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Arrests, Scrutiny Put Hedge Fund Sector on Edge

BY Carolyn O'Hara  October 19, 2009 at 3:28 PM EST

Prosecutors announce arrest of hedge fund exec; Michael Nagle/Getty Images

In what federal prosecutors say is the largest-ever insider trading scheme involving a hedge fund, Raj Rajaratnam, chief executive of $3.7 billion hedge fund Galleon Group, is accused of trafficking in insider information provided by a network of corporate informants and traders.

His co-conspirators, according to prosecutors, included a senior official at IBM, a McKinsey & Co. consultant, an Intel Corp. treasury manager, a Bear Stearns veteran and an analyst at Moody’s.

“[Rajaratnam] is not the astute student of company fundamentals or marketplace trends that he is widely thought to be,” said Securities and Exchange Commission enforcement chief Robert Khuzami at a Friday news conference after the SEC filed suit against the alleged conspirators. “He is not a master of the universe but rather a master of the Rolodex.”

Prosecutors allege that Rajaratnam and the Galleon Group made more than $20 million from 2006 to 2009 on illegal trading in companies such as Google, IBM, Akamai and Hilton Hotels. Informants allegedly fed Galleon tips for cash or, in some cases, for other insider information.

The case has been built in part on the use of wiretaps and cooperating witnesses, according to reports Monday. One witness, a former Galleon employee, has reportedly been cooperating with the government since November 2007.

Legislators, including Pennsylvania Democratic Sen. Arlen Specter, have pressed regulators to more aggressively scrutinize hedge funds. The use of wiretaps in this case could be a wake-up call to new tactics by investigators.

“Insider-trading cases are notoriously difficult to prosecute because the evidence is often circumstantial,” Bill Mateja, a former Justice Department lawyer now at Fish & Richardson PC in Dallas, told Bloomberg. “If law enforcement is actively going to go out and target this with covert investigative techniques, I think it’s going to keep people on their toes.”

The legal definition of insider trading has proven to be elastic and ambiguous over the years, and prosecutors will likely have to work hard to prove that the pursuit of information, commonplace on Wall Street, stepped into the bounds of criminality in this case.

“Every trader wants an edge, and there are many gray areas when it comes to aggressive research,” Ron Geffner, a lawyer at New York-based Sadis & Goldberg LLP, told Bloomberg. “But if you trade on material, non-public information that comes from a company insider who is breaching his fiduciary duty, odds are that it is illegal.”

Rajaratnam, who was released Friday on $100 million bail, began his career as a technology analyst and is known in the hedge fund world as having wide-ranging contacts among the technology sector. Forbes estimated his net worth this year to be $1.3 billion.

A native of Sri Lanka, Rajaratnam has drawn scrutiny in the past from federal investigators for charitable contributions he has given to groups in his homeland. In 2005 and 2006, a charity founded by Rajaratnam to help Sri Lanka rebuild after the 2004 tsunami donated funds to a charity investigators say funneled money to the Tamil Tigers, a militant separatist group that battled the government in a decades-long insurgency until earlier this year.