Do Hedge Funds Create Criminals?

Lynn Stout takes the recent charges against arrest of Raj Rajaratnam, founder of the Galleon Group, and the recent raids on expert networks as an indictment of the entire hedge fund industry. She makes the mistake of using a few bad apples to state the whole industry is corrupt. The vast majority of hedge funds operate completely in compliance with the law and ethical obligations. You would not say the entire energy industry is corrupt because of the failures of Enron.

The expert networks Stout mentions are not your classic cases of insider trading. The involved parties were trying to get information about how a company is doing. By getting access to orders for computer chips you can make some estimates about how many computers a company is producing. Depending on the type of information, some should have been protected and some is just business intelligence.

After all, there is nothing wrong with looking at satellite photos of a shopping center to see how many cars are in the parking lot. Compare the photos from year to year and you may have a good indication of whether sales are up or down.

There is plenty of evidence demonstrating that bad environments contribute to bad behavior. That is backbone for compliance. Create an environment where there is more pressure to follow the rules than to break the rules.

Stout lays out three social signals that have been repeatedly shown in formal experiments to suppress pro-social behavior:

Signal 1: Authority Doesn’t Care About Ethics.
Signal 2: Other Traders Aren’t Acting Ethically.
Signal 3: Unethical Behavior Isn’t Harmful.

Signal 1 is the classic call for a tone from the top. Signal 2 is the classic call for corporate culture. Signal 3 is the classic call for regulatory (and criminal) enforcement.

No. Hedge funds do not create criminals. Unethical work environments create criminals. It’s a problem not just at hedge funds, but every industry.

Lynn Stout is the Paul Hastings Professor of Corporate and Securities Law at the UCLA School of Law and the author of Cultivating Conscience: How Good Laws Make Good People.