18/05/2011 Author: Will Wainewright

On the insider track

In the wake of Galleon Group founder Raj Rajaratnam's conviction for insider trading, HFMWeek looks at how the industry, and the regulatory authorities in the UK and the US, are addressing the issue

The conviction of Raj Rajaratnam on 14 counts of insider trading in New York last week sparked more unsavoury headlines for the hedge fund industry. But to professionals in the space, the Galleon Group founder's guilt means more than a few negative column inches. His case and its outcome is packed with implications which the industry will attempt to absorb over the coming months.

Sound practice
After the prosecution, the focus on sound and open practice has never been greater. "The verdict taints the industry unfortunately," says Andrew Kennedy, COO at fund manager Sam Capital. "But it has made everyone review their compliance procedures." Jamie Carter, investment manager and partner at SW Mitchell, agrees: "We have to be so careful of inside information. You have to keep up the best practice and we are very diligent about doing that."

But in an industry where everyone is trying to gain an edge, the border between strong, detailed research and insider trading can sometimes be shady, meaning the verdict just increases the pressure on firms to be open and transparent about the positions they take. Leon Beukes, senior investment consultant at Towers Watson, says: "The emphasis on understanding the fundamentals and being able to explain why you take a certain position has never been greater." But the main annoyance for some in the industry is the fact that Rajaratnam's guilt will unjustly tarnish others. "There are always going to be wrong'uns out there," observes one fund manager ruefully.

Regulation and enforcement
Aside from the negative headlines, fund managers fear regulators will feel pressure to be seen to be clamping down on insider trading. Manhattan US Attorney Preet Bharara's assertion that illegal trading is "rampant" on Wall Street will not help. Many are wary that it may spark a round of ill-conceived regulation for regulation's sake, designed as much to appease public opinion as to clean up the industry. Beukes agrees this is a risk. "The Rajaratnam verdict will lead to more pressure to regulate. It will be worth it if the regulation is well thought through, but knee-jerk reactions on the fly don't help anyone," he says.

The verdict is unlikely to change the approach of regulators in the UK, but may reinforce it. The Financial Services Authority (FSA) has been building up its "credible deterrence" strategy since 2007, premised on the belief that custodial sentences, and not just fines, are required to deter would-be insider traders. After developing precedent through a string of minor prosecutions, the enforcement department is "determined to take insider dealing enforcement right into the heart of the city," Tracey McDermott, its acting head, said just before the Rajaratnam verdict.

As the table below shows, the FSA is slightly hamstrung by the lack of weapons at its disposal in comparison to the SEC - evidence obtained by wiretapping is not admissible in UK courts, for instance. Fund managers in the US expect an increase in such surveillance techniques by prosecutors emboldened by its success - Wall Street is on alert.

Expert networks
The verdict also has consequences, mostly mixed, for companies supplying expert information to hedge funds. The upside for such "expert network" firms should be greater demand for the compliance platforms they provide.

However, the nature of the case, which saw Rajaratnam gain vastly from externally sourced information, will focus the spotlight on the work they do - which they find grossly unfair. "Raj went off the grid," says one provider. "He went off the transparent, rules-based environment." Another fears the verdict may dissuade hedge funds from doing their primary research, or encourage them to do it in ways that invite less scrutiny. However, a positive consequence of the case will be that the transparency on which most firms rightly pride themselves should become clearer to all.

The drawn-out Rajaratnam trial and verdict has not been a pleasurable experience for the industry. But it could prove a healthy one, if standards and operational procedures are further enhanced to prove he was a one-off.