Galleon used another form of insider information

We already knew that Raj Rajaratnam, the head of the now-liquidating Galleon Group who is worth $1.5 billion and is free after posting $100 million bail, allegedly traded on inside information. But up until Saturday morning, I had thought Rajaratnam's alleged insider information pertained only to company quarterly earnings reports. As the Galleon probe spreads to another hedge fund, it appears a new kind of insider information may have contributed to Galleon's ill-gotten gains.

Thanks to the Wall Street Journal, we now know that Rajaratnam used another, perhaps even more useful form of information: how many shares of a particular stock a major broker is buying or selling at any given time. For example, the Journal reports that Galleon executive Gary Rosenbach forced his Hambrecht & Quist (H&Q) broker to divulge how many shares of a certain stock big firms, like Fidelity Investments, were trying to sell.

What difference does this make? Imagine that the average daily trading volume of a particular stock is 2 million shares. And let's say that Rosenbach found out that Fidelity had orders to sell 3 million shares that day. If so, it would not take a genius to realize that the price of this particular security was likely to fall unless other big brokers had even bigger buy orders.

Galleon could have used such nonpublic information to sell that stock short and profit from the decline that would ensue when Fidelity executed its sell order. Not only does this raise questions about H&Q and other brokers, it also suggests that big-volume traders -- like Fidelity -- may be disclosing information about their positions that could be confidential, and the violation of that confidentiality could cut into clients' trading profits.

In related Galleon news, Reuters reports that another hedge fund, SAC Capital Advisors, is going to great lengths to distance itself from a former manager at SAC -- Richard Grodin -- who is being questioned in connection with the Galleon case. Grodin, who left SAC in 2004, started his own fund, which employed a cooperating witness in the Galleon ase.

As I've posted, it really is impossible to explain why stocks go up and down every day. I think it would be possible if real-time information were available about which big investors were selling or buying a particular stock, and why they were taking those positions. Armed with this information before executing trades, an investor could predict where a stock's price would head and profit from that prediction.

The Journal hints that Galleon indirectly paid for some of that information from H&Q through its trading commissions. And if the SEC cared to investigate, it would not shock me if that practice turns out to be far more widespread. Depending on how you define inside information, the trading details that Galleon allegedly got from H&Q and presumably used to trade -- might not even be illegal. To me, however, it sounds like front-running, and I think it should be outlawed.

This is yet another reason why individual investors -- who lack such market intelligence and currently have $357 billlion sitting on the sidelines in money market funds -- have a tough time competing in the stock market.

Peter Cohan is a management consultant, Babson professor and author of nine books, includingCapital Rising (due in June 2010). Follow him on Twitter. He has no financial interest in the securities mentioned.

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