Hedge Funds Track Traders as Probe Puts ‘Fear’ in Firms


Saijel Kishan

Apr 7, 2011

The U.S. government isn’t the only one investigating insider trading on Wall Street. Hedge funds have joined the hunt.

Some are engaging people like Jeremy Kroll, co-founder of K2 Global Consulting LLC, a New York-based investigations firm. Kroll has created software that scrutinizes the personal, social and business relationships of traders and analysts to help detect and thwart possible misuse of confidential information. At least five multibillion-dollar hedge funds have signed on, said Kroll, who declined to name them.

“Having someone constantly watching over your shoulder sounds intense, but hedge funds are going to have to take the Big Brother approach or risk facing possible closure,” said Matt Simon, a senior analyst at Tabb Group, a financial-services consulting company in New York.

In addition to monitoring traders’ personal lives, hedge funds are holding workshops on securities law as they seek to avoid the fate of five funds that have liquidated since the October 2009 arrest of Raj Rajaratnam, the fund manager on trial in New York for insider trading.

Federal authorities raided four hedge funds in November as part of their investigation and subpoenaed at least five others. In all, investors have withdrawn at least $9 billion from funds involved in the probe. The FBI said in February that the investigation isn’t over and that there will be more arrests.

‘Nervous Compliance Officers’

“I’m seeing a lot more nervous chief compliance officers these days,” said Judith Gross, founder of JG Advisory Services LLC, a New York-based firm that advises hedge funds. “Much more attention is being paid to the origins of trading ideas.”

In January, the Regulatory Compliance Association hosted a seminar on insider trading that drew 3,800 people, said Walter Zebrowski, chairman of the New York-based non-profit group. That’s more than triple the number who registered for an event on general enforcement issues in 2009, he said.

A conference organized by the association that included a two-hour session on insider-trading today drew 350 registrants, including representatives from New York hedge funds D.E. Shaw & Co., Harbinger Capital Partners LLC and Fortress Investment Group LLC.

York Capital Management in New York held training sessions in September with its employees on the use of potential inside information given by so-called expert-network firms, which connect industry officials with investors, Mark Schein, chief compliance officer at the hedge fund, said today at the conference.

‘Hedge Funds Petrified’

Six months after Rajaratnam’s arrest, New York-based Millennium Management LLC formed an independent Regulatory and Compliance Advisory Council, which included Harvey Pitt, the former chairman of the U.S. Securities and Exchange Commission, according to an April 2010 letter sent to investors. Pitt also has held workshops with SAC Capital Advisors LP employees about complying with government rules.

“A lot of hedge funds were petrified after the raids,” said Don Steinbrugge, managing partner of Agecroft Partners LLC, a Richmond, Virginia-based firm that advises hedge funds and investors. “The government has tried to put the fear of god in hedge funds and succeeded.”

K2 Global’s technology maps a spectrum of relationships such as college classmates, tennis partners and fellow charity board members to help identify potential connections that may pose a risk to the firm, Kroll said.

‘360-Degree Perspective’

It also examines trade, telephone, e-mail and instant- messaging patterns, as well as electronic calendar entries, and matches those with information from court filings and news reports, Kroll said.

”It’s basically taking a 360-degree perspective,” Kroll said in a telephone interview. “We go beyond relationships found on Facebook and LinkedIn. We look at who they know, how and where they know them from and match that with any anomalous trades.”

The software doesn’t monitor home telephones and personal e-mail accounts.

K2 Global turns its findings over to the hedge fund’s compliance officers and in-house lawyers, who decide what action to take, he said, adding that they don’t share the information with the government. Kroll said that not all firms notify their employees of the surveillance.

‘Culture of Distrust’

Kroll, whose father, Jules, gained fame for searching out hidden assets of Ferdinand and Imelda Marcos and Saddam Hussein in the 1990s, said his team came up with the software idea in November, after the FBI raided four hedge funds. He said mutual funds and sovereign wealth funds have also signed up for the service.

Some industry consultants questioned the effectiveness of such monitoring, saying it was more likely to create distrust than catch scofflaws.

“I don’t see a mass market for this,” said Finn Christensen, chief executive officer of Risk Insider Inc., a New York-based firm that advises financial companies on trading and risk management. “The concept may have some merit but it will create a culture of distrust and that’s not good for the firm.”

‘Government Crosshairs’

The case against Rajaratnam, 53, who ran New York-based Galleon Group LLC, is the first in which the government has wiretapped telephone conversations to investigate and prosecute insider trading.

The Sri Lankan-born hedge fund manager is accused of making $45 million from tips leaked by corporate insiders. He denies wrongdoing, saying his trades were based on research and public information. Rajaratnam could spend up to 20 years in prison if convicted of fraud.

The SEC last year set up a unit focused on “identifying patterns, connections and relationships among traders and institutions” linked to suspicious trades, Daniel Hawke, chief of the agency’s market abuse unit, said when the group was founded in January 2010.

Their market surveillance helped uncover an insider-trading scheme involving Matthew Kluger, a former Wilson Sonsini Goodrich & Rosati PC attorney, who was arrested yesterday for passing on mergers and acquisition data to stock trader Garrett Bauer. Their scheme netted more than $32 million in illicit profits, according to U.S. prosecutors.

“Hedge funds have woken up to government efforts and have stepped up their training on how to deal with possible inside information,” said Elizabeth Krentzman, chief adviser to Deloitte LP’s asset-management unit, which advises 1,000 hedge fund clients said. “Investor trust is their most important asset and so it hasn’t been easy for them to be in the government crosshairs.”

Employee Hotline

Three of the four hedge funds raided by the Federal Bureau of Investigation in November — Level Global Investors LP and Barai Capital Management LP of New York, and Loch Capital Management LLC in Boston — have liquidated. Rajaratnam’s Galleon closed in 2009, as did New Castle Funds LLC.

Diamondback Capital Management LLC’s investors pulled about $1.32 billion, or 23 percent, from the Stamford, Connecticut- based firm following the raid. Balyasny Asset Management LP in Chicago, SAC Capital in Stamford, and JAT Capital Management LP in New York were among the funds subpoenaed, according to people familiar with the matter. None of the firms have been accused of wrongdoing.

Corporate Resolutions Inc., a consulting and investigative firm in New York, last month started an employee hotline to help hedge funds deter possible illegal trading. The service, which is already offered to private-equity firms, enables employees to anonymously report suspected wrongdoing at their firms.

$2,000 a Year

As many as 50 private-equity clients had signed up for the service, which costs about $2,000 a year, depending on the number of employees, according to Joelle Scott, director of business intelligence at the investigations firm.

The hotline enabled one of Corporate Resolution’s private- equity clients to identify fraud at one of their portfolio companies and subsequently fire the management there, said Scott, who declined to name the firm.

“The hotline saved our client money and gave their investors comfort,” she said. “It can help hedge funds to take action before they get a surprise visit from the government.”