More Arrests in Hedge Fund Land

publication date: Nov 6, 2009

Update 11/6/09: During the stock market panic in the fall of 2008, I warned readers of the role of naked short selling and hedge funds engaging in such illegal activity (see articles below). I have long suspected the industry was also ripe and prone to insider trading.

Now comes word of insider trading by hedge fund players and an avalanche of arrests. And, it sounds like there's more to come. An LA Times story reports, "As an eavesdropping-detection specialist, Kevin D. Murray normally works for companies concerned about possible spying by competitors. But since a blockbuster insider-trading prosecution built on wiretaps and microphone-wearing informants became public last month, frantic hedge fund managers have raced to hire him."

"You're seeing a panicked effort to escape detection," said Ted Siedle, head of investment consulting firm Benchmark Financial Services, who said he knew of funds trying to hire experts to comb their offices and phones for listening devices.

Taking a page from drug dealers, sleazy traders used disposable, pre-paid cell phones for communicating and transfered cash to one another in envelopes, bags and briefcases. 14 illegal traders racked up an estimated $53 million in profits before the arrests.

"For years, the SEC has suspected the superior investment returns obtained by hedge funds relied at least in part on illegal use of confidential information, said Amy Greer, a former SEC lawyer who is now a partner at Reed Smith in New York."

"The agency believes that insider trading is rampant at hedge funds," Greer said.

Because of their skewed compensation system, hedge funds have an incentive to take big risks in the quest for fat returns and large paychecks. Of course, taking great risks can backfire and has led to the implosion of numerous hedge funds over the years and has also led to hedge fund managers pushing the envelope legally.

Raj Rajaratnam, billionaire founder of the Galleon Group, a major hedge fund, is led in handcuffs from FBI headquarters.  The Galleon Group insider-trading scandal has now widened.

Update 9/18/09: An interesting article from the U.K.-based Register about a security hole in Yahoo message boards providing evidence that Patrick Byrne's crusade against naked short selling has legs.

Update 3/19/09: Last October, I reported on the role that short sellers played in the severe stock market decline last year. Now, we have yet another smoking gun of illegal activity. According to data compiled by the U.S. Securities and Exchange Commission (SEC) and Bloomberg, naked short sellers (described in my original article below) contributed heavily to the collapse of Lehman and Bear Stearns. Let's hope the folks at the SEC fully prosecute the folks who engaged in this illicit activity.

Now, how laughable is hedge fund short seller Jim Chanos' WSJ editorial entitled "Hedge Fund Short Sellers Keep the Market Honest" that prompted my first piece?

Update 2/12/09: In this article I originally published on 10/31/08, I discussed how short sellers, particularly at hedge funds, likely contributed to the severe decline in the stock market in 2008. One of the things that tipped me off to possible shenanigans was a 9/22/08 editorial in the Wall Street Journal (WSJ) by hedge fund short seller James Chanos (photo below) who argued for continued non-disclosure of short selling practices and holdings. As discussed below, his "trade organization" is a powerful lobbying company in Washington which Chanos (and the WSJ) failed to disclose. Another red flag was the fact that Chanos refused to return my phone calls seeking further comment on his WSJ editorial. Meanwhile, Chanos was all too willing to go onto CNBC for extended interviews where he was lobbed softball questions about his short selling strategies and where he got great p.r. for his fund.

James Chanos
Now, we have a possible smoking gun in this Bloomberg news report:

"Jim Chanos’s Kynikos Associates Ltd., a short seller of Fairfax Financial Holdings Ltd., learned of negative analyst research on that company before it was published, according to unsealed court documents. Chanos, Steven Cohen’s SAC Capital Advisors LLC and other hedge-fund managers were accused in 2006 by Fairfax of cooperating to drive down the firm’s shares through short sales, according to a complaint by Fairfax seeking $6 billion in damages. Toronto-based Fairfax owns U.S. and Canadian insurers. Chanos forwarded an e-mail about research by John Gwynn, an analyst with brokerage Morgan Keegan & Co., to rival SAC Capital, the documents show. Morgan Keegan fired Gwynn for telling clients before publication that he planned a negative report. Morgan Keegan and Gwynn were also sued. All defendants denied Fairfax’s claims. Fairfax filed that e-mail and others provided by the defendants with a New Jersey state court to support its claims."

I doubt this is the only such case which could be brought. Stay tuned...

Short selling, particularly by hedge funds may have contributed to the recent decline and bankruptcy of some major financial institutions.

Normally, folks invest in stocks through buying shares via a broker. For example, you might purchase 100 shares of Bank of America (trading symbol BAC) at a price of $23 per share for a total investment of $2,300. This is known as having a long position.

If BAC grows and increases their profits in the years ahead, its stock price should rise as well. Suppose the stock increases to $40 per share in five years. So, you would have made a profit of $1,700 (less trading fees) on your investment of $2,300.

Now, suppose you thought BAC was going to do poorly. Rather than buying shares, you could borrow someone else's shares and then sell them. This is known as shorting a stock - that is selling shares (that aren't yours) of a stock. If you sell 100 shares short at $23 per share, you would receive $2300. Now, ultimately, you're going to have buy back 100 shares at some future date to replace the 100 shares you borrowed and then sold.

As a short seller, you're hoping that the stock declines in value so that you can buy it back and make a profit. Suppose you're correct about BAC and the price plummets to $5 per share at which point you buy back the 100 shares netting you a profit of $1800 (less trading fees and having to pay the share's owner any dividends the stock paid during the time you held the stock). 

Surprisingly, until recently, the SEC only required hedge funds to report their long positions (quarterly) to the SEC. Hedge funds and other investment managers didn't have to report short positions. That changed on September 22nd. Now, once a week, investment managers with at least $100 million under management must report their daily short positions to the SEC. Some hedge funds that specialize in short selling aren't happy about this new rule.

"Such a requirement is akin to the government suddenly requiring Coca-Cola to disclose their secret formula for free to all their competitors," said James Chanos in a Fox Business interview recently. Chanos manages Kynikos Associates, a short-selling hedge fund. Chanos attacked the new rules as "hasty" and "ill-considered" and went on to say that these rules "could be extremely harmful to the capital markets." (Chanos' firm didn't return phone calls seeking comment for this article.)

Hedge funds, particularly those which focus on short selling have argued against increased SEC oversight and regulation of short selling and hedge fund reporting. In a September 22nd Wall Street Journal opinion piece by hedge fund shortseller Chanos, note that at the end of his piece he was attributed in part as "chairman of the Coalition of Private Investment Companies (CPIC)." When I web searched this organization, I was unable to find a web site for this organization. Interestingly, in the web search results, this organization's numerous comments with the Securities and Exchange Commission came up. On CPIC's letterhead with these comments, there was an address and phone number which I called and found that it is the number solely for Porterfield and Lowenthal, a Washington lobbyist company! I left messages at their number seeking comment and got no calls returned.

A number of financial firms including AIG, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, Washington Mutual were targeted by short sellers earlier in 2008. The increased selling of these stocks and accompanying rapid decline in their share prices accelerated a loss of investor, depositor and customer confidence in these firms which appears to have snowballed their decline and demise. (This Vanity Fair article provides interesting detail surrounding the rumor mill perpetuated in the financial media and especially on CNBC that brought down Bear Stearns). 

Some investment firms are believed to have engaged in the illegal practice of naked short selling wherein they sold shares of stock they never borrowed. The SEC has sent subpoenas to dozens of hedge funds to investigate this practice. New SEC rules now require firms to locate and have in their broker's possession shares of stock sold short within three business days of the transaction (they used to have more than two weeks and that rule wasn't being well enforced by the SEC).

One final point about SEC rule changes. In July, 2007, the SEC repealed its long standing "up-tick rule" which only allowed a short seller to sell when the price of the stock ticked higher. This rule was enacted in the 1930s in response to the stock market collapse during the Great Depression and concern about the role of short sellers in that decline. Since July, 2007, the stock market's volatility has zoomed and prices have fallen significantly.

The SEC is accepting public comments on what disclosure hedge funds and other investment managers should make of their short sale positions. Take the time to submit your comments. It seems to me that at a minimum, hedge funds and others should have to disclose at least twice per year as do mutual funds, all of their positions including short positions.


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Eric Tyson is the only best-selling personal finance author who has an extensive background as an hourly-based financial advisor and who does not accept speaking fees, endorsement deals or fees of any type from companies in the financial services industry or product or service providers recommended in his articles, books and his publications.