Self-Reporting Rule May Not Aid Insider Trading Crackdown

As the U.S. Department of the Treasury weighs a proposal to require hedge funds to self-report insider trading, attorneys say the rule could add an unnecessary layer of regulation that results in a flood of new tips but few meaningful enforcement actions.
The Treasury’s Financial Crimes Enforcement Network, or FinCen, said Jan. 4 it was planning to issue a proposed rule within the next few months that would place added disclosure requirements on firms registered with the U.S. Securities and Exchange Commission as investment advisers, including hedge funds. Such firms would have to file suspicious activity reports, or SARs, with the government documenting potential wrongdoing by employees and outside parties, including insider trading, money laundering and terrorist financing.
The proposal comes amid a broad crackdown on alleged tipsters at hedge funds like Galleon Group LLC and SAC Capital Advisors LLC. In the last three years, New York federal prosecutors have brought insider trading charges against more than 70 individuals with ties to hedge funds or expert networks, firms that act as middlemen by connecting big-money traders with experts in certain industries.
But critics say the FinCen rule, if adopted, may not have a dramatic impact on insider trading enforcement. Indeed, most major hedge funds already have sophisticated compliance officers tasked with reporting fraud to authorities, according toBuckleySandler LLP partner Thomas A. Sporkin.
“I don’t see how it would have more of a material impact on catching illegal conduct than would a compliance officer under the current regulatory structure,” he said.
Treasury has been weighing the rule since at least 2003, when FinCen proposed anti-money-laundering regulations aimed at rooting out alleged financing of terrorist organizations. FinCen yanked the proposal in 2008, but revisited the measure after the 2010 Dodd-Frank Act placed new restraints on investment advisers.
The SEC is working closely with FinCen on drafting the new rule proposal. SARs filed by hedge funds would go into FinCen’s already-bursting database of tips — last year, the agency collected 1.5 million SARs — and would be shared with the SEC, FBI and other agencies.
But attorneys say the SEC may struggle to keep track of new SARs from hedge funds. By many accounts, agency staff are already overburdened by the thousands of tips flooding into a newly minted whistleblower office.
The FinCen proposal “is similar to the SEC’s program on whistleblowing,” Perkins Coie LLP partner Jose A. Lopez said. “It wastes a lot of government resources, and you end up chasing a lot of false positives and dead ends.”
“I think the industry does an excellent job at self-policing,” Lopez added.
Manhattan U.S. Attorney Preet Bharara would likely disagree. His five-year crusade against insider trading, in partnership with the SEC, has focused on alleged corruption in the hedge fund industry. Prosecutors have singled out larger-than-life fund bosses like Galleon’s Raj Rajaratnam and billionaire SAC founder Steven Cohen, who has not been charged but is reportedly the subject of a tipping probe.
The FinCen measure reflects a consensus among federal officials that alleged insider trading at hedge funds is not going away anytime soon, according to Ken Springer, a former FBI agent and the founder of Corporate Resolutions Inc., which handles federal investigations for financial firms and other companies.
“This is the world we live in,” Springer said. The FinCen rule “would put more onus on the funds, and that’s a good thing.”
The rule would have the biggest impact on small hedge funds, whose compliance chiefs often serve in other executive roles and wear “five different hats,” Springer said. Such firms may be forced to expend additional resources to comply with SAR obligations, he said.
Still, the Jan. 4 proposal had some experts scratching their heads.
Regulators have long required SARs from banks, whose customers can use their accounts to launder money. Some top lawmakers, including Sen. Carl Levin, D-Mich., have long advocated for money-laundering controls at hedge funds, particularly those that use offshore accounts.
But hedge funds are in the business of managing assets, not facilitating transactions, making them less susceptible to money laundering, some attorneys believe.
“FinCen has not demonstrated there is a money-laundering problem when it comes to hedge funds,” McDermott Will & Emery LLP partner Eugene Goldman said. “If FinCen believes there is an issue regarding insider trading and hedge funds, it can share its concern with the SEC, the expert agency on insider trading regulation.”
If the SEC agreed that more regulation was needed, it could propose its own rules in this area and seek comment, Goldman added.
Indeed, the rule may simply add another layer of rulemaking that does little to uncover Galleon-like scandals, according to Sporkin, a former top SEC attorney.
“If a chief compliance officer observes a portfolio manager engaging in insider trading or any other type of violative conduct, I would expect them to pick up the phone and call the SEC immediately, not file a SAR,” he said. “The rule just seems poorly thought out.”