Aug. 24 (Bloomberg) -- The U.S. Treasury official leading a government inquiry into the hedge-fund industry is owed up to $2.5 million in payments tied in part to hedge-fund investments.

The official, Emil Henry Jr., has a severance agreement with his former firm, Gleacher Partners LLC, that entitles him to 20 percent of the 2006 profits of an asset management unit specializing in hedge-fund investments, according to his federal financial disclosure form.

The arrangement has been cleared by ethics specialists and Henry has disqualified himself from making policy decisions on hedge funds until the Gleacher payouts are completed, said Treasury spokeswoman Jennifer Zuccarelli. Still, some securities and ethics attorneys said the severance deal poses at least an appearance of a conflict of interest, especially because the Treasury hedge-fund review is closed to the public.

``The clean breach is the best breach,'' said James Cox, a securities professor at Duke University Law School. ``Anything else, you're walking a pretty fine line subject to speculation and condemnation.''

Henry became assistant secretary for financial institutions at the Treasury Department in October after leaving Gleacher, a New York-based investment banking boutique.

The $1.2 trillion hedge-fund industry has come under increasing scrutiny by the U.S. as it has attracted money from pension funds and less sophisticated investors over the past few years. The partnerships, which cater to wealthy investors, have little federal oversight.

Closed-Door Meetings

The Treasury Department hasn't released many details about its inquiry except to say that it plans to hold closed-door meetings with other government agencies and representatives from the financial services industry, including investment banks and hedge funds.

Randal Quarles, the undersecretary for domestic finance and Henry's boss, told a Senate committee last month the Treasury Department's ``comprehensive review'' is trying to determine the ``appropriate policy responses'' to the rapid growth of hedge funds and other changes in the investment industry.

``At the moment it is too soon to say what initiatives will result from this focus, but this is the lens through which we will filter the various ideas and efforts with which we will all be grappling over the next few years,'' Quarles said in July 25 testimony to the Senate Banking Committee. Quarles is leaving the job by the end of the year.

Policy Decisions

Zuccarelli said that, while Henry presided over the first meeting with other regulatory agencies last month, he isn't participating in any policy decisions on hedge funds. No further meetings have been scheduled and Henry isn't planning on attending any others until his payments from Gleacher are concluded, she said.

The meetings are non-public to allow hedge funds and other market participants to speak freely and not be worried about revealing commercially sensitive information, Zuccarelli said.

Henry, 45, has ``been involved in overseeing and planning these meetings, but he has always recused himself from hedge-fund policy recommendations, even broad ones, while at the Treasury,'' Zuccarelli said.

The severance deal was set up as a way of compensating Henry for a valuable business that he founded, called Gleacher Fund Advisors LP, that hadn't yet become profitable, Zuccarelli said. Any money Henry will get in 2006 represents compensation from his previous work at the firm, she said.

Eric Gleacher, the firm's founder, said he doesn't remember why the agreement was set up the way it was but he said Henry has severed his ties with the investment banking boutique.

Terms of Agreement

Officials at the Treasury Department and the U.S. Office of Government Ethics cleared the plan last year. Under the severance deal, Henry got 10 percent of Gleacher Partners' 2005 profits. He also is entitled to 20 percent of Gleacher Fund Advisors' 2006 profits. His total severance can't exceed $2.5 million.

Gleacher Fund Advisors manages so-called funds of funds, which farm out investments to different hedge funds. According to a March 2006 filing with the Securities and Exchange Commission, it has $467 million in assets in 118 accounts.

Kenneth Gross, a partner in the Washington office of Skadden, Arps, Slate, Meagher & Flom, said ethics rules bar federal officials from being compensated for profits their former company earns while they are in office. Federal officials can receive payments from their ex-employers if the money is compensation for work performed at the company, he said.

``Generally speaking, it all has to be in recognition of services performed prior to entering the government,'' said Gross, who counsels people entering and leaving government on their ethical obligations.

Complex Finances

Gross said that government officials with complex finances often need to work out arrangements that will allow them to get money they are entitled to and still satisfy ethics rules.

``Extracting yourself from financial services firms or hedge funds is not necessarily that easy,'' he said.

Henry's disclosure form also reports that he earned $1,248,983 in salary for about 20 months ending in August 2005. Henry was paid an additional $430,488, mostly in ``partnership income'' from various investments, according to the form.

He also reported investing between $500,000 and $1 million in a hedge fund run by Glenview Capital Management. The form, signed by Henry on Aug. 15, 2005, shows investments in broad ranges.

In a Sept. 7, 2005, letter to Treasury's ethics lawyer, Henry pledged to sell his stake in the Glenview hedge fund as well as in two limited partnerships run by Gleacher. He is keeping investments in other partnerships, including Gleacher Equity LLC and Gleacher Mezzanine LLC. Both invest in industrial and manufacturing companies.

Financial Interests

Henry said in the letter that he would recuse himself from matters involving Gleacher for a year and wouldn't participate in decisions that would affect his financial interests.

``I will not participate personally and substantially in any particular matter that would have a direct and predictable effect'' on his investments, Henry said in the letter.

Having an insider like Henry, who has invested in hedge funds, leading the Treasury review may be a positive development, said Michael Greenberger, a University of Maryland law professor and former head of trading and markets at the Commodity Futures Trading Commission.

``There is a lot of fear about what is going on in the hedge fund world,'' Greenberger said. ``If he knows something about hedge funds, he may be just the guy to look into what is going on.''

To contact the reporter on this story: Robert Schmidt in Washington at rschmidt5@bloomberg.net.

Last Updated: August 24, 2006 12:13 EDT