The Dark Underbelly of Finance

CHICAGO – If you thought that America’s financial sector had gotten enough of bad publicity, think again. The insider-trading trial of Raj Rajaratnam, a billionaire hedge-fund manager, has now begun. It is likely to provide an especially lurid exposé of the corrupt underbelly of the financial world.

Rajaratnam’s trial is remarkable in many ways. First, it is one of the few insider-trading cases ever to be brought against a professional hedge-fund manager. Historically, both state and federal attorney generals have preferred to prosecute “occasional” traders, who stick out like a sore thumb.

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For example, when a tiny Italian bank received from someone who never traded a large order for shares of US Shoe shortly before the company was acquired by Italian eyewear maker Luxottica, it was not difficult to smell a fish. In other words, precisely because occasional traders trade rarely, it is much easier to prove the nexus of causality between their trades and an illegal tip. By contrast, it is much more difficult to identify a problem when a person makes hundreds of trades every day.

In Rajaratnam’s case, the possibility of establishing such a link has come through telephone surveillance. This is the trial’s second remarkable aspect: it is the first insider-trading case to rely on an instrument generally reserved for pursuing drug or mafia cases. When the contents of these conversations are revealed in court, they will not allay the public’s already considerable distrust of the financial sector, to say the least.

But the most remarkable aspect of this case is the level of the people involved. Past insider-trading prosecutions of people other than occasional traders usually involved rogue financiers, like Ivan Boesky in the 1980’s.

This time, we are talking about the very heart of corporate America. A managing director of McKinsey, Anil Kumar, has already pled guilty to providing inside information to Rajaratnam in exchange for cash payments of at least $1.75 million. Raja Gupta, McKinsey’s worldwide managing director for nine years, is accused of being one of the conspirators, as is Rajiv Goel, a managing director of Intel.

It is so difficult to imagine that successful executives would jeopardize their careers and reputations in this way that many of us probably hope that the accusations turn out to be without merit. But recent academic research – by Lauren Cohen, Andrea Frazzini, and Christopher Malloy – shows that it is not far-fetched that university friends like Kumar, Goel, and Rajaratnam would get together to share confidential information.

This research shows that portfolio managers place larger bets on firms that have directors who are their college friends and acquaintances, earning an 8% excess annual return. A benign interpretation of these results is that college mates know each other better; thus, a portfolio manager has an advantage in judging the quality of the CEO if they spent time with him or her in college. But this benign interpretation is difficult to reconcile with the finding that these positive returns are concentrated around corporate news announcements.

After ten weeks of a trial like this, it will be easy for the public to conclude that all hedge funds are crooked, and that the system is rigged against the outsiders. Fortunately, this is not the case. While there are certainly some rotten apples in the hedge-fund industry, the majority of traders behave properly, and their legitimate research contributes to making the market more efficient.

Nevertheless, it will be difficult for legitimate hedge-fund managers to remove the taint that rogue traders have now spread over their industry. One way to do this is to be proactive in their disclosure. Hedge funds should publicly report all past trades that are at least two years old. Such delayed disclosure would not weaken their competitiveness, since the half-life of most trading strategies is very short, but it would give them the credibility that comes with having nothing to hide.

Voluntary public disclosure by hedge funds could also prevent a much stronger regulatory intervention that might otherwise cling to the alarming headlines generated by Rajaratnam’s trial.