Hedge Funds Face Heat

NEW YORK ( TheStreet) -- Federal authorities' fast-widening insider trading probe hit the stock of Goldman Sachs ( GS) Monday, but the cases could spell even bigger trouble for the hedge fund industry.
 Wall Street

"I think the public reputation of hedge funds could be severely damaged," says John Coffee, securities law professor at Columbia University.

Coffee guesses new insider trading cases are "offshoots" of the case involving hedge fund Galleon Group, in which the government has already obtained 14 guilty pleas.

"Those 14 will all be asked to cooperate by giving information and they have every incentive to exchange information for leniency," Coffee says. "That could lead the government into a variety of interlocked networks and conspiracies."

Following a report in The Wall Street Journal over the weekend about a "vast" insider trading probe, reports Monday have followed up on the Journal's report, which named Goldman and SAC Capital, saying two other hedge funds started by former SAC employees are also being investigated.

"A lot of major hedge funds look like they're going to be under investigation and what's distinctive here is the government may have been using wiretaps for some time," Coffee said. He adds that the federal investigators described in the Journal story "showing up on people's driveways and front porches and asking them to wear a wire within minutes after introducing themselves" is an indication of "a pretty confident government, or at least a government pushing its case as hard as it could."

There are very few publicly traded hedge funds. Shares of Fortress Investment Group ( FIG) a money manager that has several hedge funds straddles the fence between hedge funds and private equity, fell sharply in midafternoon trading but recovered much of those losses before the close.

Fortress hasn't been implicated in connection with the probe.

If the hedge funds industry takes a major hit, it could potentially hurt revenue at Goldman, Morgan Stanley ( MS), Citigroup ( C), JPMorgan Chase ( JPM), Bank of America ( BAC) and other firms that do lots of business with hedge funds.

Nonetheless, Coffee says he has "real doubts," that research firms the Journal says are being targeted in the probe are doing anything wrong. The report says firms including Primary Global Research and Broadband Research, which provide research to hedge funds and other money managers, such as Janus Capital ( JNS).

"The kind of consultants they were talking about there really don't have misappropriate information. They've engaged in more lawful kinds of securities research."

"Drawing the line between non-public information and just giving insight into the industry may present a challenge for the government," according to Ellen Zimiles, global head of investigations and compliance for Navigant Consulting.

"What is the non-public information that's being given? Everyone thinks they're smarter than everybody else," she says, "But do you just know the industry really well or are you saying 'this is going to happen on this date?'

While this probe appears likely to lead to some convictions, many observers have been frustrated by the fact that there have been so few criminal indictments brought in the wake of the latest crisis, while there were hundreds of convictions in the 1980's.

 John Gutfreund
John Gutfreund

John Gutfreund, who ran Salomon Brothers in the 1980s, tells TheStreet that regulators and lawmakers now take a "laissez faire," attitude toward criminal activity.

"It's not necessarily a rule of law and order as it once was. Now whatever you do you can get away with," he says.

Following a Treasury bond trading scandal, Gutfreund was replaced as Salomon CEO by Berkshire Hathaway ( BRK-B) chief Warren Buffett. Though criminal charges were never brought, Gutfreund was fined $100,000 by the Securities and Exchange Commission in 1991 and barred from ever serving as CEO of a Wall Street firm.

-- Written by Dan Freed in New York.
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