ETHICS Hedge Funds Must Follow Ethical
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ETHICS Curtis C. Verschoor, CMA, Editor Hedge Funds Must Follow Ethical The conviction of Raj Rajaratnam highlights several critical ethics Requirements issues concerning hedge funds. The use of expert networks to selective distribution of nonpublic from the Securities & Exchange facilitate insider trading is just intelligence, known as “expert net- Commission (SEC) makes it quite one example that lays bare the works,” earns substantial fees by clear that “material” and “nonpub- need for greater scrutiny to feeding the voracious need of lic” information can’t be selective- prevent unethical trading. hedge funds to beat the perfor- ly distributed to a small group of mance of their competition by any investors—it must have wide dis- means possible. tribution to the investing public. he murky world of hedge fund This revelation raises an impor- This regulation applies to invest- Tethics became much clearer tant question: Since hedge funds ment products on both securities with the conviction of Raj Rajarat- appear to operate under a differ- and commodities exchanges. A nam in Manhattan federal court ent set of ethics rules than other level investment playing field is on all 14 counts of fraud and investors because they are able to the bedrock basis and aim of the securities law violations. In 1997, obtain privileged inside informa- first securities regulation ever Rajaratnam founded Galleon tion, how can regulators and legis- enacted in the United States, the Group, a giant hedge fund that at lators best prevent unethical Securities Act of 1933. It’s called one time had assets of more than transactions? the “truth in securities” legislation $7 billion. The fund closed down According to U.S. Attorney and has two objectives, one of in December 2009 when Rajarat- Preet Bharara, “Unlawful insider which is to prohibit deceit, mis- nam was arrested. His conviction trading should be offensive to representation, and other fraud in will result in a minimum prison everyone who believes in, and the sale of securities. sentence of 15 1/2 years. relies on, the market. It cheats the The furor in legal circles about Central to the case was the ordinary investor....We will con- the secret telephone recordings apparent widespread use of paid tinue to pursue and prosecute that were used to document the informants to foster greed and those who believe they are both transmission of insider informa- corruption in the hedge fund above the law and too smart to get tion seems to be a response of the industry. These individuals share caught.” But it is the purveyors of defense bar. Such investigative sensitive and private information inside information that need to be wiretaps have heretofore been that’s significant enough to affect punished as much as the users. used only in cases involving orga- the market price of a security. The emergence of middlemen nized crime and drug dealing, not Hedge fund traders use this insid- who market secret corporate white-collar wrongdoing. From a er information to earn additional information for profit is just as public interest perspective, more “front-running” profits by making unethical as the actions of those use of all possible means should trades sometimes only seconds who use inside information to be used to catch criminals and before the information becomes make illegal and unethical gains in other ethics wrongdoers. publicly available. The cottage the securities marketplace. The fact that the prosecution industry of gatherers and very Regulation FD (Fair Disclosure) appears to have had the resources 14 STRATEGIC FINANCE I July 2011 ETHICS to match whatever efforts defense money to me.” Rajaratnam even For guidance in applying the attorneys put forth is viewed as suggested an arrangement whereby IMA Statement of Ethical pivotal to the final verdict. In spite Kumar would share trading profits of the fact that solving the federal Professional Practice to your based on how much money his deficit seems to be the number ethical dilemma, contact the tips had made. Kumar’s consulting one current priority of the federal IMA Ethics Helpline at (800) perspective caused him to reject government, even more resources 245-1383 in the U.S. or any kind of sharing. may be required to dig out the Canada. In other countries, During the trial, Kumar came ever-increasing number of fraud- dial the AT&T USADirect across as a well-spoken and believ- sters on Wall Street who currently Access Number from able witness. His testimony as well operate outside the limits of the www.usa.att.com/ as that of Rajiv Goel was said to be laws and societal norms of accept- traveler/index.jsp, then the unflappable and precise. Kumar able ethical behavior. above number. was quoted as saying he felt he For seven years, Galleon “owed [Rajaratnam] something, engaged in a conspiracy to trade given how much money he was securities based on inside infor- Company from 1994 to 2003. paying me.” Goel was a business mation received from corporate Gupta was a member of the board school classmate of Rajaratnam executives, bankers, consultants, of directors of Procter & Gamble and a former Intel, Inc. executive. traders, directors of public compa- Co. and Goldman Sachs Group, The fact that business has nies, and even loose-lipped lower- Inc. Exactly 23 seconds after hear- become increasingly globalized level employees. These individuals ing that Goldman was going to makes it much harder to keep cor- need to realize that this kind of report a loss for the first time in porate business secrets secure. Fur- behavior is not only immoral, its history, Gupta was alleged to ther, varying levels of moral values unethical, and illegal, but it also have called Rajaratnam to inform in different cultures make what is undercuts the entire process of him of the news. Rajaratnam sold unacceptable behavior in one the fairly setting the market prices at Galleon’s entire stake in Goldman, norm in another. In the May 16- which financial securities are approximately 120,000 shares. At 22, 2011, issue of Bloomberg Busi- bought and sold. the Rajaratnam trial, Goldman nessweek, Don Ching Trang Chu, The network of insiders CEO Lloyd Blankfein testified that an employee of Primary Global Rajaratnam cultivated to learn Gupta had violated Goldman Research, one of the largest inside about nonpublic information was Sachs Group’s ethics code. This information providers, said he widespread. According to The New example highlights the importance believes the SEC is “too strong.” He York Times, the South Asian immi- of compliance efforts to assure arranged investor meetings in Asia grant community in New York ethical conduct, not just the adop- because regulators aren’t aggressive City provided many of his tipsters. tion of a code. While Gupta faces a there. He stated that in Asia, This is a relatively small group of civil complaint from the SEC for “nobody cares.” successful Sri Lankans (like his actions, he apparently isn’t In the same article (“Want the Rajaratnam), Indians, and Pakista- subject to the risk of criminal Scoop on Raj?”), Daniel Celeghin, nis who had become prominent in charges. a partner in a financial consulting technology and in finance. The Another important member of firm, noted that “There’s so much South Asian club at the Wharton the circle was Anil Kumar, a for- information out there, and the School of Business also provided mer McKinsey partner. Rajarat- odds of inside information leaking several important sources of illegal nam pulled Kumar aside after a have risen exponentially.” He information. fundraiser in Manhattan and made added, “It’s a more cutthroat busi- A very prominent member of him a $500,000-a-year proposi- ness” mirroring an ethos of profit the intelligence-gathering group tion. Kumar quoted Rajaratnam as by any means necessary. It appears was Rajat Gupta, the chief of glob- saying, “You have such good the Galleon case is only the tip of al consulting firm McKinsey & knowledge that is worth a lot of continued on page 61 16 STRATEGIC FINANCE I July 2011 Ethics both at DePaul University, Chicago. continued from page 16 He is also a Research Scholar in the the iceberg in terms of illegal and Center for Business Ethics at Bent- unethical profitability from insider ley University, Waltham, Mass. trading. U.S. Attorney Bharara John Wiley & Sons has published noted, “I wish I could say that we his latest book, Audit Committee were just about finished investi- Essentials. His e-mail address is gating pervasive insider trading,” [email protected]. He added, “Sadly, we are not.” There are several lessons to take away from the Galleon case. The most important is that there is a need to consider developing a consensus that many of the cur- rent Wall Street hedge fund strate- gies should be totally shut down. This will be difficult because many in Congress and the business com- munity still favor a strategy of deregulation of business rather than focused governmental efforts in the public interest. Other lessons include the need for a fed- eral statute to clearly define in- sider trading as well as the need to solve the ongoing debate and con- troversy over implementing the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The last—but not least—lesson to take from the Galleon case is that investors should be skeptical of the claims of those who promise above-market returns. If it sounds too good to be true on a long-term and consistent basis, it just may not be true. The “quick buck” strategy isn’t likely to be sustainable. As always, the ethical approach is the best in the long run.