Insider Trading Charges Against Goldman's Rajat Gupta
By R Tamara de Silva
October 26, 2011
Yesterday Rajat K. Gupta, a Senior Partner Emeritus and Managing Director of McKinsey & Co. and Board Member of Goldman Sachs Group, Inc., was indicted on criminal charges of insider trading.[ 1] Mr. Gupta is alleged to have provided Raj Rajaratnam, the founder of one of the largest hedge funds in history, Galleon Group inside information from which Rajaratnam profited[2 ]. Mr. Gupta will likely be prosecuted by the same U.S. Attorney, Preet Bharara, who obtained a conviction and eleven year sentence (the longest sentence ever dealt on the charge of insider trading) against Raj Rajaratnam.
Mr. Gupta's arrest comes on the heels of what has been an over four year investigation of alleged insider trading on Wall Street. The principal focus of the government's investigation has been on whether information was passed along by analysts and consultants of companies that provide "expert network" analysis to hedge funds and mutual funds. Expert network companies arranged for meetings and calls with executives from hundreds of companies and then shared this information with traders at hedge funds and mutual funds.
The activities of expert network firms came to be discovered by the Securities and Exchange Commission ("SEC") by analysis of the performance results of hedge funds and mutual funds. Funds that performed much better than other funds were scrutinized and essentially targeted for wiretap and surveillance. Historically the SEC has found inside trades by looking at the ticker tape (in addition to volume and unusual options activity) before and after the release of inside information.[ 3]
Even a superficial definition of terms is necessary. Insider trading is a legal term that encompasses both legal and illegal conduct. Legal insider trading occurs when corporate insiders, defined as officers, directors, and employees, buy and sell stock in their own companies. There are times when corporate insiders are prohibited from buying or selling stocks or making options plays in their own companies. Illegal insider trading generally encompasses "the buying or selling of a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security."[ 4 ]
Illegal insider trading also encompasses the "tipping" of information obtained by virtue of a tipper's fiduciary duty, employment of relationship of trust and confidence to any third party "tippee," who trades in the markets using or influenced by this information.
There is a significant amount of ambiguity and fluidity in the definition of who is an "insider," who may become a "constructive insider," what trading "on the basis of" information means, and what information, classified as property is truly "inside information." Some of the terms used in the SEC's Rule 10b-5[ 5], which governs insider trading, are determined in their breach as much as in their observance. Many terms in Rule 10b-5 are subject to the roving interpretations of the judiciary based upon the unique fact patterns of the cases for insider trading that reach trial. The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. Efforts to more precisely describe what is and what is not insider trading have been opposed by the SEC for fear that proscribing the precise conduct of Rule 10b-5 too precisely would narrow the powers of the SEC.
Congress and the SEC have extended the prohibition against trading on unequal and inside information to include of certain types of "outside" information-information about takeovers pursued by third parties-wherein there is no insider or fiduciary relationship [6 ].
In the case of Gupta, if the alleged conduct is proven to be true and the prosecution has actual proof of the information alleged exchanged in Mr. Gupta's indictment, then it fits within the unambiguous gambit of Rule 10b-5. This would be the archetypical case of insider trading. The indictment (11 CR 907), alleges among other charges, two clear examples of insider trading:
1) In September 2008, the indictment alleges that 16-20 seconds after leaving a board meeting at Goldman wherein it was discussed that Warren Buffet would buy $5 billion of preferred shares in Goldman (at the time an extremely valuable infusion to Goldman especially given its exposure to AIG), Mr. Gupta called Rajaratnam. Rajaratnam and Galleon Tech Funds began purchasing Goldman stock immediately, which it turned around and sold after the announcement became public for a profit of $840,000 and avoided a loss of several millions of dollars;
2) On January 29, 2009, the day before Proctor and Gamble was to report its quarterly earnings, Mr. Gupta exited a board meeting at P&G wherein the earnings were revealed to be coming out below the guidance P&G had given to analysts, and conveyed this inarguably inside information to Rajaratnam. Rajaratnam immediately began shorting approximately 180,000 shares of P&G.
As in the case of Mr. Gupta, what is described in his indictment is the disclosure by an insider (board member) of unambiguous inside information. However, if the evidence of Mr. Gupta's were not based upon actual wiretap recordings (if the prosecution had no recordings of Mr. Gupta actually conveying this information) but merely on the alleged hearsay conversations between a convicted Rajaratnam, while trying to get a reduced sentence, then the case itself becomes extremely tenuous and the evidence ambiguous.
In other cases, the problem becomes defining what is inside information and what is excellent hard won research-a problem exacerbated by the ambiguities in the definitions of the building block terms that go into what constitutes Rule 10b-5's definition of "inside information." Being privy to a board meeting to discuss earnings before they are released to the public or learning about a merger through a confidential email or conversation easily constitutes inside information. An insider's disclosure of clearly inside information would violate the fiduciary duties that corporate board member and managers, as agents, owe to their principals-the ultimate principal being the shareholders.
However, hiring researchers to park next to a Federal Express shipping station and daily tally the number of shipments loaded on the trucks over time to forecast seasonal shipping performance, is by way of an example, gumshoe research that may be proprietary and hard won, but is it ever inside information? What if a hedge fund routinely employed these tactics and achieved results far superior to other funds. Assuming there are 8,000 hedge funds in the United States each trying to out guess the performance of public companies and taking a bet on whisper numbers, no one in theory has an edge aside from inside information. Unless, certain funds simply had superior information through the most aggressive research. A fund that outperformed its competitors enough would likely draw attention from the SEC, but would this fund's use of research be inside information? To some degree the work of expert networks illustrates the problems with a roving and malleable definition of insider trading. Mr. Gupta's indictment, taking the alleged facts as true, does not.@
R. Tamara de Silva
October 26, 2011
1. The topic of insider is large and discussed thoroughly and much more substantively in my upcoming book on the United States Criminal Justice System.
2. Copy of the indictment can be retrieved here: http://www.securitiesdocket.com/wp-content/uploads/2011/10/Gupta-Rajat-Indictment-Signed-and-Stamped.pdf
3. The exchanges are called self-regulatory organizations (SROs) and have historically been the best regulators and watchdogs of unusual and potentially illegal market activity.
5. 17 C.F.R. § 240.10b-5, promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under § 10(b) of the Securities Exchange Act of 1934.
6. United States v. O'Hagan, 521 U.S. 642 (1997)