Hedge Funds: Are they sacrilegious? Ask the SEC!

Now I have your attention! 

The attack on fraudulent practices in the hedge fund industry by the SEC  – perhaps too little and too late for thousands upon thousands of investors – may not do much good but certainly can’t do any harm either can it?  The objective of regulation in the securities industry is to discourage liars, either by imposing rules (handcuffs) or failing that by punishing them after the fact.  It may seem like an awful lot of manpower and money committed to mitigating just one type of “sin” but civilization has been messing with the problem for thousands of years.

Even the Ten Commandments didn’t deal with it explicitly.  It is almost universally agreed that #9, “Thou shalt not bear false witness against thy neighbours.” prohibits lying, but the wording is far more ambiguous than “Thou shalt not kill.”  It is fascinating (or rather repugnant?) that religious cultures that condemn murder, will kill (stoning) as punishment for adultery.  Others espousing the virtues of honesty nonetheless take great pride in nuturing their negotiating skills – but that’s different isn’t it?  Personally I believe that if one person asks for a price, and the initial price is purposely inflated this is still lying.  Once ignited in seemingly trivial matters, dishonesty then becomes the accepted norm.   Society provides mutliple exceptions to the rule when it comes to killing (self-defense, war, punishment) but there seems no end to sanctioned lies

At the end of last year, the Securities and Exchange Commission (SEC) targeted some alleged fraudsters in the hedge fund industry – notice how instead of simply accusing the guilty party for being a ‘liar’ we have to embellish the act with jargon like ‘misrepresentation’ or ‘misconduct.’

Washington, D.C., Dec. 1, 2011 — As part of an initiative to combat hedge fund fraud by identifying abnormal investment performance, the Securities and Exchange Commission today announced enforcement actions against three separate advisory firms and six individuals for various misconduct including improper use of fund assets, fraudulent valuations, and misrepresenting fund returns.

The SEC today charged two individuals for engaging in a fraudulent scheme to overvalue the reported returns and net asset value of the Millennium Global Emerging Credit Fund. At its peak in October 2008, the hedge fund’s reported assets were $844 million.

The SEC’s complaint alleges that Michael Balboa, the fund’s former portfolio manager, schemed with two European-based brokers including Gilles De Charsonville of BCP Securities LLC to inflate the fund’s reported monthly returns and net asset value by manipulating its supposedly independent valuation process.

The SEC charged New York-based hedge fund firm ThinkStrategy Capital Management LLC and its sole managing director Chetan Kapur with fraud in connection with two separate hedge funds they managed (ThinkStrategy Capital Fund and TS Multi-Strategy Fund). At its peak in 2008, ThinkStrategy managed approximately $520 million in assets.

The SEC’s complaint filed on Nov. 9, 2011 alleges that ThinkStrategy and Kapur engaged in a pattern of deceptive conduct designed to bolster their track record, size, and credentials.  In particular, they materially overstated the performance of the Capital Fund and gave investors the false impression that the fund’s returns were consistently positive and minimally volatile.  ThinkStrategy and Kapur also repeatedly inflated the firm’s assets, exaggerated the firm’s longevity and performance history, and misrepresented the size and credentials of firm’s management team.

Many would agree that it is okay to lie to someone if telling the truth will cause them serious discomfort or even emotional harm.  Since hedge fund investors have been told (based on extensive backtesting and sound mathematical theory???) that risk is minimal, why would one want to deliberately upset them when in reality there is both risk and losses? Perhaps if “kindness” is the motive then there is sufficient justification for telling lies.  (I sure hope you’re detecting a note of sarcasm). 

On the other hand, who would give money over to a “money” manager who honestly advertised that returns might be extremely volatile and losses very extreme if things should go badly?  Cooking the books – some harmless smoothing of the data – won’t hurt anyone and would certainly help the business grow, creating needed new jobs and helping the economy.  After all if folks wanted a risky, highly regulated and potentially ineffective investment solution, they could buy mutual funds. But when they want blue sky with minimal risk they’d be foolish not to expect a little sleight of hand – and the regulators should mind their own business.

Even though the odd hedge fund manager might indeed be a liar (why else circumvent conventional investment fund rules and regs) if a greedy investor is willing to gamble that even a liar might make them both wealthy, why should regulators or courts get involved at all?

When the liars become an institution, and can create havoc in financial markets because of the enormity of their available funds, then the transition from morality to law becomes inevitable.  The sins of a few cause grief for the many.  Sadly, despite the purging of financial services jobs, there is no shortage of employment opportunities when it comes to ‘compliance.’  History is rife with examples of huge infrastructures evolving to control killers and fraudsters.  But as all good conservatives agree, the costs of regulation commonly balloon far out of proportion – those that produce nothing soon outnumber and make it their mission to stranglehold the producers.  Ayn Rand’s Atlas Shrugged is more relevant today than when it was written.

Extreme instances of fraud are well publicized to support the cause of compliance (more jobs, bigger budgets) but we hear no news of those investigations that did nothing except increase the cost of doing business or even destroy the reputation and livelihoods of legitimate money managers.  How many firms become targets of investigations?  Why?  At what point do regulators become liars, in order to be able to launch investigations and demonstrate a growing work load?

According to the latest research pathological liars may have structural abnormalities in their brains.

Published on October 18, 2005 at 8:15 AM

In a new study Dr. Adrian Raine and Yaling Yang of the University of Southern California, and colleagues found that individuals who habitually lied and cheated had less gray matter and more white matter in their prefrontal cortex than normal people.

In the past studies have found that the prefrontal cortex shows heightened activity when normal people lie, and it is believed to be involved in both learning moral behavior and feeling remorse.

According to Raine, because gray matter consists of brain cells, while white matter forms the “wiring” or connections between these cells, pathological liars may have more capacity to lie and fewer moral restraints.

I suppose the real answer is there is no answer.  One day civilization may be able to identify and catalogue liars at birth, but isn’t that just a bit too extreme?  Perhaps the true answer is we should always be wary of extremes.  Anyone who adopts a mission to the point of obsession should be suspect.  

On the other hand shouldn’t a person, business or industry that exists solely to circumvent rules, and flaunts its success at cheating be high on our list of candidates warranting an inquisition? 

Unfortunately, until they are caught even dishonest successful people (wealthy, famous or infamous) are heroes and placed high on a pedestal by many, especially while they are indeed winning; success is worshipped while sins are for the most part tolerated.

I exaggerated when I said that initiatives like these by the SEC (and in Canada the Ontario Securities Commission or OSC) can’t do much good but won’t do much harm either.  Regulators can do much good, but rather than actually working to discourage liars, they will be motivated to be seen as “winners.” The methods adopted will be designed to be successful rather than righteous and can cause a great deal of harm.  Resources that should be devoted to real economic activity are wasted on growing bureaucracies.  But as long as we as a society value success above integrity, and compliance above ethics…..more regulation is unlikely to do much good at all. 

Happy New Year!

 

 

About Mal Spooner

Malvin Spooner is a veteran money manager, former CEO of award-winning investment fund management boutique he founded. He recently authored A Maverick Investor's Guidebook which blends his experience touring across the heartland in the United States with valuable investing tips and stories. He has been quoted and published for many years in business journals, newspapers and has been featured on many television programs over his career. An avid motorcycle enthusiast, and known across Canada as a part-time musician performing rock ‘n’ roll for charity, Mal is known for his candour and non-traditional (‘maverick’) thinking when discussing financial markets. His previous book published by Insomniac Press — Resources Rock: How to Invest in the Next Global Boom in Natural Resources which he authored with Pamela Clark — predicted the resources boom back in early 2004.
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One Response to Hedge Funds: Are they sacrilegious? Ask the SEC!

  1. Pingback: SEC and other regulators on a another Witch hunt? | QUANTLABS.NET

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