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Hedge Fund Manager Profited From Death Arbitrage

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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A vital function of the financial system is to shift risk, but that is mostly a euphemism. Finance can't make risks go away, or even really move them all that much. When the financial system shifts the risk of X happening from Y to Z, all that means is that Z gives Y money if X happens. If X was going to happen to Y, it's still going to happen to Y. But now Y gets money. 

Death is a central fact of human existence, the fundamental datum that gives meaning to life, but it is also a risk -- you never know when it will happen! -- and so the financial industry has figured out ways to shift it. Not in any supernatural sense, I mean, but in the regular financial-industry sense: by giving people money when death happens to them. One cannot know for certain how much of a consolation that is.

Another vital function of the financial system is to brutally punish the mispricing of risk through arbitrage. Actually I don't really know how vital that one is, but people are pretty into it. If someone under- or overestimates a risk, someone else will find a way to make them pay for it. That's how markets, even the market for death, stay efficient.

The normal way to shift the risk of death is life insurance -- you die, the insurance company gives you money -- but there are other, more esoteric versions, and they are more susceptible to arbitrage. One version involves "medium and long-term bonds and certificates of deposit ('CDs') that contain 'survivor options' or 'death puts.'" Schematically, the idea is that a financial institution issues a bond that pays back $100 when it matures in 2040 or whatever. But if the buyer of the bond dies, he gets his $100 back immediately, instead of having to wait until 2040. He's still dead, though.  

But the bond can be owned jointly by two people, and when one of them dies, the other one gets the $100 back. If you and your friend buy a bond like that for $80, and then your friend dies, you make a quick $20.

But what are the odds of that? "Pretty low" was presumably the thinking of the companies issuing these bonds. But they didn't reckon with Donald F. "Jay" Lathen Jr. and his hedge fund Eden Arc Capital Management: 

Using contacts at nursing homes and hospices to identify patients that had a prognosis of less than six months left to live, and conducting due diligence into the patients’ medical condition, Lathen found Participants he could use to execute the Fund’s strategy. In return for agreeing to become a joint owner on an account with Lathen and/or another individual, the Participants were promised a fixed fee—typically, $10,000.

That is, needless to say, from the Securities and Exchange Commission administrative action against Lathen and Eden Arc. Lathen and a terminally ill patient would buy survivor-option bonds in a joint account, using Eden Arc's money; the patient would die, Lathen would redeem the bonds, and Eden Arc would get the money. You are ... somehow ... not supposed to do this?

But why? The tempting answer is to say that it's pretty mean to the terminally ill patients. (The SEC's headline is "Hedge Fund Manager Charged in Scheme Involving Terminally Ill.") But while the scheme was obviously in poor taste, it didn't harm those patients at all. The survivor-option investments cost them nothing. There's no accusation that Lathen deceived them; in fact his disclosure to them seems to have been pretty thorough.  Lathen paid them $10,000 for signing a form. 

Or, to put it more ghoulishly: He paid them $10,000 for their deaths. These patients had something valuable. They were going to die soon. That's not normally considered valuable. But Lathen found a way to make a profit -- over $9.5 million over four years -- off of it. Lathen kept some of that profit for himself for implementing the strategy, gave some of it to the investors who supplied his capital, and gave some of it -- $10,000 each -- to the people who supplied his most important raw material: death. I don't know if that's the going rate, but he found willing sellers, anyway.

The SEC hints at its distaste for all of this, but anyone who has ever walked around a trading floor knows that poor taste is not a violation of securities laws. Lathen is not accused of doing anything illegal to the terminally ill patients he found through nursing homes.

Instead, he is accused of lying to the issuers of the survivor-option bonds, though the SEC is a touch vague on what his lies were. The gist of it is that Lathen signed his terminally ill patients up for brokerage accounts owned jointly by them and him, but that neither of them really owned the accounts: They were really owned by Lathen's hedge fund, Eden Arc, which put up the money, had control over the investments, and got the proceeds when the patients died. So when Lathen did this, the SEC says, he was lying:

When a Participant died, Lathen redeemed the instruments at full face value by sending letters to the issuers, which were located in various states, stating that the “joint owner” or “joint and beneficial owner” on the account that held the SO Investment had died. Lathen also represented that as the “surviving joint owner on the account,” he was immediately entitled to redemption.

He wasn't really the owner, and the dead participant wasn't really the owner: Eden Arc was the only owner, and, "as a corporate entity, it would not have been entitled to 'survivorship' rights." Death is a fundamental fact of human existence, but not of corporate existence, so corporate entities don't get to benefit from death puts. 

I don't know. I see their point, but on the other hand, Lathen and his patients really did have their names on the accounts. He really was the "surviving joint owner." It's just that the money came from his hedge fund, and went back to that hedge fund. Any lying that he did here was sort of metaphysical, about the meaning of the concept of "ownership," rather than literal. "We have no doubt that Mr. Lathen’s investment strategy is entirely legitimate and violates no law, and we intend to vigorously defend him against the SEC’s meritless charges," says his lawyer

The SEC's other charge is that Lathen and Eden Arc didn't do enough to protect their investors' funds, because they sloppily invested Eden Arc's money in accounts in the name of Lathen and his participants, rather than in segregated accounts under Eden Arc's name. You can see the difficulty here: For the strategy to work, the accounts had to be in the names of individuals (the terminally ill patients, who would die, and Lathen, who wouldn't). But, for obvious reasons, hedge fund managers are not supposed to put their funds' money into personal accounts under their own names. That makes it a little too easy to steal the money. Not that Lathen did! In fact, the SEC describes all the hoops he jumped through to reassure his investors that their money was safe in his personal accounts. And it was safe; there's no allegation that he pocketed any of it.

But he couldn't win: His investors needed to know that the death-put bonds were owned by the hedge fund, while the issuers of the bonds needed to know that they were owned by individuals. In the SEC's interpretation, there was no way to do this scheme legally. Which is of course the point: This scheme is gross, and the SEC wants it to be impossible.

But, again: why? The SEC is not protecting terminally ill patients here: They got $10,000 each from Lathen's scheme; without it, they'd be $10,000 poorer. It's protecting the issuers of the death-put bonds, financial institutions that Lathen caught mispricing the risk of death. 

And you can sort of see why. The death put is a form of insurance, a way for people to smooth out the financial harms of unexpected catastrophe. If a married couple buy bonds as a long-term investment, and then the breadwinner dies suddenly and the survivor needs ready cash, it's nice if the bonds can be redeemed immediately at 100 cents on the dollar. It's a little bit of a financial cushion that the issuers are willing to provide, for a price. And the issuers presumably had some reason for pricing the risk of death the way they did; they presumably did some actuarial calculations about how many people would die and how much it would cost them in death puts. And those calculations were presumably based on, you know, normal people. They didn't assume that everyone buying their bonds would have months to live, or that they'd be funded by a secretive hedge fund trying to profit from inefficiencies in the price of death. If they had, they'd have priced the survivor option differently, or not offered it at all, and its insurance function for regular people would be lost. A survivor option priced correctly for death-put arbitrageurs would lose its insurance function for the rest of us. A world where ruthless hedge funds can profit from death options is a world where no one else can. 

  1. The intuition is that he paid to shift some of his risk of death to the bond issuer: The issuer presumably offered the death put in exchange for a lower interest rate on the bond. It's a probabilistic kind of life insurance.

  2. Presumably all this was easier before all interest rates went to zero. What kind of bond trades below par now, come on.

  3. I mean, presumably they had some actuarial sense of how many of their investors would die each year, etc. 

  4. E.g., the participant agreements said that “Participant shall have no additional payments with respect to the account(s) unless the Account(s) are terminated and the funds in the Account(s) disbursed prior to Participant’s death,” but “Lathen does not intend to terminate the Account(s) during Participant’s lifetime and, therefore, it is unlikely that Participant or Participant’s estate will receive any additional amounts.” The patients did not sign on thinking that they'd get anything other than the $10,000. But they got the $10,000.

  5. From the SEC:

    Through December of 2015, Lathen set up over 60 joint brokerage accounts with various Participants. The Fund’s profits through December 2015 have been over $9.5 million. And, for the period from May 2011 through September 2015, EACM has claimed total returns for the Fund of 74.73%.

  6. The SEC is not specific, but he apparently made at least a million dollars or so:

    Specifically, Lathen (as the principal of EACM) and EACM have profited through their fraudulent activity through management fees of between .5% and 2% of assets under management. In addition, Lathen (as the sole owner of the EACA), and EACA profited through their fraudulent activity through performance fees of between 16% and 30% of Fund profits.

  7. This is different from the case of Joseph Caramadre, who was sentenced to six years in prison for a similar scheme that involved much more explicit lies to insurance companies. (He also maybe deceived his terminally ill patients a little.) Caramadre allegedly wrote false statements about how he knew the patients, etc., whereas the only alleged deception in Lathen's case is a metaphysical one about who ultimately owned the accounts.

  8. The SEC quotes Eden Arc's private placement memo as saying that Lathen would "serve as Nominee for the Partnership on the Joint Accounts for no consideration": That is, his name would go on the account as a joint owner, but only as an agent of Eden Arc.

    Incidentally there was sometimes a third owner on the account, a relative of Lathen's, "so that if Lathen were to unexpectedly pre-decease the terminally ill individual, the relative could return the assets in the joint accounts to the Fund."

  9. As the SEC puts it:

    As a result of the conduct described above, from approximately October 2012 through approximately February 2016, EACM violated and Lathen willfully aided and abetted and caused EACM’s violations of Section 206(4) of the Advisers Act, which prohibits fraudulent conduct by an investment adviser, and Rule 206(4)-2 thereunder, which requires client funds and securities to be held in an account under EACP’s name, or in an account that contained only EACP’s funds and securities, under EACM’s name as agent or trustee for EACP.

  10. I assume that is part of the explanation for Lathen's shift from just investing Eden Arc's money in his joint accounts, to having Eden Arc lend him the money for the joint accounts:

    In January 2013, Lathen replaced the Investment Management Agreement with a Discretionary Line Agreement between the Fund and Lathen, and a Profit Sharing Agreement between the Fund, Lathen, and EACM.

    Whereas the Investment Management Agreement explicitly provided that Lathen and EACM were the managers of the Fund’s investments, which were held by the Fund’s Nominees and Participants, the new agreements purported to change the relationship between the parties to that of a lender (the Fund) and a borrower (Lathen). Thus, under the Discretionary Line Agreement, the Fund was to advance money to Lathen, on a non-recourse basis, at a rate of prime plus three percent per annum.

    However, as reflected in the corresponding Profit Sharing Agreement, Lathen simultaneously promised the Fund that he would return all profits and losses he derived from the joint accounts to the Fund.

    Same basic idea, but perhaps the investors can sleep a little better knowing that their hedge fund's assets are invested in loans to the manager, rather than directly in accounts in the manager's name. I mean, neither is exactly best practice, but this is not a best-practices sort of strategy.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
Brooke Sample at bsample1@bloomberg.net