WSJ: Galleon and the Trouble With Insider Trading

It happened almost every earnings season. Our hedge fund would own a million shares in some company and two weeks before it was to report quarterly earnings, its stock would start dropping. There was no news to explain it. We were in the dark, even though it was my job to know. Inevitably, the company would report a disappointing quarter, missing Wall Street’s earnings expectations by a penny or two. Someone knew. A salesman’s brother-in-law heard a few deals didn’t close. Or maybe an insider was singing.

The recent arrest of Galleon Group hedge fund’s Raj Rajaratnam on insider trading charges puts a spotlight on this game. Is trading on industry knowledge widespread? Absolutely. That’s how many hedge funds and mutual funds get an edge. Is insider trading also widespread? Only the Securities and Exchange Committee’s wire-tappers know for sure.

It’s a short walk from running an information network to being an insider.

Stock markets trade on information. Millions of people generate billions of trades every day. Each trade contains a tiny piece of information built into it. ("I think Apple is killing Nokia" or "I think GM is toast.") Eventually we are proved right or wrong, and we make money or we don’t. In the long run, the market is always right. On any given day, your guess is as good as mine.

As long there have been markets, there have been those who have tried to get an edge. Whoever could get the first news from a battlefield, of an oil discovery, or figure out that a company’s earnings were better than anyone expected could reap almost instant profits. Edward Calahan invented the stock ticker (later improved by Thomas Edison and Alfred Vail) just so J.P. Morgan could sit in midtown and get stock quotes from the New York Stock Exchange faster than anyone else. Everyone else had to wait for the Dow Jones Customers’ Afternoon Letter with closing prices.

Now it has come to the point where firms are spending millions and putting wicked fast computer servers next to exchanges so they can have an edge and, through a system of high-speed or "flash" trading, figure out which way individual stocks or the markets are heading before anyone else.

Can individual investors compete? Many just buy the whole market with index funds or ETFs, but these investors end up owning all the clunkers like Ambac and Qwest. Other investors focus on dividends and end up overloading on GM and Citigroup. Edges are hard to come by.

Sadly, there is a long history of those who don’t have any particular edge cheating to get one. In 1792, William Duer, who had been assistant secretary of the Treasury under Alexander Hamilton, used inside information on the pricing of government debt as his edge. He used a little too much leverage in his speculation and died in debtor’s prison. The Pecora Commission in 1932 revealed that J.P. Morgan and Co. provided inside information to former President Calvin Coolidge and a number of other wealthy types (including apparently the CEOs of GE, AT&T and Standard Oil) allowing them to buy deals on the cheap that would later be marked up to retail investors. In the mid-1980s, Ivan Boesky (who later was convicted of insider trading) stuffed $800,000 in cash into a brief case to pay investment banker Martin Siegel for tips on takeovers before they happened. Let’s also not forget lifestyle doyen Martha Stewart, who ran into trouble for a well-timed sale of ImClone shares. She later served time in federal prison for obstruction of justice.

And what about Raj Rajaratnam? I’ve known Raj for almost 25 years. We were competitors following tech companies and both started hedge funds around the same time in the 1990s. Raj’s Galleon sucked the air out of fund raising, pulling in big bucks from many tech company CEOs, making it harder for other funds to raise capital. I was told by a few investors that Galleon promised them a network of information about the goings on in the industry. That was Galleon’s edge. And by the way, there is nothing illegal about that.

But word around Silicon Valley was that Galleon had insiders at many tech companies, a so-called "Indian mafia" of assistant treasurers and comptrollers (though Raj is Sri Lankan). Many assumed that’s how Galleon beat the market, eventually growing to $7 billion in assets. Galleon also had a floor on 57th Street in New York filled with smart traders. They never owned anything for long. Raj told me once that if he ever had a long-term capital gain, it was because he forgot to sell something.

We can argue whether insider trading should be legal or not, but for now, trading on any material, nonpublic information you possess, or are told in confidence, is illegal. Period. Even with an edge, the market is cruel, and Galleon lost money on AMD shares even when the SEC alleges it had information on a lucrative financing deal. It’s a short walk from running an information network to being an insider. I’m hoping Raj is clean, but if he paid for inside information, prosecutors will likely throw the book at him.

Information now travels at the speed of light. The edge to human traders is mostly gone, arbitraged out by fast computers. Near-term blips in stocks will always be driven by those with industry contacts, legal or illegal. The only way to truly beat the market long term is to use your head, think out long-term trends, figure out where productivity and therefore wealth is being created in the economy, and invest alongside it. This might include investing in wireless commerce, gigabit broadband, personalized prescription drugs, oil shale extraction, or electric smar grids that can better allocate power to where it is needed.

Some investors will make money trading daily and a few will get news that gives them an indication of where to invest before everyone else. But the edge of focusing on the next mountain to be climbed, while fast money chews up the foothills directly in front of us, is the surest way to make money over the long run.