Hedge funds are playing the role of Wall Street villain again. This time, the charge is rampant insider trading. First came the 2009 arrest of Raj Rajaratnam, founder of the Galleon Group. Then came the November 22, 2010 raids of three hedge fund headquarters by FBI agents who seized documents and confiscated BlackBerries. Now authorities are serving subpoenas on other, larger hedge and mutual funds. Attorney General Eric Holder has announced the government's widening investigation is "ongoing" and "very serious." (Recently, though, Jesse Eisenger in the New York Times called these investigations a "side show.")
These events raise suspicion that many hedge fund traders may have succeeded at beating the market not through careful research and original analysis but by breaking the law. The question, then, is, Why does a large slice of the hedge fund industry seem to have succumbed to illegal behavior?
I would argue that it's not so much about misaligned incentives, as we might guess from standard economic theory, but rather because, from a behavioral perspective, hedge funds are "criminogenic" environments that can turn even ethical people into conscienceless sociopaths.
The Science of Prosocial Behavior
Economic theory treats people as rational, selfish actors who would not hesitate to break the law or exploit others when it serves their material interests. Luckily, behavioral science (and everyday experience — mostly) teaches this trope simply is not true. Innumerable experiments and field studies have proven that people often act "prosocially" — unselfishly sacrificing opportunities for personal gain to help others or to follow ethical rules. Few people steal their neighbor's newspapers or shake down kindergartners for lunch money.
My research, shows that people's circumstances affect whether they are likely to act prosocially. And many hedge funds provide exactly the wrong circumstances for encouraging a prosocial behavior like obeying the laws against insider trading.
Killing Conscience
Hedge funds, both individually and as a group, can send at least three powerful social signals that have been repeatedly shown in formal experiments to suppress prosocial behavior:
Signal 1: Authority Doesn't Care About Ethics. Since the days of Stanley Milgram's notorious electric shock experiments, behavioral science has shown that people do what they are instructed to do. Hedge fund traders are routinely instructed by their managers and investors to focus on maximizing portfolio returns. Conversely, instructions to conform to federal insider trading laws are given only in passing, if at all. Thus it should come as no surprise that not all hedge fund traders put obeying federal securities laws at the top of their to-do lists.
Signal 2: Other Traders Aren't Acting Ethically. Behavioral experiments also routinely find that people are most likely to "follow their conscience" when they think others are also acting prosocially. Yet in the hedge fund environment, traders are far more likely to brag about their superior results than their willingness to sacrifice those results to preserve their ethics. Indeed, some may even brag about their ability to profit from breaking the law. The result is a moral race to the bottom in which traders conclude it's okay to trade on illegally-obtained nonpublic information because everyone else is doing it, too.
Signal 3: Unethical Behavior Isn't Harmful. Finally, experiments show that people behave act less selfishly when they understand how their selfishness harms others. This poses special problems for enforcing laws against insider trading, which is often perceived as a "victimless" crime that may even contribute to social welfare by producing more accurate market prices. Of course, insider trading isn't really victimless: for every trader who reaps a gain using insider information, some investor on the other side of the trade must lose. But because the losing investor is distant and anonymous, hedge fund managers can convince themselves their insider trading isn't really doing harm.
Using Behavioral Science to Discourage Hedge Fund Insider Trading
Recognizing that hedge funds present social environments that encourage unethical behavior allows us to identify new and better ways to address the perennial problem of insider trading. For example, because traders listen to instructions from their managers and investors, insider trading would be less of a problem if those managers and investors could be given greater incentive to urge their own traders to comply with the law, perhaps by holding the managers and investors — not just the individual traders — accountable for insider trading. Similarly, because traders mimic the behavior of other traders, devoting the enforcement resources necessary to discover and remove any "bad apples" before they spoil the rest of the barrel is essential; if the current round of investigations leads to convictions, it is likely to have a substantial impact on trader behavior, at least for a while. Finally, insider trading will be easier to deter if we combat the common but mistaken perception that it is a "victimless" crime.
As the example of hedge fund insider trading shows, a solid understanding of the social cues that drive prosocial behavior is vitally important to understanding why and when people choose to ignore legal and ethical rules. In the quest for a law-abiding society, we should pay attention not only to incentives but to conscience and the tools that can encourage it — the cheapest and most effective police force one could hope for.
Lynn Stout is the Paul Hastings Professor of Corporate and Securities Law at the UCLA School of Law. She is the author of Cultivating Conscience: How Good Laws Make Good People. via : Harvard Business Review
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