The Scourge of Insider Trading: Enforcement Not Enough — We Need an Improved Ethical Culture
Like a crowd of zombies in the night, insider trading has come back to torment us. We thought the scourge had been buried with the huge Wall Street settlement from a decade ago, but there’s a new dynamic at work today. As James Stewart notes in his 7 December New York Times article, the rewards on Wall Street today — especially in hedge funds — are so huge that the temptation to cheat is worse even than in the days of Ivan Boesky and Michael Milken. The taint of insider trading threatens to derail investor trust in hedge funds and other alternative strategies. Given these investors’ passion for privacy, the burden of proof for their leaders is made all the more difficult by reputational damage caused by the bad apples in their midst. Is it time for a new level of self-examination by hedge fund bosses around compensation systems, ethical codes, and the culture of the firm itself?
As Stewart notes, the intensity of competition for capital among funds explains some of the temptation to cheat, as does the sheer mountain of cash available for funds or analysts with an “edge.” While the landscape hasn’t changed dramatically on the enforcement side of the equation, compensation for those who deliver outsize returns has blown through the already impressive tens of millions to arrive at 10-figure sums. And in turn, as capital chases and aggregates around those with success, a few moderate wins in super-sized portfolios can mean huge absolute returns. With so much at stake, only the naïve must wonder at why mere mortals give way to temptations to seek and trade on inside information, either a little or a lot.
We have no way of actually knowing how much of this is being caught by regulators. The headlines recently are full of convictions, beginning with Raj Rajaratnam and Galleon. What regulators have learned over the past 20 years has certainly made their toolkit more robust. Those with ill intent from the beginning to game the system need navigate the checks and balances set forth to make insider trading difficult. The insidious aspect of the current rash of insider trading convictions is the collusion among analysts and traders, along with presumably respectable executives and professionals from industry, whose heads are being turned by large sums of cash and entertaining.
The journey from “expert networks” to “insider networks” hasn’t taken too long. So what’s to be done? We asked our members, and an overwhelming majority said that diminished ethical culture at firms was the largest contributor to lack of trust in finance. How fortunate that something that our profession can so directly shape and influence — the norms and accepted behaviors of those who are truly professional investors in every sense of the word — to address some of the ethical cracks in our landscape. Rich rewards can and should remain for outstanding talent, but paying for performance earned through illegal activity which threatens the integrity of the system overall cannot and should not be tolerated. Leadership starts with the owners and operators of hedge funds. A culture of compliance, ethical codes, compensation systems, and the commitment to long-term value delivery for clients are part of the solution.
And let’s not give up on the deterrent effect of solid enforcement. In the U.S., investigative techniques more at home in organized crime investigations are helping identify serious allegations of insider trading and other frauds. Our regulators need sustained access to better resources, human and otherwise, to keep pace with rapidly changing financial markets and the people who seek to unfairly profit from them. Beyond government leadership, we need leadership from our profession. Asset owners — investors — need to express unequivocally their demand for ethical conduct from those they choose to engage. And asset manager executives need to set the tone at the top, setting forth a business model that relies on intellectual rigor and innovative thought as the driver of portfolio returns, shunning those who can’t compete on those terms and turn to tactics that shred the fabric of the markets. Charitable impulses shouldn’t inspire this kind of commitment, for markets that fail because of lack of trust will damage all of our businesses and personal investments as well. We must change the risk-reward equation to make clearer the very real costs associated with the risk of deteriorating market integrity.