Hedge funds brace for fallout from insider-trading bust

NEW YORK -- Some hedge fund managers are bemoaning the arrest Friday of Raj Rajaratnam, the billionaire co-founder of Galleon Group, at a time when Congress is preparing to move ahead on legislation to overhaul financial regulation.

Rajaratnam, along with executives from some of the biggest names in corporate America, were charged in one of the largest insider-trading cases in history.

"It makes everything harder," said Jerome D. Abernathy of Stonebrook Capital Management, a hedge fund with $300 million under management. "Whatever regulations are being considered, this is just a lubricant for their passage."

While most hedge funds have come to accept -- and even support -- the registration of hedge funds being advocated by the Obama administration and some lawmakers, lobbying efforts by the $1.2 trillion hedge fund industry have focused on other aspects of the regulatory reform proposal.

Some smaller hedge funds such as Stonebrook are worried about a proposed rule before the Securities and Exchange Commission that would prohibit the use of third-party marketers by funds to solicit investments from public pension funds.

Bigger players, meanwhile, are concerned about the scope of regulators' powers to oversee systemic risk and the derivatives markets. If deemed large or risky enough, some hedge funds may face review by regulators who could require them to have more capital, less leverage and higher collateral in trading over-the-counter derivatives.

Former regulators, hedge fund managers and law experts are divided over whether the Galleon case will prompt Washington to call for tighter industry regulation. Rajaratnam, 52, is accused of making up to $20 million on illegal tips over several years. He has denied the charges through his attorney. Others charged include executives at Intel, IBM and McKinsey & Co.

"It's an indication of why more oversight is needed," said Harvey Goldschmid, a Democratic commissioner at the SEC between 2002 and 2004 who pushed for the registration of hedge funds. "What we do know is that there is fair amount of trading by hedge funds. There's been significant amount of fraud at hedge funds. Some of them do present systemic risk, and the case for the SEC being able to inspect hedge funds is overwhelming."

John Coffee, a law professor at Columbia University, said the Galleon case adds to the already substantial anger among the public and on Capitol Hill toward Wall Street. Whether that outrage simply translates to more support for the hedge fund registration requirement, widely expected to be in the final bill, or spills over into the more controversial rules remains to be seen, Coffee said.

"Main Street -- which is facing high unemployment, scarce credit, few jobs -- sees people receiving arguably obscene fees and bonuses which are partly paid by taxpayer dollars," he said. "Now you add to it the possibility that the extraordinary returns being made at these hedge funds are driven in part by systemically illegal misconduct . . . This may activate a certain amount of Congressional outrage."

Stephen Massocca, a hedge fund manager at Wedbush, doesn't see more regulation coming his way -- at least not because of Galleon. "I don't quite know what regulatory changes other than increased surveillance would be proposed," he said. "There is already pretty specific legislation on the books outlawing insider trading."