New York, NY – As the insider trading case against Galleon founder Raj Rajaratnam comes to an end, we look back on the case and scratch our heads about the strategy used by the defense. Frankly, we are puzzled about the defense strategy because if it works, it would encourage other hedge funds to continue engaging in dubious behavior because they could gather and trade on material nonpublic information if they could hide behind the screen of a formal research process. The following blog discusses the main aspects of the defense strategy used in the Galleon insider trading case.
Material Nonpublic Information Not Questioned
The first thing that became clear in the Galleon trial is that the defense team did not try very hard to cast doubt that Raj received what has been alleged to have been material nonpublic information. This is probably because it is hard to cast doubt on information that was discussed openly in various recorded conversations.
However, the defense team did try to cast doubt on the veracity of some of the prosecution witnesses, including former Galleon portfolio manager, Adam Smith. Both John C. Pernell Jr. and Robert H. Hotz Jr. testified that Smith told them in private that he had done nothing wrong, and that he admitted to some acts of insider trading he hadn’t committed because he was pressured by the government.
Trades Based on Rigorous Research
From the very beginning of the insider trading trial, Raj Rajaratnam claimed that he was innocent and that he had based his trades on legitimate research. Raj’s defense team presented numerous e-mails and both internal and external research reports supporting the trades that the government alleges were illegal.
Probably the most compelling witness for the defense in this regard was Rick Schutte, Galleon’s former president for U.S. operations and head of research. During about 10 hours of direct testimony, Schutte testified that the trades by his ex-boss were based on a rigorous research process of “arbitraging consensus”. Schutte testified how Galleon’s 35 analysts received thousands of reports which supported, or at times even contradicted the alleged illegal trades made by Rajaratnam.
Ultimately, the defense team tried to build a case that Raj’s trades were based on a mosaic of legitimate research and information, and that the information the government says is material nonpublic information were small pieces of this puzzle. The defense team tried to make the case that the alleged material nonpublic information was not the cause for any of Raj’s trades.
Material Information Already Public
In our estimation, the most compelling argument made by Raj’s defense team was that much of the information he purportedly received was already in the public domain. Certainly, Schutte testified that this was the case with eBay, where many in the marketplace were talking about possible layoffs well before the official announcement was made.
Gregg A. Jarrell, a finance professor at the University of Rochester’s graduate business school and the SEC’s chief economist from April 1984 to January 1987, also testified that Raj’s pattern of stock trading was “consistent” with information that was readily available to investors before the Galleon founder allegedly received inside information.
Professor Jarrell presented more than 200 charts, highlighting published news stories, and conclusions reached by Wall Street analysts that he said were available to investors before Raj Rajaratnam allegedly received inside information about a number of stocks, including Advanced Micro Devices, Clearwire, Goldman Sachs, and Google, Inc.
However, it is not clear to us whether Professor Jarrell and the defense effectively made the case that the alleged information Raj received was already in the public domain in every case.
Problems with this Strategy?
The defense team of John M. Dowd, Terence J. Lynam, William E. White and James E. Sherry of Akin Gump Strauss Hauer & Feld LLP ultimately tried to make the case that Raj Rajaratnam made the trades in question based on a mosaic of internal research and public information, and that the alleged “insider tips” he received were not the basis for his investment decisions.
One question this strategy brings up is whether an investor can legally trade in a stock after they receive material nonpublic information about that company, even if they have other research which supports the trade?
Certainly, most buy-side compliance officers we speak with explain that the moment they receive notification that someone in the firm has received material nonpublic information about a company, that firm’s stock is placed on their restricted list. This means the money manager cannot trade that stock, regardless of what their internal research suggests.
We think the biggest problem with the defense strategy is that it actually encourages hedge funds to seek out material nonpublic information, if they can also prove that they have a rigorous research process which would have supported their investment decisions. In other words, the hedge fund’s research department becomes the screen which protects the firm from being convicted of insider trading charges.
Closing arguments in the Galleon insider trading case are expected next week, and it will be interesting to see what the jury decides.