The Hedge Fund Fraud Casebook

Bruce Johnson

• Publisher: Wiley
• Year: 2010
• Print ISBN: 9780470560464
• eBook ISBN: 9780470602935
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

An in-depth, well-researched look at 100 hedge fund frauds

Compared to mutual funds, hedge funds are the James Bonds of the marketplace. They have been relatively unfettered by government regulation, and they play bigger games, take bigger risks, use unorthodox methods, and have the power to capture the public imagination in a way that their lesser counterparts have difficulty approaching. At once fascinating and startling, The Hedge Fund Fraud Casebook provides readers with a broad knowledge of hedge fund regulation through a look at the first 100 cases of proven fraud at hedge funds.

Compiling concrete data on cases of hedge fund fraud, The Hedge Fund Fraud Casebook provides you with a factual foundation for assessing this difficult area of risk.

• First comprehensive survey of hedge fund fraud including 100 chronological fraud cases
• Includes descriptions of each case, diagram of the player interaction, and tables detailing monies recovered, fines paid, prison terms, and professional sanctions
• Useful for both individual and professional investors, particularly given the last eighteen months of fraud and mismanagement among leading financial professionals and companies

The Hedge Fund Fraud Casebook provides a hedge fund professional's look at fraud and can help you prevent or avoid similar frauds in the future. It's a vital resource for any hedge fund manager or investor.

PART ONE

Life, Death, and Degeneration

For decades, hedge funds have been the dream factories of finance where fortunes were made in mysterious ways, and occasionally lost. For those few who found hedge funds to be a school of hard knocks, it is probably apparent that the hedge fund life cycle can include a high “infant mortality rate,” that hedge funds seem to die off in large numbers and, now and then, succumb to fraud.

Part One, Life, Death, and Degeneration, runs through three parallel strands of analytical development. Chapter 1 is an historical narrative of how laws continued, largely unsuccessfully, to grapple with the control of fraud. Chapter 2 looks at why current laws make it easier to discover—and bring to justice—perpetrators of fraud. Finally, Chapter 3, shows the unique structure of hedge funds how can contribute to the creation and continuation of fraud.

CHAPTER 1

Historic Roots of Prohibitions against Fraud

Hedge fund fraud is a conjunction of an ancient crime and a modern application. Fraud itself is a composite crime conjoining theft with deception. The earliest legal codes had clear proscriptions against theft (“thou shall not steal”), but a more ambiguous response to deception in general, focusing instead on false accusation (“thou shall not bear false witness”).

FRAUD IN THE EARLIEST LEGAL SYSTEMS

In ancient history, laws that directly addressed commercial behavior tended to lag behind those that ensured the power of rulers. There are exceptions, however. The Code of Hammurabi and the Twelve Tables of the Roman Republic directly address fraud. The Code of Hammurabi dictated the death penalty for many crimes including theft and for “fraudulent sale of drink.” The law 265 states that if “a herdsman, to whose care cattle or sheep have been entrusted, be guilty of fraud and make false returns of the natural increase, or sell them for money, then shall he be convicted and pay the owner ten times the loss.” Romans were liable under the stricture of Tablet VIII, law 21, which stipulated that if “a patron shall defraud his client, he must be solemnly forfeited (‘killed’).”

However, despite the threatening tone of the early statutes, most were ineffective in their implementation and, until modern times, caveat emptor was the main defense against fraud. Most of the efforts to control fraud were applied to the sale of food in public markets, though here too the concern may have been more about preserving social order than protecting the rights of individuals. The regulation of food markets in post-Medieval England illustrates these early efforts. A number of specific selling practices were outlawed, with variable success. These included proscriptions against “forestalling,” “regrating,” and “engrossing,” all of which concerned exploitative or deceptive practices by market sellers of food.

England’s first chartered joint-stock company, the Muscovy Company, was founded in 1555, in part based upon the earlier model of medieval shipping joint ventures, which enabled the collective funding and sharing of risks. Over the next hundred years, the number and scope of these companies expanded rapidly—by 1696 there were over 150 traded—and with them, the scale and complexity of the market for shares and the emergence of brokers, jobbers, and dealers, and along with them, the numbers and types of market abuse. One such early abuse was the “corner,” where investors colluded in the use of options to gain effective control of the market for a particular security or commodity.

Another financial innovation that greatly expanded the scope of fraud was the creation of a market for government debt. In England, the first such issue was in 1693. The Bank of England was established the following year and it assumed the responsibility for funding the government by debt issues, further expanding the scope of the investing public.

Within a very few years of these new markets getting underway there was a growing chorus of opinion and ridicule calling for controls to be put in place to limit abuse. Bills were debated by Parliament in 1694 and 1696, and in 1697 a bill was passed to limit the number of brokers to 100 and requiring that they be licensed by London’s Lord Mayor. The Lord Mayor took the initiative by putting in place a number of regulations for brokers to follow.

In 1720 the exponential growth in the value of the South Sea Company and its subsequent calamitous collapse ultimately caused a seismic shift in legislation and the regulation of markets culminating in the passage of the “Bubble Act” by Parliament, often referred to as the “first securities law.” The act banned the sale of stock in unchartered companies and specified four forms of sanction: fines and other punishments related to public nuisance offenses, imprisonment, and forfeiture, the right of investors to sue for treble damages, and the loss of license for brokers who engaged in such sales. Unfortunately, the Bubble Act was little used in the following decades, with one case prosecuted in 1722 and the next not until 1808, despite the proliferation of unchartered companies.

The next big legal innovation in England was Barnard’s Act, which sought to regulate widespread abuses caused by stockjobbers. This act restricted their activities in three areas: restricting the use of options, contracts for differences, and naked shorts. But Barnard’s Act proved as ineffective in enforcement as the earlier Bubble Act.

The growth and sophistication of the U.S. economy progressed more or less in parallel with that of England and with it so did the financial innovations and attempts to control them. Actions to combat fraud in securities advanced on two fronts: in private actions under common law and in state and federal statutes. State courts recognized the right of private actions as early as 1790. A decision in Connecticut (Bacon v. Sanford) was based on a case where the buyer of a security sought damages against the seller who apparently knew the correct value but chose to deceive the buyer, who did not. Many such cases of intentional misrepresentation and false statements in selling followed. Some of these cases reached criminal courts.

Over the years leading up to the mid-nineteenth century, English and American courts extended the interpretation of misrepresentation in common law cases to include statements made by sellers in public documents (as opposed to specific documents given to the buyer). This gave buyers of securities the general form of redress against fraudulent sellers that exists in modern times.

Progress at the state and federal level continued in parallel. Massachusetts issued public debt bonds in 1751 and was soon copied by other states. The national government in the form of the Continental Congress issued its first debt bonds in 1776. Patterns of trading closely followed English models as did market abuses. The onset of the Revolutionary War exacerbated the abuses and led to public calls to curb them. A number of speculators were arrested in Pennsylvania in 1779 for forestalling and engrossing.

Perhaps the earliest effort to regulate trading at the national level in the United States were provisions against insider trading that were included in the act that established the U.S. Treasury in 1789. This was the first statute to specifically address this crime in the United States or England and arose because of bad experiences with corruption and speculation in prior government debt issues, especially during the war period.

After a severe market crash in 1792 various states considered enacting versions of England’s Barnard’s Act, restricting stockjobbing. Pennsylvania tried to pass a weaker version, but even this failed; however New York later passed an act nearly identical to the failed Pennsylvania one. The statute was reenacted in 1801 and again in 1812. Some provisions were eased in a subsequent version, though a ban on selling shares that one did not own (short sales) remained until 1858 when the act was repealed.

Over the next few decades, the individual states legislatures and courts were active in efforts to rein in stock speculation. These efforts included acts to license stockbrokers, ban time trades, establish maximum settlement times, specify minimum holding periods for bank stocks, restricting banks from speculating in stocks, and applying ad hoc stipulations in the issuance of initial offerings.

In a then-famous 1862 case involving the Parker Vein Coal Company, officers of the company were found to have issued a $1.3 million tranche of fraudulent stock as part of a larger bona fide issue. This led the states of New York and Michigan to criminalize fraud in the issuance of securities. However, these findings only applied to misstatements and did not impose any obligations on issuers or sellers to make disclosures.

In 1882, New York State convened a special committee, the “Boyd Committee,” to investigate the operation and use of stock market corners. “Do evils exist in the methods of the operators?” Chairman Boyd asked of a subpoenaed witness. “Not only do evils exist,” the witness responded, “but they shall entail a public calamity.” “Do you think it is the duty of the Legislature to remedy the evil?,” the chairman asked another witness. “In every aspect of the case,” he answered, “it is just as much the duty of the Legislature to remedy this evil as any other evil affecting the material and moral welfare of the people.”¹

The Boyd Committee concluded:

• A tax should be placed on futures trades where no physical delivery takes place.

• Futures sales for physical delivery are legitimate.

• Puts and calls and bucket shops are gambling and should be treated as such.

In 1887, the state of Illinois put into effect a law banning bucket shops. A similar New York state law followed two years later.

MODERN DEVELOPMENT OF SECURITIES FRAUD REGULATION AND ENFORCEMENT

With the arrival of the twentieth century, the evolution of securities fraud regulation and enforcement became more coherent and cohesive. The first 35 years of the new century swept the nation from a long history of fragmented efforts by different states to stamp out an array of ill-defined evils to a concentrated national program to establish a comprehensive regulatory infrastructure for securities. Progress during this period was driven by three stock market panics, in 1907, 1914, and 1929, and a progression of state and federal investigative commissions to determine the causes of each as well as attempts to rid society of the evils that undermined it and hampered the economy. By the beginning of the new century, the list of interrelated evils plaguing the markets included:

• Bucket shops

• Combinations

• Corners

• Gambling

• Short selling (without physical delivery)

• Speculation

• Stock gambling

• Stockjobbing

• Time trades

• Trusts

In tackling these evils, the United States had to find a way to overcome the jurisdictional duality embedded in its legal system, comprised as it was of states and a federal government. It was not entirely clear who bore the responsibility for crimes within the securities markets, though the states had possession of the physical exchanges and therefore had to control them, but with national industries and nationwide investment it was hard to see how some 40-odd states each with their own laws and many with their own exchanges could function as effective enforcement.

On top of this, there was the deep divide that exists to this day over the need to protect the public from all manner of theft and corruption versus the need to maintain free and open markets. Caught within these challenging and conflicting frames of reference the easiest solution was to do nothing, and that sufficed for most of the time, but the devastating drumbeats of crashing global markets and in the middle of this period the first war to be fought on a global scale kept up the pressure for action.

THE MONEY TRUST AND THE PANIC OF 1907

From the late 1880s, the myriad evils that were perceived to be plaguing the markets began to coalesce in the public’s mind into a super evil called the “money trust....

Table of contents

• Title Page
• Copyright Page
• Dedication
• Preface
• Acknowledgments
• Introduction
• PART ONE - Life, Death, and Degeneration
• PART TWO - Cases and Conclusions
• Index