Did Galleon Fall Through the Cracks Before?

The disclosure of the government’s sentencing memorandum against Roomy Khan, the former Intel employee who pleaded guilty in 2001 to leaking confidential information to the hedge fund executive Raj Rajaratnam, poses an interesting question for the government’s current insider-trading case.

The sentencing document, unsealed last week, shows that prosecutors and the Securities and Exchange Commission had suspected Mr. Rajaratnam of insider trading since at least 1998. But the government decided in 2002 that it didn’t have enough evidence at that time to pursue a case against him, and he seems to have fallen through the cracks until years later, when the S.E.C. again began looking at his trading.

(The New York Times noted that Ms. Khan agreed in 2002 to participate in undercover operations.)

Ms. Khan has entered into another plea agreement with the government for her involvement in insider trading. This time, she recorded conversations with Mr. Rajaratnam indicating he received insider information from her, much like what purportedly happened in the earlier case.

The 2002 case raises a host of questions about why the government didn’t monitor Ms. Khan’s activities or Mr. Rajaratnam’s trading more carefully.

Ms. Khan pleaded guilty for having faxed “highly confidential” information about Intel’s chip sales to Mr. Rajaratnam; Intel even videotaped her doing so. While the wire fraud charge only related to two instances of leaking information, she admitted to doing it over an extended period of time. Prosecutors played down her culpability in the case, arguing that her crime involved only minimal planning, resulting in a shorter sentence.

Prosecutors argued that she not be sentenced to jail, objecting to the United States Probation Office’s recommendation that she serve 12 months to 18 months. The judge sentenced her to six months’ home confinement, a light sentence for a defendant who admitted stealing confidential information from her employer to tip off a stock trader.

While the sentencing memorandum claims that prosecutors and the S.E.C. were continuing their investigation, that appears to be little more than a sop to support their request for a lower sentence for Ms. Khan. They had already determined that there was insufficient evidence to show Mr. Rajaratnam traded on the information he received from Ms. Khan, so she was of limited use to them.

It is not clear why prosecutors or the S.E.C. didn’t pursue a case against Mr. Rajaratnam. It may be that Galleon did not trade around the time she leaked the information, so the government couldn’t show Mr. Rajaratnam traded on the insider information. It’s not illegal under the securities laws to receive material nonpublic information so long as one doesn’t trade on it. Or he could have lost money on Intel trades, which would not make for a very appealing securities fraud case.

The sentencing memorandum hints that Ms. Khan’s information “may be useful in connection with other possible criminal activity on his part, unrelated to Intel.” But The Times has reported that the government never spoke with Mr. Rajaratnam about his trading at the time, or even about the information Ms. Khan leaked to him.

That’s not how the typical insider trading investigation is conducted, and it’s unusual for the S.E.C. not to seek testimony from Mr. Rajaratnam or trading records from Galleon to at least pin down their side of the story.

Despite harboring suspicions about Galleon, it does not look like the S.E.C. inquired into the firm’s trading again for at least four years. Ms. Khan was sentenced on July 1, 2002, and I think there is a good chance that the case just fell through the cracks as the S.E.C. grew consumed by other accounting frauds erupting at major corporations at the time.

Just six months earlier, Enron collapsed, and within a few weeks of Ms. Khan’s sentencing, WorldCom and Adelphia filed for bankruptcy. Congress passed the Sarbanes-Oxley Act on July 30, 2002, putting an enormous burden on the S.E.C. to draft a slew of new rules and police the markets for corporate accounting fraud. With its resources stretched thin, the agency’s enforcement division may have seen no need to pursue the case further.

But even then, one would expect the S.E.C. to file its own civil enforcement action against Ms. Khan, piggybacking the criminal case. For some reason, the commission did nothing, at least not publicly. There does not appear to be a clear reason why, though perhaps the Justice Department wanted no further actions or the S.E.C. staff simply lost interest.

In the midst of that unprecedented maelstrom, is it a surprise that a seemingly small case – in which prosecutors couldn’t even prove that the tippee traded on insider information – got lost in the shuffle? It is not quite a case of Bernard L. Madoff and numerous missed red flags; here, the alleged insider trading at Galleon may have fallen victim to other priorities until a few years later, when the same characters reemerged doing almost the exact same thing.

For its part, the F.B.I. was shifting many of its resources to the terrorism front at this time. Monitoring a former low-level corporate employee who passed inside information would not have been much of a priority.

With the same basic allegations involved in the current charges against Mr. Rajaratnam, the earlier case will be scrutinized for hints about whether Galleon engaged in insider trading for far longer than the government alleges. The same issues that undermined the case against him could well be present again. Ms. Khan is unlikely to be a very strong witness in the case as a two-time violator who stole corporate information and obstructed justice.

Mr. Rajaratnam can argue that he is willing to exchange information with anyone, but that he traded on his firm’s own research and not any inside information. In fact, he’s already said as much.

http://dealbook.blogs.nytimes.com/2009/12/07/did-galleon-fall-through-the-cracks-before/?ref=business