Hedge Fund Turkeys Stuffed with Search Warrants

by Paul Springer

Press releases from the FBI usually come in the morning and provide a page or so describing some perp’s alleged doings and the number of decades in Club Fed likely to result.

But a late-breaking epistle on Monday about activity in New York, Connecticut and Massachusetts was terse:

The FBI has executed court-authorized federal search warrants in an ongoing criminal investigation. As with any investigation, this step is to gather evidence. Per FBI guidelines, we can confirm that searches were conducted, but because the affidavits are under seal, we cannot disclose the nature of the investigation to which the searches pertain.

The paperwork for such searches can take various forms. In this case, investigators advertised the fact that they whipped out search warrants. This tactic has more teeth than the use of a grand jury subpoena, according to The New York Times:

The execution of search warrants at three hedge funds marks a significant escalation of the government inquiry into insider trading. By using a search warrant rather than a grand jury subpoena, prosecutors have signaled there is a good chance that securities laws were violated… Prosecutors do not ask for a warrant based on a hunch or suspicion, especially in an insider trading case, and it is executed out in the open, so everyone knows who is linked to the possible criminal activity.

Reuters soon reported massive cash outflows from three funds that were raided by federal investigators:

The offices of Boston-based hedge fund Loch Capital Management and Connecticut-based funds Level Global Investors and Diamondback Capital Management LLC were searched on Monday in connection with a widening probe by U.S. officials into insider trading.

Lawyers familiar with the multi-pronged investigation said the government appears to be focusing on networks of traders and managers amid suspicions by authorities the funds traded on nonpublic information about stocks.

Thanksgiving week started off with a bang — and a bust — for the hedge funds, about a day after rumors began circulating that a major insider trading investigation was going to blow wide open.

Talk about a case of the Mondays. Reuters reports: “At about 10 a.m., FBI agents, including one in a sweatshirt, entered Diamondback offices and shouted into the trading room. They ordered about 60 employees to halt work immediately and herded them into a conference room for about one hour, according to one employee at the firm.”

This is all part of an ongoing investigation, and no one has admitted any wrongdoing.

But Bloomberg reports that Diamondback’s returns at times have been preternaturally good — almost three times better than its peers’ returns:

Diamondback gained 73 percent from mid-2005 through July this year, compared with 22 percent for funds with a similar approach, as tracked by Chicago-based Hedge Fund Research Inc. The fund beat so-called multistrategy funds in 2006, 2007 and 2008, when it skirted losses from the credit crisis. It has lagged behind the strategy average since then.

Not everyone is delighted by the Feds’ zeal, and some feel it has little to do with the quest for truth, justice, and the American way.

“If insiders could trade, stock prices would more likely reflect the true conditions of a company,” says CNBC.

Backblast from the Galleon case has led to questions about the use of wiretaps, and more importantly the ongoing inquiry has been characterized by some as an inquisition.

The investigation has also led to debate over what really constitutes material non-public information. Over the weekend, a Wall Street Journal report on federal attempts to ensnare information sharers quoted John Kinnucan, a Broadband Research principal who was visited by a crew of crew cuts and disagreed with their ideology. The article said Kinnucan divulged the nature of the visit to clients in an email:

“Today two fresh faced eager beavers from the FBI showed up unannounced (obviously) on my doorstep thoroughly convinced that my clients have been trading on copious inside information,” the email said. “(They obviously have been recording my cell phone conversations for quite some time, with what motivation I have no idea.) We obviously beg to differ, so have therefore declined the young gentleman’s gracious offer to wear a wire and therefore ensnare you in their devious web.”

One focus of the investigation is the role of consultants and the specialized knowledge that they bring to the table in securities analysis. Is a granule of information an illegal insider hot tip or simply the reasonable conjecture of someone with deep background knowledge?

Primary Global Research, a Silicon Valley consultant whose motto is “Generate Alpha,” says on its website that its consultants “are forbidden to disclose to PGR or to any of its customers or partners any material, non-public, confidential or proprietary information belonging to any previous or current employers or others.”

At the same time, information providers are on their own recognizance:

If an expert must receive permission from his or her employer, it is the expert’s responsibility to obtain that permission prior to accepting a consultation request. The decision of whether to accept a particular request is always the expert’s alone.

That decision making process and the use of such information by hedge funds will meet heightened scrutiny this week, and in coming months long after this week’s bird carcass has been tossed out with the Thanksgiving search warrants.

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