//BY STEFAN LINSSEN & ROBERT MCGARVEY

One night in the not-so-distant future, an associate at the Thai office of an international hedge fund learns from a Chinese government official (who moonlights as a consultant to the fund) that an American technology company likely paid a series of bribes to win deals.

The fund shorts the stock and then sends an anonymous tip to the U.S. Department of Justice (DOJ). DOJ launches an investigation.

The American firm conducts its own investigation. Four weeks later, the company files an 8-K with the SEC announcing potential irregularities in payments overseas. The stock drops 20 percent overnight.

The hedge fund profits immensely. The associate smiles. Another win. Then he thinks to himself, I wonder how far that other company's stock will fall when the Board of Directors gets my anonymous note about the married CEO trolling for sex partners on a gay-themed Internet site?"

A true story? Not yet. Could it happen? It already has. Hedge funds are already betting on companies real or perceived compliance and ethics failures, and lots of money is being made on these bets.

SEC COMMISSIONERS, POLITICIANS JOIN HEDGE FUND PARADE
Seduced by the glamour. Attracted to the opportunity to prove that you are smarter than everyone else. Happy to make a bundle off other peoples' money without sharing the downside risk. The are some of the reasons that so many want a piece of the hedge fund action.

As a result, a tsunami of money continues to flow into hedge funds.

According to Hedge Fund Research (HFR), hedge funds now number more than 9,500, and in the first quarter of 2007 hedge fund assets under management topped $1.5 trillion. Hedge funds also continue strong growth: The first quarter's in flow of $60 billion is nearly four times last year's rate.

ENORMOUS, NON-ACCOUNTABLE RESEARCH BUDGETS
Hedge funds control 30 to 50 percent of trading volume on major exchanges because, by their very nature, they are aggressive traders that move their money around. This high trading volume also means they rank among Wall Street's very best customers. In return, they get good information from Wall Street. In addition, funds can afford to invest in their own proprietary research and investigations or purchase it from third parties. Many funds won't think twice about spending upwards of $1 million a year to have access to networks such as Gerson Lehrman or Vista Research, two outfits that claim to have more than 100,000 experts "on call" who are paid on an hourly basis to talk to investors.

This premium research is critical because between Regulation FD and the Internet, the investing public has access to the basic data and SEC filings submitted by corporations. A lot of Wall Street's information has been commoditized, but not all.

Allegations arise that sometimes these "experts," made available by high-priced research out? ts, are employees of corporations and are expected to talk about their industry in general. But could the conversation veer into company-specific secrets and operations?

Or, in the case of biotech, the experts whom these firms have "on call" may be doctors conducting clinical trials. After a few dozen calls, a hedge can obtain immediate and accurate insight to the efficacy of any particular drug being studied- perhaps even before the company conducting the trial.

As top-rated stock analyst Quynh Pham told the Seattle Times last year,"When it comes to gathering information I really can't hold a candle to the hedge funds. They're able to do things that are unethical."

COMPENSATION STRUCTURES ENCOURAGE RISK
"The compensation structure for managers creates inducement for ethical lapses," says Michael Panzner, author of Financial Armageddon (Kaplan, 2007). The argument: Traditionally, mutual fund managers are compensated based on the amount of money they manage and, while strong returns may bring in more investment, it doesn't immediately translate into more money in the pocket of a mutual fund manager.

Furthermore, the nature of the typical management agreement further drives the emphasis on short-term results. The management fee is two percent of assets plus 20 percent of the gain, but there is no penalty to the manager for losses, other than a reduction in the money under management.

At hedge funds, strong returns do boost compensation for managers. When Institutional Investor's Alpha reported last year on hedge fund manager compensation, at the top of the list was James Simons, who pulled in $1.7 billion. The average compensation for the top 25 earners was $570 million. The low pay on the list was $240 million. Nobody is claiming these managers have done anything wrong- but digest those numbers and consider the consequences.

"Their compensation attracts attention. It also encourages very high levels of risk taking," says Sergey Barabanov, finance professor at University of St.Thomas, Opus College of Business in St.Paul, Minnesota.

Michael Edesess, author of The Big Investment Lie: What Your Financial Advisor Doesn't Want You To Know (Berrett-Koehler, 2006) explains a key ethical concern among experts: Hedge fund managers pro? t on the upside but don't customarily share losses. When a fun profits, the manager takes the typical 20 percent fee; when the fund stumbles, the do not pony up a proportionate payback.

"They take a piece on the upswing and put in nothing when the fund goes down says Edesess. The problem here is that very compensation structure encourages risky behavior. Why not bet the farm when the farm isn't yours?

MONEY ALSO ATTRACTS RULE BENDERS
That very compensation structure may have another side effect: "It may attract unscrupulous people," says Michael Josephson, head of the Los Angeles based Josephson Institute of Ethics.

While high-profile names are getting into hedge funds, fraudsters are too. Background checks on potential managers are increasingly prevalent.

At Corporate Resolutions, where Ken Springer, a former FBI agent and fraud examiner, serves as president, a constant stream of customers want to know one thing before they turn over $5 million, $10 million, or more to hedge fund managers: "Who the heck are these guys?"

Springer turns to old-fashioned, gumshoe investigative techniques to probe into the identity of hedge fund managers. The frightening finding: "About 15 percent turn out not to be who they say they are," says Springer.

In some instances, hedge fund managers have had multiple personal bankruptcies. "In my business we call that a clue," Springer says with a wry chuckle.

In other cases, managers have been disciplined by the SEC and are persona non grata at regulated funds. Others may have lied about educational experience, but some also lie about job experience, such as omitting positions that didn't pan out or perhaps claiming positions they did not actually hold. Springer does not claim that any of these lies instantly translates into financial losses for investors- but he does say that all of these are red flags.

Two tips Springer offers: "In every case, verify that the people you are dealing with are who they claim to be," and, "Whenever a hedge fund manager leaves a fund, track him down and ask why." Sometimes it turns out that the fund was skating at the ethical edge, and this manager wanted out before the bubble burst.

HEDGE FUNDS CRAVE VOLATILITY
In order to make money under their risk-inducing compensation packages, hedge fund managers need stock or any other security to move and the more violent the move, the better.

That is "volatility."

Volatility is the engine for profit, and hedge funds need it in part because their own investors are fickle and demand quick and immediate results.

As the Chairman and CEO of Goldman Sachs, Hank Paulson (now the current Secretary of the U.S. Treasury no less) quipped in a cover story for Forbes back in May 2000, "Volatility is our friend. If it wasn't for volatility, why would you need Goldman Sachs? Why would you need to take positions or risk?"

Traditionally, a stock that moves more than a few percentage points within a few days is deemed volatile.

Through financial engineering, a savvy hedge fund can turn a few percentage point gain or loss into a multifold return on investment. First, the fund can increase its purchasing power simply through leverage: Borrowing to be able to purchase more shares. And then a fund can multiply its exposure through purchasing call and put options, or still more sophisticated derivatives.

The limits to leverage are surprisingly high. For example, in the Long Term Capital Management hedge fund meltdown of 1998, calamity in the financial market was narrowly averted when the U.S. Treasury convinced a collection of major banks to continue to offer liquidity to the market so that the assets of the fund could be orderly unwound without financial panic.

During this unwinding, regulators and bankers got a first hand look at extremely high leverage limits and their impact. 100:1. In other words, for each dollar in equity, through loans and other leverage, Long-Term Capital bet $100.

But all this volatility is exactly the opposite of what regulators want to see. According to ethicist Michael Josephson,"The point of regulation of the financial sector is to control instability." Step by step from placing controls on margin buying to outlawing naked shorts federal regulatory bodies have sought to reduce the volatility and thereby reduce the risks involved in investing.

Hedge funds are playing chicken with that body of law and regulation. "Hedge funds sometimes seek to maximize instability and to profit from it," observes Josephson.

Kingman Penniman, president of the high-yield research firm KDP Investment Advisors, pointed out to Bloomberg new earlier this year, "The market wants volatility. The worst things that can happen is nothing" [so funds seek to] find triggers to make things happen."

INCREASINGLY, HEDGE FUNDS BETTING ON EVENTS
According to HFR, an increasing number of hedge funds are beginning to focus primarily on an "event-based" investing strategy. In other words, they are waiting or betting on a particular event occurring and that a stock or bond will move in a volatile fashion as a result.

A decade ago, only about four percent of assets under management were focused on an event-driven strategy. Now it has become one of the more popular strategies. HRFI calculates that event-driven strategies now account for 13 percent of all fund investing methods -- a proportion that is expected to increase.

But what constitutes a material event? For hedge funds, these events include factors such as taking a company private, a significant litigation win or loss, a management change, a merger or acquisition, and more recently -- in this day of transparency, regulation and corporate governance -- an ethical or compliance failure.

And each event has a trigger that sets it off.

Consider how on August 13 of this year, the multi billion dollar semiconductor chip company Qualcomm (NASDAQ: QCOM) fired its General Counsel. This came on the heels of a series of legal setbacks for the company in its patent litigation proceedings brought against it by competitor Broadcom.

Qualcomm's outside counsel discovered documents the company hadn't previously produced that revealed facts "inconsistent with certain arguments that we made on Qualcomm's behalf."

In other words, Qualcomm was concealing documents improperly and potentially illegally.

Despite an apology letter from the General Counsel, the judge ordered Qualcomm to pay all of its competitor's legal expenses and subjected them to public admonishment. That was the trigger.

Just five days later came the event: The General Counsel was pushed out of the company.

On the day of the ouster, Qualcomm's stock went up three percent. That may not sound like much, until you realize that three percent in this instance was equivalent to $1.7 billion.

Or consider the case of Beazer Homes USA (NYSE: BZH). On June 27 of this year, the company mentioned in an SEC filing that it fired its chief accounting officer "due to violations of the company's ethics policy stemming from attempts to destroy documents in violation of the company's document retention policy."

No press release was issued by Beazer. Just a quiet SEC filing. The stock dropped nearly 15 percent in response, wiping out approximately $160 million in shareholder value.

Just a month earlier, the $49 billion healthcare giant out of Indianapolis, Wellpoint (NYSE: WLP), suffered a similar fate. On May 31, 2007, the company announced that its CFO had been terminated for violating the company code of conduct. In this case the company made it clear that the violations had nothing to do with the business. It was soon revealed that the CFO had been carrying on multiple romantic affairs, and the company found this conduct sufficiently unbecoming that it decided to fire him.

All the same, the company's stock dropped by $1.8 billion.

All these cases reflected a compliance or ethics failure that occurred among the executive ranks of the company.

Compliance and ethics failures that serve as trigger events impacting a company's stock price need not occur in the executive suite. A breakdown elsewhere in the organization can have a material impact as well.

The example of FARO Technologies (NASDAQ: FARO) bears this out. On March 15, 2006, the company announced that a low-level employee at a subsidiary in China may have made payments to customers in violation of the U.S. Foreign Corrupt Practices Act. Despite the fact that the revenues affected by these payments were less than one percent of FARO's aggregate revenues, the company's stock price dropped immediately by 20 percent and did not recover for months. Currently, the company is conducting an internal investigation into the matter and has voluntarily notified the SEC and DOJ.

And finally, a compliance or ethics breakdown does not even have to be intentional; it could be due simply to carelessness or ignorance. One of the best examples of this is the protection of confidential customer information. A joint study released last year by the consulting firm Hydrasight and Colorado-based Enterprise Management Associates (EMA) found that the stock prices of companies that experience an information breach fall significantly. Regardless of the industry, within the four weeks following public disclosure of an information breach, stock prices dropped five percent or more and remain at depressed levels compared to the overall market for nearly a year.

TJX Companies, Inc. (NYSE: TJX) needs no convincing. The company found out the hard way in early 2006 after disclosing a significant breach of its customers' credit card records. Within two months the company shed more than 10 percent, or over $1.3 billion in value, and it took nearly a year for the stock to recover back to pre-breach disclosure levels.

The bottom-line is that in today's investment universe, where hedge funds set the tempo, suddenly gaffes, missteps, even peccadilloes -- things that might have been ignored by investors before -- suddenly are ways to generate short-term profits for hedge fund managers and their investors. This is not to say that, for instance, misconduct by a general counsel is a good thing, but should it trigger out-sized profits for rapacious money managers? The answer is plain in today's hedge fund dominated world.

INSIDER TRADING IS EXPLODING
Any thought that hedge funds are shy about using insider information is naive. Insider trading is hitting record levels that haven't been seen since the days of Ivan Boesky (and his fictitious alter ego, Gordon Gekko) of the 'Greed is Good' 1980s.

For example, the world's third-largest hedge fund, the $20 billion European-based GLG Partners, has been fined twice this year alone by French market regulators for illegal insider trading. And in June, GLG settled 14 separate charges with the SEC for illegal insider trading over a two-year period.

GLG, along with its top trader Philippe Jabre, was also fined last year by UK market regulators, Financial Services Authority (FSA). Jabre's response? He registered a new fund in Geneva, out of the FSA's jurisdiction.

GLG is far from the only hedge fund accused of insider trading. Insider trading fines have also been levied against three other hedge funds, including UBS O'Connor, Meditor Capital and Ferox Capital Management.

Yet many cases of obvious insider trading continue unabated with no enforcement action taken to date.

One example was the buyout of Hilton Hotels (NYSE: HLT) by the private-equity group, Blackstone, earlier this year. In the day before the deal was announced (July 3, a day before a national holiday and a day where stock volume should have been abysmally low), Hiltonís stock rose over 6 percent with an extraordinarily high volume of trading. The stock option traffic on HLT stock was equally impressive, climbing to nine times the normal average. Was any of this insider trading? No charges have been brought, but a valid question is why so much stock moved at such a propitious time and on a day when trading volume was otherwise typically light.

Accept this blunt truth: Insider trading on illegally obtained information is acceptable to most traders. A July 2007 survey by Trader Monthly magazine polled 2,500 traders on whether they would trade on illegal insider information if the deal were to generate a $10 million profit for them and if there was no chance of getting caught. The result --58 percent said they would.

How much insider trading is occurring? No one knows. But the threat of being caught can have a deterrent effect, so the SEC, NASD, and FSA have launched a flurry of probes and actions. Hedge funds engaged in such activities had better beware.

As Steve Luparello, Senior EVP for market regulation at NASD told Business-Week earlier this year, "Hedge funds misusing nonpublic information is a growing issue. In this situation people sometimes cut corners. We are devoting substantial resources to these investigations."

Early in 2007, rumors began to swirl that some hedge funds were bribing employees at brokerage firms to tip them off to large orders placed by mutual funds. Published reports have said that Merrill Lynch, Morgan Stanley, and UBS, among other large brokerages, have been requested by the SEC to turn over information pertaining to various trades.

Peter Bresnan, associate director of the SEC's Division of Enforcement, told a conference that what sparked these investigations was information that "mutual funds have come to us and have said hedge funds are front-running their orders."


MONEYS NOT IN THE REACTION BUT OVERREACTION
Most people naturally think that in order to make money, a "negative event" is needed for a stock to drop, and that a shrewd investment would be to place a put, betting that the stock price will fall when bad news is released.

However, stocks don't always go down in response to negative events. A case in point is Starwood Hotels & Resorts (NYSE: HOT). Earlier this year, Starwood's board of directors ousted the company'­s CEO, Steven J. Heyer, over allegations that the married executive sexually harassed employees. Supposedly rumors had been swirling within the company for months -- information that could have and probably was shared with outsiders. The official message was that Heyer was leaving voluntarily ... but who in their right mind would voluntarily leave behind $35 million in severance pay as Heyer did?

What happened to the stock upon this announcement? It jumped nearly 10 percent, adding $1.3 billion in shareholder value. Why? Because analysts figured that without a CEO, the company would be put "into play" to be bought by a competitor.

That doesn'­t mean that an investor has to guess the direction of the stock in reaction to executive peccadilloes. The reality is that hedge funds purposefully stake out contrarian positions. For example, rather than betting that a stock will go up or down as a result of an event, they bet both. With the use of both puts and calls, the real bet is that the market will overreact to the news that comes out.

And betting on overreaction is usually right.

In the ensuing weeks after Heyer's departure, when it became apparent that neither a competitor nor a private equity player was going to make a bid for Starwood, the stock drifted back down to even lower levels than preceded the CEO's ouster.

PROFIT NOT JUST IN THE STOCK MOVEMENT
One of the most well-known, widespread compliance and ethics failures in recent years has been the stock-option backdating scandal. Unfortunately,this activity is not an entirely new development. As far back as 1995, New York University finance professor David Yermack did research across a swath of companies that suggested grants were dated to coincide with good news.

However, it was the May 2005 publication of a study by Professor Erik Lie from the University of Iowa that brought the issue to the forefront.

The scandal spread and, by recent counts, now involves more than 125 companies, many of them household names. In turn, the publicity has prompted numerous indictments and convictions, and experts expect more to come.

What made stock-option backdating so unique is that it involved the most senior executives. And when compliance and ethics failures involve executive leadership, inevitably some of them will lose their jobs (another trigger event).

Soon savvy investors began to see a way to profit from this compliance failure. One such firm, Whitebox Advisors, a $1.8 billion hedge fund out of Minneapolis, decided to do its own research.

Over a period of months, Whitebox intensely studied 6,000 companies and 60,000 option grants. They found several hundred companies that seemed to have suspiciously timed option grants, probably many of the same companies referenced (but purposefully not publicly identified) in Professor Lieís analysis.

What did Whitebox do with this information? First, it sold short the stocks of 80 companies identi? ed as potential back-dating offenders. Then the fund examined publicly traded bonds of these same companies. If the bonds were trading below par (below the level at which they would be ultimately redeemed), Whitebox likely purchased them as well.

For many of the companies, as soon as they disclosed the stock option investigation, their stocks dropped, thereby creating immediate profit for Whitebox's "shorts."

In regard to the bonds, the hedge fund knew that many of the companies in question would no longer be able to file their financial statements with the SEC on time. The fund bet that no CEO or CFO in his right mind would personally attest to the accuracy of the company's financials (as now required by Sarbanes-Oxley Section 302) while the company was undergoing an investigation that could require that the financials be restated.

Without filing with the SEC, the bonds would go into default. In the past, a bond investor might have looked the other way. Not Whitebox. With the bonds in default, the hedge funds found themselves in the position where they could demand that companies either pay them a fee or immediately repay the full face values of the bonds.

Normally when a company doesn't file its financial statements, the price of its bonds might suffer. However, this hedge fund investment strategy of exploiting companies' technical defaults has actually led bond prices to rally for companies that fall under accounting and stock option investigations.

COULD IT GET UGLIER? IT WILL
Event-based investing strategies. Unethical investors. Huge research budgets. Compensation structures that reward risky behavior. Collect these factors into a highly competitive, unregulated market, and it's an explosive mix.

Who could have predicted that disclosure of a sexually-harassing CEO, a CFO's fraudulent resume, or a married CFO's romantic affairs would move a stock? Inside information is valuable tender, and some companies are stooping to increasingly unethical means to acquire it.

What about the Hewlett-Packard scandal of 2006 whereby agents of the company hacked into the telephone records of board members and sifted the trash of reporters? Was it an isolated lapse in judgment? Not exactly. Consider these other incidents from the past 12 months, many of which were not covered in the press:

• Private investigators were caught trying to hack into the computer used by the head of the Jimmy Choo shoe empire by sending infected email attachments. It was a UK job that employed a Phoenix, Arizona-based hacker, and neither were charged.
• Investigators from Telecom Italia spied on newspaper editors who wrote negative information about the company, including hacking their computers, stealing business plans, and even hiring a call-girl to troll the bars frequented by the chief editor in hopes of compromising him.
• Lawyers in a wrongful termination case hired a private eye to tail the general counsel of publicly traded real estate brokerage firm, Realogy, during a weekend in March. The investigator videotaped the GC drinking bottles of wine while taking a hundred-mile meandering drive through New Jersey.

Watch for instances where bad behavior by senior executives triggers interest from- and investments by- hedge fund managers who have taken what prior generations viewed as the private woes of corporate leaders and translated it into profits. Funds that learn about the misery early can exploit it, such as through well-timed shorts coupled with whispers to scandal-hungry journalists.

More is coming. According to one hedge fund executive who wished to remain anonymous for obvious reasons, one Deborah Jeane Palfrey now looms large on their radar. Known as the "D.C. Madam," Palfrey ran an escort service in the Washington, D.C., area for over a dozen years, catering to high-pro? le clientele. After a protracted legal battle, she recently posted nearly 100,000 easy-to-search records of calls made to her business since 1994 (www.dcphonelist.com).

According to this manager, more than one fund has been looking into triangulating these numbers back to executives' offices and cell phones.

That is exactly the kind of scandalous scoop that triggers executive upheaval- and upheaval means dollars to hedge funds.

BRAVE NEW WORLD
Short of aggressive new regulation by the SEC and FSA, which is unlikely to happen, this is the new reality for publicly traded companies.

Hedge funds attract smart, yet not necessarily ethical, people. And the environment in which they invest is a kill-or-be-killed, aggressive culture.

As Scott W. Friestad, an associate director at the SEC's Enforcement Division notes "Hedge fund assets have grown significantly, and there is a lot more competition for returns." In this pressure for returns, whether a fund outperforms will depend on the quality proprietary information that it can gather and analyze- first determining how such information may impact a security, and then perhaps even helping to disseminate the news.

In the case of the stock option back-dating scandal, due to careful analysis some hedge funds knew that specific companies had problems before those companies themselves even knew that they had a problem.

Invariably, in the search for information, some firms will turn to research methods that go beyond what most people might find ethically acceptable.

"How much of what hedge funds do is ethically shady?" adds Chief Ethicist for iDNA, David Schmidt. iDNA is a strategic communications and technology company that specializes in producing corporate meetings, orientation modules, and ethics trainings for companies. His answer: "The reality is, we don't know. That is what happens when there isn't transparency."

As unsettling as these investment tactics and trends are, it is the new reality. The smart Board of Directors and CEO recognize this and put a proactive defense strategy in place (see "Seven Steps to Fighting Back").

Could it be summarized as "don't lie, don't cheat, don't steal" and everything will be fine? Unfortunately it's not always that simple.

However, one universal truth remains: Above all else, self-examine, uncover and address all potential compliance, ethics and moral problems internally first- before an outside hedge fund uncovers and exploits them. If the hedge fund gets there first, your organization will likely have lost control of its ability to control the resolution of the compliance or ethics breakdown.

And should a hedge fund investor attack your company, claiming that it's simply trying to root out corporate misconduct, before you go on your justified counterattack- hand them a mirror.