Here's A Test To See If Raj Rajaratnam Is Guilty Of Diligence Abuse

There was a time in this country, before the SEC, that fiduciaries were expected to perform as much due diligence as possible before committing an investor’s funds to any company. This included discussions with management, vendors and customers, and a thorough evaluation of a company’s prospects. Due diligence, plus the principles of diversification, were considered the prudent way to manage money and eventually led to the “prudent man rule.”

Today, the way the rules are interpreted, if you ask too many questions before you invest you may find yourself locked up. What happened!?

Almost a century ago when the masses realised that equities could outperform bonds more and more people began to invest in the equity markets, and many did so without experience. The result was informed investors (those that did their due diligence) outperformed uninformed investors.

After the ’29 crash, the newly formed regulators instituted a number of progressive actions intended to level the playing field. They required companies to make regular disclosures of financial data, release material information in a timely manner, and more recently, prohibit overly inquisitive investors from interrogating company stakeholders. It is the later action that is questionable.

The line of demarcation between information and “insider” information was initially easy to see. If you obtained knowledge before it was publicly disclosed (in one famous case a trader obtained it from the printer of the annual report a few days before it was to be released), you crossed the line. But if you happened to infer the same information by the sweat of your brow, by market analysis, sampling vendors and customers, etc. you were ok. But lately the line has shifted to make even this honest due diligence questionable.

Here are three hypothetical situations. Pretend you are a money manager and see if you can answer them correctly and still act in your client’s best interests:

A. You happen to know a doctor that is testing a new drug for a biotech company and he tells you that in his opinion the drug is amazing. You are uncertain if this information is public. Can you buy shares in the company?

B. You were studying Apple Computer a few years ago and read that they are coming out with a mobile phone. Can you check with friends you know that are Apple vendors and beta customers before you decide to buy shares?

C. You are thinking of investing with Bernie Madoff but the returns sound too good to be true. Can you check with the regulators to make sure there are no outstanding problems or investigations before you invest?

You are not going to like the answers.

A.  The latest interpretations of the rules suggest that biotech can’t be bought. It does not matter what you think about the news or how you learned it. If the news you uncovered is deemed to be material you are in jeopardy. Sorry.

B. Nor can you invest in Apple if you talked to vendors or customers that might have inadvertently revealed material information. I know you only wanted and find out if the product looked good but under today’s interpretations, such inquiries are tantamount to cheating. Sorry again.

C. Good news. You can invest with Madoff. It is ok to check with the regulators. Sorry they didn’t actually know anything useful, and sorry you lost your client’s money, but at least you didn’t break the law.

In an effort to level the playing field among investors the regulators have effectively lowered the bar on due diligence standards. You are now expected to rely on what the company discloses, take comfort in the regulators, and avoid digging too deep.

No doubt Raj went overboard on his diligence and broke the rules as they are now interpreted. Couple this with arrogance and making a lot of money and Raj is cooked.  I am not trying to defend him just suggesting we don’t throw the baby of diligence out with the bathwater of overly restrictive rules.

Instead of discouraging extensive diligence we should adopt a system that encourages aggressive price discovery. What better way to root out the Enron’s and Madoff schemes than a market full of super diligent investors. This would be hundreds of times more effective than relying on the regulators to spot all possible frauds. If this approach is too Ayn Randian for some we could require that any undisclosed material information discovered be posted on a public forum 24 hours before it is acted upon. Thus, effectively creating a “safe harbor” for the discoverer – and encouraging more rogue research.

The free market may be messy but it sure trumps the efforts of most well-meaning regulators when it comes to getting to the bottom of things. Raj had a talent – too bad he failed the abuse test.

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