* Rule would apply to registered investment advisers
* FinCEN expects to publish proposal in first half of 2013
* Insider trading can trigger suspicious activity reports
By Emily Flitter
NEW YORK, Jan 4 U.S. financial regulators are pushing to turn hedge funds into informers on the white collar crime beat.
The Financial Crimes Enforcement Network (FinCEN) is working on a rule that would require U.S. hedge funds to file formal reports notifying U.S. authorities of any suspicious trading by employees or outside parties, the regulatory agency said.
The rule being crafted by FinCEN, part of the Treasury Department, would force the $2 trillion hedge fund industry to police itself in much the same way banks, brokerages and mutual funds are required to do by filing suspicious activity reports (SARs) with the unit.
Steve Hudak, a FinCEN spokesman, said a proposed rule for the hedge fund industry could be filed for public comment some time in the first half of this year.
But the rule, which would cover activities such as insider trading and money laundering, will force funds to spend more money on building out their compliance and legal departments.
Hedge fund lawyer Ron Geffner said he expects many in the industry will oppose the new rule as being both intrusive and costly.
"Anytime there's any regulatory hook into a firm, it's like a domino," said Geffner, a partner at the law firm Sadis Goldberg in New York. "When taken together, all of the rules and regulations, both new and revised, serve to intimidate entrepreneurs."
A spokesman for the largest hedge fund trade group, the Managed Funds Association, did not respond to a request for comment.
The measure also could heighten tensions in the the hyper-aggressive hedge fund world as it could put firms and their employees in a position to snitch on their competitors.
FinCEN's move is not entirely new. In 2003, the agency began looking at imposing a SARs requirement on hedge funds, but eventually withdrew a proposed rule in 2008 after deciding it was too hard to define a hedge fund and enforce the requirement.
The agency now believes the new mandate in the Dodd-Frank financial reform law that requires U.S. hedge funds to register as investment advisers gives it the ability to require hedge funds file SARs.
James Freis, a former FinCEN director, said the new rule is long overdue and would require hedge funds to do more due diligence on their employees and customers. He said it also would require hedge funds to hire staff who are well-versed in anti-money laundering procedures, which is one of the main reasons banks are required to file SARs.
"Suspicious activity reporting would put an affirmative obligation upon investment advisers, including certain hedge funds, to notify the authorities of suspected illegal activity," said Freis, now an attorney with the law firm Cleary Gottlieb in Washington.
Freis served as the director of FinCEN until September, when he was forced out over disagreements with Treasury officials over FinCEN's priorities, according to a person familiar with the matter.
During his tenure he was an advocate for a hedge fund reporting requirement.
The filing of SARs reports took on new urgency for the financial industry in the wake of the Sept. 11, 2001 attacks on New York and Washington as federal lawmakers moved to require banks to become more aggressive in tracking money flows by terror groups.
The SARs reporting requirement is one that banks and brokers do not take lightly. Jay Hack, a partner at Gallet Dreyer & Berkey in New York, said many banks file a "defensive SAR" when they see something even remotely suspicious to keep the regulators satisfied.
In the brokerage world, the SARs requirement has provided securities regulators and federal prosecutors with leads about investment scams and insider trading rings, securities lawyers said.
From 2003 to 2011, securities firms filed more than 110,000 SARs, with most of those involving incidents of money laundering or unusually large transactions, according to FinCEN. Roughly, 3,500 of those SARs involved a suspected insider trading incident. Final numbers for 2012 are not yet available.
But the agency reports that the number of SARs filed involving insider trading was up 34 percent in 2011 from 2010. The increase came at a time when U.S. authorities were engaging in a massive crackdown on insider trading in the hedge fund industry that has led to more than 70 convictions.
Many hedge funds maintain relatively small compliance and legal departments, often preferring to hire outside contractors to perform that work.
SAC Capital, the $14 billion hedge fund with 900 employees that has drawn scrutiny in the insider trading investigation, is rarity in that it has more than 30 people working on compliance matters. People familiar with SAC Capital, which declined to comment, said the firm's compliance team is one of the largest in the hedge fund industry.