No Safe Haven

There's $400 billion in unregulated money stashed in offshore hedge funds. It's time to expose this Crescent of Corruption.

By Christopher Byron
January 17, 2003

We know of a fellow who claims to be running a more than half-billion-dollar offshore hedge fund empire from an office in downtown Boston. He's got himself a seat on the board of directors of what looks to be a cutting-edge high-tech company. He's got a $1 million apartment on Beacon Street, an Ivy League diploma hanging on the wall, and a Web site that broadcasts his accomplishments to the world.

Unfortunately, not a whole lot of what our man claims--about himself or anything else--seems to bear up under scrutiny. Everybody likes our friend, with his winning ways and that smile as big as all outdoors. But look carefully at that Ivy League diploma and it turns out to be from the university's equivalent of night school. As for his teams of analysts, who are said to spend their days peering into rows of flat-panel Bloomberg terminals, searching for nuggets of equity gold, well, has anyone ever seen them? Even one of them? Or seen an audited statement of one of his funds? Or spoken to someone at a Wall Street clearing house who's handled a trade for him?

When they tire of such a fellow in Texas they say of him, "All hat and no cattle," and let it go at that. But our friend is in a line of work--the offshore hedge-fund game--where things have suddenly gotten more serious, and the stakes a lot higher. In short, where it's ceased being cool to talk of having a business in Tortola, Nevis, or even Bermuda or the Cayman Islands.

In the post-September 11, 2001, predicament of a world on permanent high alert, the words "offshore money" no longer sound exotic. Now the mystery comes tinged with insecurity and even menace, and in Washington, D.C., the questions have begun: Where did all these offshore hedge funds come from anyway? What's their game, and who's behind them? Aren't they answerable to anyone?

Just as Winston Churchill said of Russia, the world of offshore money is a riddle wrapped in a mystery inside an enigma. And though the denizens of the hedge fund world may wish it to stay that way, change is in the air: like it or not, the most rapidly growing, freewheeling, and least understood part of the U.S. capital markets is about to feel the lash of government regulation.

Closed Books

In the wake of the September 11 terrorist attacks, pressure has been building in Congress and elsewhere to draw back the curtain on this mystery world that lies just over the horizon--and not just concerning hedge funds. Incoming Senate Finance chairman Chuck Grassley (R: Iowa) is sponsoring two separate bills designed to stop U.S. companies and individuals alike from using offshore havens to avoid U.S. taxes. More narrowly, an investigation is underway within the Bush administration to develop a base level of information about the workings of actual hedge funds, both offshore and domestic.

The reason for the interest was put succinctly last March by the seven-nation Financial Stability Forum, which is based in Basel, Switzerland, and is composed of the top finance officials of the G-7 nations. In a report on global financial issues following September 11, the forum warned that unregulated international hedge funds may have already developed, at the margins, into financial Laundromats for global terrorism.

Unfortunately, more than a year after Congress passed the USA Patriot Act to prevent the hot money of global crime from gaining access to the U.S. banking system, the door into and out of America's capital markets through the hedge fund laundromat remains as wide open as ever.

One widely cited set of data--from a research unit of New York-based Dome Capital Management, which has been tracking hedge-fund growth since the '80s--puts the current number of offshore hedge funds operating in the U.S. markets at 3,500--quadruple the number of just six years ago. The folks at Dome estimate that offshore funds under management have soared from $91 billion to more than $400 billion over that time. McFall Lamm, chief investment strategist for Deutsche Bank, figures hedge funds in the aggregate may now account for as much as $1 trillion--an amount equal to 10 percent of the Standard & Poor's 500 index.

Because no one really knows much about the funds, both the Securities & Exchange Commission and the National Association of Securities Dealers have launched extensive formal studies of hedge funds and their growing presence in the U.S. capital markets. "I'll tell you the truth," says a top market surveillance official at the NASD, "we don't know the first damned thing about these funds. But we're going to find out."

Hedge funds are a mystery because they are exempted from regulation by both the Securities Act of 1933, which covers the offering of shares to the public, and the Investment Act of 1940, which covers mutual funds. The theory is that the customer base for hedge funds--investors who make more than $200,000 a year in gross income and have a personal net worth in excess of $1 million--should have enough financial savvy to look out for itself.

So, stock promoters looking to raise investment funds from such people get a regulatory break, and neither have to register the deals as stock offerings under the 1933 Act nor report on their activities later under the 1940 Act. The result is an almost total lack of regulatory oversight of the funds' actual activities. In the past three years, the SEC has brought only ten enforcement actions against hedge funds--and usually only in the case of outright fraud.

Craven Havens

As a result, offshore hedge funds, which are likewise exempt from U.S. oversight and regulation, have been able to operate with impunity from one of the most historically suspect business environments on earth. These offshore tax-haven countries girdle the globe like a Crescent of Corruption, from the Pacific island sandbar-nation of Vanuatu in the west, to the Channel Islands off the coast of Britain.

The passage of the Patriot Act was intended to staunch the flow of illicit dollars into and out of the United States through these countries. Nearly all have the status of sovereign nations in international affairs, though many have no apparent purpose other than to provide a false nose and mustache for the money-laundering activities of drug smugglers, arms dealers, and even the financiers of the al-Qaeda terrorist network.

Not all offshore funds fall into that category, of course, and many are set up quite legitimately to facilitate investing by U.S. institutions that are already tax-exempt. But enough of what goes on in this world is truly worrisome.

Consider the Pacific island of Nauru. At 21 square kilometers in size, Nauru is the third-smallest country on earth, after Vatican City and Monaco. Nauru's 12,300 inhabitants must share a mere 2,000 telephone lines and 500 TV sets, on an island with no arable land where almost everything has to be imported. But Nauru does have super-accommodating bank secrecy laws, which explains why in 1998 (the latest year for which data is available) the offshore banks of this country functioned as the spin cycle for more than $70 billion in hot money from the crime-drenched economy of Russia.

In a similar spirit, consider the pseudo-state of Montenegro, which lies north of Albania on the Adriatic coast. Montenegran banks attract the secrecy-obsessed by billing the locale as "the most private jurisdiction in the world, "offering anybody a "private coded account, which is no longer allowed even in Switzerland." For about $1,000, Montenegro's Maranatha Bank will set up a shell company for you in Panama. Throw in an additional $500 or so and the bank will even provide a hand-picked board of directors, and you'll be protected behind the secrecy laws of not just one, but two, sovereign members of the Crescent of Corruption. Your ultimate line of defense: a board of see-no-evil directors who don't even know who you are.

The Patriot Act targets such operations by requiring that all U.S. banks doing business with foreign financial institutions determine who specifically is behind any specific account before conducting transactions of any sort with it.

This has already brought the so-called brass plate banking business (tax-haven private banks that consist of nothing but a brass name plate) to a standstill in a number of countries. "I know lawyers in the Cayman Islands who have seen their entire practices crumble before their eyes," says Jack Blum, the former special counsel to the Senate Foreign Relations Committee from 1987 to 1989 and a leading authority on the underworld empire of offshore finance. "The American bankers are now all afraid to death of going to jail so they've stopped dealing with correspondent banks, period. In that sense at least, the Patriot Act is proving a big success."

Offshore Thing

Unfortunately, there's still a gaping hole in the system. Offshore hedge funds provide an end run around the entire crackdown by allowing money to be moved anonymously in and out of the United States without ever going near a U.S. bank. Instead of using banks for laundering, offshore hedge funds can use the stock market, turning listed companies and U.S. investors into unknowing participants in the spin cycle of dirty money. And because the law specifically exempts the funds from registration or disclosure requirements of any sort, there is no way to know whether the individual funds themselves are legitimate operations.

In some cases, suspicion is inevitable. That is especially so when the funds turn up as investors in companies in which yet another form of identity-hiding offshore finance--tax-haven shell companies--appear as big investors as well. The secrecy of the shell companies combined with that of the hedge funds, makes it impossible to determine whether the owners of those shell companies are also limited partners in the offshore hedge funds, which in turn may be using their capital to invest in U.S.-traded companies in which the shells already hold hidden interests.

A New York mafia figure named Salvatore Mazzeo made more than $17 million in the '90s running variations on this scam, using a brokerage firm he controlled called Westfield Securities and a Vancouver operation named Pacific International Securities. Two top international lawyers--Montreal's Harry Bloomfield and London-based Stuart Creggy--are currently on trial in New York and face up to 15 years in prison for setting up shell companies in Liberia and Belize for Mr. Mazzeo.

Last summer, in the culmination of a three-year undercover operation dubbed Bermuda Short, the Federal Bureau of Investigation arrested 58 U.S. and Canadian stock brokers and hedge fund operators for yet more stock swindles in the Crescent. Among those arrested: a notorious Canadian penny-stock promoter, Mark Valentine, who was accused last spring by Canadian regulators of fostering a "culture of noncompliance" at his now-defunct investment firm, Thomson Kernaghan.

Into the Unknown

Sources on the SEC staff say that the hedge-fund study, begun last May at the direction of then-chairman Harvey Pitt, is now drawing to a conclusion, and that its results could be released soon. The best bet as to what the commission will recommend is that not just offshore funds, but all funds, be treated as mutual funds under the Investment Act of 1940.

Such a move wouldn't reveal the identities of investors in the funds, any more than current law requires companies to publish lists of their own shareholders unless a shareholder owns 10 percent or more of a company's stock (owners of 5 percent or more shares have to file forms of their own in which they identify themselves). But treating hedge funds like mutual funds would mean that hedge funds' holdings would be revealed publicly--albeit as much as six months after the fact. That's information that really should be public, and making it so would help reveal to all U.S. investors just how much influence these murky entities are gaining over the capital markets of the United States.


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