Analysis: Is FrontPoint the next Galleon?

By Svea Herbst-Bayliss and Emily Chasan

BOSTON/NEW YORK (BestGrowthStock) – It may be premature for the hedge fund industry to dismiss last week’s insider trading case against a French doctor as being limited in scope and potentially harming just one hedge fund firm — FrontPoint Partners.

Securities experts caution the $1.9 trillion hedge fund industry may be in for a shock as this case has the potential to shine the spotlight on the murky behind-the-scenes role that doctors and other medical experts play in serving as paid consultants to hedge funds.

Yves Benhamou, the infectious disease specialist charged by the U.S. government with having provided a FrontPoint portfolio manager with secret information about a clinical drug trial conducted by Human Genome Sciences Inc (HGSI.O: ), also served as a consultant to other hedge funds, according to the criminal complaint filed on November 2 and to people familiar with FrontPoint and the hedge fund industry.

In fact, Benhamou served as a consultant-for-hire with several so-called expert network firms — businesses that specialize in matching-up hedge funds with lawyers, engineers and doctors who have expertise in various fields to help the managers untangle data and gain an investment edge. And at a time hedge fund managers are under extra pressure to generate the out-sized returns that justify their stiff “2 and 20 fees,” thousands of managers help expert-network firms earn hundreds of millions in revenue a year.

Hedge funds traditionally charge a management fee of 2 percent and take 20 percent of the profits they earn.

The matchmaking business has long generated scrutiny from regulators who are wary that experts hired by hedge funds could either deliberately or inadvertently pass on confidential information about companies that also may employ the experts as consultants.

“Everyone uses them,” said Bradley Alford, founder of Alpha Capital, a firm that invests with hedge funds. “Where there is smoke there is often fire.”

WORKING BOTH SIDES

Federal prosecutors targeted Benhamou after allegedly finding evidence that the doctor had crossed an ethical line by serving as an adviser to both a drug company and a hedge fund.

Specifically, Benhamou was one of five people on a steering committee overseeing Human Genome Science’s drug trial for Albuferon, an experimental treatment for hepatitis-C. At the same time, according to a criminal complaint, he was a consultant “to another company” to which FrontPoint paid substantial fees.

FrontPoint has been owned by investment bank Morgan Stanley (MS.N: ) (Read more about the money market today. ) since 2006 and is currently in the process of being spun off.

Just as federal authorities did not identify FrontPoint in the criminal complaint, neither did prosecutors name the consulting firm.

Two of the expert network firms that Benhamou has worked for as a consultant over the years include Gerson Lehrman Group and Guidepoint Global, said people familiar with the hedge fund industry and the investigation.

A representative for Gerson Lehrman, the industry’s largest expert network firm, said Benhamou was not a consultant with the firm during late 2007 and early 2008 when authorities allege the doctor passed on confidential information about problems with the Human Genome Sciences drug trial.

GuidePoint did not return several calls seeking comment.

“Here was a doctor who was working both sides of the street,” said Bradley Simon, a criminal defense lawyer.

“He was serving as an expert on drug trials and then passing confidential information to the hedge fund manager.”

An attorney for Benhamou, an associate professor in the Department of Hepatology and Gastroenterology of Pitie-Salpetriere Hospital in Paris, declined to comment.

EXPLOSIVE

While Benhamou, 50, is hardly a household name, in the medical industry he was viewed as one of the top experts in the study of diseases of the liver. He had a long list of prominent clients according to industry publications that reveal he had worked as an adviser at times to drug companies like Merck & Co (MRK.N: ) and Novartis Pharma (NOVN.VX: ).

People familiar with the expert network industry said given Benhamou’s specific knowledge, he was in high demand at hedge funds.

Federal authorities have not alleged any wrongdoing by the expert network firm that Benhamou was affiliated with during the period he allegedly passed on the confidential information.

But securities lawyers said that in charging Benhamou, prosecutors may be trying to determine if the French doctor passed on confidential information about clinical drug trials to managers at other hedge funds.

If evidence emerges that Benhamou was sharing confidential information with other funds, the case has the potential to become as explosive as last year’s arrest of Galleon Management co-founder Raj Rajaratnam and nearly two-dozen others. The Galleon case revealed a vast web of trafficking in corporate secrets by hedge funds and some technology company executives.

“It does drive some concern about independent sourcing of individual research,” said one hedge fund industry investor who is not permitted to speak publicly. “It does highlight a manager who is not doing their own homework and instead is simply soliciting ideas from companies.”

A spokesman for FrontPoint declined to comment on whether it is still working with any expert network firms.

REGULATORY SCRUTINY

Federal authorities did not identify FrontPoint in the complaint. Authorities also did not charge or name FrontPoint portfolio manager Joseph F. “Chip” Skowron III, who allegedly received the tip from Benhamou. FrontPoint said last week that it is cooperating with the probe and that Skowron, who earned his medical degree and a doctorate in cellular and molecular biology from Yale, had been put on leave.

Prosecutors contend that the timely tip about a death in the clinical trial prompted FrontPoint to begin selling shares of Human Genome Sciences in late 2007 and saved the fund from incurring $30 million in losses.

FrontPoint, a $7 billion hedge fund firm, is racing to control the damage from the Benhamou case, hoping it can stop the bleeding in its healthcare funds from harming the other strategies it offers.

Since the news on FrontPoint and Skowron broke, investors have demanded to pull about $750 million, about half of the healthcare funds’ assets, said an investor who was briefed by the firm but was not allowed to speak about it publicly.

An attorney for Skowron, who lives in Cos Cob, Connecticut, declined to comment. Skowron had been prominent in the Greenwich area but recently withdrew as a board member for the disaster relief and humanitarian aid group AmeriCares.

Meanwhile, for expert network firms, this is not the first time they have found themselves facing regulatory scrutiny.

The New York Attorney General’s office in 2006 subpoenaed some of the industry’s biggest expert network firms about their relationships with hedge but that probe ended without any action. The Securities and Exchange Commission also launched an inquiry. But people familiar with both probes said the investigations came up dry because most expert network firms do advise consultants not to divulge confidential information.

GLG, for instance, warns its experts about insider trading and forces them to follow strict compliance rules.

(Reporting by Svea Herbst-Bayliss and Emily Chasan, editing by Matthew Lewis)

Analysis: Is FrontPoint the next Galleon?