Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Galleon Insider Trading Charges

The US Justice
and the US SEC filed
insider trading complaints against the billionaire Raj Rajaratnam,
his Galleon hedge fund and several other friends and associates a few
days ago. All the interesting stuff (for example, the transcripts of
telephone conversations) are in the criminal complaints filed by the
Justice Department. If one reads only the SEC complaint, one would not
realize that there are several smoking guns here.

The fact that the whole thing was made possible by the FBI’s
use of informants and wiretaps appears to provide some support for a
controversial paper by
Peter Henning posted at SSRN last month. In this paper, titled
“Should the SEC spin off the enforcement division?,”
Henning argued that “To allow the SEC to regulate Wall Street
properly, splitting off at least a portion of the enforcement function
to an agency with expertise in prosecutions – the United States
Department of Justice – is at least worthy of consideration as
the government looks to increase regulation.”

One reason why the Department of Justice had all the advantages
here is that insider trading is very simple to understand. There is no
need for a PhD in finance to recognize insider trading if the
prosecutors have access to all the communications that are taking
place. But absent such access, insider trading is notoriously
difficult to prove. So here, wiretapping expertise beats finance
expertise hollow.

At another level, it was interesting to find that with all the
insider information that they had from multiple sources, the
defendants lost money trading AMD shares prior to its announcement of
the spin off of the fabrication facilities and a capital infusion by
Abu Dhabi. The complaint attributes it to a general decline in stock
prices due to the global financial crisis. The defendants bought AMD
stock beginning August 15, 2008, the Lehman collapse occurred in mid
September, the AMD announcement happened on October 7, 2008 and the
defendants sold stocks around October 20, 2008.

But the global financial crisis is not the whole story as seen from
the graph below. Even if the defendants had hedged their AMD long
position with a short position in the Nasdaq Composite index, they
would not have made money. Yes, AMD does outperform Intel over the
period, but not by a huge amount.

AMD versus Nasdaq price graph

It appears from the graph that around the time that the defendants
were buying AMD on inside information, many others were also
buying. They could also have been buying on inside information or on
pure rumours. The graph reminds me of the old adage: “buy the
rumour, sell the fact.” It is also possible that the Abu Dhabi
deal was not as attractive as people initially thought and the prices
reacted to this reassessment. In other words, if Galleon had the
advantage of superior information, other traders might have had the
advantage of superior analysis. The complaint contains the transcript
of a telephone conversation where two defendants agree on a division
of labour: one of them is to collect the information and the other is
to analyze it. The second person probably was not up to the task.


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