Should Hedge Funds Be Clipped?

The SEC made much noise to the effect that hedge funds should be more regulated or at least forced to [...]

July 7 2006 by JP Donlon


The SEC made much noise to the effect that hedge funds should be more regulated or at least forced to disclose whether felons are running the store. All that changed when the D.C. District Court of Appeals challenged the agency’s authority to regulate the funds. Most hedge funds, pools of money for rich people run by rich people are benign. Some cater to pension funds and are more innocuous than mutual funds. Considering the number and financial power of hedge funds-Connecticut attorney general Richard Blumenthal told the Financial Times that there 13,000 with assets exceeding $24 trillion-there is potential for fraud and market mayhem on a scale that would dwarf the aftermath of Long Term Capital Management. In the minds of many CEOs hedge funds have a dark side. A number act in concert with analysts in seizing upon real and imagined shortcomings of a target public company aiming to drive down the price of its shares in order to reap huge profits from short selling the stock.

Manipulative short selling has a long and rich history of disrepute. In testimony to the Senate Judiciary Committee recently, The American Enterprise Institute’s Alex Pollock said that such manipulation goes back to at least the seventeenth century and that the problem on the London Stock Exchange caused the British Parliament to outlaw short selling from 1734 to 1860. He added that so-called “bear pools” were a notorious feature of  the New York Stock Exchange during the 1920s.

Short and Distort

It should be said that bringing new information to markets via short-selling is not illegal and often benefits investors who are innocent of such information. In addition, there is something to be said for allowing people to be compensated for the service of making markets more efficient. But University of Alberta law professor Moin A. Yahya asserts that there is evidence that plaintiffs and their attorneys are profitably short-selling companies they are about to sue and that it is time the legal status of such activities is cleared up.

Spreading nasty rumors in order to make an easy buck is bad enough reckon many business chiefs, but seeking to influence the SEC and other government agencies in using their investigative powers to hammer a company into submission for the benefit of a few is way over the line. The well-publicized saga of Overstock.com CEO Patrick Byrne’s allegations that short-selling hedge funds conspired with investment research firms to produce misleading and negative research reports about his company is a singular example.

Then there is the interesting case of Cardinal Investment Capital, a Texas hedge fund, that decided to short the stock of Santa Clara, CA-based cable modem maker Terayon Communications Systems. When Terayon’s share price didn’t tumble as expected a scheme was hatched where allegations of fraud and supposed regulatory improprieties were spread among business writers and reporters. For good measure a letter writing campaign aimed at the SEC was undertaken in the hopes the agency’s enforcement division would call out the cavalry to save innocent shareholders. It succeeded in triggering an investigation.

But a funny thing happened after plaintiff’s law firm Milberg Weiss filed suit seeking damages. It turned out Cardinal had previously sold short 400,000 shares of Terayon, exposing Cardinal to $80 million in losses if the stock price didn’t plunge. The judge was not amused by the trash-and-dump scheme it tried to conceal and disqualified both plaintiffs, Cardinal and Milberg Weiss. But the damage was done. The company’s Nasdaq listed stock took a 26 percent hit.

Then there is the strange case of Dynegy, a Houston-based energy company that experienced financial difficulties and resorted to questionable trading practices known internally as “project alpha.” Ted Beatty, an employee, learned about the project and told a friend who happened to work for a hedge fund that subsequently took a short position in Dynegy’s stock. Much to the hedge fund’s surprise the stock didn’t drop. The fund persuaded Beatty, who had since left the company, to beat the publicity drum about project alpha. For good measure the fund hired a plaintiff’s lawyer to assist him, but made certain that the lawyer’s involvement was concealed. After working the media and credit agencies they contacted the local SEC office and an investigation ensued. The lawyer’s firm launched a lawsuit over fraudulent practices and the hedge fund netted $150 million when the stock tanked.  

Such trouble might be dismissed as rare or of little consequence to most companies were it not for the fact that one of the unintended consequences of Sarbanes-Oxley is that the law acts as a roadmap for the plaintiff’s bar.  When does a wonky internal control rise to the level of a material weakness? Is every earnings restatement cause for alarm? No wonder minutes of board meetings contain as little useful detail as possible so as to minimize the scent to the wolves of the plaintiff’s bar.

Eat My Shorts

For its part the SEC is well aware that financial motives and interested agendas  are associated with many claims brought to their attention. Here’s the dilemma. In a post-Enron world the SEC can ill-afford to ignore another corporate fraud. But as AEI’s Pollock cogently pointed out to the Judiciary Committee in June, “There is no political or public relations penalty on the SEC for imposing great costs and market losses on the shareholders of the target company.” The financial interest of the investor group and its activity are not required to be disclosed at all. This, he argues, can only be remedied by full disclosure. Anyone bringing claims of financial or accounting irregularities to the SEC should be compelled to disclose all short and long positions in the company in question.  Also, parties acting in concert with others should  be compelled to make this known with stiff penalties and fines for failing to disclose or filing false or misleading statements about such activity.

In speaking to the New York Financial Writer’s Association in June, SEC chairman Chris Cox took another opportunity to bang the drum for more disclosure-the kind he likes. His proposal for full disclosure of CEO earnings has received more than 20,000 comments, more than any other proposal in SEC history. “No shareholder should have to don a pith helmet and carry a machete to hack through the dense rain forest of legalese to understand what the CEO makes,” he intoned triumphantly. Maybe so, but one would hope he would also carry the disclosure banner into the tussle over hedge fund scrutiny. 

After all the recent market turmoil that whacked some of the biggest hedge funds highlights a growing concern that a herd mentality infects the industry. 

If you would like to speak out, please eMail me at: jpdonlon@chiefexecutive.net