Rajaratnam Conviction Serves As Powerful Warning Shot On Wall Street

NEW YORK -- The conviction of billionaire hedge fund manger Raj Rajaratnam on all 14 counts in a sprawling, unprecedented insider trading case will serve as a powerful warning shot to Wall Street, legal and financial experts say.

The case against Rajaratnam, formerly the head of the Galleon Group, centered on an extensive network of tips he received over the course of at least six years, giving his hedge fund unauthorized insight into pending mergers and acquisitions, upcoming quarterly earnings at other companies and other transactions. The government estimated that Rajaratnam's firm, once one of Wall Street's biggest hedge funds, netted more than $63 million in gains and avoided losses over the time period.

Experts said that Rajaratnam's offense was so egregious that his conviction doesn't represent a shift in how the law defines insider trading, but rather, the government's willingness and ability to go after and convict such offenses.

"This was the least gray case I've ever seen. There was overwhelming evidence," said John C. Coffee, Law Professor at Columbia University and director of its Center on Corporate Governance. Rajaratnam plans to appeal the case because evidence was obtained through wire-taps and not, Coffee points out, because of the content of the charges themselves.

"The definition of insider trading is not really involved with this case," he said. "It is a case about whether or not the evidence was lawfully obtained."

The billion dollar question for investors and analysts is whether the conviction will cause hedge funds -- particularly those that use expert networks to help determine investing decisions -- to fundamentally reassess the way they operate?

"For well-counseled hedge funds, that reassessment began many many months ago," said Joseph A. Grundfest, a Professor of Law and Business at Standford University who previously served as a commissioner of the Securities and Exchange Commission.

Grundfest said hedge funds he does business with began increasing transparency and scrutinizing the use of expert networks when Rajaratnam was arrested and charged with more than a dozen counts of securities fraud and conspiracy to commit securities in October, 2009. At that time, the U.S. Attorney’s Office called the case “the largest hedge fund insider trading case in history.”

The case also marked the first time that wiretaps were used as part of a major insider trading investigation. More than 40 recordings collected over the years figured heavily into the case against Rajaratnam, including a tape showing that he had received information about an expected quarterly loss at Goldman Sachs from Goldman board member Rajat Gupta.

Some of the most significant testimony in the trial came from Anil Kumar, a former McKinsey & Co. consultant who pleaded guilty to conspiracy and securities fraud and later agreed to cooperate with the government in the case. According to the Wall Street Journal: Mr. Kumar's four days of testimony provided the cornerstone of the government's case, including damaging testimony from the consultant that he was paid $500,000 a year by Mr. Rajaratnam through an offshore account to an account in his housekeeper's name in exchange for insider tips. One such tip, involving the acquisition of ATI Technologies Inc. by Advanced Micro Devices Inc. in 2006, generated Galleon profits of nearly $23 million.

The strength of the conviction on all counts serves, Grundfest says, as a game-changer and a powerful bargaining tool for the government in all future cases of insider trading. "Now, the U.S. attorney will be able to sit down with the defendant and say [two] word[s]: Raj Rajaratnam. And that changes the complexion of the conversation. The government has now demonstrated that in situations that it has wiretaps and cooperating witnesses, they can convict."

Not everyone is convinced of the verdict's power on Wall Street. Charles Ferguson, director of the Academy Award-winning Inside Job, said that the focus on Rajaratnam's trial is misguided. “The total amounts of money and the consequences in insider trading are trivial," says Ferguson, according to The New York Times, "compared to the damage caused by the behavior that caused the financial crisis[.]”

But many argue that the deterrence factor of a criminal conviction -- Rajaratnam faces a minimum of 15-1/2 years -- is symbolically huge.

"The one thing we do know is that finance professionals are uniquely susceptible to general deterrents," said Coffee. "The street criminal may have very little alternative -- it's either sell drugs or stay poor -- but the person running a hedge fund sees the high risks involved that this case dramatically communicates. Looking at this case, he learns that expert networks that continue for a while have a good chance of getting revealed."

Rajaratnam is only one of 26 people charged in the Galleon case so far, and a second trial of three former securities traders, including a former Galleon hedge employee, is scheduled to start next week. Coffee expects that we will see more convictions in the coming months. As for whether there are hedge fund managers feeling anxious about the morning's news, Coffee put it simply:

"This is good news for honest expert network firms, bad news for those that were crossing the line. Good news for hedge funds not seeking insider information, bad news for those that were," Coffee said. "Professionals learn what is lawful based on who goes to prison and for what. This is a vivid message that you can go to prison for insider trading even if you are a sophicsticated business professional."

After the financial crisis, Bernie Madoff, years of slow economic growth and high unemployment, this is a message that will be likely welcomed by many, both on Wall Street and off.

"We've just been bombarded with a whole series of ponzi schemes, meltdowns and people making an enormous amount of money," said David Larcker, professor of accounting at the Stanford Graduate School of Business and author of Corporate Governance Matters. "The government is saying here 'look, let's pull it back to the middle here and show the population that we are serious about this -- that you can't just do anything you want.'"