Wall Street's Courtoom Showdown

The huge insider-trading trial beginning tomorrow is a diversion from U.S. failure to nail anyone for the meltdown—and a battle for the future hedge funds.

03.07.11 12:12 AM ET

The huge insider-trading trial beginning tomorrow is a diversion from the U.S. failure to nail anyone for the meltdown—and a battle for the future hedge funds.

The conventional wisdom is that Raj Rajaratnam, the hedge-fund billionaire set to go on trial tomorrow in the biggest insider-trading case since Michael Milken, is going down. The prosecution is armed with wiretaps, cooperating witnesses like Goldman Sachs CEO Lloyd Blankfein, and the public's outrage at Wall Street, not to mention an imposing track record: Around 90 percent of such cases end in guilty verdicts, or plea agreements (including Milken’s)

The hedge-fund business, which has grown exponentially over the past 15 years, and now manages around $2 trillion on behalf of rich people, has already internalized that outcome. Some of the biggest and, until recently, most reputable funds have revised their compliance systems, foisted crash courses in securities law upon their money managers, and hired lawyers to shield them from emboldened prosecutors looking elsewhere for their next target. I am told that SAC Capital, the most high-profile hedge fund in the world, run by legendary investor Steven A. Cohen, is even considering banning business activities over private email accounts and private cellphones. (SAC has no comment.)

In other words, a lot is at stake for the increasingly less-lightly regulated hedge-fund business, and top executives know it: Hedge funds have been able to beat the market because they enjoyed an information edge over the average investors for years now—probably forever—simply because they trade so much through Wall Street firms and supply traders their with gazillions in commissions that the big banks have every incentive to pay the hedge funds back with information and research not available to the general public. More recently, the hedge funds have gained an additional edge by hiring expert networks that funnel sales data and performance information on companies that prosecutors believe often crosses the line into passing illegal inside information, igniting a new probe that has grown out of the Raj case.

As one senior-level law-enforcement official told me: “We now believe insider trading is baked into the business models of many hedge funds.”

“We now believe insider trading is baked into the business models of many hedge funds.”

That belief may translate into action if the Justice Department wins the Raj case and Preet Bharara, the U.S. attorney for the Southern District, is emboldened to hunt other big targets, including additional players at Steve Cohen's firm, or even the man many suspect is Bharara’s ultimate target: Cohen himself.

A spokesman for SAC has said the firm, which boasts one of the best compliance systems in the hedge-fund business, is fully cooperating with government investigators and received, like other funds, only a single wide-ranging subpoena demanding information about its trading activities.

Even so, I hear the government is feeling pretty cocky about its burgeoning investigation. The new probe has already resulted in a slew of recent arrests (including two former SAC fund managers who managed to evade the firm's great compliance system) and the closing of one large hedge fund as investors yanked their money even before the fund or its management was charged with anything, not to mention the indictment last week of Rujat Gupta, accused of passing tips to Raj Rajaratnam while a director of Goldman Sachs. "The prosecutors think this insider-trading case is like shooting fish in the barrel," a prominent attorney who deals with the Justice Department recently told me.

In many ways, the Raj case is just the government’s attempt to change the subject. Insider trading had nothing to do with the bubble that caused the 2008 financial collapse that ignited a bailout of the big banks, led to the Great Recession, and has the general public demanding Wall Street accountability. Not a single Wall Street executive has gone to jail over the excesses that led to the collapse. For all the millions spent on examining the bankruptcy of Lehman Brothers, the collapse that sparked the broader meltdown, the government is having a difficult time even coming up with a civil case against its senior executives where they can avoid jail but simply pay fines and possibly face a bar from doing business in the securities industry. Prosecutors are coming to the conclusion that it's difficult, maybe impossible, to put people in jail for greed and irrational exuberance.

Because the Raj case is the sideshow, not the main event, I'm skeptical it will be a layup. What's known as insider trading was created through court precedent that has evolved over the past 30 years of the government trying to level the playing field between sophisticated investors who have access to tips and non-public information and regular folks who have to rely on ill-informed stock brokers for advice.

As a result, insider trading has been loosely defined through a mishmash of confusing verdicts and precedents. Study those cases and you'll see that government officials can't seem to agree on what exactly is insider trading. As a result, the Justice Department, after much soul-searching, came to the conclusion earlier in the decade that as bad as it looked, it was perfectly legal for Martha Stewart to receive non-public information when she was tipped by her broker that the family owning a substantial stake of company was unloading its shares so she should sell hers as well (her fate ultimately came down to lying about her non-crime).

But it's apparently the height of illegality for Raj Rajaratnam to make money buying Goldman stock after receiving a non-public tip from Gupta, the Goldman Sachs board member, that Warren Buffett was making a substantial investment in Goldman during the height of the 2008 financial crisis.

And when all is said and done, after all the the wire taps are played, the government will have to explain to jurors that based on all these contradicting rulings and cases, what exactly is the difference between information that is legal and information that is illegal. Keep in mind, the government's record in this regard isn't exactly stellar. The last time the Justice Department tried to put a high-profile Wall Street executive in jail, during its prosecution of the Bear Stearns hedge fund managers over various improprieties that included lying to investors, the conventional wisdom was the feds would win in a walk. Instead they lost and have been limping ever since.

Insider trading was supposed to be the government's redemption, a way to prove that the feds aren't powerless against the greed of Wall Street. But if government loses to Raj, attorneys involved in the broader probe tell me most of those other cases will evaporate as well, as another precedent would be established: Prosecutors can snare mob kingpins with wiretaps but not Wall Street kingpins.

Maybe Preet & Co. have the goods this time around with all the cooperating witnesses and stool pigeons, not to mention those wiretapped conversations. Starting tomorrow, the hedge-fund industry will watch nervously, as their future rests in the balance.

Charlie Gasparino is a senior correspondent for Fox Business Network. He is a columnist for The Daily Beast and a frequent contributor to the New York Post, Forbes, and other publications. His latest book, Bought and Paid For, is about the Obama administration and Wall Street.