It's not the typical heard-it-from-a-friend-at-the-company stuff, either. In the last decade hedge funds have ventured into the deepest reaches of finance. They've gone from trading stocks and bonds to making loans, participating in private placements, sitting on bankruptcy committees, and agitating for positions on corporate boards. In the process they've obtained all sorts of nonpublic information -- and regulators are worried that many have been mismanaging it at best and illegally profiting from it at worst.
The SEC, NASD, and Financial Services Authority in London have launched a flurry of probes. So far the inquiries have resulted in only a handful of insider-trading charges against hedge fund managers. But regulators expect the improper handling of insider information to be a big focus of enforcement actions in 2006. "Hedge fund assets have grown significantly, and there is a lot more competition for returns," says Scott W. Friestad, an associate director at the SEC's Enforcement Div. "In this situation people sometimes cut corners. We are devoting substantial resources to these investigations." Steve Luparello, an executive vice-president for market regulation at NASD, agrees. "Hedge funds misusing nonpublic information is a growing issue," he says.
Perhaps the easiest avenue of abuse: private placements, or restricted shares of public companies that are sold directly to investors. Regulators are cracking down on funds that participate in private placements and then take advantage of the information they glean. The biggest case thus far has been that of Hillary L. Shane, the manager of hedge fund FNY Millennium Partners LP. The NASD and SEC charged her in May with fraud and insider trading for allegedly agreeing to buy unregistered shares as part of a private placement in Maryland security systems outfit CompuDyne Corp. (CDCY
) and then short-selling the registered stock, betting that it would fall in value.
Investment bank Friedman, Billings, Ramsey Group Inc. (FBR
) invited Shane to participate in the placement on the condition that she treat the information as confidential. Shane has paid a $1.45 million fine to settle charges brought by the SEC and the NASD. She never admitted or denied wrongdoing. Shane's lawyer declined to comment.TIP OF THE ICEBERG
There's likely to be much more fallout from the CompuDyne case. NASD says it's still investigating individuals and entities. Regulators haven't accepted FBR's offer to pay $7.5 million to settle charges that it aided the hedge fund manager. FBR declined to comment.
Meanwhile, an investigation into Van D. Greenfield, the 60-year-old principal of New York-based broker-dealer Blue River Capital LLC, has brought the issue of mishandling of nonpublic information obtained from bankrupt companies' creditor committees to the forefront. In November, Greenfield paid the SEC $150,000 to settle charges that he failed to guard sufficiently against the potential for misuse of insider information he obtained while serving on the bankruptcy committees of WorldCom, Adelphia Communications, and Globalstar Telecommunications.
Greenfield had agreed to keep all information confidential and informed his employees that he couldn't trade in the securities of those issuers. But the Chinese wall separating him from his traders was porous. Greenfield frequently walked through his firm's trading room -- which consisted of four desks on the ground floor of his New York City townhouse -- and asked employees for stock quotes for Adelphia and WorldCom securities, according to the SEC complaint. Greenfield did not admit or deny the charges. And "there was no finding of any misuse of material nonpublic information," says Greenfield's attorney, Arthur S. Linker of Katten Muchin Rosenman LLP. "There was no finding of insider trading."
Nevertheless, the settlement has spurred other industry veterans to lodge complaints of possible insider trading by hedge funds and other creditor committee members. "We have heard that there's more insider trading and misrepresentation to get on creditors' committees than had been reported to us," says Alistaire Bambach, chief bankruptcy counsel in the SEC's Enforcement Div. "We are very concerned about these activities."
In London, the Financial Services Authority is investigating abuse of confidential borrower information. The case everyone is talking about: a probe into whether a trader at GLG Partners LP, a London hedge fund, improperly used information provided by Goldman, Sachs & Co. (GS
) in advance of a security offering by Sumitomo Mitsui Financial Group Inc. in 2003. "The FSA is concerned about any instances where parties who are made insiders then use that information to trade in related securities," says spokesman David Cliffe. The crackdown is just beginning. By Emily Thornton, with Amy Borrus in Washington and Stanley Reed in London