By Ron Orol

In June 2006, then-Senate Judiciary Committee Chairman Arlen Specter lashed out at the Securities and Exchange Commission, hoping to press staffers into getting serious about what he perceived to be a growing problem: hedge fund managers committing insider-trading fraud.

The Pennsylvania Republican had called a hearing after charges of bungling by the SEC of a major insider-trading investigation involving a large hedge fund, Pequot Capital Management Inc., and a prominent, politically influential Wall Street executive, John Mack. "Hedge funds are too big and too powerful, too much an area for abuse, not to have some oversight," he told those present.

After poring through 10,000 pages of e-mails, transcripts and other exchanges between employees of companies and hedge funds, legislative aides for the Judiciary Committee joined with former Senate Finance Committee chairman Chuck Grassley, R-Iowa, in August 2006, to send SEC Commissioner Christopher Cox a variety of recommendations on how the commission should go about investigating insider-trading cases. To Specter and other lawmakers, the SEC investigation still has no resolution, and the agency still isn't doing enough to deal with insider trading by hedge funds.

In response to the pressure, Cox has promoted his own strategies for identifying and prosecuting hedge fund inside traders. He established a task force within the agency's enforcement bureau to focus on the issue. Cox told lawmakers on July 31 that he created the squad to improve communications between SEC officials and other law enforcement agencies charged with finding such types of fraud. Agency staffers have said that insider-trading investigations and lawsuits involving hedge funds are on the rise.

That hasn't appeased Specter and Grassley, and continuing public skirmishes between Congress and the SEC has continued over how the commission should go about identifying and prosecuting insider trading. Each side argues that it has a greater understanding of how to go about tackling problems with the $2 trillion hedge fund industry. "Congress is pressing the SEC to focus more on its priorities, while Cox is saying the SEC is an independent agency and should be left alone," says Scott Meyers, chair of the litigation practice at Levenfeld Pearlstein LLC in Chicago.

The SEC faces many challenges on this issue. Insider trading has always been a tricky legal issue. In fact, says William Natbony, a partner at Katten Muchin Rosenman LLP in New York, in some jurisdictions in Asia and Europe, insider trading isn't even a crime. "The growth of global managers trading in the U.S. and U.S. managers trading globally has led to a greater number of insider-trading cases," Natbony says. "I have international clients that are aghast when they hear about U.S. insider-trading rules."

Other litigators point out that because of increasing layers of complexity in financial transactions and hedge fund strategies, government officials have trouble even detecting when insider trading exists. Jonathan Sablone, partner at Nixon Peabody LLP in Boston, says that problem has worsened over the past year and a half. "The SEC is having a hard time with hedge fund insider trading, and that has everything to do with the fact that they are behind the curve in figuring out how the industry works," Sablone says. "Insider trading by a hedge fund can be much harder to detect than insider trading by an individual."

One example, says Nixon Peabody partner Timothy Mungovan, is that traders are exploiting a lack of transparency in the credit derivatives market to conceal their trading on inside information. He says that many hedge fund managers trade on inside knowledge about the creditworthiness of credit default swaps, a type of derivative that hedges against credit risk. This strategy works typically when managers have, for example, advanced knowledge of a private equity buyout. "Someone with insider information about whether a company is going to go private can take that information and make a credit default swap trade that is extremely difficult to track," Mungovan says. "Credit default swaps are traded in largely unregulated markets."

The increase in SEC investigations into alleged hedge fund insider trading is connected in part to the rise of activist investors buying large minority stakes at companies and agitating for changes to improve the share value of target corporations.

"As hedge funds start playing a more active role in the management of companies, they are accumulating a great deal of information that their hedge fund predecessors may not have had access to," says Vikas Agarwal, assistant professor of finance at Georgia State University's J. Mack Robinson College of Business. "While pressing for a sale, they may gain nonpublic information about a soon-to-be-released announcement of a completed auction."

There is also the recent rise of the hedge fund as financier, which brings new informaton streams and potential conflicts. When funds lend money to companies, they gain access to information that could include confidential details about a planned merger or other market-moving news. They are then in a position to trade that information with investment bankers or other funds in exchange for favors — much less obvious than directly trading on the information itself.

SEC regulators argue that they are on top of the hedge fund schemes. In fact, the New York SEC office first set up an insider-trading working group in January 2006, before Specter began expressing concerns. Sensing that hedge fund insider trading may be on the rise, Mark Schonfeld, the New York unit's regional director, initiated a focus group on the issue to encourage sharing of information among New York SEC enforcement officials. A year later and under pressure from Specter, the agency decided to bring the concept to SEC headquarters in Washington.

Walter Ricciardi, deputy director of enforcement at the SEC, helps oversee the national group, which he says enables key commission staffers to learn about and communicate the latest trends and schemes in hedge fund insider trading. Before the group's formation, agency personnel investigating a possible scheme worked in isolation and learned very little, if anything, about ongoing investigations undertaken by their peers, he says. No individuals have been hired for the group, but SEC officials participate on an ad hoc basis. "Traditionally, the SEC worked in silos," Ricciardi says. "This group enables our staff to look across cases and helps us identify and punish those engaging in insider trading."

So far, SEC staffers have participated in a number of internal educational events, where different agents have presented their own approaches to identifying insider trades. One event in July was attended by roughly 200 SEC officials. Another featured staffers exchanging new tactics for sorting through phone records and trading data — all critical for tracking and identifying key relationships among fund managers, investment bankers, analysts and corporate executives, Ricciardi says. "If there is a more efficient way, it is shared with the group," he says. "We get presentations on how to go about investigations, and various members of our personnel make recommendations about how to go about these investigations."

Therese Pritchard, partner at Bryan Cave LLP in Washington and former attorney in the SEC's Enforcement Division, points out that there has always been an official in Washington coordinating investigations around the country. But she added that this new attempt at sharing information is a positive move that will help agency staffers, particularly less experienced ones, figure out how to identify recurring schemes.

Cox's SEC also launched and settled a number of hedge fund insider trading cases, some of which took place after Specter and Grassley's public criticism began. Cox has repeatedly trumpeted a case the SEC set in motion on March 14 against defendants involved in two schemes that netted them $15 million. The first complaint alleges that eight securities industry professionals, three hedge funds, two broker-dealers and a day-trading firm made thousands of illegal trades and millions of dollars in illicit profits using inside information misappropriated by a UBS executive to trade ahead of UBS analyst recommendations. The second scheme involved trading ahead of yet-to-be announced megadeals.

The SEC also increased the number of insider trading investigations and suits involving hedge funds and or private investments in public equities, or PIPEs. With PIPEs, a hedge fund manager with inside information can short the stock of the company that will receive the private investment because of its expected immediate dilution and drop in share price once that transaction is consummated. In 2006, the agency launched PIPE-­related insider trading cases against a number of hedge funds, including Gryphon Partners LP, SG Cowen & Co., now Cowen and Co. LLC, Langley Partners LP and Spinner Asset Management LLC. According to Pritchard, the agency has stepped up its enforcement of PIPEs over the past three years.

One SEC official points out, only half-jokingly, that the agency may have some time to catch its breath on insider trading if a credit crunch casts a pall over the deal landscape, offering fewer mergers for hedge fund managers to make illicit gains from early trades.

Meanwhile, the political back-and-forth will continue. Grassley and Specter have used their hearings and the release of first an interim and later a final report raising questions about Mack, now the CEO of Morgan Stanley but at the time of the alleged incident poised to run Credit Suisse First Boston. Included with the criticism of how the SEC handled the Mack and Pequot probe, was a series of recommendations aimed at Cox. They included the creation of a procedures manual for conducting enforcement investigations and allocating additional resources to its enforcement division.

Drafters of the report also expressed concern that there was not enough documentation of communications among key SEC supervisors, agency staff and outside individuals under investigation. It suggested that the agency hike its documentation efforts and discourage supervisors from engaging in communications with subjects of inquiries without the knowledge of the lead SEC staff attorney assigned to the matter — apparently a problem in the Mack case.

Cox says he will review the recommendations. It's unclear, so far, whether the agency will actually implement any of them.

In the end, it may be that SEC staffers need to figure out a way to adapt more quickly to changing insider-trading tactics. Yesterday's managers may have been involved in PIPE schemes; the more current trend may be more complex instruments like credit default swaps.

After all, hedge funds aren't stupid. As Bryan Cave's Pritchard says, hedge fund managers are already heeding the SEC's message on PIPEs. "Trading in advance of PIPE deals has stopped," he says.