A lesson from the Galleon scandal

(breakingviews.com) -- Galleon may have been holed below the waterline. The indictment of Raj Rajaratnam, the technology-focused hedge fund firm's founder, on insider trading charges is likely to scare investors away. Amid the shock and the intriguing details of the allegations, there's a broader lesson for investors about hedge fund governance.

Rajaratnam is alleged to have made more than $20 million for his funds by using inside information -- from tipsters at places ranging from chip maker Intel (INTC, Fortune 500) to rating agency Moody's (MCO) and consultancy McKinsey.

If he is guilty, it's hard to see why he bothered. The winnings were a drop in the ocean compared to Galleon's $3.7 billion under management and its Sri Lankan founder's $1.3 billion personal wealth, as calculated by Forbes.

Galleon said it was "shocked" and hadn't even known about the investigation. That's alarming. If the boss did the things he's accused of and the compliance staff didn't check, didn't spot them or didn't have the clout to follow up, it sounds like the firm's controls were inadequate.

The prominent figurehead of the fund firm now faces a barrage of potentially ruinous allegations, although he will be free on $100 million bail. With such a close association between founder and firm, and questions over the solidity of internal processes, it's hard to see how most investors can justify anything other than taking their money out of Galleon as soon as possible.

That would be a blow to Galleon's unsuspecting staff. It might cost the investors some money, too. Although the group said its assets were "highly liquid", rival hedge funds and traders could try to try to profit from any scramble at Galleon to liquidate positions.

All hedge fund investors should learn from the Galleon example: take a hard look beneath the performance and portfolio composition. Weaknesses in the infrastructure -- internal checks and balances, outside verification, depth of leadership and investors' rights -- can sink a fund group. Many managers could do a better job. Investors should insist they do.