Illicit Hedge Fund Trading Defies Reason

October 21, 2009 Updated: October 21, 2009

Last week, Raj Rajaratnam, the chief executive officer at Galleon Capital Management, one of the top ten hedge funds worldwide, was arrested on charges of an illegal insider trading scheme.

With the help of his partners in crime—Anil Kumar from McKinsey Consulting, Robert Moffat Jr. from International Business Machines Inc. (IBM), Rajiv Goel of Intel Corp., among others—Raj is suspected of earning around $20 million in profits over the last 3 years from illegal trading using private company information tipped to him by insiders.
If proven guilty, Raj could serve up to 20 years in prison and pay severe fines for fraud. At the moment, he is free on $100 million bail.

The news has greatly shocked the market—and the hedge fund industry. This case is the most high-profile ever levied against anyone in the hedge fund industry.

As for the motives of such a crime, no one seems to comprehend them. Raj is a renowned figure, the richest man in his home country, Sri Lanka, owning $1.3 billion in personal wealth and managing around $3.7 billion of assets at Galleon.

He is known for his numerous charitable donations—including helping to restore Sri Lanka following recent tsunamis. Why would such a wealthy man bother to get involved in such a trivial fraud that only net him around 1.5 percent of his wealth and could cost him 20 years in jail, not to mention possible injunctions against his hedge fund Galleon?

“This may spell the end of [Galleon],” said Craig Lilly, a Palo Alto, Calif.-based attorney at Squire, Sanders & Dempsey LLP. “They will probably face a tremendous wave of redemptions as well brain-drain as senior people head for the exit door.”

One of the suspected motives of such a crime could be Raj’s competitive spirit and risky nature.

“It is pride, and I want to win,” Rajaratnam was quoted in "The New Investment Superstars," a book written by Lois Peltz and published in 2001. “After awhile, money is not the motivation. I want to win every time. Taking calculated risks gets my adrenaline pumping.”

An insider, by law, is considered to be any person who has access to a company’s “material” private information that is not allowed to be disclosed or used for any purpose outside the company.

In the United States and many countries worldwide, insider trading is considered an illegal activity punishable by law (the Securities and Exchange Act of 1934). In contrast to insider information, everyone has the right to access public information about companies that is openly published in company reports.

In the case of Rajaratnam, he made trades based on insider information tipped to him by executives at McKinsey, IBM, and others who had access to nonpublic information on a large number of companies worldwide. As a result, Rajaratnam took advantage of and profited from trading shares of Google, AMD, Polycom Inc., Hilton Hotels Inc., and others over the last three years.

“Every trader wants an edge, and there are many gray areas when it comes to aggressive research. But if you trade on material, nonpublic information that comes from a company insider who is breaching his fiduciary duty, odds are that it is illegal,” said Ron Geffner, a lawyer at New York-based Sadis & Goldberg LLP.

The Wall Street Journal reported this week that clients have requested to withdraw more than $1.3 billion in funds, out of a total of $3.7 billion in assets held by Galleon.