Life in the hedge fund world may be due for an overhaul.
Some lawyers and managers are now predicting that a new round of arrests and charges in the U.S. government's widening insider trading probe could force changes in the way the $1.7 trillion hedge fund industry does business and cause some wealthy investors to back away from hedge funds.
Already reeling from negative headlines, the industry got another shock on Wednesday when U.S. authorities arrested an industry networking firm executive, as their cases seem to be focusing on how managers use consultants to gather information for stock research.
This latest arrest suggests that last year's big insider trading crackdown, which led to the arrest of Galleon Management co-founder Raj Rajaratnam and nearly two-dozen others, was just the start of things to come.
"The message is unless you — the hedge fund community — police this better yourself, we — the government — will police it for you and you can expect to meet us at 6 a.m.," said Thomas Dewey, a lawyer who represents hedge funds at Dewey Pegno & Kramarsky LLP.
The whirlwind of bad news began on Monday with federal agents raiding the offices of three hedge funds — Diamondback Capital, Level Global and Loch Capital Management. Then the next day, a number of other hedge funds and mutual funds, including SAC Capital Advisors, Wellington Management and Janus, disclosed that federal authorities had asked them to turn over a broad range of information and documents.
Then came Wednesday's arrest of an executive at so-called expert network firm Primary Global Research, on charges that he helped hedge funds get access to confidential corporate information, making for three straight days of negative headlines.
"This investigation could have the biggest implications for the industry since the Bernie Madoff Ponzi scheme," said Andrew Fisch, who invests in hedge funds at SSARIS Advisors LLC.
The flurry of activity already has prompted some anxious investors to call and e-mail hedge funds about whether their managers have been contacted by the government.
So far, investors say their money seems to be safe because none of the firms have reported huge losses. And this means that many plan to take a wait and see attitude until more is know about exactly what the government is looking for.
Investors in the three searched hedge funds face a different dilemma. industry sources said, speculating that there is no way for these funds to go on. "Once the FBI knocks on your door, the fund is done," SSARIS' Fisch said.
Institutional investors are, however, playing it cool for the moment, particularly because the deadline for submitting year-end redemptions for most hedge funds already has passed.
But the huge worry for investors will be whether the long-established way of gathering information in the hedge fund world can continue as it has.
The arrest of Primary Global executive Don Ching Trang Chu comes a few weeks after prosecutors charged French doctor Yves Benhamou with providing confidential information to a portfolio manager at FrontPoint Partners. The French doctor, at the time, was working as consultant for expert network firm Guidepoint Global, people familiar with the situation previously have told Reuters.
Expert network firms are businesses that take fees to match-up hedge funds with consultants who are experts in particular industries such as medicine, engineering and technology. Experts frequently are essentially moonlighting from their regular jobs.
There are about three-dozen expert firms, but just a handful — such as Gerson Lehrman Group, Guidepoint Global and Coleman Research Group — control the lion's share of the business.
Thousands of hedge funds and mutual funds use expert networks for data on industry trends, the effectiveness of drugs, and how competitors are doing, for example.
"It is perfectly legal for me to pay someone for information on the industry as long as that expert is not violating any duty of confidentiality," said Thomas Kamp, chief investment officer at hedge fund Cornerstone Capital.
But many hedge fund managers and their investors are now worried about people who may be crossing the line and wonder who will be investigated and held responsible: the hedge funds that use the information, the expert networks that create the relationships or the experts themselves who have the information.
Several managers who did not want to be identified said the concern is that a crackdown on a few bad apples could hinder legitimate information gathering.
"You do all you can to get edge," said Lars Kroijer, who ran the London-based hedge fund Holte Capital until it closed in 2008. "You talk to companies and suppliers, customers and the whole range. You don't want to cross the line for the obvious reason that its illegal, but if you cross it and you know you cross it, then you've sort of done a lot of work and you can't trade the stock."
Some hedge funds have strict rules about how and what their traders can ask experts they meet through the networks, but some do not. And companies that let their employees consult for expert networks may also need to do more training about what types of disclosures are allowed, said Jeff Morgan, president of the National Investor Relations Institute.
Hedge fund defense lawyers say they are already fielding calls from fund managers who want them to hire them for compliance training to refresh portfolio managers' memories on exactly what is legal.
"Suddenly the focus is not on making money, the focus is on making money and making sure you don't get caught up in a criminal investigation," said John Bartko, a former assistant U.S. attorney and securities lawyer at San Francisco law firm Bartko Zankel.