Illegal Insider Trading: A Reflection of CharacterPublished: October 22, 2009 in India Knowledge@Wharton
According to Ignatius Chithelen, managing partner of New York City investment firm Banyan Tree Capital Management, recent news of illegal insider trading charges against Raj Rajaratnam of Galleon Group, a US$3.7 billion hedge fund, has inspired a round of gallows humor on Wall Street. But the charges against Rajaratnam and five others also raise fundamental questions about the relationship between character and success, and why investors need to take notice of any potential red flags, Chithelen argues in this opinion piece.
Recent news of the illegal insider trading charges against Raj Rajaratnam of the hedge fund Galleon Group and five others, the biggest such case in decades, has spawned its own round of jokes on Wall Street. Who are the most sought-after professionals in finance these days? Answer: Electricians, who are experts at figuring out if cell phones, landlines or offices have been bugged by the FBI. And what is the most popular spot in New York City? Answer: The area under the Brooklyn Bridge, where in the 1980s Ivan Boesky, the last big financial executive to be convicted of illegal insider trading, was said to exchange non public material information about stocks the old fashioned way -- directly in person.
As with most cases of gallows humor, a kernel of truth lurks in these jokes. Wall Street witnesses constant rumors about some people becoming wealthy due to illegal insider trading or by breaking other laws. Such stories are as much a part of the street's folk lore, the seamy underbelly discussed discreetly or after the third drink, as are the images of glamour and wealth which attract ambitious talent to hedge funds and other financial jobs. Barton Biggs, the veteran investment strategist and hedge fund manager, in his 2006 book Hedge Hogging, provides insights into how various hedge funds operate, by narrating stories of fictional characters. In a chapter titled "Divine Intervention or Inside Information?" he talks about Judson Thomas, a stockbroker at a third-tier investment bank, who becomes a financial guru and celebrity because of his mystical ability to read tomorrow's market-moving news in today's financial newspaper.
Some articles in the media have argued that prosecutors will have a tough time proving their case against Rajaratnam and the others. They say this is because there is a thin line between the web of legal information gathering and research relied upon by funds, and illegal insider data from sources who have a fiduciary duty to not disclose it. Indeed, the strength or weakness of the legal case could be debated and will soon be decided in a court of law. But, going by news reports, there was a breach of ethics, since prospective earnings and other stock-moving information, which was not publicly known, was apparently used by Rajaratnam to make profitable trades.
Most MBA programs -- including the one at Wharton -- require students to take a course in ethics, where illegal insider trading cases are discussed in detail. Similarly, all Chartered Financial Analysts, hundreds of thousands of whom work on Wall Street, have to pass an ethics exam. Yes, it is likely that few students took their ethics courses seriously. But at the very least, they were made aware of the right and wrong way to handle inside information, and the potential perils if they chose the wrong path. Also, funds like Rajaratnam's, which are registered with the Securities and Exchange Commission (SEC), are required to have codes of conduct under which employees pledge not to trade on inside information.
Character and Success
What is it that leads people, who usually have the talent to become wealthy through ethical means, to break laws like those concerning insider trading -- and moreover, as was the case with Martha Stewart, to do so for a relatively small gain? Perhaps it is greed, combined with the belief that they are smart enough to avoid getting caught. By hiring the best lawyers and other professionals, preferably former regulators, and by creating a maze of reporting layers and structures, the law breakers must assume they can shield their direct involvement from legal scrutiny.
The cold calculation of the managers may be that, at worst -- even if their fund's actions are minutely investigated by the FBI and the SEC -- an outside consultant or in-house analyst will be found to have acted on his or her own and found guilty for carrying out the illegal work without the manager's knowledge. After all, the prospect of earning massive consulting fees or big bonuses has been known in several cases to blind some people into doing illegal work.
"The most important thing is character and the quality of the people.... It's everything," David Swensen recently told the Financial Times (October 10, 2009) when asked about what he looks for in outside fund managers he hires. Swensen, who runs Yale's $16 billion endowment, has a strong long-term performance record. It is debatable whether good character is nurtured during childhood or whether it can also be acquired later in life, following repentance for wrong actions. Religious texts, philosophers and great novelists have wrestled with this question through the ages. For purposes of ethics on Wall Street, the relevant question is whether there is anything in a person's background that raises doubts about his character. Swensen joked that his team's deep due diligence includes interviewing a potential manager's high school geometry teacher.
Warren Buffett, CEO of Berkshire-Hathaway and arguably the most successful investor the world has known, expressed some timeless wisdom on the relationship between character and success during a 1999 speech at Wharton. Speaking to an auditorium packed with students and faculty, Buffett asked his audience: "If you were asked to select a person and were told that you could retain 10% of his or her earnings for the rest of your life, whom would you choose? Someone with the highest SAT or IQ test scores? Probably not. Chances are that you would pick someone with a steadfast character, whom you could trust to function well through life. Conversely, what kind of person would you shun? Most likely, the type who cuts corners and is generally undependable. Each of these qualities is a characteristic of choice and can make the difference between success and failure."
Developing characteristics such as trustworthiness and integrity, Buffett noted, is a matter of forming the right habits. "The chains of habit are too light to be noticed until they are too heavy to be broken," he said. People who stray from these values often show up on Wall Street; they may initially even shine, but eventually they self-destruct. "That is sad, because it does not need to happen," says Buffett. "You need integrity, intelligence and energy to succeed. Integrity is totally a matter of choice -- and it is habit-forming."
In Rajaratnam's case, there was a major red flag. In 2005, the Galleon Group paid an $800,000 fine to the SEC to settle charges that it improperly profited from shorting stocks. The SEC alleged Galleon violated securities rules by using shares obtained in a secondary offering to cover pre-existing short positions. Regulators claimed the risk-less strategy generated $1 million in trading profits for Galleon.
The fine raises questions about the level of due diligence or the ethics of investors who put in billions in Galleon, including a university endowment, even after the SEC action was disclosed. As was the case with Bernard Madoff's ponzi scheme, if a fund manager's superior investment gains seem too good to be true, since there is no rational, verifiable explanation for the process, or there is a hint of improper activity, investors -- as well as job seekers -- should stay away.
According to news reports, several more people will soon be charged with illegal insider trading. If found guilty, legal experts say that Rajaratnam could spend up to 20 years in jail. Prosecutors should be applauded for seeking the maximum prison sentence. Quite apart from the public loss of face, assuming the guilty care about such things, the fear of spending years in jail should scare some people away from trying to pursue easy money by breaking laws such as those on insider trading. Maybe then there will also be more space under the Brooklyn Bridge for tourists on their way from Wall Street to New York's Chinatown.