Insider Trading and Hedge Funds: A Dangerous Pair

By Strohmenger, Richard | Fordham Journal of Corporate & Financial Law, January 1, 2010 | Go to article overview

Insider Trading and Hedge Funds: A Dangerous Pair


Strohmenger, Richard, Fordham Journal of Corporate & Financial Law


I. INTRODUCTION

In recent years there has been dramatic growth in the hedge fund industry, accompanied by an equally sizable increase in the public notoriety of such funds. Hedge funds currently control a substantial portion of trading in many financial markets and are subject to less federal regulation than nearly any other type of financial entity or institution.1 Their significant holdings, opaque nature and lack of governmental oversight place hedge funds squarely in the spotlight of the public and the U.S. Securities and Exchange Commission (the "SEC").2 In the ten year period from 1999 to 2008, the SEC brought over 130 enforcement actions against hedge funds.3 Specifically, the SEC has recently made cases involving insider trading within hedge funds a priority, a change that can be attributed to the perception that there is widespread insider trading in these funds.4 This Note illustrates why the structure of hedge funds makes them prone to instances of insider trading and why the SEC struggles to deal with this problem.

Part II of this Note details the basic structure of hedge funds and how they operate on a day-to-day basis. Part III examines the relevant legal theories, case law and federal securities laws governing insider trading cases. Part IV discusses the susceptibility of hedge funds to insider trading due to their structure and the organization of the financial markets in which they operate. Part V describes how the SEC brings an insider trading enforcement action against a hedge fund and the problems that come along with it. Part VI highlights several recent insider trading cases involving hedge funds and their advisers. Part VII concludes by explaining what action the SEC should take.

II. THE STRUCTURE OF HEDGE FUNDS

While the term "hedge fund" has become well-known in recent years, no formal definition exists for what classifies a business entity as a "hedge fund."5 Instead, hedge funds are categorized by the following characteristics: a business that is not an investment company, holding a wide range of securities and other assets, and not required to register its holdings with the SEC.6 Furthermore, hedge funds are known to have a small number of investors, can use leverage without restriction, and provide performance fees for their advisers.7

Hedge funds are structured to avoid tax consequences and to limit their liability. These goals are accomplished by organizing funds as limited partnerships or limited liability corporations.8 Investors in these funds tend to be "wealthy individuals and institutions," because regulatory restrictions require minimum investments in hedge funds ranging from $100,000 to as high as $5 million.9

Alfred Winslow Jones established the first hedge fund in 1947 and labeled it to reflect its investment strategy of "hedging" its bets, accomplished through the short-selling of some securities while simultaneously taking long positions in others.10 However, the term "hedge fund" is no longer associated with that practice, instead referring to entities that are "private and unregistered investment pooI[s]."" While numbers can never be exact due to their unregistered status, there are approximately 6,000 to 9,000 hedge funds that are believed to collectively maintain over $1 trillion worth of assets in total.12 The exponential growth of the hedge fund industry in the last several decades can be credited to their unregulated nature, which allows them to take advantage of market conditions by investing in a wide range of securities without being affected by leverage requirements.13

Hedge funds tend to be much more highly leveraged than other investment vehicles. Leverage is "[t]he use of credit or borrowed funds to. . .increase an investment's rate of return."14 Other investment vehicles like mutual funds and investment banks are subject to restrictions on the amount of leverage that they can use to purchase securities.15 Hedge funds, however, have none of these restrictions. …

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