Browsing December 18th, 2008
Fund of Funds Pass the Buck and Lose It For Their Clients
“If it sounds too good to be true…It probably is.”
We’re hearing this phrase repeatedly with regard to Bernie Madoff’s alleged Ponzi scheme. Under a cloak of secrecy, Madoff’s funds reportedly delivered handsome returns year after year regardless of market volatility. To the best of my knowledge, only the Treasury Department can print money, but apparently that fact was lost on a great many of so-called “sophisticated” investors.
Retirees and smaller investors deserve a pass (and their money back) for falling victim to Madoff’s reported schemes. Even if the returns were unbelievable, they didn’t have a frame of reference to make a complete judgment. After all, Mr. Madoff was a respected member of several wealthy communities and donated large amounts of money to various charities. On the surface he appeared to be a Wall Street legend. By the same token, if any reasonable amount of due diligence had been performed, the red flags were out in the open. From his secret formula, to outsized returns and even a one-room auditing firm, there were plenty of reasons to be suspicious of Mr. Madoff. And indeed, many were and chose to invest elsewhere.
Which is why, as we all shake our heads at the clear signs of fraud, we should be shaking our fingers at the managers of the feeder funds who ignorantly - perhaps even fraudulently - invested huge percentages of their assets under management with Bernie Madoff. It is the fund of funds manager whose job it is to be on the look out for warning signs of potential fraud risks. They have a fiduciary responsibility, and are paid handsomely, to make suitable investment decisions for their clients. They were paid to have the frame of reference individual investors cannot possibly have.
Fund-of-funds exist to seek out and vet the very best - and safest - money managers. They are also expected to diversify so that in case of a large collapse, the damage is mitigated. They are usually paid 1 to 1.5 percent of total assets under management as well as a hefty chunk of the returns. One of the fund-of-funds that had significant exposure to Madoff Securities is Ascot Partners, managed by J. Ezra Merkin. He has reportedly lost $1.8 billion of his client’s money. According the New York Times, Mr. Merkin took just three paragraphs to explain his losses to clients; this compared to a fifty-four page offering memo.
Ascot, as well as other feeder funds such as Fairfield Greenwich, Tremont and Maxam Capital Management could have significant liability for their losses if in fact their firms did not perform a reasonable amount of due diligence for which they were paid. Through this negligence, they may have empowered Mr. Madoff to pull of what many are saying is the scam of the century.
In addition to negligence, it’s likely that there are disclosure issues at stake. Fund-of-fund investors likely had no idea such a huge percentage of their money was under Mr. Madoff’s control - or any single money manager for that matter. Huge concentrations like this are indicative of “style drift,” which occurs when a manager diverges from the original strategy promised to investors…usually because of large losses.
For these reasons and the impending litigation, the fund-of-funds industry has been dealt a huge blow. It was redemption requests that led to Bernie Madoff’s undoing. I certainly hope he’s an exception to the norm, but I have my doubts.
Will Mary Schapiro Be An Investor-Advocate At the SEC?
Late into the news cycle last night, two Democratic officials confirmed that Mary Schapiro will be named chairperson of the SEC. Ms. Schapiro currently serves as chief executive of the Financial Industry Regulatory Authority (FINRA), a self-regulatory entity created when both the New York Stock Exchange (NYSE) and National Associated of Securities Dealers (NASD) combined their oversight responsibilities. She is the first person to hold the position since the creation of FINRA.
I am optimistic that Ms. Schapiro will use her new position, assuming she is confirmed, to revitalize the SEC. She has both enforcement chops as well as experience rebuilding an outdated regulatory regime having created FINRA basically from scratch. While I am no fan of Wall Street’s obsession with self-regulation, Ms. Schapiro has done a commendable job given the circumstances.
It is concerning that while she was in her position Bernie Madoff was able to allegedly perpetrate his Ponzi scheme and enforcement actions have slid, and I expect this to be a major issue during her confirmation hearing. But I believe Ms. Schapiro’s experience will eventually temper those concerns.
Perhaps most importantly, Ms. Schapiro’s nomination breaks a destructive line of SEC leaders with close financial ties to the securities industry. She has served as a regulator nearly her entire career. She will also have the winds of reform at her back allowing her to more easily institute massive changes at the SEC.
For these reasons, Mary Schapiro is a good choice to oversee the SEC.
Hedge Fund Shorts
Auction Rate Securities Hearing in Washington: Wall Street’s Comeuppance?
Today, House Financial Services Committee Chairman Barney Frank, Chairman Spencer Bachus and Ranking Member Paul Kanjorski will hold a hearing to examine the continuing crisis in the markets for auction rate securities and auction rate bonds. The witness list will be comprised of regulators, investment-service providers, dealers and issuers of auction rate securities. Specifically, the hearing cover potential solutions to the auction rate securities market, which continue to be frozen.
Originally only large institutional investors bought auction rate securities. But following a 2005 SEC advisory clarifying the way corporations could account for auction rate securities forcing them to stop including them as cash on the balance sheet, Wall Street targeted retail investors. The pitch, as we all know, is that they were an alternative to money market funds.
According to most reports, over 160 arbitration claims related to auction rate securities have been filed since March 2008 including many by Zamansky & Associates. Four enforcement actions arising from auction rate securities investigations have been lined up for hearing. Credit Suisse is the latest financial institution to settle an auction rate probe, agreeing to buy back the securities from individuals, charities and small businesses with accounts valued up to $10 million.
But despite the fact that several major banks have agreed to repurchase auction rate securities from the retail investors, investors still hold billions of dollars worth of auction rate securities. Moreover, investors that are included in auction rate securities buybacks will not be compensated for their significant consequential damages unless they file securities arbitration claims to recover these damages.
I’m quite sure the committee understands the scope of this issue. But just in case, they should read a recent Legal Times article: “The auction rate securities debacle is the largest bond market failure in U.S. history. Although the buyback agreements represent real progress, any suggestion that auction rate securities holders no longer have enough at stake to merit their continued representation by counsel would be misguided.”
Chairman Frank has shown himself to be a results driven regulator. He urged that issuers of auction rate securities be permitted to bid in auctions for their own securities, and demanded fast action on pending requests from mutual funds seeking clearance to issue new auction rate securities.
Still, here are some questions I hope he will address at the hearing:
- Why did the SEC allow the auction rate securities market to continue business as usual after investigators found impropriety in 2006?
- What training did retail brokers have before they were told to sell auction rate securities to investors?
- Given that many Wall Street managers bought auction rate securities themselves, did any of them sell their auction rate securities knowing that the market was soon to collapse? If so, how will they be punished?
- Wall Street sold many auction rate securities as hybrids in the private market under names such as auction pass through trusts, auction market preferred stock, among other now dubious names. Purchases of these securities were not included in the buy back settlements. How will Wall Street be held accountable for fraudulently marketing these?
- Will the brokerage house executives who oversaw the sale of auction rate securities be fined or punished?
- Exactly how much revenue did Wall Street generate through the auction rate securities market and did the fines that were levied along with the settlements equate to those revenues?
No doubt, today’s hearing on auction rate securities is necessary and warranted; let’s just hope it’s productive.