You're Entering a Regulator-Free Zone
On the surface, Laser Advisers Inc., a group of hedge funds that Michael L. Smirlock ran from tony Short Hills, N.J., was as respectable as could be. Yes, some of the securities purchased for the three hedge funds were somewhat exotic: options on interest-rate swaps--known as swaptions--that are thinly traded and difficult to value. But Smirlock, a former Goldman Sachs & Co. trader, seemed to have the right credentials to manage the $600 million that investors entrusted to him.
Yet on Dec. 21, the Securities & Exchange Commission sued Smirlock for overstating the value of his funds and hiding losses of more than $71 million. Smirlock denies the SEC allegations, and the case is pending. As it turns out, that's not the first time Smirlock has tangled with the feds. In 1993, Goldman executives discovered that Smirlock, a fixed-income trader, had falsified books and records. Smirlock was fined $50,000 and suspended from the securities industry for 90 days. He left Goldman at that time.
OPEN INVITATION. Welcome to the lightly regulated world of hedge funds. The huge amounts of money at stake and relative lack of oversight are an open invitation to fraud by unscrupulous operators. While fraud is still relatively rare, it does seem to be growing. Last year, the SEC and the U.S. Attorney's office sued five hedge funds for securities fraud involving more than $500 million in investor losses, says William R. Baker III, associate director of the SEC's Division of Enforcement. Though the number of suits may sound small, the pace of enforcement is stepping up: There were as many last year as in the entire previous decade.
The common thread in the cases: managers who bloat their returns and lie about losses. In the largest case, Michael W. Berger, founder of Manhattan Investment Fund, hid losses of almost $400 million from his investors. He pled guilty on Nov. 28 and is awaiting sentencing.
Why does it happen? Hedge funds are expected to outperform in down markets, and that puts pressure on money managers to cheat. "Unfortunately, it's a fact of life," says John D. Finnerty, a partner at PricewaterhouseCoopers corporate-investigations practice. And once a fraud starts, it can be a lot harder to pin down than in other investment vehicles. Hedge funds are not subject to routine oversight by the SEC. "They're not examined the way broker-dealers are, and they don't have the same reporting requirements as mutual funds," says the SEC's Baker.
Don't look to Capitol Hill to enact tougher anti-fraud laws, though. "It has long been recognized that it's difficult, if not impossible, to legislate against fraud," says securities attorney Kenneth M. Raisler of Sullivan & Cromwell. If hedge-fund investors want more protection, they had better stick to more regulated products, such as mutual funds, he says.
Even if hedge-fund investors avoid outright fraud, other hazards await them. Unscrupulous hedge-fund managers who operate personal accounts can be tempted to book their most profitable trades to those accounts rather than the fund. "There can be real serious conflicts if money managers have separate accounts and are not above-board about it," says Jane Buchan, managing director at Pacific Alternative Asset Management Co., a fund of funds based in Irvine, Calif.
The same risk applies to mutual-fund companies that are offering hedge funds to tap into a richer vein of fees. Unlike mutual funds, hedge-fund managers keep 20% of the profits they make each year, as well as charging expenses. So the temptation to flip the best trades into their hedge funds could be overwhelming. "It's a problem waiting to happen. It's such an obvious area for abuse," says Barry P. Barbash, a securities attorney at Sherman & Sterling in Washington.
Hedge funds may be the hot new thing. But the way investors can get scammed couldn't be older.
By Debra Sparks