Future Effects of the Galleon Trial

Monday, November 28th, 2011 at 9:47 am, by Jennifer Warne

On November 8th, Judge Rakoff of the Southern District Court of New York ordered Raj Rajaratnam, the head of the Galleon Group hedge fund, to pay a $92.8 million civil penalty. The decision marks the conclusion of two highly publicized district court proceedings against Mr. Rajaratnam—one civil and one criminal—that arose out of Securities and Exchange Commission (SEC) investigations of his insider trading activities. Rajaratnam has filed a notice of appeal indicating that he will challenge his conviction and sentencing in the criminal trial. The civil fine is the maximum that can be imposed by law—three times the amount of Rajaratnam’s ill-gotten gains from insider trading.

Judge Rakoff rejected the defense’s argument that because of the severity of the criminal punishment imposed—Rajaratnam already received an 11-year prison sentence, a $10 million fine, and a forfeiture of $58.3 million in ill-gotten gains—a civil fine was unnecessary. Indeed, the 11-year sentence, though less than the 19 to 24 years the SEC was requesting, is significant. Because the federal sentencing guidelines increase the base offense level of an insider trading violation according to the gains received, Rajaratnam was subject to a severe penalty. In fact, had Judge Holwell, who imposed the criminal sentence, heeded the defense’s request for a six-to-eight year sentence, he would have been placing Rajaratnam in the same boat as those serving average prison sentences for kidnapping and sexual abuse.

It is interesting to contemplate the effect that Rajaratnam’s high profile trial will have on future insider trading cases. The number of insider trading actions brought by the SEC is on the rise, and it seems the outcome of the Rajaratnam trial will influence both settled and litigated cases. In 2003, King & Spalding partner Russell G. Ryan noted that a string of SEC litigation successes gave the agency an advantage at the bargaining table, which led to increases in settlement amounts for subsequent insider trading cases. It certainly seems likely that the Rajaratnam ruling will have a similar effect, especially given the copious amounts of publicity the trial has received. Judge Rakoff emphasizes that—unlike the criminal penalty, which should address moral blameworthiness, the civil penalty in an insider trading case is designed to “make such unlawful trading ‘a money-losing proposition … for all who would consider it, by showing that if you get caught … you are going to pay severely in monetary terms.” Given the willingness of the judges in both the civil and criminal trials to impose such harsh penalties, many future defendants will likely seek settlement with the SEC, even if the settlement terms require fines greater than the usual amount of the ill-gotten gains. In retrospect, Rajaratnam may well wish he settled with the government instead of proceeding to trial in his case; despite the mounting evidence against him, Rajaratnam reportedly based his decision to continue to court on astrological signs. At the very least, the Rajaratnam trial should serve as a warning to future defendants not to let that particular sort of advice dictate their settlement negotiations.

However, in looking at the future influence of the Galleon trail, it is important to note that the case represents one of the most egregious insider trading violations in history. Judge Rakoff notes that while judges are given broad statutory discretion to determine the magnitude of such a fine, the Southern Circuit has established a five-factor test that considers “(1) the egregiousness of the defendant’s conduct; (2) the degree of the defendant’s scienter; (3) whether the defendant’s conduct created substantial losses or the risk of substantial losses to other persons; (4) whether the defendant’s conduct was isolated or recurrent; and (5) whether the penalty should be reduced due to the defendant’s demonstrated current and future financial condition.” The opinion emphasizes that Rajaratnam meets every criterion for applying treble damages, especially given the duration and “huge and brazen nature” of the defendant’s insider trading. Indeed, it is difficult to imagine a scenario in which an alleged inside trader conforms more closely to the criteria for determining a civil fine than Rajaratnam did.

Perhaps, however, we will see more evidence of similarly unabashed behavior in future cases if the SEC continues to employ the aggressive wiretapping tactics that significantly bolstered their case against Rajaratnam. It should be noted that despite the ostensible magnitude of the penalties inflicted upon Rajaratnam, the SEC also did not receive its requested penalty in the civil case. There was a discrepancy in the base profit figure calculated by the parties (due to differing methods of calculating the amount of profit gained after the “reasonable period after public dissemination”), and Judge Rakoff elected not to delve into the technicalities of the calculations and use the lower figure supplied by the defense. Though, in the total range of civil penalties that could be imposed, the $92.8 million fine is at the high end of the spectrum, the SEC’s proposed fine would have just surpassed the $100 million mark. Thus, the commission narrowly missed out on sending a message to future insider traders with the shock value of a 9-figure civil fine.

In any event, it remains to be seen how precisely the Rajaratnam trial will affect future insider trading cases. Despite the high profile nature of this trial and the ongoing prosecution of Goldman Sachs board member Rajat Gupta in connection with the Galleon Group insider trading, the current political climate may require the SEC to refocus its enforcement resources on other issues. As “Americans [question] why authorities have not pursued charges against bank executives over their role in the financial crisis,”and Occupy Wall Street continues to rally fervently against home foreclosures, the unemployment rate, and the banking sector as a whole, insider trading may take a back seat, leaving the influencing potential of the Rajaratnam trial limited.