Millennium Partners, one of the hedge funds at the center of the mutual fund trading scandal, has set aside 10% of its investors' money in preparation for a possible settlement with federal or state regulators.

Investors at the $3.2 billion hedge fund run by Israel Englander, the storied Wall Street trader and buyout specialist, learned in December that some of their money would be set aside for the firm's legal reserve, even as backers clamored for their cash. About $800 million has streamed out of two Millennium hedge funds since the firm surfaced in the mutual fund late-trading and market-timing scandal last October.

Millennium's decision to set up a legal reserve looks prudent, particularly after a former trader, Steve Markovitz, pleaded guilty in October to making illegal late trades in shares of mutual funds. The action is similar to one taken by Veras Investment Partners, a Sugar Land, Texas, hedge fund that put away up to $100 million to cover any fines and penalties regulators might impose in their investigation of its role in the mutual fund scandal.

Harry Davis, a partner with Schulte Roth & Zabel and one of Millennium's outside attorneys, didn't return repeated phone calls. Tom Daly, a Millennium spokesman, declined to comment. TheStreet.com reported Tuesday that a number of witnesses familiar with Millennium and Markovitz have appeared before a New York state special grand jury that is investigating the mutual fund industry.

While Millennium investors have been pulling out of funds, the situation would be worse if not for restrictions in their investment agreements that allow Millennium to bar larger withdrawals. Millennium's investors include Duke Management Co., which runs Duke University's $5 billion endowment; the Belzbergs, one of the richest families in Canada, and many funds of hedge funds.

According to an investor that still has "a few million" in one of Millennium's hedge funds, word of the legal reserve was one of very few communications the beleaguered Englander has offered to his backers in recent months. While the fund was once open about market-timing, a legal-if-frowned-upon strategy involving frequent trades, it clammed up around the time of the Markowitz late-trading plea, the investor said.

"We weren't even aware that you could actually do that," the investor said of late-trading, in which fund shares are bought at stale prices set prior to the disclosure of market-moving news. "We weren't aware that you could get away with something like that. I'm sure people who knew that strategy better than we did had some more ideas about it, but we were never aware of what was being done."

Millennium's communications with investors have never been particularly voluminous, according to one investor, who said the quarterly reports the firm issued eventually stopped describing the allocation of each fund to different strategies. Recent reports included only "a whole bunch of statistics" that left investors to figure out how much of the fund was dedicated to statistical arbitrage, merger arbitrage or market-timing of mutual fund shares.

"It's not their style to send out letters," the investor said. "It's not like you'd know people in the company. The idea was this was Israel Englander's fund and you trusted him."

Englander, a 1980s Wall Street contemporary of Ivan Boesky and a former partner of John Mulheren, started the hedge fund in 1990 with $13 million and backing from the Belzbergs, the Canadian family that made its money in finance, real estate and other businesses. Millennium fared well from the outset, and established an 18% average annual return over its first 10 years.

This gave Millennium both cachet and the freedom to set terms for its investors that some may now regret.

From at least 2000 onward, investors had to pony up a minimum of $5 million to get one of a number of limited partnership slots. The law limits hedge funds to 499 investors who generally make minimum investments of $1 million, or 99 investors who commit at least $5 million. Because hedge funds generally charge 1% annual management fees, they often have an incentive to maximize the amount of money they control, and investors with less money are sometimes turned away.

Millennium had the returns and the clout to set the bar high.

"They were the elite group, the top 10 or 20," the investor said. "They didn't publicize themselves, but everybody in the industry mentioned them on various occasions."

With a 30.66% return in 2000, a 15.6% return in the dismal days of 2001, a 9.62% return in 2002 and a 10.89% return last year, the offshore fund was a bright spot for investors who lost money in the equity markets.

As large institutional investors began to look more closely at hedge funds during those years, Millennium revamped its agreements with investors, toughening restrictions on withdrawals.

Because hedge funds can have volatile stretches, particularly in times when markets are shifting, provisions -- or gates -- that keep investors from redeeming all their shares on short notice are common, said Ron Geffner, head of the financial services practice at New York law firm Sadis & Goldberg.

"These gates often vary from fund to fund depending in part on the strategy, with an eye to the liquidity and volatility of the portfolio," he said. "They are designed to prevent a run on the bank, by investors who may panic and could cause unnecessary fluctuation in the returns the fund would generate. Gates are not such a bad thing -- they're not just designed to protect the manager."

However, that's just what Millennium's restrictions are doing: shutting up its largest and most recent investors' money for a minimum of three years in a conventional lock-up period.

Between the original terms of their investments with Millennium and the firm's now-locked gates, the hedge fund has been able to hang on to billions of dollars that investors would like back.

"You can't get out since the scandal broke," said one investor, who said Millennium has returned 10% of each of his redemption requests. "We got out what we could and we continue to get out what we can. It could have been half their assets -- if not more -- if they didn't have the gate. They're extremely lucky they've got the gates, or they'd probably be finished."

Amazingly, sources said some investors are still putting money into Millennium hedge funds, even after it warned existing investors about the legal reserve it established.

Millennium raised more than $1.5 billion between 2001 and last November; according to the industry newsletter MAR Hedge, much of it from large institutions.

Officials at the Duke Management Co. declined to comment on the university's investment with Millennium, but it is thought the school is among the many college endowments that put money into that and other hedge funds as they shifted away from equity markets after 2000.

The earliest investors are faring only somewhat better -- their agreements with Millennium allowed them to withdraw money once a year.

Demand for redemptions hasn't ebbed, said the investor, who called Millennium's recent hiring of Simon Lorne, a former Securities and Exchange Commission general counsel, "a desperate attempt to make them appear more kosher."

"People are pretty pissed off that they are activating this gate," the investor said. "People were hoping they wouldn't, and that they'd be let out. The harsh questions haven't been answered, like how it could happen on Englander's watch. I don't think one is coming."

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