Friday, October 16, 2009

Master Of The Rolodex

Raj Rajaratnam, the founder of hedge fund Galleon Group, was arrested this morning for insider trading. According to prosecutors, Rajaratnam received tips from other hedge fund managers, corporate executives including employees of IBM and Intel, a McKinsey consultant, and former employees of Bear Stearns. (What is it with these ex-Bear guys and insider trading?) Rajaratnam's fund is alleged to have profited to the tune of $17 million through these tips. I think there's a lot more to come. The size of the alleged scheme doesn't make sense relative to the rest of the facts.

Anyone who's worked on Wall Street is told, from the get-go, that insider trading is one of the deadliest of sins. If you are caught, and you WILL get caught, you will go to jail, and you will never work in the industry again. Ever. You will also have to pay back all the money you illicitly gained, plus hefty penalties. You're regularly reminded of this through stern lectures from your compliance officer, presentations made by outside counsel, and by the occasional front-page article like the one we saw today. The SEC is ever-vigilant, we are told. They investigate the slightest hiccup in trading volumes, and do not stop until they get their man.

The reality isn't so simple. Work on the street long enough, and you'll realize that insider trading is pretty easy to commit. People talk. They say things in elevators or in hallways when they think nobody is listening. They leave papers lying around all the time that contains sensitive information. (Bud Fox in Wall Street totally had the right idea, btw. The fact that the cleaning ladies in my office don't drive Bentleys says a lot about either the quality of their character or a significant language barrier.)

What deters most people from acting on this inside information isn't the fear of the SEC directly. Rather, it's a cost-benefit analysis. If I put on a huge position in a stock just days before it's taken over, my account would be red-flagged in an instant. There's no chance of getting away with it. The only chance of success, as it were, would be to put on a position that's small enough to fly under the SEC's radar. And here's where the system works - I'm just not going to bother. There's no point in risking my entire career over a profit of maybe $20k. Most people on the street earn ten times that in a year, often more. Even if you're 99% certain you'll never get caught, that 1% chance is still more costly than the PV of a successful Wall Street career.

Getting back to the day's news - this is what doesn't make sense to me. Why would Rajaratnam risk his reputation, his career, and his freedom, over such a small amount of money? The guy is a billionaire. $17 million doesn't move the needle for a guy like Rajaratnam. And, assuming he traded the stocks in question through is fund, rather than in a personal account, he'd personally take home only a fraction of that amount.

I suspect these insider trading profits are a lot larger than what Rajaratnam has thus-far been charged with. The prosecutor has already hinted at this according to Bloomberg: "The prosecutor said there’s additional evidence and may be more charges against him and that the case is “overwhelming.” " I'm also suspicious that Rajaratnam would be worried enough about a $17 million case that he would consider fleeing the country, as was implied in an earlier WSJ article:

In court documents, prosecutors said Mr. Rajaratnam had expressed to another individual that he believed a former Galleon Group employee was wearing a wire and that Mr. Rajaratnam had purchased a plane ticket to fly to London on Friday from New York's John F. Kennedy International Airport.

So, it sounds like Rajaratnam was onto the Feds, and the prosecutor had to act with what he had before Rajaratnam could leave the country.

I'd keep an eye on this case - I think we may see some much bigger numbers, and potentially a few more hedge funds dragged into the mix.

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