Let's talk hedge fund regulation. What sort of oversight is most appropriate?
We don't need more regulation; we need better regulation. The majority of the problems we see in the current crisis emanated not from the hedge fund industry, but from the banking sector, which is probably the most highly regulated industry in the world. The main theme of my work has been to create more transparency in the financial sector, because one of the problems that arose and is still causing problems in our banking system is the lack of transparency and the fear it breeds. One of the strongest kinds of fear is fear of the unknown. That's exactly where we're at today with people fearing what they don't know about "toxic assets," about defaults, about where some of these pricing models will lead us.
What should a new regulatory framework look like?
The major highlights are relatively straightforward. One is we ought to create some kind of a systemic risk oversight agency. I propose creating something like the National Transportation Safety Board for financial markets.
By Bill Singer -- On Feb. 25 the Securities and Exchange Commission issued a 22-page Complaint: Securities and Exchange Commission v. WG Trading Investors, L.P., WG Trading Company, Limited Partnership, Westridge Capital Management, Inc., Paul Greenwood And Stephen Walsh,(Defendants) And Robin Greenwood And Janet Walsh (Relief Defendants).
The SEC characterizes the matter as an "emergency enforcement action to halt ongoing securities fraud involving the misappropriation of hundreds of millions of dollars of investor assets." In reality, the WG Trading case represents yet another long-term fraud (described in the Complaint as dating back to 1996) that went undetected by our nation's many regulators and prosecutors for far too long with disastrous consequences.
Exposure And Enhanced Management
The Defendants are charged with soliciting institutional investors, including educational institutions and public pension/retirement plans, by promising to invest in a so-called "enhanced equity index strategy."
Starting at Paragraph 21, the Complaint details the supposed intricacies of this scam. First off, you got "exposure." Oh, how I love that term of art! Invest with us and we will give you "exposure" to the market. The minute you start hearing such gobbledygook, head for the hills! Nonetheless, like most porn movies, the strategy here involved a lot of exposure to a stock index. The Defendants explained that they would be making purchases of “long positions in equity index futures that provided exposure to the entire index.” Now that's a very difficult market strategy. Hmmm . . . if I buy an S&P 500 index future I get exposure to the entire index. My, what a complicated concept. Sort of like, if I buy one share of Apple stock I get some kind of exposure to... what...no...wait a minute...don't tell me....I'm getting it...it's exposure to an entire share of interest in the Apple company. Right?
If you feel that you understand the arcane exposure strategy, then read on. We are now going to discuss the second prong of Defendants' sophisticated investment plan: the "enhanced cash management." This is a very complex spin on the prior exposure thingy. Here, instead of buying the futures index, the Defendants would sell the index short and buy the underlying index equities. You got that? You sell short the index but also buy the underlying stocks. You do that to lock in a rate of interest. Of course, as part of this super sophisticated exposure and enhanced management technique, the Defendants often took the extreme measure of doing the exact opposite of the complicated sell/buy program. Yes...indeed....they engineered the buy of the index and a sell of the underlying stocks. That's the famed double reverse flip with a half gainer into the index pool.
Getting Stiffed By A Steiff
According to the SEC's Complaint, those Defendants "used client money invested in WGTI as their personal piggy-bank to furnish lavish and luxurious lifestyle which include the purchase of multi-million dollar homes, a horse farm, cars, horses, and rare collectibles such as Steiff teddy bears." See Paragraph 2. And we're not talking chicken feed here. No, this is $667 million in investor funds, of which Greenwood and Walsh are accused of misappropriating $554 million—okay, well, sure, the SEC does allow that some of that money went to Greenwood's spouse (R. Greenwood) and to Walsh's ex-spouse (J. Walsh). You also have to give these guys some credit for bravado. As recently as February 5, 2009—in the midst of the Madoff case and the growing rumors about Stanford, and, well, add all those other lurid names as you see fit—the Defendants raised another $21 million from the University of Pittsburgh, an existing client.
On February 5, 2009, the National Futures Association (NFA) started an audit of Defendants and those good auditors were likely astonished to discover that the balance sheet showed only $95 million had been invested in the stock arbitrage strategy. Some $573 million was largely in notes payable to WGTI from Greenwood and Walsh—notes dating back to 1996! Apparently not getting the answers and assurance the NFA regulators sought, the organization suspended Greenwood's and Walsh's NFA membership. What had NFA uncovered? Nothing more complicated than an apparent effort by Greenwood and Walsh to take investors money from the business, use it for their own personal desires, and to cover the withdrawals through the issuance of personal promissory notes. That was the third prong of their strategy. First prong was the exposure. Second prong was the enhanced cash management. Third prong was take the suckers for all they are worth and issue promissory notes back to the firm.
If the allegations are proven true, it's no small wonder that the SEC has beaten a hasty retreat to the courthouse and is seeking an immediate temporary restraining order and asset freezes. Then there is also the sensible demand for disgorgement of the ill-gotten gains and for civil money penalties. Now it's not like WG Trading Company (WGTC) was some fly-by-night pennystock promoter. Certainly not—if that were the case I'm sure our regulatory community would have been all over such a little fraudster. No, in this case, WGTC is a New York Stock Exchange (NYSE) member firm. That always meant that you were just a cut above the riff raff. How times have changed.
Anyone Getting Mad And Not Wanting To Take It Anymore?
Here are some tough questions that I think the public needs to demand are answered:
How many times did the NFA, NYSE, NASD, FINRA, CFTC, and SEC examine the Defendants since 1996, and what were the findings?
Why are we only now learning about this and other multi-year frauds (many of a decade or more duration), and why did the regulators fail to detect them earlier?
Why did the promissory note scenario escape regulatory scrutiny for over a decade?
Who was personally in charge of NFA, NYSE, FINRA, CFTC, and SEC's regulatory program during the past 13 years (as it related to the Defendants) and what explanations do those individuals offer for the apparent failures to detect the serious fraud?
Bill Singer is a shareholder in the Securities Practice Group of law firm Stark & Stark. His private practice focuses on securities industry matters, with a concentration in the areas of: regulatory/compliance counsel, white-collar criminal, congressional hearings/investigations, membership listing issues, and litigation/arbitration. More of Singer’s musings can be found on his blog, http://www.brokeandbroker.com/.