Trader Daily's new legal expert predicts sweeping changes in hedge-fund regulations thanks to Bayou Management.

This isn't the first time. And it certainly won't be the last. But it's all over the news right now -- just Google "Bayou" for proof of the scandal's bona fide explosion. And rightfully so -- the way it's playing out, eventual repercussions from the Bayou Management regulatory investigation could lead to sweeping changes in hedge-fund regulations, and in the ways traders can legally do business.

Bayou is but one hedge fund among 8,000, and the estimated $400 million that has seemingly vanished from Bayou coffers is insignificant compared to the more than $1 trillion managed by those other 8,000 hedge funds. So we can safely say this is an aberration. Contrary to this one blip on the radar, the overwhelming majority of hedge funds provide a positive investment vehicle for experienced, savvy investors. Still... this case is too sexy.

Changes in the legal landscape don't happen based on theoretical notions of right and wrong, and they don't happen when the underlying story is boring. Most cases about investments are dull and tedious: a hedge fund fraudulently reports its "success," and then fails to return any of its investors' funds, leading to regulatory investigations and lawsuits. This is how the Bayou story should have read. However, a suicide letter emerged from Daniel Marino (Bayou's CFO, not the Hall of Fame quarterback) containing allegations that Bayou's founder, Samuel Israel III, at one point held a gun to Marino's chest. Marino is still alive -- though understandably not in the best of spirits.

The suicide letter alone is enough to keep this case in the headlines, where otherwise a tale of murky financial accounting practices and account losses might get buried and forgotten. The authorities have to accomplish something here, or risk looking bad in the press. So far, the U.S. Attorney, FBI, Connecticut State Attorney General, state banking authorities and the local police are all investigating. Investor lawsuits are beginning to hit the fan, though it's unclear what, if anything, will be available for investors to collect.

Critically, Bayou -- unlike most hedge funds -- also operated a securities brokerage business. This allowed Bayou to earn hefty commissions for the fund's trading. It also meant that the brokerage arm, at any rate, was regulated by the NASD and SEC. This gave Bayou the veneer of transparency, luring wary investors who ironically feared sending large blocks of money into murky, unregulated hedge funds.

Bayou successfully marketed itself as a safe investment vehicle precisely because the NASD could always walk in and conduct a surprise audit. If any NASD audits ever took place, they certainly failed to safeguard Bayou investors. Which brings me back to my original point -- the Bayou debacle could lead to sweeping changes in the way regulators treat hedge funds.

With February 2006 fast approaching, hedge funds are facing impending required registration anyway. With an engaging and scintillating case that will continue making headlines while potentially threatening to embarrass regulators, the SEC and federal prosecutors have an acute incentive to make an example of Bayou. Traders should expect to face heightened regulations, along with more reporting and compliance obligations. Penalties for violations stand to be greater. The Bayou case is bad for the industry in any event, but in light of the surrounding circumstances, the timing couldn't have been much worse.

uretsky@phillipson-uretsky.com

9/2/05