Hedge Hogs

Forbes.com
By Liz Moyer
June 28, 2006

Washington, D.C. – So who should be overseeing the $1.2 trillion hedge fund industry? Apparently no one is now. But the U.S. Senate Judiciary Committee has two ideas.

Either the nation needs new legislation to tackle allegations of widespread trading abuses by the hedge funds, or law enforcement officials should simply be encouraged to do the right thing with laws they already have at their disposal?

Already a turf war is brewing. The Judiciary Committee is clashing with colleagues on the U.S. Senate Banking Committee, who claim that hedge funds, research analysts and other corners of Wall Street are their exclusive jurisdiction.

Still, that didn't stop the Judiciary Committee from holding a hearing Wednesday to consider evidence about possible market manipulation in the $1.2 trillion asset hedge fund industry.

The witness list included Gary Aguirre, a former U.S. Securities and Exchange Commission investigator who has accused Pequot Capital of insider trading (the fund has denied wrongdoing); Kim Blickenstaff, the chief executive of San Diego-based Biosite, who claims his investors were harmed by a short-selling trading scheme involving misleading research; and a former employee of Camelback Research Alliance, now Gradient Analytics, the firm that is caught up in a short-selling trading scandal.

A notable absence was Patrick Byrne, chief executive of Overstock.com, who has accused short-sellers of driving his company's share price into the ground. Byrne has filed suit against Gradient and Rocker Partners for colluding in a short-selling scheme based on what he claims was fraudulent research.

Lawmakers' focus has shifted from hedge funds bilking their own investors to those whose trading tactics directly or indirectly harm outside investors. In recent months, hedge fund critics have raised the issues of aggressive short-selling, hedge fund collusion with research analysts to manipulate a stock to their benefit, and short-sellers who skirt rules on stock settlement and clearing to make profits.

Absent from the witnesses Wednesday were representatives of hedge funds SAC Capital and Rocker Partners, both defendants in separate civil lawsuits involving allegations of manipulative short-selling, as well as representatives of Gradient. All were invited but declined to appear.

Witnesses said there have been few, if any, criminal prosecutions of hedge funds, which are accused of harming investors other than their own, mostly because such cases are hard to prove and few people bring them to the attention of the U.S. Department of Justice or state attorneys general.

According to Aguirre, from 1999 to 2003, all 38 enforcement actions the SEC brought against hedge funds involved the funds victimizing their own investors. There have been two big investigations since then, one involving hedge funds being allowed to market-time trades in mutual fund shares, and the other involving insider trading in PIPEs, or public investments in private equity.

And Matthew Friedrich, principal deputy assistant attorney general at the Department of Justice, said that while there had been several high-profile cases against chief executives, naming the conviction of WorldCom’s Bernard Ebbers as one example, criminal cases against hedge fund managers accused of fraud have been rare. "I'm not aware of any closed cases," Friedrich said.

That gets at the heart of what the Judiciary Committee said it was examining Wednesday: Are current laws enough to adequately enforce proper trading practices at hedge funds, or do they need to be strengthened to improve prosecutors' chances of bringing winning criminal cases that result in jail terms?

Sen. Arlen Specter, R-Pa., the chairman of the Judiciary Committee, emphasized that prosecutors need to get more aggressive. "We're dealing with a matter of enormous importance," Specter said in his closing remarks at the three-hour hearing. At the hearing, the spectator gallery was standing room only, but Specter and fellow committee member Sen. Orrin Hatch, R-Utah, spent much of the time listening to testimony. "The Department of Justice and state prosecutors have an important role, and the committee intends to push the DOJ to do that."

Aguirre, who was the panel's star witness Wednesday, contends that the importance of hedge funds' to Wall Street will make it tough to go after them.

Hedge funds paid $25 billion in fees to Wall Street banks in 2004, making them a lucrative customer base that investment banks are motivated to protect. "Hedge fund influence with those banks will continue to grow as well," wrote Aguirre in his remarks.

Aguirre has accused the SEC for firing him last August after he aggressively pursued a case alleging insider trading at Pequot Capital, one of the largest hedge funds in the business. Aguirre told the panel that he referred his allegations to the U.S. Attorney in New York and to the Federal Bureau of Investigation. He said he met with officials from those offices in June 2005, but nothing ever came of the meeting.

Aguirre testified that he had uncovered evidence in the course of his investigation of Pequot's trading that John Mack, now chief executive of Morgan Stanley, might have tipped off Pequot to an upcoming 2001 deal, allowing the fund to position its trades to benefit when the deal was announced. "Mack was the top possibility" of several possible tipsters, Aguirre said Wednesday.

A spokesman for Morgan Stanley, which Mack rejoined as chief executive one year ago Friday after a few years as CEO of Credit Suisse Group, said, "No one has provided any evidence that Mr. Mack has engaged in any wrongdoing, and Mr. Aguirre provided none today."

The lawyer who has filed suit on behalf of Biovail, the Canadian drug company, against SAC Capital and Gradient, testified that the potential for collusion and market manipulation between traders and stock analysts is "stunning." Marc Kasowitz, senior partner at Kasowitz, Benson, Torres & Friedman in New York, said disclosures by so-called independent analysts and their relationships with hedge funds are inadequate, particularly where the hedge funds are paying for customized research.

Some companies, like Overstock.com and Biovail, have claimed that hedge funds and analysts have conspired to publish negative research on their stocks to benefit from short positions amassed before the publication of the research. "The schemes are strikingly simple but frighteningly destructive," Kasowitz said.

After the hearing, Sen. Specter told reporters that he wanted to examine e-mail Aguirre said he sent to various SEC officials before deciding how credible his testimony had been.

Sen. Hatch said lawmakers needed to go back to the drawing board and put tighter controls on the activities of hedge funds. The SEC has put some restrictions in place, namely registration requirements and the tracking of aggressive short-selling, but those are not enough. Registration was even tossed out by the D.C. Court of Appeals last week.

"Hedge funds are the Wild West of our financial markets," Sen. Hatch said Wednesday. "It's critical that the power and influence that hedge funds have obtained be exercised responsibly."

The tug-of-war within the Senate over these issues became clear when Sen. Charles Schumer, D-N.Y., popped in briefly to note that the Senate Banking Committee, of which he is also a member, has "exclusive" jurisdiction of hedge funds and research analysts.

Sen. Hatch's pro-legislation tilt got support from fellow Judiciary Committee member Sen. Charles Grassley, R-Iowa, who missed the hearing but submitted written testimony that the Sarbanes-Oxley rules enacted three years ago might not have gone far enough. "I want to find out whether the Department of Justice has a need for more tools and/or resources to get the job done," Grassley said in his statement.

Connecticut Attorney General Richard Blumenthal testified that Congress needed to enact new laws covering hedge fund activities and that law enforcement needed to exact stiffer penalties, or the states would beat it to the punch. In Utah, home of Overstock.com, which has accused a hedge fund and a research firm of colluding to drive down its stock to their own enrichment, lawmakers have already passed one such law.

"Federal inertia invites state action," Blumenthal said.

Of course, hedge funds did have some friends on the witness panel. Joseph McLaughlin of Sidley & Austin, representing the Managed Funds Association, said short-selling has an important function in maintaining orderly markets. "Companies that complain most bitterly about short-selling are often the companies most in need of governmental investigation and possibly prosecution," he said in his written testimony.

Proponents of this view use Enron as their example. Short-sellers had started selling off Enron in early 2001, well before the company's accounting fraud became public.

Owen Lamont, a professor of finance at Yale who has spent several years studying the activities of short-sellers and their effects on the markets, said, "There is a natural tendency to feel that short-selling is somehow inherently malevolent or un-American." But, he added, short-sellers play an important role in preventing stocks from overheating. When these traders and company executives fight, the short-sellers are frequently vindicated.

In 1989, the House of Representatives Committee on Government Operations had hearings on the evils of short-sellers, taking testimony from executives of three allegedly aggrieved companies, Lamont recalled. After the three testified, the presidents of two of the three firms were charged with fraud by the SEC.

"Thus, when you hear companies complain, keep in mind that short-sellers are often the good guys," Lamont said Wednesday.

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