Pocket Change Or Prison: The Galleon Hedge Fund Scandal

By Douglas Rice | October 27, 2009 AAA
Pocket Change Or Prison: The Galleon Hedge Fund Scandal

It has been called the largest hedge fund insider trading case in history and it focuses on Mr. Raj Rajaratnam and his firm Galleon, which was recently reported to have $3.7 billion under management.

The complaint alleges that several high profile individuals in addition to Rajaratnam used material nonpublic information, commonly called insider information, to generate $25 million in illicit profits.

It might be too early to know all the lessons from this potential scandal, but here are a few things we can already take away.

Risk Vs. Reward
The most obvious lesson here is that even smart, rich people can do really stupid things. In this case, Rajaratnam has been arrested for potentially making $25 million dollars using illegal insider information. But $25 million is less than 1% of the size of the assets. So he risked jail for an additional 1% return.

For someone that has been reported to have over $1 billion in personal net worth, this is unbelievably stupid. Integrity may not make you rich quick, but lack of integrity can sure turn your life upside down. (We look at some of the landmark incidents of insider trading in Top 4 Most Scandalous Insider Trading Debacles.)

Now You Know Who's Listening
Another obvious lesson stems from the unprecedented use of wiretaps by prosecutors. They have tapes of several people saying things like, "I'm dead if this leaks," and "I'll be like Martha Stewart."

Also, the U.S. attorney with jurisdiction over Wall Street has said that they plan to use them again in similar investigations. One can only imagine how many Wall Street insiders now wonder if their own phone is tapped.

While the wiretap lesson won't fall on deaf ears for those who are knowingly skirting the law, a related underlying lesson may be missed by most everyone. Why wasn't this done before? There wasn't anything stopping the SEC from getting court orders for wire taps and going more aggressively after these lawbreakers, but previous to this case no one ever did it. Rules and regulations are only as good as the people that enforce them.

Making Up For Past Mistakes
No one has forgotten that the SEC allowed Bernie Madoff to get away with fraud for decades or how it missed Allen Stanford's billion dollar ponzi scheme. It's only natural for the SEC to want to make headlines in a positive way. That lesson was apparently missed by Mr. Rajaratnam and the others. Enforcement may have missed Madoff, but they sure weren't going to miss everyone.

This goal, combined with the remarks about future use of wire taps, makes it likely that there will be even more high profile cases. (Check out these bizarre insider trading cases that helped define the SEC's laws against it. Don't miss Infamous Insider Traders.)

No Bail Out Here
Tie that into a lesson that may be lost completely. Galleon used heavily traded securities almost exclusively. This means that while there will be some time to unwind the positions, the securities are liquid and easy to sell without disrupting the markets. In other words, Galleon isn't too big to fail so there's no reason to do anything other than shut them down.

With financial regulations being overhauled, hopefully these lessons won't be lost on legislators.

Guidance Matters
For stock traders, the complaint shows how much company guidance toward future earnings matters to a stock's price. Often stocks will rise or fall based on earnings announcements, but in some cases, the guidance from management is crucial to the buy or sell decision.

Knowing it ahead of time can be profitable, but illegal. The complaint in this case discusses not only knowing about the future earnings reports, but what the future guidance will be as well.

The Martha Stewart Lesson
And finally, there is the biggest lesson learned from this that everyone should take to heart: don't take risks you don't have to. This was the same lesson Martha Stewart's adventures provided. She went to jail for lying about $30,000 worth of stock. She was a billionaire that shouldn't have talked to anyone about anything that only amounted to $30,000, especially a stock broker trying to wheel and deal.

Mr. Rajaratnam, apparently another billionaire, could serve decades in federal prison for profits of $25 million. And these profits weren't even all his; they were profits going to the investment firm which he ran. Investors were making the returns. Of course, he was likely an investor so he would have seen some of it, but nevertheless, when someone says to you, "I don't like talking over cell phone on this," alarm bells should ring. (Find out how these Wall Street high-rollers landed themselves in hot water in 4 History-Making Wall Street Crooks.)

The Bottom Line
To make a good risk and reward decision, consider the consequences of what could happen and weigh the consequences. In this case, he could make a few more bucks, but if caught, he could go to prison. Basically, it was pocket change vs. prison. When viewed this way, it was clearly an astronomically bad risk and reward decision and there's a lesson in that for everyone.

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