By Anne Urda

Seeking to combat the image of laxness currently associated with hedge fund regulation, the U.S. Securities & Exchange Commission has decided to establish a special unit within its enforcement division to crack down on the growing problem of insider trading in the hedge fund industry.

On Tuesday, SEC Chairman Christopher Cox revealed the unit's creation while giving testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs on the agency's recent work and plans for the future.

“In the past few years, the Commission has brought numerous enforcement actions alleging that hedge fund portfolio managers engaged in insider trading,” said Chairman Cox. “We have created a hedge fund working group within our Enforcement Division to, among other things, coordinate and enhance our efforts to combat hedge fund insider trading, including by working with other federal law enforcement agencies and self-regulatory organizations.”

The SEC's move comes in the wake of increasing uneasiness about the trillion-dollar hedge fund industry, with critics pointing to the recent implosion of two Bear Stearns hedge funds as a prime example of the inherent danger.

Late Tuesday, the pair of Cayman Islands-based hedge funds filed for bankruptcy protection after running into trouble over risky investments connected to subprime mortgage loans.

At yesterday's hearing, Cox faced tough questions from senators regarding the SEC's plans for regulating complex mortgage securities and the hedge funds, like the ones from Bear Stearns, that invest in them.

The recent turmoil on Wall Street has been blamed in part on fears that trouble in the subprime mortgage market could spread. Last week was the worst in nearly five years for the Dow Jones Industrial Average.

Quizzed over a lack of transparency in hedge fund procedures, which typically do not come under government regulation, Cox said he thought the agency was “increasingly getting a clearer picture of what's going on,” according to testimony.

But despite widespread concern, the hedge fund industry has proved to be a slippery subject for enforcement in the past, with regulators often skittish to become too involved in the field.

In February, a presidential panel issued a series of self-policing guidelines for the $1.2 trillion hedge fund industry, arguing that the industry would be better at protecting investors than the government.

The President’s Working Group on Financial Markets said a “principles-based approach” would best address the issues surrounding a fast-growth industry that uses unusual investment strategies to help its investors win, and sometimes lose, vast amounts of money.

Unlike mutual funds, pension funds and insurance companies, hedge funds are not currently subject to any direct regulation by the SEC or the NASD. The number of hedge funds has increased to 9,000, growing 10% in 2006 alone.

The funds came under heightened scrutiny after Long-Term Capital Management, a hedge fund founded by John Meriwether, lost $4.6 billion in less than four months in 1998. It folded in 2000.

The fall of Amaranth Advisors LLC, a Connecticut-based hedge fund, prompted the report. Amaranth lost $6.6 billion in a single week on natural gas futures. Its September 2006 collapse was the largest in history.

However, the panel, led by Treasury Secretary Henry Paulson and members of the U.S. Federal Reserve, the SEC and the Commodity Futures Trading Commission, said that government regulation would do more harm than good.

“Those who would believe that the role of regulators is to guard against any losses or somehow prevent losses or to prevent a hedge fund from having problems, they have a different philosophy about regulation than I do,” Paulson said.

According to the panel’s guidelines, hedge funds should enhance the amount of timely information provided to investors; investors should consider the suitability of their investments; creditors should set aside reserves in case of big losses; and regulators should work together to maintain market integrity.

“These guidelines should serve as a foundation to enhance vigilance and market discipline further, which will strengthen investor protection and guard against systemic risk,” Paulson said.

But some have complained that the guidelines do little to address the problems in the hedge fund industry. Connecticut Attorney General Robert Blumenthal argued that the guidelines “will do virtually nothing to make them more transparent.”

“These vague recommendations lack substance and specifics, making them unenforceable. In a perfect world, everyone would already follow these guidelines—but in the real world we need real protections.”

He threatened that “federal inaction and inertia will invite—indeed, fuel—state initiatives.”

 But Scott A. Meyers, chair of the litigation practice group at Levenfeld Pearlstein LLC, believes that the SEC may have heeded the message, suggesting that the special unit's creation signals a new willingness to crack down on the hedge funds.

 “The SEC does not marshal its troops unless it actually intends to go to war,” said Meyers. “The hedge fund unit is at the intersection of three of the Commission's top priorities: prosecuting insider trading; protecting the elderly; and regulating hedge funds.”

 Meyers contends that Cox has chosen to throw his weight behind a “safe and appealing” area of regulation, one that individuals on either side of the political spectrum can support.

The new initiative may also help the SEC to gain back some of the credibility the agency lost after an unsuccessful public campaign to force hedge fund managers to register as investment advisers, according to Meyers.

“The SEC can now seek to reclaim its initiative in this area by focusing on hedge fund fraud,” he said. “Given this perfect storm of regulatory interest, it is not surprising that the SEC has created a hedge fund insider trading unit and I expect that it will be very busy.”