Cypress Semiconductor ( CY) and its CEO T.J. Rodgers have long been controversial. Revelations the firm owns a stake in two hedge funds raise yet another red flag in Cypress' checkered history.

The chipmaker revealed its unusual investment in a footnote buried within its annual report, filed earlier this month. Notably, Cypress only revealed its investment -- ongoing since at least 2002 -- because gains in one of the hedge funds amounted to a material portion of Cypress' 2003 pretax income.

Adding to the drama, one of Cypress' hedge fund investments held short positions in five semiconductor equipment makers, including Applied Materials ( AMAT) and Novellus Systems ( NVLS).

The revelations raise questions about what Cypress is doing with shareholders' cash and the transparency of its investments, said Todd Fernandez, a senior research associate at San Francisco-based Glass Lewis.

"Those are shareholder funds. They should either be reinvested in the business or dividended back to shareholders," Fernandez said.

Others were even more critical. Gary Lutin, an investment banker and shareholder rights advocate, likened Cypress' investments in the hedge funds to the company using shareholder funds to make a bet at the race track.

"That is not what people contribute capital to a corporation for," Lutin said.

Cypress spokesman Joe McCarthy declined to respond to the criticism or answer specific questions about the company's hedge fund investments.

"Like any company, we make certain investments. This one was approved by our board of directors," McCarthy said.

Cypress' board has approved some controversial practices in the past, and these investments will be news to most investors. Aside from those in the company's most recent annual report, no other mentions of "hedge fund" or "limited liability partnership" or "Digital Century Capital" -- the name of one of the funds -- turned up in a search of the chipmaker's regulatory filings going back to 1986.

According to the annual report, Cypress has been invested in the funds since at least 2002. But the company did not specify when it originally invested in the funds, how much it originally invested, or whether it has added to or subtracted from its original investment.

To be sure, Cypress' current stake in the two funds amounts to a small fraction of its total assets.

As of Dec. 31, Cypress owned 9.5% of Digital Century Capital fund and 13.2% of another, according to the company's annual report. The total stake in the two funds was worth $4.8 million, or less than 1% of Cypress' total assets; at year-end, Cypress held about $183.71 million in cash and $14.91 million in short-term investments.

"The partnerships are not significant to Cypress' operations and effectively represent investments primarily in equity securities by Cypress," the company said in its annual report.

But Cypress' investment in one of the two hedge funds was significant to its pretax income last year, forcing the company to disclose the investment.

In 2003, Cypress posted a pretax loss of $2.51 million and a total net loss of $5.3 million, or 4 cents per share. Meanwhile, Digital Century recorded net income of $11.59 million, of which Cypress' share was $1.5 million, according to Cypress' annual report. That amounted to about a penny a share before taxes for Cypress.

Cypress Pushes the Edge, Again

A corporate investment in a hedge fund -- at least one that is publicly acknowledged -- is unusual, said Walt Nightingale, a general partner of Nightingale & Farber, a Seattle-based hedge fund. Wealthy individuals are more typical investors in hedge funds, which are notoriously risky because, unlike most mutual funds, they are able to short stocks.

Indeed, at the end of last year, the shares Digital Century sold short were worth about $3.5 million more than the fund sold them for, according to the fund's report. Meanwhile, the fund posted losses of $25.76 million in 2002, and $61.85 million in 2001. Combined losses for its two hedge fund investments were $34 million and $61.8 million in those same years, respectively, Cypress said in its annual report. The company did not disclose its percentage stake in the two funds in those years, nor its share of their losses.

"I would never think of any operating entity putting money into a hedge fund," Nightingale said. "You're running a ... business, not making bets on the financial markets. That to me gets you in trouble." (Nightingale & Farber has no position in Cypress.)

Mark FitzGerald, who covers the chip and chip equipment industry for Banc of America, agreed. "Why are they taking corporate money and investing it in a damn hedge fund?," he wondered. "What if it turned into a $10 million loss? That's an element of risk that no one could factor in." (FitzGerald does not own Cypress shares and Banc of America does not have any investment banking business with Cypress.)

While unusual, Cypress' hedge fund investment is not unprecedented. Italian dairy and food giant Parmalat fell apart last year after it revealed it had not received a nearly 500 million euro (about $606 million) payment due it from a Cayman Islands-based hedge fund. Parmalat later filed for bankruptcy protection.

There's no evidence that Cypress' hedge fund investments are anywhere near as risky as Parmalat's. Still, Digital Century's only short positions as of the end of last year were in chip-equipment makers, according to Digital Century's annual report, which Cypress included with its filing.

In addition to Applied and Novellus, Digital was short Cymer ( CYMI), KLA-Tencor ( KLAC) and Lam Research ( LRCX).

The short positions raise the potential of conflicts of interest for Cypress shareholders.

As an industry insider, Rodgers has potentially valuable information on chip-equipment makers. Some analysts wondered whether Rodgers helped direct or influence Digital Century's investments.

"A lot of times these funds do get these kinds of investors," FitzGerald said. "They shop for Silicon Valley executives to get the information flow."

Cypress' McCarthy declined to say whether Digital Century had held a position in Cypress' stock, or whether it was even permitted to under its bylaws. Rajiv Chaudhri, who runs Digital Century, declined to comment.

The lack of disclosure about the fund's investments disturbs some analysts. Theoretically, Digital Century's investments could be used to prop up Cypress' stock. Or Cypress investors could be placed in the awkward position of investing in a fund that was shorting their own stock.

"This always raises the possibility that conflicts of interest will arise," said Carol Bowie, director of governance research at the Investor Responsibility Research Center.

The hedge fund investments are only the latest move by Cypress to raise the eyebrows of governance watchdogs.

Last year, for instance, the company's board quietly passed a 20 million-share increase in its pool of stock options days before the action would have required shareholder approval.

Critics have also questioned Cypress' use of an obscure form of compensation that grants employees and managers nominal equity stakes in its wholly owned subsidiaries.

Meanwhile, Rodgers has drawn attention for his ardent defense of stock options and the company's practice of excluding the cost of options from its income statements. That attitude runs counter to the prevailing sentiment among accounting and governance experts and some prominent investors.

The hedge fund investments are further evidence that Cypress' management and board may not always have the best interest of shareholders at heart.