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Two Rights Equal One Wrong :

June 28, 2006 In The News

Every once in a while, in the topsy-turvy world that is our federal government, two rights can make a wrong.

That’s what happened last Friday when the U.S. Court of Appeals for the District of Columbia Circuit, perhaps the most influential court on investor issues, struck down the Securities and Exchange Commission’s effort to force hedge fund managers to list basic contact information publicly before accepting investors. Indeed, the SEC’s efforts to apply a minimum level of transparency to the secret world of hedge funds and the court’s decision to scuttle the program are equally appropriate.

Under the “15 clients” rule, the SEC and Chairman Christopher Cox never had the
authority to make such a request of hedge funds. So, the court decided that Congress needs to change the wording of the law before such a request can be made forcefully.

It’s unlikely that the Supreme Court will disagree with the latest ruling, which is one of the reasons – certainly not the only one – today’s Senate Judiciary Committee hearing is trying to apply some semblance of law and order to the Wild West mentality of hedge fund managers.

The other major reason for the hearing is that small-town business owners are now plunking down $25,000 for “alternative investment” products, since money is now longer growing on trees in the equity market. But the small-town investor doesn’t have a legion of advisers at his disposal like someone with an ultra-high net worth does; he just has the guy at Merrill Lynch who made him a few bucks in the past and treats him to an annual round of golf.

Sen. Arlen Specter, R-Pa., who, as chairman of the Judiciary Committee, called for the hearing, should be applauded for his efforts. He’s showing the same moxie he did as a young district attorney in my hometown of Philadelphia. (Full disclosure: The guy has impressed me so much that I made a $2,000 campaign contribution to him in 2004, and I don’t even live in his state anymore.)

Specter clearly is not afraid to play in the Senate Banking Committee’s sandbox, and that’s fortunate, because its members, led by Sen. Richard Shelby, R-Ala., are too influenced by Wall Street to enact any meaningful law that benefits the individual investor. For proof, just watch what happens to the Sarbanes-Oxley Act as Wall Street lobbies to eliminate or water down the law. Finally, someone in Congress is realizing that hedge funds are too powerful to ignore, and their activities affect our day-to-day lives. It’s not just that these speculative funds are marketed to smaller investors; hedge funds are highly active in the commodities market, which is responsible for a heck of a lot of oil and gas speculation. Hedge funds are using leverage to drive public companies into tail spins, then making money on short positions.

All of this may, in fact, be legal – some would even argue beneficial – but with 8,000 hedge funds now actively investing $1 trillion, the chance of malfeasance is extremely high.

Already, the committee has explored some of the murkier hedge fund strategies.
Specifically, the ghost of Henry Blodget, the disgraced former Merrill Lynch Internet analyst, is alive and well in the form of so-called independent research firms, which issue reports bought and paid for by hedge funds with significant financial interests in the companies cited.

Sen. Orin Hatch, R-Utah, focused on exposing hedge funds that practice the “short and distort” strategies, where a research report bought and paid for by a hedge fund is disseminated in an effort to affect a company’s stock price. According to Demetrios Anifantis, who testified at the hearing, one such research firm, Gradient Analytics, formerly known as Camelback Research Alliance, was influenced on a regular basis to issue reports on companies that jelled with its clients’ stock positions. (Gradient has, in the past, denied that it was influenced.)

The regulation of these research firms notwithstanding, on the surface, there doesn’t appear to be a need for regulation outside of a registration requirement, but as emphasized by Specter’s line of questioning, new criminal statutes to specifically address hedge fund fraud are in order. The proposal, submitted by the attorney general of Connecticut, that hedge fund managers pay “treble-damage penalties” when their activities illegally affect the market, is a first step. But jail time will be the real deterrent.

Remember, this is registration, not regulation. Disclosure is a first step, and hopefully it is the only step needed – but if funds take advantage of the individual investor, then things will change. Sadly, the financial industry’s track record in that regard isn’t so good. So, as the saying goes, investor beware.