Regulators Will Need A Solid Case To Sink Galleon's Founder

For Galleon Group, a hedge fund firm whose lead portfolio manager has been accused of insider trading, the water just kept rising too fast around the ship's decks. But it is the regulators who are under pressure from an increasingly incensed public that ought to be careful how the game ultimately pans out.

This morning, media outlets reported that Raj Rajaratnam's $3.7 billion healthcare and technology-focused hedge fund empire was pursuing "an orderly wind down" of its various funds. Rajaratnam, a fund manager who was accused last week by federal prosecutors of conspiring with five other senior executives in a Silicon Valley-linked insider trading ring, is currently out on $100 million bail.

It's an odd case for regulators to bring with such fanfare, given the relatively paltry amount of money supposedly generated from the scheme and the time period in which it was operating.

The Securities & Exchange Commission (SEC), which is filing a separate civil action suit against Rajaratnam, estimates the fund manager made around half of the total profits earned from the scheme, or $12.7 million. The profits were earned between January 2006 and July 2007, according to the filing; at the same time, Galleon had more than $7 billion under management.

Nasdaq and many of the tech-related stocks which trade on its market have often generated similar scandals, so it's not unlikely there is some kind of fire behind the smoke. Still, it is amazing that no one has pointed out how unlikely it is that a fund manager would risk breaking the law so flagrantly in order to generate less than a 0.2 percent profit. Even in hedge fund circles, that is peanuts in performance -- it's around a tenth of the funds' overall management fees.

Reuters blogger Matthew Goldstein points out that if the case ever gets to trial, then the defense is likely to argue that the overall picture is much more complicated than prosecutors are letting on:

If the insider trading case against Galleon Management co-founder Raj Rajaratnam ever gets to trial, expect a vigorous defense strategy built around the difference between information that's considered insightful "market color" versus top secret, market-moving trading tips.

The hedge fund manager's lawyer will probably argue that the handful of trades that prosecutors say were the result of illegal tips were cherry-picked from the tens of thousands of clearly legitimate trades Galleon's funds made over the last three years.

And the lawyers can note that the questionable transactions often were part of a complex trading strategy that can look more incriminating when taken in isolation.

Rajaratnam's defense team may contend a tip about a company's upcoming earnings report is nothing more than helpful insight, especially if the executive passing on the information fails to provide specific details like figures for revenues and net profits.

But regulators have been constantly accused this year of failing to act when they have received information from whistle-blowers about potential frauds. The most notable example was in the case of Bernard Madoff Investment Securities, where derivatives analyst Harry Markopolos warned the SEC several times to no avail about the potential that the firm was merely a shield for the world's largest ponzi scheme.

Hopefully, regulators and prosecutors are not jumping the gun in this instance merely to save some face for their previous failures. Because on the surface of it, this looks like one case where they might actually end up having to concede defeat.