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The Moody's Investors Service associate analyst is among a string of tipsters U.S. prosecutors on Friday accused of passing information to hedge fund founder Raj Rajaratnam in the biggest hedge fund insider trading case ever.

"There's no question that this prosecution and the mere mention of a Moody's analyst as a potential source highlights the need for strict and stringent vigilance," Connecticut Attorney General Richard Blumenthal said in an interview.

The case has raised concern about the agencies' business model, in which they are paid by companies they rate.

The system is fraught with potential problems, not least as agencies come under financial pressure following the credit crisis, analysts say.

Allegations of insider trading follow broad criticism of agencies for the role they played in fueling the crisis by assigning unjustifiably high ratings to toxic mortgage-backed securities that later defaulted.

Moody's has been singled out after a whistleblower came forward to testify the agency has continued to favor revenue over ratings quality.

Former Moody's Managing Director Eric Kolchinsky in September said credit policy remains weak and analysts continue to be "bullied" by managers into issuing artificially high ratings.

BUSINESS MODEL UNCHANGED

In the insider dealing case, U.S. prosecutors say the Moody's analyst was paid $10,000 in 2007 for passing on a tip Hilton was about to be bought by the Blackstone Group.

The analyst learned of the buyout when Hilton executives called the agency and told them of the upcoming deal, according to the government complaint. Hilton spokeswoman Ellen Gonda said Hilton has assisted with the investigation and will continue to do so as needed.

U.S. prosecutors say Rajaratnam purchased 400,000 shares of Hilton stock after getting the tip, booking a $4 million profit for his Galleon Technology Funds.

Though still unproven, the allegations call into question the cozy relationships that develop when financial reviewers are paid by the firms they review, market participants said.

Moody's spokesman Michael Adler said the agency has a strict policy against divulging confidential information and will assist the government in its investigation.

The Moody's associate analyst was not charged in the hedge fund insider trading case unveiled on Friday.

"Hopefully this gives yet another reason for cleaning up the credit rating industry and addressing it not with additional regulations but rather by prohibiting issuer compensation," said Sean Egan, managing director at rival agency Egan-Jones Ratings Co in Haverford, Pennsylvania.

Overall, the agencies have a record of protecting inside information, said Charles Calomiris, professor of finance and economics at Columbia Business School in New York.

A one-off allegedly unethical person "is something that happens in all organizations no matter what," he said.

A bigger concern for Calomiris and others is the agencies' pervasive incentive to inflate ratings.

"The concern is first of all that they (rating agencies) have the confidential information, which we think is a fundamental problem," said Egan of Egan-Jones. His firm accepts no confidential information from companies he rates.

Regulators have approved broad new rules in an attempt to curb the power of the three major agencies, Moody's Corp's () Moody's Investors Service, McGraw-Hill Cos' () Standard & Poor's and Fimalac SA's () Fitch Ratings.

S&P, FITCH RESPONSE

A Fitch spokesman declined to comment on the case beyond referring to the firm's compliance document which bars employees from using inside information for personal or others' gain.

S&P also referred to its code of conduct, which bars employees from disclosing or trading on confidential information.

But if the allegations prove true, they will focus more attention on the agencies, said Haag Sherman, co-founder and managing director of Salient Partners, a Houston based investment firm.

"Tipping is illegal whether you are a rating agency or you are a person on the street," he said.

(Editing by Andrew Hay)