Why Hedge-Funders Should Be Worried

3 reasons why the Raj Rajaratnam arrest could keep hedge-fund managers awake at night

The downfall of hedge-fund manager Raj Rajaratnam seems to be rattling the shrouded, little-regulated, high-stakes world of hedge funds. This new case, observers say, is about much more than a single instance of financial malpractice. Here are three things that business commentators say should make the hedge-fund community nervous:

• Wiretaps and Big Bonds Show New Toughness  Bruce Watson at Daily Finance explores the theory that Rajaratnam's record-setting $100 million bail shows "a new sheriff is in town": In the U.S. justice system, Watson explains, "the bondsman"--a person essentially hired by the defendant to post bail--"is a basic part of the judicial process, given that even people charged with relatively routine crimes are often hit with large bail judgments." So what? Well, Watson explains, "there's a limit to how much money bondsmen will put up, and judges have recently shown a growing tendency to use gargantuan bond judgments to ensure that wealthy defendants will finance their own prison release." This is what happened with Madoff and Rajaratnam. Hedge-funders better sit up and take notice, Watson suggests, particularly with the new use of wiretaps in the Rajaratnam case as well.

• New SEC Program for Insider Trading  "On a broader scale," writes New York Magazine's Chris Rovzar, "the hedge-fund community has bigger things to worry about than this particular scandal." The new SEC insider trading identification program, for example, "mines data from the hundreds of millions of 'blue sheets,'" which are SEC stock exchange records, "to find patterns of traders who make similar lucrative, well-timed bets over time." Though "Raj Rajaratnam wasn't brought down using this technology," Rovzar acknowledges, "his downfall ... combined with the revelation of this new system ... might mean big changes for a secretive industry that currently can easily hide suspicious trades here and there behind a cloak of thousands of other trades, coincidence, and what they call skill."

• Investigation 'Domino' Effect  "[T]his case," writes Allan Dodds Frank at The Daily Beast. "which uses wiretaps as if the fund was a Mafia crew--is startling because it could trigger investigations around the world about how Galleon funds made investment decisions and huge gains in China, India, and elsewhere in Asia and Europe." But perhaps equally startling, he notes, is the blemish it leaves on the previously trustworthy reputation of consulting firm McKinsey & Co. Anil Kumar, McKinsey director, was arrested for feeding Rajaratnam insider information from his other clients. "No doubt," writes Frank, "those ... companies will now be wondering what Kumar and his teams might have leaked."