By Don Miller
Associate Editor
Money Morning

The insider trading scandal surrounding the Galleon hedge fund took a complicated turn yesterday (Thursday) when it was revealed Galleon paid hundreds of millions to Wall Street banks in return for a steady stream of information not available to most investors. 

The Financial Times, citing executives familiar with the matter, said Galleon paid about $250 million to banks, including Goldman Sachs Group Inc. (NYSE: GS) and Morgan Stanley (NYSE: MS), in 2008 to gain an “edge” in trading against rival hedge funds in New York and London.  The executives said it paid more than that when Wall Street was flourishing earlier this decade.

The huge payment to banks is the latest development in a massive insider-trading case brought by the U.S. Securities and Exchange Commission (SEC) that on Oct. 16 led to arrests and charges against six people– including Galleon founder Raj Rajaratnam, who is free on $100 million bail.

As it grew into a behemoth managing over $7 billion in assets, Galleon’s short term trading strategies regularly put it in close contact with Wall Street traders and sales people.  Galleon employees constantly pushed those people for information – known on the Street as “color”— on big buy and sell orders and other market developments.

“Color” is most often couched in Wall Street slang.  The FT cited one example where traders discuss a “page one seller” of shares – a reference to the first page of the Bloomberg L.P. list of big holders of listed companies.

“They were tough and aggressive. They cared about short-term returns and cared a lot about the impact of their trading and the costs. They expected a lot of market information,” a former Goldman executive who provided services to Galleon told the FT.

Gathering some information from Wall Street insiders is legal and common.  In fact, some of the best analysts are known for interpreting information that companies put out.

Hedge funds, in particular, use “color” to guide their decisions on trades to generate small returns in high volumes.

“High-velocity hedge funds aren’t really about investing,” one hedge fund founder told the FT. “It is a cat and mouse kind of thing, a game.”

But the allegations against Rajaratnam say he went beyond the standard, often demanding his analysts produce tips from employees and consultants about financial details at certain companies. The allegations say he traded on the information to make money before the information became public.

Employees who failed to deliver useful information were squeezed out, according to the FT, citing people who worked there. A Galleon presentation to investors last year described the team as its “eyes and ears on portfolio companies.”

The latest revelations may put a chill on what kind of information is shared between hedge fund traders and bankers because the legal definition of insider trading – as defined by the SEC – may be changing. 

“We need a better definition of what insider trading means,” one investor who invests money from wealthy families and pension funds in hedge funds told the FT. “It is tough legally, because there are a lot of grey areas, and it is tough for the industry because it is one more cloud.”

The Galleon scandal is just the latest blow to the hedge fund industry, which was tarred most recently by the $50 billion Bernie Madoff Ponzi scheme.  Insider trading at hedge funds has been rumored for years but the arrests surrounding the Galleon scandal represent the biggest crackdown to date.

News and Related Story Links:

• Financial Times:
  Galleon paid banks millions for ‘edge’
• Money Morning:
  Galleon Insider Trading Scandal Rocks Investors & Technology Giants
• Financial Times:
  Galleon’s Reach

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