

Other hedge-fund firms have gone out of their way to get information about companies and other potentially market-moving information, sometimes going beyond what's acceptable, according to regulators.

In May, the SEC charged Renato Negrin, a former portfolio manager at hedge-fund giant Millennium Partners, and Jon-Paul Rorech, a salesman at Deutsche Bank AG (NYSE:DB) , in what it said was the first insider-trading case involving credit-default swaps, which are bets on the likelihood of a company defaulting on debt.

The SEC alleged that Rorech tipped Negrin about a bond-structure change that allowed Negrin to make a $1.2 million profit trading such swaps on Dutch media company VNU.

The U.K.'s Financial Services Authority fined GLG Partners (NYSE:GLG) , another big hedge-fund firm, and a former managing director at the firm, Philippe Jabre, 750,000 pounds each in 2006 for trading ahead of a convertible bond offering by Sumitomo Mitsui Financial Group.

In the case of Jabre, who now runs his own hedge-fund firm Jabre Capital, the FSA fine was the biggest ever for an individual.

GLG was also fined in 2007 by France's financial regulator for trading ahead of a Vivendi convertible bond offering. Three other hedge funds -- UBS O'Connor, Meditor Capital Management and Ferox Capital Management -- also were fined for the same offense.

'I'm the best'

Federal prosecutors described Moffat and Chiesi as "friends." In August 2008, she told Kurland that she was meeting Moffat at her mother's house on a Sunday. Chiesi also was planning a meeting a day later with an unidentified AMD executive.

Chiesi allegedly was trying to dig up information about an AMD reorganization involving big investors in Abu Dhabi and IBM. She told Kurland she was going to get a new cell phone to talk to the AMD executive, and Kurland pressed her for more information on the deal.

On Aug. 22 that year, Chiesi called Moffat and put him on speakerphone, then called Kurland on another line so he could hear the IBM executive.

Moffat explained the AMD deal "from scratch" for Chiesi and Kurland, according to federal prosecutors. Soon after the call, Kurland told Chiesi to focus on getting more information and not to worry about financial analysis.

"Get more relationships, like Microchip, Akamai. ... Why don't you just worry about getting the information and don't worry about the numbers," Kurland allegedly said.

A month later, Rajaratnam bragged to Chiesi about being as good at digging up information on AMD as she was, telling her details of the company's upcoming quarterly results, which hadn't been released yet, prosecutors say.

"Tell me I'm the best in AMD. ... You might know [the AMD executive] or whoever. ... I wanted to compete with you in your own backyard. ... I must defer to you on IBM," Rajaratnam said.

"And Akamai too," Chiesi responded.

"Akamai too. But AMD? Bring it on baby," he said.

Chiesi also asked Rajaratnam for advice on making sure her trading didn't catch the attention of regulators. She was worried that if AMD shares rose a lot, her large purchases of stock might attract attention.

"I think you should buy and sell, buy and sell," Rajaratnam said, according to federal prosecutors.

Rajaratnam emphasized the importance of being quiet and boasted about his access to information on other companies. "On Akamai or IBM, anything, be radio silent," he said. "Like, you know, I get shit on lots of companies."