Hedge Funds Concede Oversight Inevitability in Wake of Madoff
By Bob Ivry, Saijel Kishan and Ian Katz
Dec. 22 (Bloomberg) -- Hedge-fund managers say Bernard Madoff may succeed where Christopher Cox failed: forcing regulation of their $1.5 trillion industry.
The 70-year-old Madoff’s alleged bilking of up to $50 billion begins to uncover a part of the investment industry that has skirted government scrutiny. Though Madoff was registered with the U.S. Securities and Exchange Commission, the agency Cox heads, fund executives who fed him customers’ money weren’t.
“This is an Enron moment for hedge funds,” said Peter Rup, chief investment officer at New York-based hedge fund Orion Capital Management LLC, with $400 million in assets under management. “Regulation would be welcome, primarily from a trust standpoint.”
Suggestions for rules range from strengthening whistleblower programs to imposing capital requirements similar to those for mutual funds. Such regulation would restore confidence in a market, shriveled by losses and investor withdrawals, according to Rup and others.
Hedge-fund assets may shrink as much as 45 percent in 2008, the industry’s worst year on record, according to Morgan Stanley.
Enron Corp., once the world’s largest energy-trading firm, imploded in 2001 amid allegations of accounting fraud. Less than a year later, Congress passed the Sarbanes-Oxley Act, which set tighter corporate accountability rules for publicly traded companies.
There were calls for greater regulation of hedge funds following the 1998 collapse of Long-Term Capital Management LP, which lost $4 billion in a multination debt default kicked off by Russia. It wasn’t until 2002 that the SEC conducted a study of the industry.
Regulation Killed
No regulation was enacted until three years later, when hedge-fund managers were required to register with the commission. The agency’s rule was thrown out by a federal appeals court in 2006 after Phillip Goldstein, now the founder and principal of Bulldog Investors in Saddle Brook, New Jersey, sued the SEC.
Goldstein, 63, doesn’t think the registration would have made a difference in uncovering the alleged Madoff fraud anyway, he said in a telephone interview Dec. 19. He manages $250 million, he stated in an e-mail.
“I don’t see the connection between Madoff and more regulation,” Goldstein said. “Isn’t fraud already illegal?”
Even so, he now admits the need for certain federal protection.
“There should be a friendlier system to encourage and communicate with whistleblowers,” said Goldstein.
Whistleblower Protection
Harry Markopolos, former chief investment officer at Rampart Investment Management, sent the SEC a report in 2005 outlining suspicions he had about Madoff since 1999, according to an e-mail from the ex-CIO.
Fairfield Greenwich Group, Tremont Group Holdings Inc. and other so-called funds of funds had at least $20.3 billion under management with Madoff.
The investments raise the question whether sufficient due diligence is being done by those considered among the market’s most sophisticated investors, according to Karim Leguel, chief investment officer in New York for London-based Rasini & C. Ltd., which advises clients on investing in hedge funds.
Investment managers, including hedge funds, with more than $100 million in assets are required by the SEC to disclose quarterly their holdings of U.S. stocks. By comparison, mutual funds have to publish their net asset values daily and update their daily returns based on the previous day’s market close.
Conflicts of Interest
“There needs to be greater oversight of the fiduciary roles where there are clear conflicts of interest as in the case of Madoff,” said Mehraj Mattoo, London-based global head of alternative investments for Commerzbank AG. “Investment advisory and custody roles have to be segregated. This is critical to avoid frauds. To reduce investment risks, we need greater disclosure of the magnitude of leverage.”
“It doesn’t matter which agency is entrusted with the job of regulation, so long as it is adequately staffed and has sufficient resources and technical expertise to carry out the job,” he said.
Mary Schapiro, President-elect Barack Obama’s pick to lead the SEC, has said the Federal Reserve should be given broader authority to oversee hedge funds.
“Some firms were using misleading historical-related performance data, substituting current adviser or related fund data for the fund’s actual performance,” she told a National Association of Securities Dealers conference in May 2003.
Inadequate Risk Disclosure
“We found inadequate risk disclosure and touting, such as how the fund can beat the market with less volatility and promises about expected returns,” she said. Schapiro, 53, has served as NASD chairman and president of its enforcement arm.
Not everyone in the industry has opposed regulation. Four hedge-fund managers -- George Soros of Soros Fund Management LLC, John Paulson of Paulson & Co. and Philip Falcone of Harbinger Capital Partners, all of New York, and James Simons of Renaissance Technologies Corp. in East Setauket, New York -- testified before Congress that some form of federal oversight was appropriate.
Investors “have a right to know what assets companies have an interest in -- whether on or off their balance sheets -- and what those assets are really worth,” Falcone, who heads Harbinger Capital, with $20 billion in assets under management, told Congress.
Fund Standards
The holdout against regulation at the Congressional hearing was Kenneth Griffin, whose Chicago-based Citadel Investment Group LLC halted year-end withdrawals from its two biggest funds, which have lost 49.5 percent of their value through Dec. 5, according to a letter to clients. Citadel has $13 billion in assets under management.
Hedge funds should be held to minimum capital standards and borrowing ratios, just like mutual funds, said John Coffee, professor of securities law at Columbia University in New York.
Those requirements are needed because the failure of a major hedge fund, such as Citadel, could be just as destabilizing as the failure of Lehman Brothers Holdings Inc. or American International Group, Coffee said.
“I think that the focus of any legislation will be on protecting financial stability, not consumer protection,” he said.
To contact the reporters on this story: Bob Ivry in New York at bivry@bloomberg.netSaijel Kishan in New York at skishan@bloomberg.netIan Katz in Washington at ikatz2@bloomberg.net.
Last Updated: December 22, 2008 00:01 EST |
