After SAC Plea, Fellow Funds May Pay

In striking its $1.2 billion settlement with SAC Capital Advisors, the government set a record for insider trading penalties. For the hedge fund industry, the hidden costs of the deal are even bigger.

Tougher regulatory scrutiny since the financial crisis and changes in the law have forced hedge funds to spend millions of dollars a year on new compliance measures to make sure that they are not ensnared in the same net as SAC. This has added to the cost of doing business, which can cut into returns.

“It is getting much more expensive for hedge funds,” said Thomas A. Sporkin, a partner at Buckley Sandler and a former enforcement lawyer at the Securities and Exchange Commission. “What kind of returns are you going to need to make in this business given the compliance and regulatory burdens?”

The history of SAC’s rise as it became one of the biggest and most successful hedge funds and its subsequent fall, punctuated by the settlement on Monday, is part of a larger story of how the industry has evolved since the 1980s, when insider trading charges were treated with the seriousness of a parking ticket. Today, within many of the wood-paneled offices of Wall Street firms, insider trading has been elevated to grand larceny.

Across the industry there is a sense that hedge fund managers are “trading in their motorcycles for regular cars,” as one industry insider put it, as they seek to limit risk and stay clear of regulators.

The regulatory broom sweeping through the hedge fund world is the result of a wider multiyear crackdown on Wall Street that culminated on Monday with a statement from Preet Bharara, the United States attorney for the Southern District of New York, declaring that no firm should consider itself “too big to jail.”

Exhibit A was SAC, which agreed to plead guilty to five counts of insider trading violations and pay the record $1.2 billion penalty. The broader plea deal will also impose a five-year probation on the fund and require it to hire an outside monitor. A plea hearing on the deal has been scheduled for Friday.

The change in the government’s tone was demonstrated in a Manhattan courtroom two years ago when Raj Rajaratnam, the hedge fund billionaire who ran the Galleon Group, received an 11-year prison sentence for insider trading. It was a watershed moment for regulators, who for years had focused on individuals they knew to be engaging in insider trading but could not convict.

“Galleon was really another one of the big moments in time when you look back and say, ‘That took on a more heightened significance,’ ” Mr. Sporkin said.

Prosecutors were already looking into SAC, and from its investigation into the firm and Galleon, the S.E.C. was able to piece together the chain of information flow to other hedge fund managers and firms, helping regulators to connect the dots and emboldening them to pursue more firms.

As regulators delved into new investigations, they began to issue more subpoenas, sometimes to firms that were two or three steps removed from the target fund in the investigation but had important information.

At a recent conference for hedge fund general counsels at the University Club in Manhattan, David A. Chaves, a special agent at the F.B.I., described how his team found a key informant in an insider trading case five years ago. The anecdote illustrated how investigators are keeping hedge fund lawyers up at night.

“We would follow him every day for months,” Mr. Chaves said. “We would work out with him at lunchtime.” The informant ultimately led investigators to discover new links and informants around the world.

“We have a pretty good listening post of what is going on,” Mr. Chaves said.

As regulators were gaining a clearer view of what was going on in hedge funds, the Dodd-Frank financial overhaul law in 2011 forced the funds to provide more information about their businesses. As part of the new rules, hedge funds were required to have a compliance officer. For many firms, whose chief financial officer also served informally as the compliance officer, this meant hiring at least one more employee. It also meant diverting resources to new technology.

Then this year, under the leadership of Mary Jo White, who became chairwoman in April, the S.E.C. took a harder line on hedge funds. In particular, it is pushing defendants to admit guilt, reversing a longstanding policy of letting them “neither admit nor deny” any wrongdoing.

This summer, the S.E.C. extracted its first admission of wrongdoing from the hedge fund billionaire Philip A. Falcone. As part of his $18 million settlement, Mr. Falcone and his hedge fund, Harbinger Capital Partners, admitted to committing “multiple acts of misconduct.” Referring to the case at a conference in September, Ms. White said it was “extremely important that our settlements have teeth and be as strong as they possibly can.”

Steven B. Nadel, a hedge fund lawyer at Seward & Kissel, said, “Mary Jo White seems to be saying that the S.E.C. is going to take a tougher stance with persons who are accused of securities violation.”

For clients, this means spending time and money to ensure they are fully compliant in their practices, Mr. Nadel said. “There is a realization in the industry that the S.E.C. is going to be harsher on people who fail to comply with the rules.”

Compliance costs for large fund managers can run as high as $14 million a year, while midsize managers spend about $6 million, according to a recent study by KPMG.

With regulators hovering nearby, institutional investors have asked for more assurances that their money is safe. This, along with the costs associated with compliance with new rules, has made it harder for new funds to raise money.

But there is perhaps one group that will not bear any significant costs: high-net-worth investors.

“This will not put the fear of God into the individual investor,” said Martin D. Sklar, a lawyer at Kleinberg, Kaplan, Wolff & Cohen. “The S.E.C. and Justice Department have not made any of the investors bear the losses — in a way, you are not incentivized to invest away from the crooks.”

Even with new compliance measures in place, many of the industry’s biggest names are still uncertain of what SAC’s settlement with the government will mean.

“It’s pretty hard to feel any sense of relief or have any knowledge of what happens next,” said one longtime hedge fund executive who spoke only on the condition of anonymity because of concerns about breaching client confidentiality.

“I think that most hedge funds had pretty good procedures and have stepped up their compliance in the face of what is going on,” he added. “They know that to be sued for insider trading is the death knell for a firm.”