The Billionaire's Apprentice: The Rise of the Indian-American Elite and the Fall of the Galleon Hedge Fund

by Anita Raghavan

  Every year, ITC hired a number of students with postgraduate management degrees as trainees. It also took a few bright undergraduates straight into its management program. But the company is not without its prejudices. It has its own good old boy network. When students interview at ITC, as a running joke goes, they are asked not what school they attended but what house they were in. The company is filled with “Doscos”—men who went to India’s preeminent boys’ school, the Doon School.

  Since its founding in 1935 by a moderate group of Indian nationalists led by an eminent Calcutta barrister intent on establishing an Indian version of England’s venerable Eton College, the Doon School had been the preserve of India’s privileged. The grandsons of independent India’s first prime minister, Nehru; the late Sanjay Gandhi, who perished in a plane crash in 1980; and his brother, Rajiv, who was prime minister of India from 1984 until he was assassinated in 1991, attended Doon. Over the years, the school has milled best-selling authors including Vikram Seth and Amitav Ghosh, noted television interviewers such as Karan Thapar (the Mike Wallace of India), and titans of business such as Bhaskar Menon, one of the first Indians to rise to the top of a Western company, Britain’s recording giant EMI Music Worldwide. Even ITC, the company that offered Gupta a position, was headed by a Dosco, Ajit Haksar.

  In the India of the 1970s, a job at ITC was a ticket to the upper echelon of society. The tobacco company by then had branched out into packaging and was on the cusp of scaling other industries. In his ITC interview, Gupta impressed the panel of executives with his maturity and foresight. Though only twenty-two years old, he described a leader as “one who can motivate his colleagues and get things done without making his teammates feel that it was the leader who actually got the work done.” He was not a Dosco, but he was perfect for ITC.

  When Gupta declined the company’s job offer, Haksar, ITC’s then chairman, was stunned. He himself had gotten his start at the company as a trainee and was something of a rarity: he was one of the few men at the helm of an Indian conglomerate who could boast having an MBA. He’d earned it way back in 1948, the year Gupta was born.

  Shocked by Gupta’s chutzpah, Haksar asked the young man to explain himself—in person. He sent Gupta a plane ticket to Calcutta, where ITC’s headquarters were located. Gupta jumped at the opportunity. “It was the first time I had been on an airplane,” he would say years later. Besides, as he liked to joke, he had some good friends and relatives that he could visit in Calcutta. When Gupta met Haksar, he told him the dilemma he faced: “Either I can join you or I can go to Harvard Business School.”

  Haksar, an HBS man himself, didn’t hesitate.

  “Go to Harvard. It is the chance of a lifetime.”

  Chapter Five

  Birdie Trades

  “Let’s get some boots on the ground,” David Markowitz, the assistant regional director of the SEC’s New York office, told his branch chief, Sanjay Wadhwa. As soon as UBS’s John Moon left their offices, Markowitz and Wadhwa decided to dispatch an SEC examination team into Sedna. They knew that banks like UBS routinely reported misdemeanors like cherry picking at Sedna because they were required to and it helped them earn a goodwill chit from the SEC—nothing more. Still, why not take a peek at Sedna? An examination—a common check of a registered hedge fund to make sure it is complying with securities laws—would be the perfect cover to poke around Sedna. By sending in the exam staff, the SEC wouldn’t ring any major alarm bells either.

  Often, when a hedge fund learns that the SEC’s enforcement staff is formally investigating it, instant messages and emails mysteriously go missing. Wadhwa and Markowitz didn’t want to run that risk. Examiners didn’t freak people out like enforcers did. Within two days of Moon’s visit, an exam team decamped to Sedna.

  Dispatching examiners also would get the regulatory ball rolling before a formal order of investigation was in place. In 2006, when Christopher Cox, a California congressman, led the SEC, enforcement lawyers often got pushback when they sought formal powers to probe. Cox believed that financial players like investment banks and hedge funds could be trusted to regulate themselves. During his time, the agency missed some stunningly huge fraudsters, such as Bernie Madoff, who ran a Ponzi scheme for nearly two decades. It also overlooked troubling practices such as collateralized debt obligations that led to the financial system’s near meltdown in 2008.

  For a month, the SEC’s exam staff camped in Sedna’s offices. They turned up instant messages and emails that seemed to point to something suspicious. What exactly was going on was less clear. On September 21, 2006, Wadhwa received an order of investigation captioned “In the Matter of: Sedna Capital Management LLC,” giving the SEC the authority to subpoena documents and take testimony. Digging into the practices of a tiny hedge fund might not yield career-making headlines, but Wadhwa was intrigued and had a hunch it could lead to a bigger case.

  One of Sedna’s traders, a gregarious young man by the name of Bill Lyons, was a prodigious instant messager who liked to enliven his dull day with some cyberbanter with a cousin. Lyons, a political science graduate from Rutgers University, had bounced around a bit, working at a liquor store and attending a chiropractic college in Atlanta before he decided to start a career as a day trader.

  As the exam’s staff trolled through Lyons’s IMs, they found a series of odd messages that came to be known within the enforcement staff as the “birdie trades” IMs. One in particular stood out. In late July 2006, just after Hewlett-Packard agreed to acquire Mercury Interactive, an Israeli technology company, for $4.5 billion, Lyons instant-messaged his cousin Matt Read, who was a trader at another firm, and told him that Sedna was “long”—or taking a bullish position—on 140,000 shares of Mercury Interactive, making a bundle on the trade. “You guys are on fire,” Read messaged back, “shazamm…birdies are flying all over the place…duck.”

  In another IM exchange, after Lyons cautioned Read that Sedna’s IMs were being logged, Read messaged back, “Does the SEC know what a birdie trade is; LOL.” Though it sounded cryptic and vague, the frequent banter about “birdie trades” got the attention of the SEC examiners. They suspected a “birdie trade” was code for the fact that someone—a birdie—was tipping off Sedna to valuable inside information like news of Hewlett-Packard’s acquisition of Mercury Interactive. In October, Wadhwa took testimony from Lyons. Neither he nor his cousin Read was ever charged with wrongdoing, but not long after Lyons visited the agency, Wadhwa brought in a new colleague to work on the Sedna case.

  Andrew Michaelson joined the SEC in New York in October 2006, a month after he and his wife, an urban planner, had their first child. He was thirty-one years old and hoping to focus on corporate fraud. Growing up in Weston, Connecticut, he always knew he wanted to work in government. After graduating from Harvard Law School and clerking for a judge in New Orleans, he joined Boies, Schiller & Flexner, a small but prestigious firm known for big cases such as the landmark Bush v. Gore.

  At the SEC, Michaelson hit the ground running. He combed through thousands of pages of trading records and emails, and it quickly became clear to him that the Sedna case was not just a case of cherry picking. There were two trades that first caught Michaelson’s eye. One was the big and early wager the friends and family account made in Arris. Michaelson was struck by how Rengan was itching to make the trade in the personal fund. On July 25, the day he started accumulating a big short position, Rengan pressed his chief operating officer about whether the money he wired to fund the friends and family investment pool had hit the account.

  “Please check to see if the money has reached us,” Rengan instant-messaged his COO. “Check once every hour please; as I need to trade.” The words “I need to trade” were highlighted in bold.

  Unlike his brother Raj, Rengan’s net worth was far more modest, about $4 million. To be so persistent and to be happy to wager his $700,000 investment all on one trade and all on one stock, Michaelson reasoned that Rengan had to know it was going to be a wi
nner. The question was how. A possible clue lay in the thick stack of emails that the SEC obtained through a subpoena it issued Sedna on October 3.

  Rengan sent several emails on July 17, shopping the résumé of Rajive Dhar, a corporate strategy executive at Arris. In one to the private equity firm Apax, Rengan described Dhar as someone who knows “telecom and cable industries cold.” Dhar normally worked for Arris in California, but the week before the company’s earnings were to be released, he was at its headquarters in Atlanta. It was unusual for Dhar to know Arris’s earnings before they were announced, but that quarter he was sent the draft earnings release because he was working on a corporate deal for the company. For the SEC, here was the first piece of the puzzle: a possible tie between Rengan and a company insider whose shares he was dabbling in. (Dhar says he spoke to Rengan but not in the context of earnings. He notes he has never been contacted by the SEC and has never divulged information specific to the company. He has not been charged in connection with the Sedna case.) To build an insider trading case against Rengan, the agency still had to show actual communication between him and Dhar about earnings, which proved harder than expected.

  The second curious trade that stood out to Michaelson was a big bullish bet that the Sedna friends and family fund made in Advanced Micro Devices (AMD) call options—a bet that a company’s stock price would rise. On July 31, 2006, Rengan’s big brother Raj Rajaratnam wired his $1 million investment into the friends and family fund. Rengan deployed that money and all his capital and winnings from his trade before Arris’s earnings into AMD call options. It was the only position in the fund, and it was a bold, gutsy gamble for a hedge fund manager with an ordinary track record.

  To Michaelson it seemed like a sure-bet trade, and in this case, it looked like the information was flowing from Raj to his kid brother Rengan. Michaelson was convinced there was no way Raj would give Rengan $1 million to pour into one stock if he was not certain that the investment would be a winner. Rengan also would not risk his brother’s money unless he was sure the trade was going to be a slam dunk.

  That July 31 evening, at 8:32, Bloomberg News reported that Dell would start selling notebook computers with AMD processor chips as early as October. It didn’t go unnoticed at the SEC that Rengan’s order to buy AMD options was made just hours before the article hit the newswires. During the evening, the Bloomberg article was followed by a flurry of others. Shortly after midnight on the morning of August 1, the Wall Street Journal, citing Bloomberg, mentioned that IBM was “increasing its use of semiconductors” from AMD.

  When the Rajaratnam brothers woke up the next morning, they were pleased with themselves. Sometimes their trades—no matter how well constructed and planned—had a way of going awry. Whenever that happened, obscenities flew between the two—“fuckers…screwing my picture,” Rajaratnam instant-messaged his brother Rengan once when an investment bank issued a research report that conflicted with his take on the company. “Sucks,” replied Rengan.

  But, on the morning of August 1, 2006, the Rajaratnam brothers took to high-fiving each other electronically.

  “see the ibm/amd news; on wsj,” Raj instant-messaged Rengan at 8:27 a.m.

  “very nice; also did you see the digitimes? On Dell and amd?” Rengan replied.

  “On Dell…yes,” Raj wrote back.

  A little over an hour later, Rengan wanted some advice from his brother on AMD.

  “are you going to hold the amd?” Rengan instant-messaged Raj.

  “y thru the 13th,” replied Raj, using the shorthand “y” for “yes.”

  “cool, will do the same,” said Rengan.

  The reference to the thirteenth puzzled Michaelson; August 13 was a Sunday and it was rare for companies to make corporate announcements on a Sunday, aside from negative news or to unveil a breaking merger or acquisition. Since the bet that Sedna made on AMD was a bullish one, it looked like the news the Rajaratnam brothers expected was positive. In any case, the instant-message exchange buttressed a hunch that Michaelson had had all along. Unlike the Arris earnings intelligence, the information on AMD was flowing from Raj to Rengan.

  Two weeks after the IM banter, Dell released its earnings and said it would unveil desktop computers with AMD processors. That same day, August 17, Sedna’s friends and family fund sold the options for a gain of $2.8 million. At 11:34 a.m., Matt Read was back with his usual cyberbanter. He instant-messaged his cousin Bill Lyons at Sedna.

  “AMD,” Read said.

  “story to tell you man; this weekend,” Lyons said.

  “Birdie,” Read countered.

  “Nothing big; talk on weekend,” Lyons replied.

  “dude you always do that,” Read said.

  On October 19, 2006, the SEC issued a subpoena for testimony from Rengan Rajaratnam. He was surprised to receive it. “I can’t believe I am being asked to testify,” he told his elder brother. Though Raj Rajaratnam had never been asked to give testimony to the SEC, he was used to dealing with regulatory inquiries. The agency had been investigating Galleon on and off since 2003. Invariably because of their prolific trading, hedge funds like Galleon often cropped up on regulators’ radars. The probe consumed a lot of time and resources, but all the investigating had not amounted to much. In 2005, Rajaratnam paid a fine of $2 million to settle an SEC case over the alleged improper short selling of seventeen stocks just before the companies sold additional shares. By the time the Sedna investigation started heating up in the fall of 2006, all was quiet on the regulatory front at Galleon and business was thriving. In late 2006, Galleon moved into swanky new offices at 590 Madison Avenue. To ensure the move was auspicious, Rajaratnam’s wife, Asha, organized a puja, or religious ceremony, in the new offices. A Hindu priest presided and offerings were made to the gods.

  On December 20, 2006, five days before Christmas, Rengan Rajaratnam, flanked by his lawyers, strode into a testimony room on the fourth floor of the SEC’s New York offices at Three World Financial Center. It was Michaelson’s first deposition at the SEC, and he and his boss, Wadhwa, were eager to hear explanations for some of the curious trades and the chatter around them. From the time Rengan started giving testimony, Wadhwa was struck by his manner. He veered between extreme cockiness and moments of unease. His body language was nervous, and at times he seemed contemptuous of the SEC’s line of inquiry. When asked if he consulted with his brother Raj before making the big purchase of AMD options because so much money was at stake, he said he didn’t remember and then was dismissive of the question.

  “First, let’s frame this,” he said, taking a didactic tone that the SEC lawyers found highly irritating, “a million dollars is irrelevant to my brother, absolutely irrelevant. He’s worth several hundred million. So I don’t think he cares.”

  A minute later, when Michaelson showed him the instant-message exchange in which he asks his brother Raj, “Are we going to hold AMD?” and Rajaratnam responds by saying that he would hold the stock through the thirteenth, Rengan said he did not know the relevance of the thirteenth and he could not think of any market-moving news, such as a merger, around that time that would impact AMD’s stock. As hard as he tried, he still could not remember if he told his brother that he was buying AMD options. Sparking laughter among his lawyers, he explained that he forced his brothers to redeem their investments in the friends and family fund because he didn’t want to get any flack from them if the fund floundered.

  “Even though they’re my brothers, if I am down 30 percent I am going to hear about it,” said Rengan. “I don’t need that. I just don’t need that. Trading is a very psychological game. If someone gets in your head, it can really mess you up.”

  At other times, the SEC lawyers were struck by Rengan’s high-handed manner and inflated view of his own intelligence. When discussing his move to short Arris’s stock in July 2006, Rengan said he looked at the analysts’ models and saw they were expecting a steep ramp-up in gross margin, or revenue minus costs of goods sold.

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��Analysts, no offense to them but they tend to be somewhat lazy, they have a trend, they just draw a straight line,” Rengan said. “They don’t sit there and kind of really think is the mix shifting and what does that impact. They kind of take whatever the company says.” His job, what investors are paying him to do, Rengan explained, was to take one more step and consider other factors that might bear on a stock’s performance. Rengan was actually taking a page from his big brother’s playbook. Expectations about a stock are set by analysts working for Wall Street securities firms—so-called sell-side analysts who are in the business of getting investors to buy shares—but money was made when these analysts turned out to be wrong. Raj always impressed on his buy-side analysts that their task was to figure out “the reality,” or how on or off the mark a sell-side analyst was.

  This “arbitraging of consensus” favored hedge funds. Unlike analysts at the banks, who are judged by the forward-looking accuracy of their calls and are slow to change estimates, hedge funds like Galleon can be more fleet-footed, adjusting their assessments of a company and its prospects at will. And unlike mutual funds, hedge funds can take short positions, or have pessimistic views of a stock.

  Even at times when Rengan was trying to seem humble he came off as arrogant. When asked whether the $700,000 he invested in Sedna was his risk capital, he replied, “I’m single. I am a bachelor. I live in the same apartment I lived in for five years, my rent is a couple grand. I don’t spend money. If I lost it, it wouldn’t touch my life.”