Caught in a web of tape

WHICH came first: the crime or the investigation? With insider trading, the answer until now was always simple: the crime came first. But the case against Raj Rajaratnam, the hedge fund manager who was convicted by a US federal court jury yesterday, stemmed from an investigation that began well before the crimes were committed.

And that made all the difference.

In normal insider-trading cases, whether the ones involving someone's brother-in-law or the celebrated one that brought down Ivan Boesky a generation ago, the investigation starts only after someone notices suspicious trading, like the purchase of stock just before a takeover offer is announced or the short-sale of the stock just before bad earnings news is released.

Once the investigation begins, the Securities and Exchange Commission can find out who made the trades, and can ask why they chose to make the trades in question. It can also search for a source who might have leaked the "material non-public information", to use the legal term for inside information.

That investigative technique often fails to find proof, even if the investigators are convinced the law has been broken. It is more likely to work with small fish than with whales. If the trader in question has never bought options before and then made a killing by purchasing call options just before a merger is announced, the investigators can be virtually certain there has been a leak.

If it turns out that the chief financial officer of the company being acquired is also a neighbour of the lucky investor, and that phone records show they had talked just before the trade was made, the case is clear. In many cases, either leaker or leakee will admit what has happened, and often identify others who shared in the tip.

But that technique is all but useless if the suspect is a hedge fund manager like Rajaratnam. His firm made dozens, if not hundreds, of trades every day. It had a bevy of analysts and access to all the research by Wall Street firms. If a trade was somehow questioned, the firm could come up with any number of reasonable-sounding explanations, as Rajaratnam's lawyer, John M. Dowd, did in the case that ended in his conviction.

But those explanations sounded pretty lame when stacked up against the audio tape recordings of conversations in which corporate insiders gave confidential information to Rajaratnam.

Those tapes exist only because the Justice Department got involved in the investigation at the beginning. Presumably, it had reason to believe that insider trading was happening and persuaded a federal judge to approve wiretaps.

As a result, the FBI could listen in as the information was provided just before trades were made. And they could hear Rajaratnam discussing ways to throw off a normal inside-trading investigation. He suggested sending choreographed emails with fake reasons for a trade. He recommended trading in and out of a stock that was being accumulated because of inside information.

It seems likely that Rajaratnam had used just such tactics in the past to explain away trades that had aroused suspicion. But hearing him describe them turned a defence into a virtual confession.

Those tapes "showed that the defendant knew what he was doing was not only wrong but illegal", said a prosecutor, Reed M. Brodsky, in closing arguments to the jury.

Insider trading was a common practice at Rajaratnam's firm, Galleon. There were numerous leakers, and they came from the cream of American business from insiders at major corporations like Intel and Goldman Sachs and from McKinsey, perhaps the most prestigious management consulting firm. Chief executives of smaller companies provided Rajaratnam inside information about their companies, and profited because they were allowed to invest in his funds.

Galleon ended up sounding like a criminal enterprise, where illegal information was bought through elaborate chains aimed at concealing the source of the money. Hedge fund investments were made in the name of a housekeeper, and money was transferred overseas and back to cover the trail.

In another instance, a leaker gave Rajaratnam the password to access the leaker's account at Charles Schwab, a brokerage firm. Rajaratnam then traded in the account, and generated a lot of profit for his source.

The seemingly endless list of taped conversations made clear that Rajaratnam and his colleagues did not think trading on confidential information was unusual, even if they did think it needed to be hidden from authorities.

It is often the testimony of one participant that enables the government to make a major case. With Boesky, a prominent trader who was arrested in 1986, the break came when Dennis Levine, a managing director of Drexel Burnham, was caught doing his own trading through an account at a Caribbean branch of a Swiss bank. That investigation began the old-fashioned way, with trades that seemed suspicious.

Levine had believed that bank secrecy laws would keep the SEC from learning his identity. When he realised that would not work, he embarked on a cover-up strategy that bore a remarkable resemblance to Rajaratnam's principal defence. He set out to print old analyst reports that recommended the stocks he had bought, circling points that he could claim showed he had reasons for the trades other than inside information.

To do that, he had to make sure that the printouts did not show when they were printed, and he could not let anyone know what he was doing. That aroused amazement and admiration at Drexel. A managing director was working on weekends, and doing his own clerical work.

When that cover-up failed, he admitted to investigators that he had provided information to Boesky, who was then the best-known risk arbitrager, as traders who specialised in betting on takeovers were known.

The insider-trading cases of the late 1980s helped to establish the reputation of Rudolph Giuliani, then the United States attorney in Manhattan, who went on to become mayor of New York and a presidential contender.

If the prosecutors who mounted the latest investigation of insider trading by hedge funds hoped they could gain fame as Giuliani did, they may be disappointed. It is the financial crisis, which erupted after the investigation of Rajaratnam began, that has captured public attention, not the insider-trading accusations.

Rajaratnam is likely to serve a long prison sentence, assuming he does not win an appeal, and he may face substantial financial penalties. The conviction may encourage prosecutors to seek evidence against other successful hedge funds, particularly if their previous trades have aroused suspicion.

In providing clear evidence that the stockmarket playing field was tilted in favour of those with few scruples and lots of money, the government may have helped to even the field. At a minimum, other hedge fund managers will be much more careful during telephone conversations.