Alison Frankel

Remember the children’s game Telephone? One kid whispers something in another kid’s ear, the second kid turns around and whispers what she heard to the next child, and so on down the line. At the end, the last one to receive the whispered message says aloud what she heard, the kid at the start of the chain announces the original phrase, and everyone laughs because the message was inevitably mangled as it was passed along. That’s why courts have a rule barring hearsay. Witnesses can testify about conversations they participated in, but they can’t generally tell jurors what they heard secondhand about discussions they weren’t directly involved in, because hearsay isn’t considered sufficiently reliable.

The same principle applies when prosecutors obtain wiretap evidence of phone conversations. Obviously, wiretaps provide a record of direct conversations. But when one person on a recorded phone call tells another about a conversation he had with someone else, is that evidence or hearsay?

For Rajat Gupta, the former McKinsey chief and Goldman Sachs director accused of passing tips to convicted inside-trader Raj Rajaratnam, the hearsay rule could well be the difference between acquittal and a long prison sentence. As I’ve previously reported, prosecutors from the U.S. Attorney’s office in Manhattan are relying on tapes of three conversations between Rajaratnam and his colleagues at the Galleon Group hedge fund to link Rajaratnam’s illegal trades with tips he allegedly received from Gupta. The government conceded in a brief filed earlier this month that those tapes are the best evidence it has – in a case in which there’s no proof Gupta profited from his alleged insider trading – that Gupta actually passed confidential information to the hedge fund billionaire. Without Rajaratnam’s fleeting recorded references to tips about Goldman Sachs, the government’s case against Gupta is all inference, requiring jurors to draw lines between phone records and Rajaratnam trades.

The prosecutors, Assistant U.S. Attorneys Reed Brodsky and Richard Tarlowe, don’t assert that the wiretap evidence is anything but hearsay. But they argued in their brief that the recorded conversations fall under exceptions to the bar on hearsay evidence in the federal rules of evidence. The government has asked U.S. Senior District Judge Jed Rakoff for a pretrial ruling that the tapes are admissible because they contain statements that were against Rajaratnam’s interests and were made in furtherance of a conspiracy involving both Rajaratnam and Gupta. Prosecutors also argued, in a bit of circular reasoning, that Rakoff should admit the hearsay evidence because the government really needs it to prove its case. The tapes “are the most probative evidence available that Rajaratnam traded Goldman shares based on a tip from Gupta,” the government’s brief said, citing a rarely invoked “residual exception” to the hearsay rule. “The introduction of these statements would be consistent with the rules of evidence and advance the interests of justice.”

Late Friday, Gupta’s lawyers at Kramer Levin Naftalis & Frankel filed their 41-page response to the prosecutors’ hearsay brief. It’s a do-or-die filing that argues against admission of the tapes on both procedural and substantive grounds. This is as good an examination of the hearsay rule, and its application in the 2nd Circuit Court of Appeals, as you’re going to find.

From the beginning of the criminal prosecution of Rajat Gupta, it was clear that the government didn’t have the sort of evidence usually at the heart of insider-trading cases. Gupta didn’t profit directly from the tips he allegedly passed to Raj Rajaratnam, who has since been convicted of insider trading. In fact, as his lawyer, Gary Naftalis of Kramer Levin Naftalis & Frankel has said repeatedly, Gupta lost millions in his investment with Galleon, Rajaratnam’s hedge fund. That evidentiary gap has left space for Naftalis to argue that the government unfairly targeted his client because of Gupta’s high profile as a former head of McKinsey and director at Goldman Sachs. It also puts pressure on prosecutors to link Gupta directly to Rajaratnam’s tainted trades, since nothing else shows he was part of the conspiracy.

As Gupta’s May 21 trial date fast approaches, the latest filings from both sides disclose exactly how the government intends to establish that link, using phone records and wiretap evidence to show that Rajaratnam traded specifically because of tips he received from Gupta. But the new briefs also spotlight the inferences prosecutors will have to ask jurors to draw. The government’s case leans heavily on wiretapped conversations in which Rajaratnam tells associates at Galleon what he found out in alleged phone conversations with Gupta that were not taped by the government. Prosecutors argued in a motion in limine last week that Rajaratnam’s taped calls with Galleon conspirators fall under an exception to the rule barring hearsay evidence. If U.S. Senior District Judge Jed Rakoff disagrees, the government will have a much tougher time convincing jurors that Rajaratnam’s inside information came from Gupta.

The prosecution’s latest bill of particulars against Gupta includes allegations that Gupta tipped off Rajaratnam about Procter & Gamble news (Gupta was also a director there). But the government’s strongest evidence appears to involve two alleged Goldman tips. The first alleged tip came on the day in September 2008 that Goldman Sachs directors learned of Warren Buffett’s $5 billion investment in the bank. Moments after Gupta disconnected from the board’s conference call, his assistant placed a call to Rajaratnam, according to phone records. After that very brief call, which concluded only minutes before the end of the trading day, Rajaratnam placed orders to buy as much Goldman Sachs stock as he could snap up. He ended up paying about $25 million for more than 200,000 shares. The next day, according to wiretap evidence, Rajaratnam told his personal Galleon trader, an unindicted co-conspirator named Ian Horowitz, that he rushed to order hundreds of thousands of Goldman shares because he “got a call at 3:58 … saying something good might happen to Goldman.”

The Justice Department and the Securities and Exchange Commission apparently do not have the evidence to assert a classic insider-trading case against former Goldman Sachs and Procter & Gamble director Rajat Gupta. Typically, the government brings insider-trading cases against people who profited directly from trades based on confidential information. Gupta doesn’t fall into that category. Neither the SEC nor the DOJ claims that he realized any direct profits from the trades Galleon Group chief Raj Rajaratnam allegedly made based on his tips. Indeed, Gupta’s lawyer, Gary Naftalis of Kramer Levin Naftalis & Frankel, has said many times that Gupta “lost his entire investment” in Rajaratnam’s hedge fund. “[Gupta] did not trade in any securities, did not tip Mr. Rajaratnam so he could trade, and did not share in any profits as part of any quid pro quo,” Naftalis told Reuters in a statement.

But while the absence of a direct profit motive complicates the Justice Department and SEC cases against Gupta, it doesn’t preclude them. The government doesn’t have to show that Gupta directly profited by tipping Rajaratnam, only that he benefited in some way from passing along inside information. “It’s not your standard model, but it’s not unprecedented,” said Thomas Gorman of Dorsey & Whitney, who represented an Ohio State business-school professor convicted in a no-profits insider-trading case in 2005.

The government, in fact, has broad leeway to define the benefits a tipster derived from disclosing confidential information, Gorman said. Benefits can be as amorphous as enhancing a friendship or angling for future favors. In the Gupta case, the SEC and the Manhattan U.S. Attorney are so far offering only vague motives for his alleged insider trading. The SEC’s new complaint asserted that Gupta received indirect profits from Rajaratnam’s illicit trades, since he was an investor in Galleon funds. The complaint also refers to Gupta’s “variety of business dealings with Rajaratnam,” and alleges that the former McKinsey chief “stood to benefit from his relationship with Rajaratnam.” Similarly, the U.S. Attorney’s indictment said Gupta revealed inside information to Rajaratnam to deepen his relationship with the Galleon chief. “Gupta benefited and hoped to benefit from his friendship and business relationships with Rajaratnam in various ways, some of which were financial,” the indictment said.