Implications of the Rajaratnam Verdict for the “Mosaic Theory,” the “Knowing Possession” Standard of Insider Trading and Criminal Wire Fraud Liability in the Absence of a Trade

For a decade, Raj Rajaratnam, the founder and principal partner of the much heralded Galleon Group hedge fund, forged a reputation as one of Wall Street’s most accomplished traders.  Galleon managed over $7 billion in assets at its peak and Rajaratnam’s personal wealth, estimated at $22 billion dollars at one point, made the first generation Sri Lankan immigrant one of the wealthiest individuals in the United States.  Not surprisingly then, Rajaratnam’s May 11, 2011 conviction on 14 counts of conspiracy and securities fraud has roiled the hedge fund industry.  The government’s unprecedented use of wiretapping in a securities fraud case serves notice that a powerful and invasive investigative tool will be unleashed against suspected inside traders; there are also strong indications that the unraveling of the Galleon empire and the 25 other indictments flowing from it foreshadow other charges and investigations in the New York investment sector.  As legal precedent, however, the far flung Galleon case has not generally been considered significant.  The prosecution’s theory – that Rajaratnam and his network of associates obtained confidential corporate information from company insiders and then parlayed their knowledge into millions of dollars of gains from stock transactions – is a classic insider trading scenario that has not moved the boundaries of established law.  But beyond the verdict in United States v. Rajaratnam are legitimate questions about the state of insider trading law, most of which is made by judges and bureaucrats rather than lawmakers.  For example, what is the nexus that the government must prove between illegal inside information and specific stock transactions, and what should it be?  For the white collar defense bar and the hedge fund industry, the Rajaratnam verdict also portends trouble for the viability of the “mosaic theory” that the defendant pinned his hopes on at trial.  The jury’s rejection of that defense, and Rajaratnam’s contention that Galleon’s trades were based on a “mosaic” of legitimate, non-confidential pieces of information, raises new uncertainties for a range of investment analysts whose business model depends on the accumulation of information.  Finally, as the government more vigorously pursues insider trading cases, new cutting edge claims of liability are emerging: defendants are being ensnared even when stocks were not actually bought or sold, as occurs in at least some of the December 2010 charges in United States v. Shimoon, et al.  In a guest article, former Congressman and current SNR Denton Partner Artur Davis provides a detailed analysis of: the implications of the Rajaratnam verdict for the mosaic theory; the nexus between inside information and a specific trade required for insider trading liability to attach; the judicial – as opposed to regulatory – basis for the “knowing possession” standard; practical consequences of the verdict for hedge fund investment analysis and trading; how the verdict will impact the ongoing expert networks investigation; potential strategies for a legal challenge to the theory of causation espoused by the SEC in insider trading enforcement actions; the relevance of the “honest services” doctrine for insider trading jurisprudence; and the potential for “wire fraud” charges to criminalize breaches of corporate confidentiality agreements.

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