SEC Scrutinizes Hedge Funds in Insider-Trading Probe

Date: Tuesday, September 18, 2007
Author: esse Westbrook and Jenny Strasburg, Bloomberg

Sept. 18 (Bloomberg) -- The U.S. Securities and Exchange Commission is examining hedge funds for signs of insider trading, demanding information about relationships between managers, employees, family members and public companies.

SEC officials told hedge funds to list clients and workers who serve as officers or directors of publicly traded companies, along with the names of any relatives who hold such posts, according to a 27-page letter to industry executives obtained by Bloomberg News. The SEC confirmed its authenticity.

``The SEC is really drilling down, trying to get very specific information that might give them leads on insider trading,'' said Nora Jordan, a lawyer at New York-based Davis Polk & Wardwell who represents hedge funds in SEC examinations. ``Some of the information that they have asked for has never been asked for before, and many clients are not keeping it.''

Unusually high trading in shares and options before takeover announcements by companies including TXU Corp. and Dow Jones & Co. has intensified scrutiny of how market-moving information spreads among hedge funds, investment banks and leveraged buyout firms. The SEC's office of compliance and inspections referred 223 cases of potential securities violations to the agency's enforcement division during the latest fiscal year.

The SEC's New York office started using the new examination letter, which is more extensive than previous versions, after lawmakers including U.S. Senator Charles Grassley questioned the agency's record in detecting illegal trading.

Fund Inspections

In addition to information about officers and directors, the SEC wants the identities of any relatives who work at brokerage firms, as well as a detailed description of any ``deal'' that a fund manager ``was asked to consider'' and turned down ``because the proposal was deemed inadvisable, inappropriate, unethical, or possibly illegal.'' The letter asks for e-mails and contact information for all involved.

The SEC's questions focus on ``risks for potential insider trading,'' said Mark Schonfeld, who oversees the agency's New York office. ``Investment advisers are required to have controls in place to prevent the misuse of non-public information, and to enforce those controls.''

He declined to say which funds received the letter.

Hedge funds are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether the price of assets will rise or fall. They accept investments from wealthy individuals and institutions such as pension funds.

2,400 Reviews

The SEC can inspect hedge funds and demand detailed information about their investments and clients when the manager is a registered investment adviser. About 1,980 hedge fund advisers have voluntarily signed up with the SEC, down 21 percent from June 2006. That's when the U.S. Court of Appeals in Washington rejected the regulator's attempts to require registration.

Phillip Goldstein, the money manager who successfully sued the SEC to block the adviser-registration rule, said the range of questions in the agency's latest letter is ``stunning.''

``Registration is even worse than I thought,'' said Goldstein, founder and principal of Saddle Brook, New Jersey- based Bulldog Investors.

Hedge-fund managers receive SEC questionnaires tailored to their risk profiles, said Thomas Biolsi, an associate director for examinations in the agency's New York office. SEC inspectors conducted about 2,400 reviews of investment advisers and brokers during the fiscal year ended September 2006, according to the agency's annual report.

`Misuse of Information'

``We know hedge funds are trading very heavily,'' said Harvey Goldschmid, who served as an SEC commissioner until 2005. ``When you want to find out whether there is misuse of information and the magnitude of the misuse, you ask these kinds of questions.''

Earlier this year the SEC's enforcement division appointed Bruce Karpati, an assistant regional director in the agency's New York office, to oversee a hedge-fund working group to hone methods for investigating misconduct.

The SEC accused hedge-fund managers and former employees at Morgan Stanley, UBS AG and Bear Stearns Cos. in March of participating in a network that leaked details about corporate takeovers.

A month earlier, the SEC asked at least 10 Wall Street firms to hand over stock-trading records for the last two weeks of September 2006, seeking to determine whether they leaked details about stock trades to favored clients such as hedge funds.

Both probes are ongoing.

To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net ; Jenny Strasburg in New York at jstrasburg@bloomberg.net .