Could Rajat Gupta be innocent of insider trading

Could Rajat Gupta be innocent of insider trading? On March 1, the United States Securities and Exchanges Commission (SEC) chose to file a civil, not criminal, case against former McKinsey chief Rajat Gupta for his involvement in the biggest hedge fund insider trading case in US history. Gupta is accused of giving illegal tip-offs based on confidential information from Goldman Sachs and Procter and Gamble-he was on the boards of both companies-to Galleon hedge fund chief Raj Rajaratnam between June and October 2008.

The Sri Lankan-born Rajaratnam is accused of having netted $45 million in illicit profits from insider trading with the help of Gupta and others. If convicted by a special sec-designated court, the worst that could happen to Gupta is a heavy fine and a permanent bar on being appointed to any company board. Forty-six people, including Rajaratnam, have been charged in the insider trading case. Twenty-nine have pleaded guilty. Gupta is the only one facing civil, not criminal proceedings.

On April 12, Gupta's lawyers filed a request in the New York court of US District Judge Jed Rakoff, who is hearing all Galleon-related cases, requesting that Gupta's case, like the others, be heard in a federal court. "Gupta is the only Galleon-related defendant faced with the denial of the right to a jury and important protections available only in federal court," said Gupta's lawyer, Gary Naftalis, in papers filed in court.

If convicted in a criminal insider trading case in a federal court, Gupta could face up to 20 years in prison. Why would Gupta want to trade a relatively innocuous civil trial for a criminal one? Because it may be easier for him to prove his innocence in a federal court where a jury (for conviction it has be a unanimous verdict of all jurors) requires the case to be proved beyond reasonable doubt before determining guilt than in a special administrative court where an sec-appointed judge will adjudicate his fate, with a slightly lower burden of proof. Hearsay can be used as evidence in civil proceedings but not in criminal proceedings. This is crucial because much of the evidence is in the form of wiretaps of conversations between Rajaratnam and the other accused, including Gupta, whose lawyers clearly believe the case against their client is weak. Perhaps the sec lawyers secretly hold the same view.

Gupta has a reasonably good chance of getting his case transferred to a federal court. The sec has used the 2011-enacted Dodd-Frank Act to bring administrative proceedings against Gupta. Under the earlier law, the sec could only bring civil administrative proceedings against a person registered as a broker-dealer. Gupta's lawyers will argue that the Dodd-Frank Act cannot be applied to their client with retrospective effect-Gupta's alleged offences were committed in the second half of 2008.

Judge Rakoff may yet agree with Gupta's lawyer. Hearing the case against Adam Smith, a former Galleon trader, Rakoff expressed bewilderment over the charge against Gupta. He said, "I don't understand why Gupta is the subject of an administrative proceeding before the sec while everyone else is the subject of a proceeding before a district court judge." Rakoff also expressed concern about the Dodd-Frank Act in early April, "One concern I have about Dodd-Frank is that it puts more adjudication in the hands of the SEC," he said at Fordham University Law School.

Gupta's fate will depend on what happens in the criminal trial against Rajaratnam and 27 others that is being heard in Judge Rakoff's court. The prosecution, led by US Attorney Preet Bharara, has finished presenting its case. The defence has rounded up its arguments. The jury will deliver its verdict in the next fortnight. The prosecution has tried to prove Rajaratnam used illegal tip-offs from friends and top corporate executives, all of whom disclosed information not publicly available, to help Rajaratnam make a profit of $45 million. Gupta's name featured frequently in the prosecution case against Rajaratnam, though he is by no means the key co-conspirator. The evidence against his former McKinsey colleague, Anil Kumar, is much stronger. Kumar and two others have turned approver and are helping the sec nail Rajaratnam. The defence lawyers continue to argue Rajaratnam based his trading on a "mosaic" of publicly available information.

Two sets of wiretapped conversations were used to link Rajaratnam to Gupta. In the first conversation, Rajaratnam asks Gupta about a rumour that Goldman Sachs was considering buying either Wachovia or AIG. Said Gupta, "Yeah. This was a big discussion at the board meeting?Buy a commercial bank. And, you know it was a uh, divided discussion in the board...A, AIG, it was definitely on, in, in, in, the discussion?"

According to the prosecution, there was another conversation in October 2008 in which Rajaratnam tells "employees" that "he was told by a Goldman Sachs board member that the investment bank was losing $2 a share". Gupta is not named in the conversation.

Compare those wiretaps as evidence with excerpts from a conversation Rajaratnam had with Gupta's former colleague Anil Kumar on August 15, 2008. Kumar is giving him information about investments from sovereign wealth funds in chipmaker AMD:

AK: So yesterday, they agreed on, at least they've shaken hands, and said they're going ahead with the deal.

RR: Should I buy?

AK: Yeah, go ahead and do that.

The Rajaratnam-Kumar conversations are evidence of illegal tip-offs being used to trade shares and make profits. The Gupta conversations are not. There is more evidence.

Prosecutors told the court that a tallying of phone records and trading records showed that Rajaratnam, on more than one occasion, traded in Goldman Sachs shares within seconds of talking to Gupta. The prosecution has alleged that phone records show that Gupta called Rajaratnam right after the Goldman Sachs board had approved a $5 billion investment by Warren Buffet's Berkshire Hathaway in Goldman Sachs in the last week of September 2008. Within a minute of that conversation, Galleon bought 175,000 Goldman shares.

There are other instances when phone records show that Gupta and Rajaratnam spoke soon after Gupta learnt of Goldman Sachs' quarterly earnings from ceo Lloyd Blankfein, well before they became public. There is evidence of Rajaratnam trading in Goldman shares right after these conversations.

Not everyone is convinced that any of this is smoking gun evidence of insider trading. Jeff Ifrah, co-author of "Federal Sentencing for Business Crimes", told Bloomberg Businessweek, "Intent is hard to prove. The disclosure of the information in and of itself is not a crime."

Jacob Frenkel, a sec lawyer, is also sceptical about the evidence. Speaking to Bloomberg Businessweek he said, "The government is unlikely to bring criminal charges against Gupta because the proof against him appears circumstantial."

Gupta's lawyer Naftalis has been insisting that there is nothing to show that his client was engaged in a quid pro quo with Rajaratnam. According to Naftalis, Gupta lost the entire $10 million he had invested with Rajaratnam in the GB Voyager fund during the financial crisis.

What, if not money, then motivated Gupta to break rules of confidentiality? Rajaratnam had a theory which was revealed in a wiretapped conversation between the Galleon founder and Kumar. Said Rajaratnam about Gupta, "He's enamoured with Kravis, and I think he wants to be in that circle. That's a billionaires circle...I think he sees an opportunity to make $100 million over the next 5-10 years without doing a lot of work."

Kohlberg Kravis Roberts and Company was one of the biggest private equity firms in the US and Gupta knew its boss Henry Kravis through their common passion for philanthropy. In the years of boom between 2003 and 2008, private equity and hedge funds emerged as the new poster boys of corporate America, acquiring money, stature and influence that far exceeded management consultants in McKinsey, Bain or Boston Consulting. In 1994, when Gupta won an election to the first of his three terms as head of McKinsey's global practice, management consultants and investment bankers were the elite of corporate America. By the mid 2000s, finished with the top job at McKinsey, Gupta wanted to move into the charmed circle of private equity.

In 2006, Gupta founded a fund called New Silk Route with Parag Saxena, Victor Menezes, and Rajaratnam. He would have been aware of their dodgy reputations. Saxena had paid a fine of $250,000 to sec in 1994. Menezes, a former Citibank senior vice-chairman, had paid the sec $2.7 million in fines after dumping Citibank stock before bad news from its Argentine subsidiary became public. In 2005, Rajaratnam's Galleon group had paid $2 million in a fine to settle claims for improper trade. His ambition had got the better of his judgement. By 2008, he was discussing the possibility of a role in Galleon. It didn't materialise.

Gupta may or may not be convicted of insider trading. What is certain is that the one-time business icon will never recover his reputation. His conversations with Rajaratnam may not be a smoking gun in a court of law. But they lay bare the almost casual manner in which he broke confidentiality rules and violated codes of ethics. Even if he is acquitted, no reputed company is likely to ever appoint Rajat Gupta to its board.

The arrest of Congress MP and disgraced Chairman of 2010 Commonwealth Games (CWG) Organising Committee Suresh Kalmadi is only as the beginning. The Central Bureau of Investigation (CBI) is now widening its scope of investigations to include others who were part of decision-making for the Games and those who awarded contracts in an arbitrary manner.