Hedge fund managers step up internal regulation

US authorities, say hedge fund managers, are seeking to bring high-profile targets to book with the same hard-line tactics used to target Wall Street rule-breakers such as the arbitrageur Ivan Boesky or the so-called junk bond king Michael Milkin in the 1980s.

In the wake of the arrest of Raj Rajaratnam, the founder of the Galleon Group, few hedge fund managers have missed the message.

For many, the difficulty will be in stepping up their own internal checks on the activities of their funds and their traders – or at least, showing their investors they have done so.

What used to be seen as minor trading floor indiscretions have the chance to be prosecuted as significant crimes.

“We’re certainly in a technological era where communications designed to perpetrate a fraud on the market are susceptible to being intercepted and becoming the basis for a prosecution,” according to Jacob Frenkel, a partner at law firm Shulman Rogers and a former SEC enforcement lawyer and federal prosecutor.

Managers are worried about the implications of US authorities’ new-found zeal, and the chances of further future high-profile prosecutions of a similar nature that could be hugely damaging to an industry that is only just finding its feet again.

“I’d say that 60 per cent of the charges are for the kind of stuff you see people doing all the time. Swapping rumours and trading on them is how the whole system works,” said one portfolio manager at a London-based hedge fund.

“It’s always the hedge funds that get targeted though because we’re perceived as being fair game.”

Compliance has, however, been at the forefront of many hedge fund managers’ minds since the Madoff scandal last year. Investors, in particular, are keen to see robust internal control procedures at the funds they invest in.

Funds need to demonstrate both an ability to control their staff and show that they can survive even if top traders or managers depart or are implicated in regulatory issues.

“Obviously in the wake of this we have to be careful. But most big funds have been for some time now,” according to one risk officer at a large European hedge fund.

“The biggest funds already have the kind of regulatory and legal compliance procedures you’d expect at a bank.”

Investors are, however, now sensitive to the slightest suggestion of impropriety. A study by academics at the Stern School of Business at the University of New York concluded earlier this month that rule-bending by fund managers was a leading indicator of fund collapses.

For others, though, the question remains as to why Mr Rajaratnam apparently transgressed market abuse rules in so minor a fashion.

“The one thing that never ceases to amaze me is how someone who is so wealthy is willing to take so much risk for what is by comparison quite a small return,” said Sol Waksman, president of BarclayHedge, a US-based hedge fund research firm.

“$20m is for you and me a lot of money. For him it was nothing.”