The Galleon Trial and the Future of Hedge Funds

The US government knows it must react after the Rajaratnam case, but I cannot fathom a world in which a government agency actually knows equal or more than the industry it is trying to regulate. The upshot is that now everyone has to pay the price.
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Winston Churchill once said that the US government will always do the right thing, but only after it has exhausted all the alternatives.

That quote has been ringing through my head a lot lately while observing the insider trading trial of hedge fund manager Raj Rajaratnam. As I write this, a New York City jury has begun deliberating the verdict of what the U.S. government is calling the largest hedge fund insider trading case in history. For those who have not been following this case, which opened nearly two months ago, Mr. Rajaratnam was the founding partner of the hedge fund Galleon Group. In October of 2009, he was arrested and charged with 14 counts of securities fraud and conspiracy. He was alleged to have booked north of $60 million in illicit profits. If convicted, he faces up to 25 years in prison. Some of the trades that he is accused of executing with inside information he actually wound up losing money on.

In recent weeks, those following along have been afforded a number of treats in this trial. Among them: testimony from a range of people, including Goldman Sachs CEO Lloyd Blankfein and Harlem Children's Zone creator Geoffrey Canada; new terminology (drop the phrase "expert networks" into Google and see what comes up); a front row seat to an ideological battle between the US Supreme Court and the Securities and Exchange Commission; and 2,400 secretly recorded phone calls in what is without a doubt the broadest use ever of wiretaps in a white collar crime case. This final point is what has caught my attention.

As someone with extensive experience working in countries whose governments eavesdrop often without blinking, and some of whose wiretap initiatives have directly targeted me, I know firsthand the effects that government interference can have on business. With this in mind, I have no doubt that regardless of Mr. Rajaratnam's guilt or innocence, this trial and the tactics the government deployed in building a case against him will surely change several aspects of how the hedge fund industry conducts its affairs, if it hasn't already. In light of the proportion of capital that hedge funds control in our world economy, I think it worth our while to reflect on just what this will mean going forward for Mr. Rajaratnam's colleagues who have been watching this trial both from within the US and abroad.

If the Galleon case hasn't scared the hedge fund community, it at the very least must be prompting interested parties to consider how to continue their fiduciary duties to investors while staying on the right side of the law without any detrimental effect to day-to-day execution. There are three main fronts in the hedge fund world where the bulk of the ramifications are likely to play out: strategy, compliance and investor relations.

Regarding strategy, that a full paper trail for each and every trade idea is necessary must now be taken as a given. This in turn must affect procedures, which will essentially lengthen the time to trade execution. Changes in trading frequency and/or volume are also no doubt in store. Less rapid-fire trading would presumably result in slightly lower profits, while simultaneously triggering fewer legal audits but also fewer commission dollars to spread around.

That said, the means by which these ideas are communicated will necessarily change as well. I have no doubt that electronic communications use in hedge funds will certainly decrease if it has not already done so in the 18 months since Mr. Rajaratnam's arrest. One friend of mine at a prominent US hedge fund told me he thinks that for every investment professional at his firm, he believes there to be at least two regulatory officials monitoring activities inside the firm. Since Mr. Rajaratnam's arrest, this friend of mine has had been called to account for one instant message and one email correspondence by in-house compliance and was subsequently reprimanded.

Generally, the use of IM and email will surely decline amongst those who are really aware of things. An acquaintance of mine at another hedge fund has said that although she does occasionally log into her personal email at work, she makes a point to delete her browsing history every day before leaving the office. Nevertheless, there are still plenty of people in her firm who use the same personal electronic communications device--mostly Blackberries--for work as they do for their personal lives. To what extent people are thinking about the ubiquity of Bloomberg instant messenger I do not know, but I would imagine that anybody who has nothing to hide will continue using it.

On the compliance front, legal audits and requirements cannot be blown off as easily as they once were, but more importantly, the compliance function will no longer be seen as an annoyance. Hedge fund professionals would be well-advised to operate under the assumption that regulators can physically enter the premises at any moment. Granted, this may have always seemed obvious, but until the Feds took Mr. Rajaratnam out of his own house in handcuffs, I seriously doubt anyone thought it could really happen. In keeping with this assumption is that those very same Feds could be listening to any phone conversations undertaken by hedge funds. What was once thought of as a rarity must now be looked upon as a likely probability.

For Wall Street lawyers, of course, all of this only opens more opportunities to provide legal services. Resources within a hedge fund that in previous days may have been assigned to analytics or systems will now be allocated to compliance. This is not a bad thing or a good thing, but a merely a reallocation of resources.

From the investors' standpoint, I am told that there is already an increasing culture of due diligence, and in counterparty selection as well, which can only be a positive development. At the risk of beating a dead horse, the fact of the matter is that if anyone had asked more questions of Bernie Madoff, a lot of this could have been avoided.

But to a certain extent, these new rules merely constitute a band aid solution at best--no deeper issue that needs reform has successfully been reformed with this trial, nor has it even been set on a proper path to reform. The US government knows it must react but I cannot fathom a world in which a government agency actually knows equal or more than the industry it is trying to regulate. The upshot is that now everyone has to pay the price. Maybe regulators won't miss the next Madoff or Rajaratnam, assuming investors don't uncover him first, but none of this makes Main Street any richer or Wall Street any poorer. And of course it doesn't even come close to addressing the economic crisis that began in 2008.

I do believe the US government will do the right thing eventually. But judging by some of the features of the Rajaratnam trial, it still hasn't exhausted all the alternatives.

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