Download is the SEC adequately protecting the nation’s capital markets

“Frequently we are told that this regulation has been throttling
the country's prosperity. Bitterly hostile was Wall Street to the
enactment of the regulatory legislation. It now looks forward to
the day when it shall, as it hopes, reassume the reigns of its
former power. . . .
The public, however, is sometimes forgetful. As its memory of
the unhappy market collapse of 1929 becomes blurred, it may
lend at least one ear to the persuasive voices of The Street subtly
pleading for a return to the “good old times.”
Ferdinand Pecora, Wall Street Under Oath: The Story Of Our Modern Money
Changers), Author’s Preface.
The “Good Old Times” Are Back Again
I suggest the “good old times” are now back again and the device your
Committee designed to protect the public investor--the SEC--needs
fixing.
The first step in getting a handle on the risks posed by hedge funds is
to separate and tag them. I believe there are three risks: (1) hedge fund
conduct that cheats their own investors; (2) hedge fund conduct that
randomly cheats everybody else, and (3) the systemic risks such as
those that surfaced when Long Term Capital Management (“LTCM”)
collapsed.
May 30, 2006, letter of Gary Aguirre to the U.S. Senate Committee on Banking, Housing and
Urban Affairs.
How the SEC Learned Hedge Funds Cheat Others;
the Mutual Fund Scandal
For twenty-five years, from 1979 to 2004, hedge fund fraud and
manipulation operated under the SEC’s radar. The SEC brought
no cases against hedge funds for manipulation, insider trading, or
fraud directed against other market participants. During this
period, the SEC recognized only one species of hedge fund
fraud: that committed by a hedge fund against its own investors.
The SEC first publicly recognized that there were two classes of
hedge fund fraud in July 2004. Its proposed rule requiring hedge
funds to register noted: “Since the staff report [of September
2003], a new species of hedge fund fraud has been uncovered (emphasis
added).”
May 30, 2006, letter of Gary Aguirre to the U.S. Senate Committee on Banking, Housing and
Urban Affairs, p. 11-12.
SEC Proposed Rule for
Registration Under the Advisers Act
of Certain Hedge Fund Advisers
“Since the staff report [of September 2003], a
new species of hedge fund fraud has been
uncovered. Advisers to hedge funds have been
key participants in the recent scandals involving
mutual fund late trading and inappropriate
market timing.”
July 28, 2004
Aside from the PIPE cases, the SEC has recovered approximately $110,000
from hedge funds and their principals for all other types of insider trading. How
could this be? The explanation is quite simple: the SEC has brought a total of
six cases for insider trading against hedge funds.
Three of those cases involve a cookie cutter type of insider trading: the
violator shorts a public company in advance of an announcement of a Private
Investment in Public Entities (PIPE). The SEC’s concentration of its
resources on PIPE insider trading cases is curious. The PIPE market is
relatively small: $20 billion in 2005. By comparison, the merger and
acquisition market was $1.46 trillion over a recent twelve month period. … So
why do half the SEC insider trading cases against hedge funds arise out of
PIPE transactions? One obvious answer: next slide
December 5, 2006, testimony of Gary J. Aguirre before the U.S. Senate
Committee on he Judiciary.
Low Hanging Fruit
“The boom in corporate mergers is creating concern that illicit trading ahead
of deal announcements is becoming a systemic problem…
“[A]n analysis of the nation’s biggest mergers over the last 12 months
indicates that the securities of 41 percent of the companies receiving buyout
bids exhibited abnormal and suspicious trading in the days and weeks before
those deals became public. For those who bought shares during these periods
of unusual trading, quick gains of as much as 40 percent were possible.”
August 27, 2006.
12
“GOD-GIVEN MARKETS”
Throughout the course of the investigation … no
matter what the immediate subject of inquiry … the
Stock Exchange was never very far away. Manipulation
of the markets was not merely the source of immediate
stock-market profit, but the indispensable means to
innumerable tortuous schemes and devices.
Ferdinand Pecora, Wall Street Under Oath: The Story Of Our Modern
Money Changers, at 258.
It all looks alike on the ticker
“The Public was always in the dark. It could not
tell whether sales were due merely to the ‘free
play of supply and demand,’ or whether they
were the product of manipulated activities…It
all looks alike on the ticker (emphasis
added).”
Ferdinand Pecora, Wall Street Under Oath: The Story Of Our Modern
Money Changers, at 267.
Yet the participants in the Radio operation were not
criminal types of the sort of Yellow Kid Weil and the
other celebrated con men. They were, on the contrary,
rich and eminent Americans, national leaders whose
names were known and honored everywhere. Among
them, for example, were Walter P. Chrysler; … Percy
A. Rockefeller, nephew of John D; …John J. Raskob,
Democratic National Chairman; …
John Brooks, Once in Golconda, A True Drama of Wall Street 1920-1938, at 66.
THE FIRING OF AN SEC ATTORNEY
AND THE INVESTIGATION OF PEQUOT CAPITAL MANAGEMENT
II. EXECUTIVE SUMMARY
Staff Attorney Gary Aguirre said that his supervisor warned him that it
would be difficult to obtain approval for a subpoena of John Mack due
to his ‘‘very powerful political connections.’’
Aguirre’s claim is corroborated by internal SEC emails …..
Attorneys for Pequot and Morgan Stanley had direct access to the
Director and an Associate Director of the SEC’s Enforcement Division
In June 2005, Morgan Stanley’s Board of Directors hired former U.S.
Attorney Mary Jo White to determine whether prospective CEO John Mack
had any exposure in the Pequot investigation. White contacted Director of
Enforcement Linda Thomsen directly, and other Morgan Stanley officials
contacted Associate Director Paul Berger. Soon afterward, SEC managers
prohibited the staff from asking John Mack about his communications with
Arthur Samberg at Pequot.
Seeking John Mack’s testimony was a reasonable next step in the
investigation.
SEC management delayed Mack’s testimony for over a year, until days
after the statute of limitations expired.
The SEC eventually took Mack’s testimony only after the Senate Committees
began investigating and after Aguirre’s allegations became public …”
The SEC fired Gary Aguirre after he reported his supervisor’s
comments about Mack’s ‘‘political connections,’’ despite positive
performance reviews and a merit pay raise.
U.S. Senate Final Report, p. 5
C. SEC Investigators Identify a Potential Tipper
5. The SEC Fires its Lead Investigator
The evidence suggests that the bar for taking other testimony in the Pequot
investigation was considerably lower than it was for Mack. If he were a midlevel trader instead of the head of Morgan Stanley, it seems likely that a
subpoena would have issued in short order with little or no interference from
Aguirre’s supervisors. Unfortunately, we have received anecdotal reports that
the sort of deference Mack received is not uncommon.
U.S. Senate Final Report, p. 37.
“We also commend the SEC for increased enforcement efforts
regarding insider trading, and specifically insider trading by hedge
funds, following our investigation.
On March 1, 2007, in announcing charges against 14 individuals in a
brazen insider trading scheme, Chairman Cox stated: ‘Our action today
is one of several that will make it very clear the SEC is targeting hedge
fund insider trading as a top priority (emphasis added) .’’’
U.S. Senate Final Report, p. 1.
“Peter Bresnan, Deputy Director of the SEC’s Division of
Enforcement, stated in a CNBC interview on May 11, 2007: ‘Hedge
fund managers are under enormous pressure to show profits for their
clients. . . . Not every hedge fund manager can get those kinds of
return through legitimate trading.’”
U.S. Senate Final Report, p. 2.
The key to getting an investor to plunk down $500,000 to $50 million
subject to the 2% and 20% hedge fund take: “As long as the
performance is up there, in the end the investors do not care about the
high fees.” Aguirre May 30, 2006, letter to Senator Hagel
Hedge Funds, Leverage, and the Lessons of
Long-Term Capital Management
Report of The President’s Working Group on Financial Markets
Recommendations
“Market history indicates that even painful lessons receed from memory with
time. Some of the risks of excessive leverage and risk taking can
threaten the market as a whole, and even market participants not
directly involved in imprudently extending credit can be affected
(emphasis added).”
“Currently, the scope and timeliness of information made
available about the financial activities of hedge funds are limited.
Hedge funds should be required to disclose additional, and more
up-to-date, information to the public.”
“Congress should enact legislation granting any additional
authority necessary to achieve these goals.”
Counterparty Discipline
Chairman Ben S. Bernanke
At the Federal Reserve Bank of Atlanta’s 2006 Financial Markets Conference,
Sea Island, Georgia
May 16, 2006
Hedge Funds and Systemic Risk
“The primary mechanism for regulating
excessive leverage and other aspects of risktaking in a market economy is the discipline
provided by creditors, counterparties, and
investors. In the LTCM episode, unfortunately,
market discipline broke down.”
“A recent report from the Financial Stability Forum,
which comprises representatives of major nations’
financial authorities read: "There has been some
erosion in counterparty discipline recently (such as
declining initial margins), reflecting the strength of
competition for hedge fund business … ”
Point Of View: Ex-SEC heads join hedge fund worry chorus
Associated Press Financial Wire May 29, 2007.
Hedge Funds Systemic Risks to Capital markets
These systemic concerns have two dimensions:
First is the possibility that the behavior of hedge funds in periods of market
stress could amplify rather than mitigate the shock, induce larger moves in
asset prices, or cause broader damage to the functioning of markets when it is
most important they function well.
Second is the possibility that the failure of a major hedge fund or group of
funds could significantly damage the viability of a major financial institution,
both through direct exposure to the fund and losses resulting from the impact
on other market risks to which the institution is exposed.
These concerns existed before the events associated with Long-Term Capital
Management (LTCM) in 1998, but that episode provided a powerful example
of both sets of risks, and how the erosion of counterparty discipline can
magnify those risks (emphasis added).
November 17, 2004, Timothy F. Geithner, President and Chief Executive
Officer of the Federal Reserve Bank of New York.
In Goldman, Sachs We Trust
“The most notable piece of speculative architecture of
the late twenties, and the one by which, more than any
other device, the public demand for common stocks
was satisfied, was the investment trust or company.”
John Kenneth Galbraith, The Great Crash 1929, at p. 46
“The virtue of the investment trust was that it
brought about an almost complete divorce of the
volume of corporate securities outstanding from the
volume of corporate assets in existence. The former
could be twice, thrice, or any multiple of the latter.”
John Kenneth Galbraith, The Great Crash 1929, at p. 47.