Madoff Investors vs Rajaratnam Investors

A NYTimes op-ed raises an interesting question: When we sue Madoff investors who were "net winners" to recover their ill-gotten gains, why don't Rajaratnam's Galleon investors face consequences of a similar nature--why are they allowed to keep their ill-gotten gains?  From the op-ed:

Why is this so? More to the point, why is it right?

One reason is that, unlike Rajaratnam, Madoff only pretended to be running a hedge fund; like all Ponzi schemers, he used money coming in from new investors to pay other investors. That’s why the law justifies clawing it back: Picard is essentially trying to return stolen money to the “net losers.”

Yet isn’t insider trading also a form of stealing? After all, Rajaratnam was convicted of stealing information that gave him an unfair advantage over other investors. The gains he made from those unfair trades robbed the people who, lacking the information he had obtained, sold the shares that Galleon bought. In insider-trading cases, prosecutors try to find those people so that appropriate restitution can be made. But only Rajaratnam will have to make that restitution. His investors get to keep the profits that resulted from his illegal trades.

There is a second issue. In the Madoff case, Picard has been particularly punitive toward investors who “knew or should have known” that Madoff was crooked; that is, people who, in the trustee’s view, ignored red flags that should have alerted them to Madoff’s wrongdoing. The most prominent people in this category are Fred Wilpon and Saul Katz, the owners of the New York Mets, whom the trustee has sued to claw back a cool $1 billion — despite their insistence that they had no clue.

But there were plenty of red flags around Rajaratnam, too. Hedge fund managers will tell you that there were always rumors about insider trading at Galleon. Indeed, it was at the heart of Rajaratnam’s business model.

The author goes on to conclude that investors who profit from investing in a fund that engages in insider trading should have to pay some price as well.  While I admit that this is the first time I have thought about this issue, I find myself agreeing with the op-ed.  On a broader note, investors who profit from the illicit activities of their fund managers should not be able to retain those profits.  Consistency in this regard leads to greater personal responsibility in investment decisions, which in turn increases demand for higher quality assurance.  On the whole, this will generally lead to better functioning markets and lower levels of fraud--something that I think we all want.

In writing this post, I am anticipating at least one comment from someone sympathetic to Madoff investors who will say, "yeah, this is a problem--Madoff investors should be able to keep the money they received from their investment with Madoff; moreover, they should be compensated based on their statement balances."  I don't want to spend too much time discussing what is likely an uncommon stance, but I suppose my response to such a statement would be, "in that case, who foots the bill--who makes you whole?"  Once we go down that path, we end up with either the latecomers to the scheme, the "net losers," paying the largest price, or we end up with the taxpayer footing the bill, or both.  I'm not ready to support laws that trivialize personal responsibility in making investment decisions.