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FBI Pulls Off ‘Perfect Hedge’ to Nab New Insider Trading Class

The New York field office of the FBI sits a block west of Foley Square, where Roman and Greek- inspired courthouses with four-story colonnades loom over a small town of judicial institutions in which the biggest of America’s financial crimes are prosecuted.

Almost five years ago, in a conference room 23 stories above the plaza, FBI agents David Chaves and Patrick Carroll surveyed the midtown skyline to the north, home to much of the world’s financial industry. They had received some disturbing intelligence: a surge in profits at hedge funds might be the result of an epidemic of insider trading.

The two men, head of securities and commodities fraud units at the New York office, faced a dilemma. Informants had told them the hedge fund industry was similar to organized crime: insular and distrusting of outsiders. Without people on the inside, the government would have a tough time gathering enough evidence to prosecute. They needed more tools to gather more information on traders who move faster, and more secretly, than your typical Mafia soldier.

“It was reminiscent of that scene in ‘Jaws’ where they get their first look at the shark,” Chaves said. He told Carroll, “We’re going to need a bigger boat.”

That bigger boat came in the form of a landmark change in the way white-collar crime is investigated in the U.S., agents said. The only way to uncover insider trading was to apply the same techniques agents used to dismantle the Mafia: court- authorized wiretaps of phones, informants and cooperating witnesses.

‘Perfect Hedge’

At that moment, “Perfect Hedge” was born. This is the behind-the-scenes story of that historic, sprawling, nationwide insider-trading initiative by those who ran it.

Over the next five years, the operation by the New York offices of the Federal Bureau of Investigation and Manhattan U.S. Attorney led to prosecutions that disrupted multiple rings of illegal trading by portfolio managers, bankers and consultants. It is the biggest insider trading investigation since the days of Ivan Boesky and Michael Milken, and the largest ever in the world of hedge funds.

Agents in New York spent years monitoring clandestine wiretaps as traders received and passed illicit tips. The FBI learned everything it could about fund managers suspected of being criminals, conducting surveillance as targets passed secrets on street corners, in gyms, or handed out bags of money for information.

Illicit Profit

And it all began with the realization that hedge fund managers who illicitly profited on knowledge the public didn’t have access to could be pursued as vigorously as those who commit more traditional crimes.

“We coined this investigation ‘Perfect Hedge’ because if you’re armed with that insider’s information, you can initiate the perfect hedge,” Chaves said in an interview. “You’re always protected -- the upside and the down side.”

The results can be seen in the scores of insider-trading prosecutions made in New York -- from the conviction of Galleon Group LLC co-founder Raj Rajaratnam to those involving expert- networking consultants and employees at technology and pharmaceutical companies.

To date, at least 56 people have been charged with insider trading and more than 50 have either pleaded guilty or been convicted after trial as part of the probe, according to the office of Manhattan U.S. Attorney Preet Bharara. Wiretaps played a role in many of these cases.

‘Identified The Problem’

“We identified the problem, we created the solution to infiltrate the industry and we put people in well-placed hedge funds who reported to us on a daily basis,” said Chaves, 48, a lawyer as well as supervisory special agent. He worked on the prosecutions of WorldCom Inc. Chairman Bernard Ebbers, who was imprisoned for accounting fraud, and Martha Stewart, convicted of obstruction of justice in an insider trading case.

In some circumstances, Chaves said, agents would send in people wearing wires to record incriminating statements by targets. Such evidence, he said, “could then be used to provide us enough probable cause to obtain a wiretap.”

Ironically, the wiretaps that were so crucial to bringing down defendants in Perfect Hedge will be the basis of an appeal in its biggest case so far, that of Rajaratnam.

In May, the hedge fund manager was found guilty on all 14 counts of securities fraud and conspiracy he faced. The trial showcased 45 recordings by agents working for Chaves and Carroll of the more than 2,400 taped conversations between Rajaratnam and friends, business associates and alleged accomplices.

Goldman Sachs

Prosecutors said he made more than $72 million by using illegal tips to trade in stocks of companies including Goldman Sachs Group Inc. (GS), Intel Corp. (INTC), Google Inc., ATI Technologies Inc. and Clearwire Corp. The investigation has also led to charges against former Goldman Sachs board member Rajat Gupta.

Gupta, 63, is one of two dozen people charged since August 2009 with being part of insider trading conspiracies tied to Rajaratnam, 54. Almost all have been convicted.

Once the head of McKinsey and Co., Gupta is accused of leaking inside information about New York-based Goldman and Procter & Gamble Co. (PG) to Rajaratnam, his friend and business associate. Gupta, the highest-ranking executive charged in Perfect Hedge, pleaded not guilty and faces trial next year.

Rajaratnam, who recently began an 11-year prison sentence -- the longest in U.S. history for insider trading -- has argued federal laws don’t authorize the use of wiretaps for such an offense. His lawyers claimed that the government didn't show, as required by law, that conventional techniques couldn't have been used to achieve similar results.

Electronic Surveillance

Two federal judges who ruled the intercepts admissible at trial nevertheless criticized the government’s tactics. Six other judges had authorized the use of such electronic surveillance during the investigation.

U.S. District Judge Richard Holwell in Manhattan, who presided over Rajaratnam’s case, allowed the wiretaps to be used as evidence, yet assailed the affidavit the FBI drafted to obtain them for “glaring omissions.”

The U.S. failed to disclose “the heart and soul of its investigation” and the existence of thousands of documents that had been gathered by investigators and regulators, as well as the true criminal history of a key informant, the judge said.

U.S. District Judge Richard Sullivan, a New York judge who presided over the related case of former Galleon trader Zvi Goffer, allowed wiretaps to be used at that trial. He, too, voiced concerns about the intercepts, saying he was “deeply troubled” by the FBI’s failure to stop listening to unrelated, intimate phone calls between another former Galleon trader, Craig Drimal, and his wife.

White-Collar Cases

“The government is now using in ‘white collar’ cases the same tactics that worked so well in organized crime and gang prosecutions,” said defense attorney Roland Riopelle, a former federal prosecutor in New York who represented David Plate.

Plate, a former trader at Schottenfeld Group LLC who pleaded guilty, agreed to cooperate with the FBI and testified against Goffer.

“These are very effective strategies where there is active, ongoing criminal conduct afoot, and the criminals are doing their best to conceal their conduct from law enforcement,” Riopelle said.

Obama Administration

Daniel Richman, a former federal prosecutor and a professor at Columbia Law School in New York, said the Obama administration has been under pressure by Congress and the media to go after high-stakes white-collar crimes since the 2008 financial collapse.

“Even before it goes to a judge, a wiretap application has to survive an intense vetting within the Justice Department. And even after a judge signs it, a rigorous set of legal protocols must be followed,” Richman said in an interview. “You need to have live monitoring to avoid intercepting non-pertinent conversations. You need surveillance teams ready to identify participants.”

FBI agents and prosecutors must also show that other investigative techniques aren’t likely to be adequate to prove a crime is being committed, Richman said.

“Wiretaps are highly invasive. That’s why a very robust legal showing must be made before authority is obtained,” he said. “Of course, if you just want to wire up an informant, you don’t need court authorization and it’s a whole lot cheaper.”

He said the expense to the government of wiretapping, and all the requirements that go along with it, can be prohibitive.

Safeguard For Privacy

“At the end of the day, the cost of a wiretap probably is as great a safeguard for privacy as the high legal standards that are needed to obtain one,” he said.

“The template we had going in was to pierce the hedge fund veil,” said Diego Rodriguez, who is head of the FBI New York’s Criminal Division and supervises units including the securities and commodities fraud squads.

“What we’ve done in white collar cases is just taking that blue-collar technique that we’ve used in organized crime and applied it to securities fraud,” Rodriguez said.

Under the leadership of now-retired FBI Special Agent In Charge Peter Grupe, who supervised Chaves and Carroll, the FBI’s New York office began to use cooperating witnesses to build insider trading cases. In some instances, Chaves said, agents sent in cooperators wearing wires to record incriminating statements by targets.

Such evidence, he said, “could then be used to provide us enough probable cause to obtain a wiretap.”

Pipeline of Tips

Before wiretaps were used, agents had faced a daunting task: penetrating networks of illegal activity in a largely unregulated industry where the pipeline of tips flowed from the U.S. to Europe and even Taiwan. Evidence from recent cases showed that hedge fund managers sent inside information using encrypted e-mails, spoke on pre-paid mobile telephones and used portable flash drives.

To create a pretext for their insider-trading, fund managers often conducted “cover” trades and cited analyst reports as a motive for buying or selling.

Use of wiretaps had an additional benefit: it allowed the targets of an investigation to unwittingly explain complex, multimillion-dollar transactions, making schemes easier for jurors to understand and refuting defendant claims that trades were based on a composite, or “mosaic” of publicly-available information.

Gordian Knot

“The ‘mosaic theory’ was a Gordian knot and the best way to cut through that knot was through wiretap techniques,” said Ray Lohier, who served as chief of the securities unit at the Manhattan U.S. Attorney’s Office during much of the probe. Lohier, who called the mosaic defense a “fig leaf,” made the comments at a recent insider-trading conference. He is now a federal judge with the U.S. Court of Appeals in New York.

Soon after starting Perfect Hedge, the FBI determined that insider trading was a business model at some hedge funds, Chaves said. The industry manages $1.97 trillion in assets, according to Hedge Fund Research Inc. in Chicago.

The landscape of securities fraud crimes was changing, informants were telling the FBI in 2007. So-called boiler-rooms, where corrupt brokers bilked investors by manipulating stocks, were giving way to insider-trading.

Chaves said defendants charged in so called “pump-and- dump” schemes knew something bigger was going on.

“They seemed to know people in hedge funds or analysts in the industry, and were aware of the passing of material, nonpublic information between hedge funds, analysts and company insiders,” he said.

‘Couldn’t Get In’

At first, the FBI considered sending an agent to work undercover at one of the suspected hedge funds, Chaves said.

“We couldn’t get in. It was such a closed industry -- much like an organized crime family -- that it was difficult for the FBI to either introduce an undercover agent or recruit a cooperator.”

Such an effort wasn’t unprecedented: in 2003, an undercover FBI agent in New York infiltrated a Wall Street foreign exchange business in an operation dubbed “Wooden Nickel.”

The agent, nicknamed “Mikey Suits” by colleagues, spent more than a year posing as a corrupt trader in a Lower Manhattan boiler room. Eventually the U.S. would charge more than 45 people as part of the investigation. The agent, Michael G. Grimm, is now a U.S. congressman for New York.

Secret Alliances

Insider trading was another matter, agents said. Corrupt traders relied upon secret alliances, longtime friendships and even sexual relationships.

Danielle Chiesi, a former analyst with New Castle Funds LLC who pleaded guilty in the Galleon case, obtained illegal tips from former International Business Machines Corp. (IBM) vice president Robert Moffat, who later said he had an “intimate” relationship with her.

Rajaratnam relied on Anil Kumar, a former McKinsey partner, and Rajiv Goel, a former managing director at Santa Clara, California-based Intel, whom he’d known for decades. All three attended the Wharton School at the University of Pennsylvania in Philadelphia.

Noah Freeman, a former SAC Capital Advisors LP portfolio manager who pleaded guilty in Perfect Hedge and agreed to cooperate, said he committed insider trading with two close friends.

The first was Donald Longueuil, the best man at his wedding and also a former fund manager at SAC, a Stamford, Connecticut- based hedge fund founded by Steven A. Cohen. The second was Samir Barai, founder of Barai Capital Management LP. All three have pleaded guilty and are cooperating with the federal probe.

College Roommate

Arthur Cutillo, a former lawyer with Ropes & Gray LLP, used prepaid mobile phones to pass tips about pending mergers he learned of while working at the firm. He gave them to his former college roommate, Jason Goldfarb. In turn, Goldfarb, an attorney in New York, said he gave the inside information to his boss, Zvi Goffer of Galleon. Goffer, 35, provided at least one of these tips to Rajaratnam, according to trial testimony.

With such a tightly knit circle of friends, schoolmates and even lovers, the FBI didn’t have a candidate that could work their way inside, Chaves said.

“Unless you’re a trusted or made member in the hedge fund world and have a reputation for self-dealing, no one is going to do business with you,” he explained. “No one is going to tell you their secrets, no one is going to tell you the inside information. You have to be part and parcel of that industry.”

With Perfect Hedge, the FBI identified lower-level associates and learned enough about them, their crimes and personalities to persuade them to become cooperators.

Your Dry Cleaner

“For the best FBI agents, it’s the prep work that goes into making sure their approach of a cooperator works, to understand every facet of this person’s life, everywhere they go,” Chaves said. “Because there’s the element of surprise, and the agent is there waiting for you outside your dry cleaner and says, ‘Hey, listen, we need to talk to you.’ The image that portrays to a would-be cooperator is ‘These guys have done their homework and they’ve got me.’”

Case agents working for Carroll and Chaves are advised to learn everything they can about suspects and individuals they intend to talk into cooperating, Chaves said -- everything from whether they favor “Dunkin’ Donuts or Starbucks and where they eat lunch.”

Freeman said FBI agents “flipped” him when he found them waiting by his car in the parking lot of the New England prep school where he worked, after he had left SAC Capital. They played him a recording of his own voice as he was committing insider trading. After that, he gave agents information on at least a dozen people with whom he allegedly committed crimes.

Secretly Cooperate

Jason Pflaum, a former Barai Capital analyst, said he decided to secretly cooperate after agents approached him in October 2010. He continued to work for the firm until he pleaded guilty in January. He also said he wore a wire during the same period and gave information to authorities about crimes committed by “more than 10” people.

Agents also began to be more aggressive in pressing cooperators for more names, Chaves said.

“It’s not just asking the guy in a pump-and-dump scheme, ‘What did you do?’” he said. “It’s asking ‘What else do you know?’ ‘Who did you talk to?’ and ‘What have you heard on the street?’”

In this way, the FBI convinced the same friends Rajaratnam corrupted for illegal tips -- Kumar and Goel -- to testify against the hedge fund manager at trial, along with former Galleon portfolio manager Adam Smith.

Expert Networkers

Perfect Hedge began to expand even further with cooperators such as Karl Motey, an independent consultant who posed as a hedge fund manager and wore a wire as part of the investigation. He represented a new stage of the probe, as it leapfrogged from hedge funds trading in technology stocks to the company employees who provided the tips -- all via so-called expert networking firms.

Expert networkers, or matchmaking firms as Chaves called them, place industry experts with fund managers looking for an inside perspective on a company and industry. Some also passed nonpublic information to fund managers for money, the U.S. said.

During meetings and meals in Silicon Valley, and at a Manhattan technology conference, Motey secretly recorded conversations with James Fleishman and Bob Nguyen, both executives with expert networking firm Primary Global Research LLC. He also recorded phone consultations with technology firm employees moonlighting for Mountain View, California-based Primary Global as they passed illegal tips to their hedge funds clients, according to evidence revealed in court.

Fleishman was convicted in September following a trial. Nguyen, who cooperated with the U.S. and testified against him, pleaded guilty.

Technology Companies

Motey also recorded calls with Primary Global consultants and employees at technology companies such as Dell Inc. (DELL), Advanced Micro Devices Inc. (AMD) and Samsung Electronics Co., as they passed illegal tips to him. The recordings were played at Fleishman’s trial.

“It began with hedge funds,” Chaves said, “then we started looking at analysts, we started looking at matchmaking consulting firms. We started to look at insiders at companies. The landscape keeps changing but insider trading is still the label attached to all of it.”

While wiretaps were crucial to the conviction of many defendants, including Rajaratnam, cooperating witnesses were also needed to get the wiretaps in the first place, agents said.

Roomy Khan

While she never testified at trial, one cooperating witness, former Intel executive Roomy Khan, played a significant role in Rajaratnam’s case because she provided the U.S. with the evidence needed to obtain a wiretap.

Under the law, the FBI can’t merely open a criminal case and begin intercepting calls. Evidence must first be gathered showing probable cause that crimes are being, and continue to be, committed on the targeted telephone, Chaves said.

At a hearing last year, FBI Special Agent B.J. Kang and prosecutors said they were only able to obtain the necessary evidence to get a wiretap on Rajaratnam in March 2008, after Kang convinced Khan to cooperate.

The calls which Khan made to Rajaratnam and others on behalf of the FBI provided the government with the evidence needed to apply for a wiretap, prosecutors and agents testified.

Eventually, almost 3,000 calls were intercepted by the FBI in Rajaratnam’s case and another 1,000 calls were recorded during the related probe of Goffer, according to testimony at pretrial hearings last year.

Challenged Government Methods

John Dowd, Rajaratnam’s lawyer, challenged the government’s methods before trial, saying prosecutors and agents failed to disclose to the judge who approved the wiretap that Khan had previously been convicted of wire fraud.

The government had already spent nine years investigating Galleon, Dowd said, and Rajaratnam had given a seven-hour deposition to the Securities and Exchange Commission in 2007, part of which focused on suspicions of insider trading. The U.S. had amassed thousands of documents, according to the lawyer, and the probe had “appeared” to wind down in late 2007.

“Instead, it merely marked the point at which the government shifted from the conventional investigative techniques it had been using for the last nine years in favor of a wiretap,” Dowd wrote.

Rajaratnam’s lawyers have said they will appeal his conviction, arguing the wiretaps were illegal. Kathryn Holmes Johnson, a spokeswoman for his lawyers, declined to comment.

Related Schemes

During Perfect Hedge, agents working on separate investigations began running into each other, Chaves said, eventually revealing what were initially thought to be unrelated schemes were in fact a web of insider trading conspiracies that crisscrossed industries, countries and people.

“That’s what was so amazing, that everyone who started cooperating seemed to know everyone else,” the agent said. “At first, it was very surprising to us. It seemed like daily we’d identify a relationship, like ‘Wow, I can’t believe they went to school together,’ or ‘I can’t believe he was the best man at his wedding.’ That’s when we began to see that, as big as this industry is, it’s also that small, at least the core of people who were engaged in this conduct.”

The connections can be seen in the case of Don Ching Trang Chu, a former Primary Global consultant who pleaded guilty in June.

Chu, swept up in a spate of arrests last year tied to expert networkers, admitted in June that he facilitated a conversation between Richard Choo-Beng Lee, a former partner at San Jose, California-based Spherix Capital LLC, and an unidentified employee of a publicly-traded technology company.

Foot In Door

Both Lee and his partner, Ali Far, pleaded guilty. In October 2009, they agreed to cooperate with the U.S. in the Galleon case. That month, Rajaratnam was arrested.

“We got our foot in the door with one person,” Chaves said. “That one person led us to others.”

Expert networker Mark Anthony Longoria, a former manager at Sunnyvale, California-based AMD, pleaded guilty to passing secrets while working as a Primary Global consultant and agreed to cooperate. Longoria testified that he became concerned upon reading about Rajaratnam’s arrest.

On a call with Fleishman, Longoria expressed concern that he’d be implicated for consulting with Lee and Far at Spherix. The FBI was listening in on the call.

“I was like ‘Oh crap!’ It made me extremely nervous,” Longoria told Fleishman. “I’m like ‘God, dang it! What the hell is going on?’”

Fleishman replied, “Hopefully this will just kind of …”

“Blow over,” Longoria interrupted.

A Tip’s Trail

The secret network of illegal information which Perfect Hedge was able to uncover can also be shown in a trade involving the 2007 acquisition of pharmaceutical company Axcan Pharma Inc (AXCA).

Goffer passed a tip about Axcan to Rajaratnam, according to trial testimony. The tip originated from Cutillo and Brien Santarlas, Ropes & Gray lawyers who knew an associate of Goffer, witnesses testified.

Goffer also passed that tip to Franz Tudor, a trader at Schottenfeld, who then passed the information to Anthony Scolaro, who at the time was a portfolio manager for Diamondback Capital Management LLC. Goffer, Tudor, Santarlas and Cutillo would all be charged by federal prosecutors. Cutillo, Santarlas and Tudor would all plead guilty. Goffer was convicted following a trial and sentenced to 10 years in prison.

Scolaro, who earned about $1.1 million in profits trading on the tip, secretly entered into a plea agreement with the government on Nov. 12, 2010.

Ten days later, FBI agents from New York and Boston executed search warrants at Diamondback’s offices as well as those of Level Global Investors LP and Loch Capital Management.

New Prosecutions

The FBI searches preceded another round of insider-trading cases brought by the FBI and Manhattan assistant U.S. attorneys. They included the prosecutions of Longueuil, Barai, Freeman and former FrontPoint Partners LLC fund manager Joseph ”Chip” Skowron. All have been convicted.

Some of the thousands of documents gathered by the FBI in those raids and searches have already been used at trial in Manhattan federal court. The investigation is continuing, the government said.

“We’ve seen a tremendous change over the years that has gone from ‘pump-and-dump’ schemes to subprime frauds to options backdating to insider trading,” Chaves said. “The bad guys out there will counter the things we’re doing as the facts and FBI tactics become known in court. But Perfect Hedge encompasses everything that we’ve done in the last 2 1/2 years -- and every case that’s going to come in the next 2 1/2 years.”

Easier Argument

Columbia’s Richman said the argument that insider trading isn’t covered by federal wiretap laws, a contention advanced by Rajaratnam’s lawyers, is unlikely to succeed. The crimes of mail fraud and wire fraud are covered by the statute, “and insider trading can amount to violations of those statutes,” he said.

“One of the things that the Rajaratnam case has done is make it easier for the government to claim that insider-trading conversations really will occur over the phone,” Richman said. “And just as wiretaps will naturally come up when the government is considering a large-scale corruption or organized- crime investigation, so should we now expect them to be considered in insider-trading probes.”

To contact the reporter on this story: Patricia Hurtado in Manhattan federal court at pathurtado@bloomberg.net.

To contact the editor responsible for this story: Michael Hytha at mhytha@bloomberg.net.

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