US Senator Hedge Fund Regulatory Bill

Nov. 22 (Bloomberg) -- U.S. Senate Judiciary Committee Chairman Arlen Specter is circulating draft legislation, designed to prevent illegal insider trading, that would require hedge funds that accept pension fund money to register with federal regulators.

The proposal would also force hedge funds to set up ethics codes and compliance programs, and allow the U.S. attorney general to give private citizens rewards for helping prosecutions of insider trading cases.

The draft has not yet been introduced and there are only a few days left to pass a version of it in this Congress. Still, it is the latest sign of congressional concern about regulators' inability to track hedge funds. Such a bill would mean many funds would again be subject to federal inspection, after a June court ruling struck down an earlier requirement.

Specter ``has raised a lot of questions of regulators and this is his way of saying, `I want you to do a better job so here's the arsenal,''' said Barry Barbash, a former U.S. Securities and Exchange Commission official now in private practice. ``This kind of bill is designed to be something of a legislative discussion piece. He is putting out ideas.''

Hearing Considered

The draft bill was made available to Bloomberg News by a source outside the Judiciary Committee. Committee spokeswoman Courtney Boone said only that the staff has drafted a bill and that the committee is considering holding a hearing Dec. 5 on oversight of insider trading.

Specter, 76, a Pennsylvania Republican, will step down as committee chairman in January. He said at a hearing in September that the SEC and Justice Department weren't imposing sufficient penalties on hedge funds for insider trading and aggressively investigating suspicious buying and selling ahead of merger announcements.

``Light regulation, secrecy, unregulated recordkeeping and limited compliance programs of hedge funds increase the difficulty of detecting and proving insider trading,'' the draft bill says.

Some other members of Congress also have expressed concern about hedge funds since a federal appeals court in June rejected an SEC regulation subjecting the funds to random inspection, and Amaranth Advisors LLC lost $6.5 billion in September on bad natural gas trades.

Turf Battles

Hedge funds are private pools of capital that allow managers to participate substantially in the gains of the money invested. The funds manage about five percent of U.S. financial assets. They generate about 30 percent of the volume in the stock markets and even more of other markets such as credit default swaps.

The legislation may trigger turf battles. The Senate Banking Committee, which has been run by Alabama Republican Richard Shelby, has jurisdiction over the SEC and usually sets policy for the securities and banking industries. Christopher Dodd, a Connecticut Democrat set to succeed Shelby in January, already has made it clear he expects any hedge fund legislation to go through his committee.

Congress should let the SEC, Treasury Department and other federal agencies complete a review of hedge funds before approving legislation, said Paul Roth, a New York attorney who represents hedge fund advisers and managers.

Hedge Fund Review

``Congress should shoot this over to the President's Working Group to get an intelligent recommendation as to what's important, if anything, from an investor-protection standpoint and a systemic-risk standpoint,'' he said in an interview.

Hedge funds ``increasingly are making loans, participating in private placements, and sitting on bankruptcy committees and corporate boards,'' according to ``findings'' cited in the draft. Access to such information could foster illegal trading, the draft said.

Lawsuits involving hedge funds made up 11 percent of the SEC's insider trading cases in fiscal 2006, according to agency figures. The SEC expects to file more cases against the industry alleging illegal trading in 2007, Enforcement Director Linda Thomsen said at a Nov. 13 securities conference.

The SEC sued Wynnefield Capital Inc. Managing Partner Nelson Obus in April, alleging three hedge funds he runs made $1.34 million after getting a tip about the merger of Allied Capital Corp. and SunSource Inc.

Deephaven Capital

In May, hedge fund Deephaven Capital Management LLC agreed to pay $5.7 million to settle allegations that it profited from trades made before 19 private investments in public equity offerings that were about to be announced.

Hedge funds have been largely exempt from federal oversight because they cater to sophisticated investors. Funds are open to institutions such as insurance companies, mutual funds and pension funds, and individuals with at least $1 million in assets or at least $200,000 in income for the past two years.

``Recent hedge fund collapses and fraudulent trading activities have harmed retirees and smaller investors,'' the Specter bill said. The draft says hedge funds wouldn't have to register if less than five percent of their capital comes from pension funds.

Pension Fund Loss

The San Diego County Employees Retirement Association, which provides benefits for 33,000 employees and retirees, lost about $105 million after investing in Amaranth. Amaranth's meltdown prompted Senate Finance Committee Chairman Charles Grassley to ask Treasury and SEC to boost transparency of the industry because of concerns that ``hedge fund investments could put the retirement security of American workers in jeopardy.''

Specter's bill would authorize the Justice Department to give 30 percent of any fine, penalty or settlement recovered in an insider trading case to a tipster who provided information leading to a successful prosecution. The SEC already has authorization to give insider trading informants as much as 10 percent of a civil penalty.

Specter's legislation also tries to make it easier for the SEC and Justice Department to cooperate by stipulating that Justice prosecutors can attain evidence from the SEC when the agencies are conducting parallel investigations.

Specter raised that issue at his September hearing in response to a federal court in Alabama, which last year dismissed three perjury charges against HealthSouth Corp. founder Richard Scrushy. The judge ruled that the SEC and Justice Department had improperly merged civil and criminal investigations into the company's accounting.

To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net ; Otis Bilodeau in Washington at obilodeau@bloomberg.net .

Last Updated: November 22, 2006 16:01 EST