Lessons from Galleon
In the prosecution of Galleon Group, the SEC and the Justice Department have charged the principals of the hedge fund with receiving inside information. Court documents reveal a pattern of self-destruction at the firm, according to Marianne M. Jennings, professor of legal and ethical studies at the WP Carey School of Business at Arizona State University, writing in Thomson Reuters Checkpoint’s WG&L Accounting & Compliance Alert.
He took an $800 million hedge fund and grew it into an $8 billion one over a seven-year period. He was known for eerie accuracy in his forecasts about companies. He had an active presence on the social circuit of receptions for young, up-and-coming executives.
He is Raj Rajaratnam, the former head of Galleon Group, who now stands at the center of one of the SEC’s largest insider trading rings since Ivan Boesky roamed Wall Street. The ring took nearly one-half page in the Wall Street Journal to depict fully. The ring was so widespread that U.S. officials have issued an unusual call-out in the newspapers: “If you are involved, come in early. Talk to us before we talk to you.”
In a classic tipper/tippee insider trading case, the SEC and the Justice Department have charged the principals of the Galleon Group with receiving information from insiders that they then used to position themselves profitably in the markets. The guilty pleas are flowing in, with a former McKinsey consultant awaiting indictment and entering a guilty plea to accepting payments for information he provided about clients. In what has been called the highest profile case of a generation, there are some lessons to be learned. And we can get to these lessons through a look at the presence of many of the seven signs of ethical collapse—those faint signals that trouble might be afoot. More evidence of the signs is likely to emerge as the cases proceed, but even in the initial stages there is enough from court documents and secondary reports to indicate the pattern of self-destruction was evident.
A numbers culture
Galleon had become a legend. Rajaratnam was seen at conferences with Henry Paulson, was among the biggest traders on Wall Street, and stymied many with his ability to be ahead of the curve with double-digit growth year after year. Leon Shaulove, a senior trader at Galleon, was known to scream and yell when Galleon made a trade based on an analyst’s information that turned out to be incorrect.
The iconic leader and the young ones
Galleon’s founder and owner was well known throughout Silicon Valley and was presumed to preside over a mathematical model that assured his company outperformed others. However, the picture that emerges from the charges is one of a man who cultivated relationships with young executives at companies in the Silicon Valley and then used them as sources of information from things as simple as which customers and suppliers were doing well to, as alleged, eventually gaining inside information from them. For example, one young executive who was formerly at Intel, Roomy Khan, is identified as an informant in the case and did six months of house arrest in 2002 for passing along inside proprietary information about Intel (where she worked until her termination following charges of being a tipper).
Rajaratnam often paid for the receptions and dinners of young business school graduates in order to gain access to them and whatever information they had. The flattery of his attention charmed more than a few to connect into the web that fed the information to Galleon. Among those indicted in the case are a group of thirty-somethings who occupied positions of trust at companies and investment firms, providing analysis of company stocks. The web of information-passing is filled with young people who were brought in one-by-one through the draw of friendship as well as the promise of recognition and returns. Those who have not entered guilty pleas will have their day in court, but the wiretap and e-mail evidence appears to be insurmountable.
Fear and silence
Rajaratnam also apparently ran the same sort of autocratic organization that has been typical of companies such as HealthSouth Corp., Tyco, and others with iconic and charismatic CEOs. He fined traders $25 if they were late to his morning meetings. He made cold calls to his analysts in meetings in order to check their level of preparation. Those caught unprepared or offering weak analysis were then humiliated. In a bizarre incident, he ordered an analyst to buy a black spandex outfit from Lululemon Athletica Inc., something he called research into the stock of a company that was really moving. He then made the analyst put on the outfit and walk up and down the conference table as employees laughed nervously. It was only when CFO Rick Scuttle stopped the presentation that the humiliation ended.
One analyst at Galleon was pressed so much to obtain more information about companies that he consulted an attorney about the line between analysis and inside information. His lawyer told him that his activities at Galleon were “bending the ethics bar.” When he followed his lawyers advice and did not follow the Galleon way, he was “let go” from the company. The hedge fund lived up to the training insights provided by one manager at the firm, “Get an edge or you’re gone. Galleon is looking for that little bit of extra edge. That’s what the firm is about.”
The commitment to philanthropy
Rajaratnam also fits the profile of generosity present in nearly all of the corporate leaders who have been charged with white-collar crimes. In 2005, Rajaratnam made significant donations to the Tamil Rehabilitation Organization (TRO), a group funding and organizing relief efforts following the tsunami that affected Sri Lanka and other countries in Southeast Asia.
He was generous with other organizations as well, including one that trained dogs to detect land mines, a problem in his native Sri Lanka. He was active politically through his donations to the Center for Responsive Politics and donations to Democrat candidates and the Democratic National Committee.
Some additional lessons
There is some good news amidst all the enforcement fall-out. There was at least one company that suspected an employee of passing inside information to Rajaratnam and undertook an aggressive internal investigation. Court documents filed in the case indicate that Intel Corp. undertook its investigation when it was wary because Rajaratnam’s earnings predictions were “eerily accurate.” Intel, using hidden video cameras, recorded Khan sending information to Rajaratnam. Khan entered a guilty plea and her employment was terminated.
But the follow-up lesson to this illustration of a company doing the right thing is that enforcement officials failed to follow up on what was a beginning kernel in the Galleon web. The SEC opted not to bring civil charges against Khan and, despite extensive debriefings from her on what she was doing, opted not to pursue a case against Galleon or Rajaratnam. That decision was made despite the fact that Khan went to work for Rajaratnam for one year after she was fired from Intel. It would not be until 2007, when Galleon turned over thousands of pages of documents in response to a request related to Rajaratnam’s brother, that the government would confront Khan because of the presence of stunning e-mails from Khan to Rajaratnam. Eventually, she agreed to cooperate with prosecutors. The result, five years later, would be what prosecutors and federal agents label a “dizzying ring” of insider information.
There is, of course, a fine line between gathering information and using inside information. The SEC maintains that it was unable to establish that Rajaratnam actually profited from the information Khan sent to him. However, the Khan case was not isolated and there was additional information flowing from other sources. For example, a young Hambrecht & Quist trader wrote a letter to the SEC when he overheard a Fidelity broker sharing with a Galleon employee the level of volume Fidelity was trading in a certain stock. The SEC did not follow up on the report nor did it take action at that time.
Where there is sizzle, there might be steak. In these types of cases, there usually is a precursor to the larger discoveries. At HealthSouth, a court dismissed a shareholder suit based on affidavits from employees indicating that there were issues with the company’s accounting and financial reporting. The suit was correctly dismissed at the time, but the dismissal should have been the beginning of an investigation, not its termination. The SEC also gave Tyco a pass on its investigation into its accounting practices about 2 years prior to the discovery of all the creative activities on loans, relocation packages, and loan forgiveness. The SEC was at the Madoff empire three times prior to the eventual discovery of the largest Ponzi scheme in U.S. history. Sometimes the legalities are not there, but there is conduct that requires correction before there is further damage.
The SEC indicates that it is changing both its investigation and enforcement processes so that cases such as this do not slip through the cracks. More importantly, companies that escape any legal action should not accept this as a clean bill of health. That the questions are raised and answered temporarily does not mean that the activities are not dynamic. A close eye, not a sigh of relief, is the appropriate response.
That caution has been heeded by government agencies. Preet Bharara, the U.S, Attorney for the Southern District of New York, whose office is handling the Galleon cases, has summarized the government’s view, “There is reason to fear that there is a culture—not only at hedge funds but at large firms in the financial sector—that thinks nothing of casually exchanging material nonpublic information.”
And so there is a final ethical lesson for companies involved in trading information. The young trader at Galleon who was terminated for refusing to bend ethics bar is perhaps the person who emerges from the Galleon web with the best credentials and the critical lessons. He knew that something was not quite right in that he was not making trades and money from superior skill, foresight, and industry. He was making money by pushing the envelope as far as he could without crossing over into insider trading. That is one fine line to continue to walk without the line smudging and disappearing. He got out in time. Very often the cost of honoring ethical standards in the world of high-pressure finance is a job. This young man paid that price, but in comparison to the price now being paid by those who stayed, his decision revealed more prescience than any inside information would have offered.
In addition, the companies with moles needed to step up, as Intel did in 2002 with Khan, and explore, investigate, and enforce. When analysts’ predictions are eerily close, the time has come for an internal look at what employees are doing. Insider trading requires someone who wants the information and someone on the inside willing to sell.
Prosecutors handle the discipline for those seeking the information. However, they require companies’ assistance in rooting out those within who are disseminating the information. Companies have the tools and access to do so without a warrant and may represent a key prevention point in the web-like growth of deceit of companies such as Galleon.