The New York field office of the FBI sits a block west of Foley Square, where Roman and Greek- inspired courthouses with four-story colonnades loom over a small town of judicial institutions in which the biggest of America’s financial crimes are prosecuted.

Almost five years ago, in a conference room 23 stories above the plaza, FBI agents David Chaves and Patrick Carroll surveyed the midtown skyline to the north, home to much of the world’s financial industry. They had received some disturbing intelligence: a surge in profits at hedge funds might be the result of an epidemic of insider trading.

The two men, head of securities and aommodities fraud units at the New York office, faced a dilemma. Informants had told them the hedge fund industry was similar to organized crime: insular and distrusting of outsiders. Without people on the inside, the government would have a tough time gathering enough evidence to prosecute. They needed more tools to gather more information on traders who move faster, and more secretly, than your typical Mafia soldier.

“It was reminiscent of that scene in ‘Jaws’ where they get their first look at the shark,” Chaves said. He told Carroll, “We’re going to need a bigger boat.”

That bigger boat came in the form of a landmark change in the way white-collar crime is investigated in the U.S., agents said. The only way to uncover insider trading was to apply the same techniques agents used to dismantle the Mafia: court- authorized wiretaps of phones, informants and cooperating witnesses.

‘Perfect Hedge’

At that moment, “Perfect Hedge” was born. This is the behind-the-scenes story of that historic, sprawling, nationwide insider-trading initiative by those who ran it.

Over the next five years, the operation by the New York offices of the Federal Bureau of Investigation and Manhattan U.S. Attorney led to prosecutions that disrupted multiple rings of illegal trading by portfolio managers, bankers and consultants. It is the biggest insider trading investigation since the days of Ivan Boesky and Michael Milken, and the largest ever in the world of hedge funds.

Agents in New York spent years monitoring clandestine wiretaps as traders received and passed illicit tips. The FBI learned everything it could about fund managers suspected of being criminals, conducting surveillance as targets passed secrets on street corners, in gyms, or handed out bags of money for information.

Illicit Profit

And it all began with the realization that hedge fund managers who illicitly profited on knowledge the public didn’t have access to could be pursued as vigorously as those who commit more traditional crimes.

“We coined this investigation ‘Perfect Hedge’ because if you’re armed with that insider’s information, you can initiate the perfect hedge,” Chaves said in an interview. “You’re always protected — the upside and the down side.”

The results can be seen in the scores of insider-trading prosecutions made in New York — from the conviction of Galleon Group LLC co-founder Raj Rajaratnam to those involving expert- networking consultants and employees at technology and pharmaceutical companies.

To date, at least 56 people have been charged with insider trading and more than 50 have either pleaded guilty or been convicted after trial as part of the probe, according to the office ofManhattan U.S. Attorney Preet Bharara. Wiretaps played a role in many of these cases.

‘Identified The Problem’

“We identified the problem, we created the solution to infiltrate the industry and we put people in well-placed hedge funds who reported to us on a daily basis,” said Chaves, 48, a lawyer as well as supervisory special agent. He worked on the prosecutions of WorldCom Inc. Chairman Bernard Ebbers, who was imprisoned for accounting fraud, and Martha Stewart, convicted of obstruction of justice in an insider trading case.

In some circumstances, Chaves said, agents would send in people wearing wires to record incriminating statements by targets. Such evidence, he said, “could then be used to provide us enough probable cause to obtain a wiretap.”

Ironically, the wiretaps that were so crucial to bringing down defendants in Perfect Hedge will be the basis of an appeal in its biggest case so far, that of Rajaratnam.

In May, the hedge fund manager was found guilty on all 14 counts of securities fraud and conspiracy he faced. The trial showcased 45 recordings by agents working for Chaves and Carroll of the more than 2,400 taped conversations between Rajaratnam and friends, business associates and alleged accomplices.

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