7 Ways Hedge Funds Lie, Cheat and Steal
Stay up to date with the latest headlines via email.
The verdict is in: Raj Rajaratnam, the billionaire head of the Galleon hedge fund, was found guilty of 14 counts of securities fraud and conspiracy on Wednesday: 5 counts of conspiracy, and 9 counts of insider trading – which means he could be joining Bernie Madoff in prison for the rest of his life. The prosecution, which played 43 secretly recorded conversations that revealed how insider information was sought, received and covered-up, provides the clearest view to date of how far billionaires will go to earn their riches.
Which raises an even more perplexing question: Why would a billionaire go out of his way to break the law in order to make “only” a few million more? ($63 million to be exact, which is less than 5 percent of his net worth.)
Greed? Ambition? Status? Sure all of these personal characteristics and more are in play. But maybe there’s a more basic explanation: Perhaps the entire hedge fund industry rests upon tens of thousands of instances of lying, cheating and stealing. The Raj, as he likes to be called, may not be that different from the other 8,000 hedge fund managers who amass riches beyond our imagination.
The reality uncovered by the feds is far different from the usual PR about hedge fund elites -- how they develop the best research, the best trading programs, the best analysis of the economy, and how they translate all their brilliance into hard headed trades that pay off big. If you have the stomach to read the vacuous literature about their daring deeds, you’ll find odes to their courage, their intelligence and their cojones.
But, what a number of prosecutions -- including the latest -- show is a set of guys (and a few gals) who will take any edge they can find, legal or not, to make more money. In their minds, laws are for little people. A billionaire, almost by definition, is someone who thinks he is above it all. (Maybe we would too if we made $2.4 million an HOUR, which is what the leading hedge fund manager walked off with in 2010.)
But why worry? We are repeatedly told that hedge funds only take money in very large chunks from very sophisticated investors who should know what they are doing. You don’t walk into this casino unless your six-shooter is fully loaded. And besides, the story goes, who cares if they cheat since the money the winners rake in only comes from the losers. But the truth is far more complex. When all the facts are in, we’ll see that hedge funds take a little bit from us all. And when they cheat, they take even more.
Here are seven ways hedge funds typically bend or break the law:
1. Insider Trading:
The Raj is not alone. If the Feds could tape every hedge fund we’d get an earful of how hedge funds use “expert networks" to transfer bits of illegal information that provide hedge fund managers with knowledge of events that are sure to move markets and make them a bundle. The Raj investigation already has upended several other hedge funds that benefited from this common phenomenon.
2. Tax Evasion:
No surprise here. Wherever you find billionaire financiers, you’ll find schemes to move money around the globe to dodge taxes. Fortunately, Rudolf M. Elmer, a Swiss banker, has blown the whistle on an international web of rich investors, banks and hedge funds that evade taxes by illegally shifting money to low-tax jurisdictions. There's something particularly slimy about hedge fund tax dodging, given that they only pay a 15 percent federal tax rate no matter how much they make.
3. Ponzi Schemes:
Madoff isn’t the only one. Hedge funds and Ponzi schemes are made for each other since the funds are designed to evade so many disclosure regulations. It's virtually a sure thing that every new year will reveal another Ponzi scheme through which a hedge fund steals money from investors and then uses new investor money to pay returns to the old investors. It’s so easy to do when no one is watching.
But the Ponzi problem is much bigger. The entire housing bubble was kept alive with a barely legal Ponzi perfected by the Megatar hedge fund. Pulitzer Prize winning reporters Jesse Eisinger and Jake Bernstein at ProPublica.org uncovered how Megatar created giant CDOs based on junk mortgages (even after the housing scam was unraveling) for the sole purpose of betting that they would fail. When they couldn’t sell the crap, they stuck it into the next CDO, sliced it, diced it, got top ratings and then sold it again. And when that crap couldn’t get sold, it went in to the next CDO and so forth.
The Financial Crisis Inquiry Commission Report revealed a similar patterns where hedge funds and banks would trade the junk bank and forth among themselves in order to keep the production line going. If these aren’t Ponzi schemes then the word has no meaning. These “innovative” Ponzi schemes were far more damaging than Bernie’s.
4. Front-running trades:
With their high-speed trading systems and algorithms that sense ever so slight market moves, the biggest hedge funds and banks are able to trade just a fraction of a second before the rest of us do. The SEC is also worried that brokers leak information about large trades by institutional investors to hedge funds so that favored hedge funds can pull off the trade just a split second sooner, thereby earning a quick, easy and illegal profit.
With superfast computers, hedge funds may not even need insider information to cheat the system. Their computers can sense what large mutual funds and pension funds are doing and them beat them to it. While the mutual fund is pulling off a large trade, a hedge fund computer in nanoseconds might buy the stock, for example, and then sell it to the mutual fund at a slightly higher price, pocketing the difference. This scam, which should be outlawed, raises an important question: Where do all those billions in hedge fund profits really come from? Some of it comes from draining the trades that are made for our 401ks, investment accounts and pension funds.
5. Late Trading:
When Eliot Spitzer was New York Attorney General (and earned the handle, "Sheriff of Wall Street"), he uncovered hedge funds maneuvering around trading rules like a Ferrari speeding around the hapless shmoes stuck in midtown traffic. In violation of all rules, hedge funds were allowed by mutual fund managers to jump in and out of mutual funds many more times than normal investors, enabling them to score high returns at the expense of regular mutual fund customers. They even got away with booking trades hours after the market closed for the day -- a real perk, since market-moving announcements often are made right after closing. You don't need to go to Wharton to make big bucks on this one: All you do is wait a few hours to judge the impact of the after-closing news, then book your trades at the 4 pm price. Spitzer forced the guilty parties to pay several billion dollars in fines.
6. Accounting Irregularities:
Boring stuff, but the stuff of big money. Hedge funds and banks cook the books to avoid showing losses and to artificially inflate profits. Hedge funds are also deeply involved in helping other companies -- like Enron and WorldCom – bend their books. You can get away with a great deal if you avoid internal audits. According to a study by Bing Liang at the University of Massachusetts, as of 2004, 35 percent of all hedge funds cited no dates for their last audit. Hmmm.
7. Setting up bets that can't fail:
I’m ashamed to admit it, but this is my favorite. I just can’t get enough of how banks and hedge funds collude to rig securities so that they are designed to fail. The best part is that in order to win their negative bets, they have to market the securities to chumps as if they were pure gold.
This ploy always seems to involve a big investment bank and a hedge fund. You have Goldman Sach’s dancing with Paulson and Company, and then there’s JP Morgan Chase doing a two-step with Megatar.
And what a dance it was. The hedge fund picks the mortgage pools that go into the security so that it will fail, and then bets against it. JP Morgan and Goldman Sachs then sell the crap to investors that trust the banks, which say it’s a good bet, but don’t tell them that the hedge funds were integrally involved in picking the garbage, or that they were betting it would fail. The legalities are tricky. The law seems to come down hard on those who sold the crap but didn’t fully disclose the critical information. That cost Goldman Sachs $550 million (but the hedge fund was allowed to keep its billion dollar profits). At this time, JP Morgan Chase is trying to negotiate a similar settlement with the SEC. But the hedge funds who made many billions on these bets have dodged any penalties. At the moment, there's no law against encouraging someone else to rig a bet for you -- except at the racetrack.
Just a Few Bad Apples?
As Neil Weinberg and Bernard Condon wrote in Forbes back in 2004:
Hedge funds exist in a lawless and risky realm, exempt from the rules governing mutual funds, equities and most other investments. Hedge funds aren't even required to keep audited books--and many don't. These risky funds often are guilty of inadequate disclosure of costs, overvaluation of holdings to goose reported performance and manager pay, and cozy ties between funds and brokers that often shortchange investors.
Even Société Générale, the French megabank (which no one would confuse with Mother Teresa) doesn’t trust hedge funds. Because it deals with hundreds of them and because cheating is so endemic, it has decided to use a computer program to help it identify the ones most likely to cheat.
Of course, none of this proves that any given hedge fund billionaire is a cheat or even ethically challenged. But it does offer an unflattering picture of an industry that at this very moment is trying mightily to avoid any and all new regulations or taxes that might stand in the way of its billions.
It’s not enough to get tougher sheriffs to stop the cheating. We’ll need to wipe out the entire casino if we want to get out of Dodge alive.