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SEC Plans Database to Stem Illegal Hedge-Fund Trading

Date: Tuesday, December 5, 2006
Author: Jesse Westbrook and David Scheer, Bloomberg.com

(Bloomberg) -- The U.S. Securities and Exchange Commission plans to have a database in place by next year that will help it crack down on hedge-fund insider trading, a senior agency official said.

``The SEC presently does not have an electronic system to aggregate referrals based on the identities of the specific traders involved,'' SEC Enforcement Director Linda Thomsen said before the Senate Judiciary Committee today. ``We anticipate implementing a new case tracking system by mid-2007.''

Illegal trading by hedge funds ``remains a substantial concern'' to the SEC as the $1.3 trillion industry's influence over financial markets grows, Thomsen said. Hedge funds, which are loosely regulated private pools of capital, manage about 5 percent of U.S. assets and account for about 30 percent of U.S. equity trading volume.

Today's hearing is the third convened by Senator Arlen Specter, the Judiciary Committee's chairman, in six months to examine oversight of insider trading. The Pennsylvania Republican circulated draft legislation aimed at halting illegal buying and selling of stocks that would require hedge funds accepting money from pension funds to submit to random inspections by the SEC.

His measure would also force hedge funds to set up ethics codes and compliance programs and allow the Justice Department to give private citizens rewards for helping in prosecutions of insider trading cases.

``Light regulation, secrecy, unregulated recordkeeping and limited compliance programs of hedge funds increase the difficulty of detecting and proving insider trading,'' according to Specter's legislation, which hasn't been introduced.

NYSE Effort

The New York Stock Exchange and the NASD, which refer data about suspicious buying and selling to the SEC, are coordinating efforts to share information about hedge funds, Robert Marchman, head of market surveillance for the NYSE, said in an interview.

The agencies plan to build a database with information detailing relationships between hedge funds and other ``financial business-related entities'' in an effort to uncover illegal trading, he said.

Lawsuits involving hedge funds made up 11 percent of the SEC's insider trading cases in fiscal 2006, according to agency figures. The SEC expects to file more cases against the industry alleging illegal trading in 2007, Thomsen has said.

`Increasing Pressure'

``The increasing role played by hedge funds and the expectation of consistent, market-beating returns could lead to increasing pressure on fund managers to deliver by any means, such as riskier investments, or worse, illegal trading on inside information,'' Senate Finance Committee Chairman Charles Grassley said at the hearing.

Specter's legislation would restore elements of SEC rules struck down by a federal appeals court in June that required hedge-fund advisers to register with the agency.

Lawmakers became concerned that the lack of hedge-fund oversight could put retiree money at risk after pension funds were stung by the collapse of Amaranth Advisers LLC. The Greenwich, Connecticut-based hedge fund lost $6.5 billion in September on bad natural gas trades.

Regulators should double the amount of net worth required to invest in hedge funds to $2 million to protect unsophisticated investors, Connecticut Governor Richard Blumenthal told the judiciary panel today. Currently, individuals can also invest in hedge funds if they had income of $200,000 for each of the past two years, a requirement that should be raised to $500,000, he suggested.

``A small investor in my view would be anyone who can't afford to lose the amount invested,'' Blumenthal said. ``Raising the net worth or income levels for participation in hedge funds is one of the single most important steps that this committee or the SEC could take to raise the bar.''

The SEC will consider proposing at a Dec. 13 public meeting that the amount of wealth needed to invest in hedge funds be increased. The agency hasn't specified how it might limit the pool of hedge-fund investors.

To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net ; David Scheer in Washington at dscheer@bloomberg.net .