Repeat a lie often enough and it acquires the dignified aura of truth. And that seems to be happening as securities regulators flail away at an apparent insider trading epidemic. Last week, U.S. Securities and Exchange Commission chairman Christopher Cox said, in what has become something of a mantra, “We have made it a priority to investigate insider trading in the hedge fund space because of economic and circumstantial evidence that it is occurring.”
The theme was picked up on Friday, May 11, by Peter Bresnan, deputy director of the SEC’s division of enforcement. In a spectacularly shallow segment, even by CNBC standards, he provided the following sound-bite, introduced by reporter Hampton Pearson saying “At the eye of the insider trading storm, hedge funds.”
Hedge fund managers are under enormous pressure to show profits for their clients. Their clients expect profits of between 20 and 25 percent each year. Not every hedge fund manager can get those kind of returns through legitimate trading.
Evidence? Well, not so much. In fact, based on a simple analysis of the SEC’s own litigation releases in 2007, hardly any. And certainly none that would indicate hedge funds are more likely to cross the blurry line than blabbermouths presumably unaware of their life partner’s secret lust for securities fraud infamy, or, for that matter, securities industry compliance professionals.
As of May 15, the SEC had posted 162 litigation releases this year, relating to 142 individual actions. Of those, 26—20 of them unique—included the phrase ‘insider trading’ [The analysis therefore excludes, for no other reason than the SEC’s own phraseology, cases that might arguably constitute insider trading by a common-sense, rather than a strict legal, interpretation: pump-and-dump scams, stock options backdating and PIPEs-related shenanigans (the latter being one category in which a handful of hedge funds have unquestionably been among the leading participants)].
Of those 20 actions, 16 were new filings; the others were ‘updates’ on cases originated in prior years. And of the 20 actions just two—Wow! 10 percent! Impressive!—included the phrase ‘hedge funds.’ Yet of four named hedge funds, only one would qualify for that classification by most reasonable standards.
Kept in the family
In a case brought on Feb 8, Zvi Rosenthal, a vice president of Taro Pharmaceuticals Industries Ltd (TAROF.PK), an Israeli-based pharmaceuticals company, was charged with trading ahead of eight earnings and five FDA approval announcements between 2001 and 2005. Named in the SEC civil suit were Aragon Capital Mgt LLC, general partner of and investment advisor to Aragon Partners LP, the Rosenthal family hedge fund, and Heyman & Son, a hedge fund associated with David Heyman, one of the named defendants, and funded with family money.
Rosenthal; his son Amir, a former Thacher Proffitt associate; Ayal Rosenthal, formerly an accountant with PricewaterhouseCoopers; and Heyman, formerly with Ernst and Young, entered guilty pleas for their part in the scheme and face up to five years imprisonment and a fine of $250,000 at sentencing.
The SEC complaint makes it clear that both the Aragon and Heyman funds were family investment vehicles; both Aragon and Heyman were funded by members of their respective families and used as conduits for the illicit trades. Neither made any effort to attract outside investors, and as such hardly meet any conventional definition of the term ‘hedge fund.’
In what was certainly among the most spectacular insider trading bust in recent years, 14 defendants—11 individuals, and three corporate entities, including two hedge funds—were charged Mar 1. in a complex interlocking scheme based on information supplied since 2001 by Mitchel S. Guttenberg, a UBS (NYSE:UBS) employee, and “from at least 2004 through 2005” by Randi E. Collotta, an attorney in the global compliance department of Morgan Stanley (NYSE:MS), New York. The scheme allegedly generated profits of $15 million, most of it from the UBS source.
Guttenberg was a member of the UBS Investment Review Committee, “which reviews and approves UBS analyst recommendations, including coverage initiations, upgrades and downgrades, and other UBS analyst recommendation changes, before they are issued and publicly disseminated.” He allegedly began passing the good word to his good friend, Erik R. Franklin, originally to pay off a $25,000 personal debt in 2001.
Three hedge funds, all connected with Franklin, are named in the SEC complaint:
Lyford Cay, which was not accused of wrongdoing, was an investment vehicle for “certain senior officials” of Bear Stearns (NYSE:BSC), had the benefit of Franklin’s insights for about three months, ending in Feb. 2002.
Chelsey Capital, the working name of DSJ International Resources Ltd, is the one “real” hedge fund in the mix so far this year. The New York-based fund headed by Stuart Feldman last month completed a sometimes controversial acquisition of Hanover Direct Inc, a specialty retailer offering “quality, branded merchandise through a portfolio of catalogs and e-commerce platforms.” The firm had a brush with regulators in 2001 when, according to The Wall Street Journal, both it and London-based GLG Partners were questioned in a broad investigation into whether investors paid unusually large commissions in return for participation in coveted IPOs.
Franklin returned to Chelsey, where he had previously worked as a portfolio manager, after leaving Bear; there he passed the tips to Mark Lenowitz, a Chelsey portfolio manager, until they both left in Mar. 2003. The tips allegedly generated more than $2 million in trading profits for Chelsey, which, unlike the individual defendants, has not been criminally charged.
Franklin’s illegal trading continued at Q Capital, in which Lenowitz was an investor and limited partner, from Mar. 2003 through 2006. Q Capital allegedly made profits of more than $300,000. In addition to Chelsey’s gains, Franklin is alleged to have made over $5 million between 2001 and 2006 through trading in his personal accounts, at Lyford Cay, and in an account in the name of his father-in-law.
Again, however, as with Aragon and Heyman, nothing suggests that Q Capital or Lyford Cay were ever offered beyond a very select group of participants; as well, despite Bear Stearns’ propensity for life on the regulatory knife-edge, it’s unlikely that its “certain senior officials” would have tolerated such blatantly illegal trading had they been aware of it.
And your point is...?
Certain facts are undeniable. Insider trading prosecutions are on the rise, and not just because regulators are looking for it the way they went after corrupt mutual funds a few years ago. Insider trading is on the rise, if only because it’s ever-present and the current tsunami of mergers and acquisitions and leveraged buyout activity has just as massively ramped the opportunity set. Insider trading is becoming increasingly more sophisticated, as new, largely unregulated and certainly complex enough to confound the securities lawyers that populate regulatory agencies, OTC derivatives provide more bolt-holes for wrong-doers. And, somewhere out there, is undoubtedly a ‘real’ hedge fund, or 10, or 20, or even 50, flirting with a severe upset in their headline risk book.
But this year’s haul is instructive. It has involved a material subset of Global Megabank NA—current and former employees of ABN-Amro (ABN), Bear Stearns, Credit Suisse (NYSE:CS), Morgan Stanley, Merrill Lynch (MER) and UBS have made the litigation releases page—along with the usual basket of cretinous corporate executives, creative computer hackers, corrupt accountants and attorneys, and pillow-talkers who put a securities fraud twist on the family values yarn.
But the real evidence that hedge funds are any more corrupt than any other slice of the securities pie is non-existent. The regular libeling of the entire sector on the basis of unspecified “economic and circumstantial evidence,” or sly digs about performance pressures, stand up only in the court of cheap headlines.
Slapping the ’cuffs on a GLG Partners or a Philippe Jabre, to pick a couple of names at random, and make it stick, would put a spine in the story. Then, maybe, it’ll be time to start looking past the Justice Department-style lynching of Gary Aguirre, and even that nasty piece of business enabled by some slick Californian shyster with grand political ambitions talking an earlier generation of SEC staff into looking the other way while William Edward Cooper bilked his clients.