HEDGE FUND FIELD DAY

By Christopher Byron
The New York Post
November 10, 2003

WHEN I was in high school and a bunch of us were out riding around in somebody's car, we'd come to a stop light and one of us would yell "Chinese fire drill!" and we'd all have to jump out and race around in the street to other seats before the light turned green and the car sped off.

Now really, isn't that what the government's efforts to clean up Wall Street boil down to - a lot of people rushing around bumping into each other before the light turns green and the car speeds off?

The thought comes to mind in light of the SEC's recently unfurled plan to crack down on hedge fund abuse. One likely result of this so-called crackdown will be exactly the opposite of what the SEC apparently intends. Instead of stopping abuse, the plan will actually encourage it, by exempting hedge funds from a Securities and Exchange Commission regulation known as the short-swing rule that was specifically enacted to help stop insider trading.

It's great that the SEC has finally decided to stop - or at least let us say frown upon - the mutual fund industry's practice of paying kickbacks to favored clients by allowing them to buy fund shares at the 4:00 p.m. closing price when the stocks in the fund's portfolio are all surging in evening trading.

But all the money that has ever been stolen from the market in this way - plus all the money that ever could be - will certainly never add up to even a fraction of the value that is being snatched from under the noses of the regulators every day of the week by mutual and hedge fund traders in a dozen other and far more obvious hustles.

Case in point: the free money giveaway embodied in an exemption already enjoyed by mutual funds from Rule 16(b) of the Exchange Act of 1934 - aka the "short-swing rule."

This rule, which has a nearly seven-decade growth of beard on it even as we speak, was intended to help drive the swindlers of the 1920s from the temple of capitalism by stopping in-and-out trading in a company's stock by its officers, directors and outside owners of 10 percent or more of its shares.

The idea behind the rule is that these people were perfectly positioned to profit from access to important "insider" information about their company before the news became public. The rule was supposed to remove the profit inducement by requiring that any such investor who profits by buying and then selling stock in his company during any six-month period must turn the money over to the company itself.

Unfortunately, the rule specifically exempts mutual funds from its coverage, and now it looks as if hedge funds will get exempted as well. That's because the SEC published in late September a list of proposed "get tough" reforms for the hedge fund industry - and key among them is a plan to make hedge funds register under a 1940 law that covers mutual funds.

One unintended consequence of doing so, which does not appear to have been noticed by anyone at the SEC, will be to give hedge funds the same exemption from the short-swing rule that mutual funds already enjoy. Instead of plugging a loophole, the SEC is planning to make it wider.

This means that hedge funds will soon be able to join mutual funds, which already collectively control an estimated 25 percent of all U.S. equity shares on Wall Street, and engage in all the short-swing trading they want, leaving only individuals still barred by 16(b) from this form of cheating.

What's more, by allowing the funds to buy and sell shares as fast as the traders can hit the transaction keys on their keyboards, the short-swing rule exemption in effect encourages them to create such enormous trading volumes in obscure and even worthless stocks as to give the appearance of functioning and liquid markets for shares where no such markets really exist. And now hedge funds will also get to join in this type of chicanery - as many are secretly doing already.

Consider a Connecticut hedge fund called Durus Capital, which drove the shares of four obscure tech companies into orbit earlier this year by aggressively buying and selling their stock, sometimes on a day-to-day basis. The companies are now suing to recover their profits from the fund under the short-swing rule. But if the SEC's proposal is adopted, a hedge fund like Durus will be specifically exempted from such a suit.

It is hard to know just how aggressively fund traders pursue such price-pumping tactics, because no one keeps track of the matter, and violators are almost never punished. But anecdotal evidence pops up from time to time suggests a larger pattern.

Consider some recent action in a Boulder, Colo., company called New Frontier Media, which trades on the Nasdaq National Market and delivers what the company likes to call "adult entertainment" programming via cable TV and the Internet. Two recent titles tell you all there is to know about the entertainment itself: "Teen Sex" and "Café Flesh."

If the name of the company sounds vaguely familiar, it may simply be because white-collar defense lawyer Harvey Pitt represented New Frontier Media in a dispute with the Nasdaq back in 1999, and thereby ran afoul of religious conservatives who tried unsuccessfully to block his nomination as the Bush administration's choice for SEC chairman to succeed Arthur Levitt.

Last spring this stock was selling for 60 cents per share. But talk of a $1.85 per share buyout by the company's former chief executive got it moving, and as the price rose, the volume of trading began to increase.

One of the buyers was none other than SAC Capital Associates - the secretive $4 billion hedge fund group headed by Greenwich, Conn. moneyman Steven A. Cohen. SAC had been a shareholder of New Frontier Media since 1999, with just under 11 percent of the company's stock as of early August, says the porn company's chief financial officer, Karyn Miller.

How much trading SAC undertook in New Frontier's shares thereafter is impossible to say for sure, but it clearly did at least some, because SEC filings show additional purchases of 82,500 shares in two separate transactions, and at different prices, on Aug. 11 - followed by the sale of 16,786 shares on Aug. 21 and the sale of 85,400 more on Sept. 19.

The sum total of the transactions netted cash of $96,151, which is barely a rounding error for a fund the size of SAC Capital. And the gain worked out to the net sale of only 19,686 shares from the fund's position in New Frontier. But the sales were at an average price of $4.05 per share - almost seven times the May share price.

Most important of all, the trades accounted for more than 5 percent of all buying in the stock on the day the trading began (Aug. 11), and 35 percent of all selling on the day the trading ended (Sept. 19).

Miller, the New Frontier CFO, says SAC's sales were designed to lower the fund's holding to less than 10 percent of New Frontier's stock. And depending upon how one adds things up, SAC has wound up with either 9.8 percent or 10.2 percent of Frontier's total shares outstanding.

Of course, one single sale of 50,000 shares would certainly have done the job equally well - and without all the back-and-forth wheel-spinning of two separate purchases, followed by two separate sales totaling nearly 185,000 shares over a five-week period. Call it what you will, but seen from here the whole fandango looks more like a liquidity-supporting and price-pumping exercise than anything else.

And when it comes to the SEC's efforts to crack down on hedge fund abuse, well, call that what you will too, but from here it looks more like what we used to call a Chinese fire drill than anything else.

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