Bear Stearns Hedge Fund Fraud

Bear Stearns is again under the spotlight. This time the subject is hedge fund fraud related to subprime crisis.

SEC recently charged two former Bear Stearns Asset Management (BSAM) portfolio managers for fraudulently misleading investors about the financial state of the firm's two largest hedge funds and their exposure to subprime mortgage-backed securities before the collapse of the funds in June 2007.

SEC alleges that when the hedge funds took increasing hits to the value of their portfolios during the first five months of 2007 and faced escalating redemptions and margin calls, then-BSAM senior managing directors Ralph Cioffi and Matthew Tannin deceived their own investors and certain institutional counterparties about the funds' growing troubles until they collapsed and caused investor losses of US$1.8 billion.

The Bear Stearns High-Grade Structured Credit Strategies Fund and Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund collapsed after taking highly leveraged positions in structured securities based largely on subprime mortgage-backed securities. Cioffi acted as senior portfolio manager and Tannin acted as portfolio manager and chief operating officer for the funds, and they misrepresented the funds' deteriorating condition and the level of investor redemption requests in order to bring in new money and keep existing investors and institutional counterparties from withdrawing money.

For example, Cioffi misrepresented the funds' Apr 2007 monthly performance by releasing insufficiently qualified estimates — based only on a subset of the funds' portfolios — that projected essentially flat returns. Final returns released several weeks later revealed actual losses of 5.09% for the High-Grade Structured Credit Strategies Fund and 18.97% for the High-Grade Structured Credit Strategies Enhanced Leverage Fund.

Cioffi and Tannin also misrepresented their funds' investment in subprime mortgage-backed securities. Monthly written performance summaries highlighted direct subprime exposure as typically about 6% to 8% of each fund's portfolio. However, after the funds had collapsed, the BSAM sales force was ultimately told that total subprime exposure — direct and indirect — was approximately 60%.

Cioffi and Tannin continually exaggerated their own investments in the funds while using their personal stake as a selling point to investors. Tannin repeatedly told investors, directly and through the Bear Stearns sales force, that he was adding to his own stake in the funds in order to take advantage of the buying "opportunity" presented by the funds' losses. Tannin never actually added to his investment. He mocked as "silly" at least one investor who sought to redeem instead of following Tannin's supposed example. Meanwhile, Cioffi redeemed US$2 million, which was more than one-third of his personal investment in the funds at the end of March 2007. Cioffi transferred it to another BSAM fund that he described as "short subprime," which he knew was profitable at the time.

The real hazard of hedge funds is often operational risk rather than market risk. Subprime fund managers are more terrible than subprime securities.

Investment Adviser Fined

In the two reports on thematic inspections of investment advisers, SFC stated that it had identified certain malpractices of Hong Kong's investment advisers. So far not too many cases have been concluded and announced, thus the following one is remarkable.

This week SFC issued a reprimand to Mr Choy Kwong Wa Christopher, a former responsible officer of Pacific World Asset Management Ltd (then licensed for RA4 & RA9), and fined him $570,000.

SFC found that Choy:

• mis-stated in a fund's marketing materials the credit rating of the notes in which Pacific World invested through the fund;
• accepted commission from the notes issuer without disclosing this to his clients, which may create a potential conflict of interests in that Pacific World's advice as to the suitability of this fund may have been influenced by that commission;
• failed to ensure that Pacific World's clients received updated information about a reduction in the fund's net asset value and surrender price from the fund launchers;
• failed to ensure that Pacific World's investment advisers kept a record of advice they gave their clients; and
• did not supervise the suitability of investment advice given to clients.

Pacific World has already ceased businesses of regulated activities and therefore Choy alone bears the overall responsibility. The magnitude of the fine reflects the seriousness of this case. What other IA firms would follow?

Why SG Failed to Detect the Fraud?

Societe Generale made headlines during Jan 2008 when it revealed that one of its traders made a series of unauthorized transactions over the past few years, which eventually caused a total loss of US$7.2 billion to the bank. Why did SG fail to detect the fraud?

It was reported that the 31-year-old trader Jereme Kerviel took massive "directional positions" in transactions that depend on the ability to correctly predict how the price of a security will move over time.

Kerviel had been an IT employee at SG before being moved to the bank's front office. He made over 1,000 fraudulent transactions dating back to Sep 2004 and concealed the fraud using various techniques that exploited his in-depth knowledge of the bank's computer systems and procedures. His techniques allowed him to bypass easily all the IT and process controls the bank had put in place to detect fraudulent transactions.

Last week The bank's general inspection department released a 71-page report on the incident, following a 27-page preliminary report released in Feb 2008. The report, called "Mission Green", highlighted 5 reasons the bank failed to detect Kerviel's activities despite several signs that, in retrospect, should have been obvious.

1. Supervision was lacking. Despite several internal alerts that should have triggered a closer look at his activities, Kerviel remained largely unsupervised, especially in the early part of 2007, when the bulk of his illegal activity took place. Between Sep 2004 and Jan 2007, his direct managers completely failed to detect any fraudulent activity, though there were several internal alerts. Kerviel's direct manager resigned in Jan 2007, and Kerviel did not have another manager until Apr. During this period, Kerviel was largely unsupervised and validated the earnings of his operational center himself.
2. A new desk manager assigned to Kerviel in Apr 2007 was ineffective and weak, and did not have enough support from his superiors.Kerviel's direct manager had no specific knowledge of trading practices (wow!), and no attempts were made to verify his supervisory abilities. During the second half of 2007, the desk manager and his immediate superior were caught up with other projects and in dealing with high employee turnover rates; thus distracted, they missed Kerviel's activities. The manager did not carry out an analysis of the earnings generated by his traders - a task that was supposed to be one of his primary responsibilities.
3. Several alerts by the front office got little attention and less response. Long before Kerviel's activities were unearthed in Jan 2008, there were several signals that were either simply ignored or not properly responded to. For instance, despite the suspiciously high value amount (59% of his group's earnings) and growth in Kerviel's declared earnings during 2007, no investigation or analysis was ever done. Similarly, between 28 Dec 2007 and 1 Jan 2008, there was an unusually high level of cash flow for Kerviel's primary operations center where he traded from. But no one noticed. Even two queries related to Kerviel by Europe's Eurex securities exchange did not receive much attention from Kerviel's direct manager. Neither did two alerts from SG's middle office informing Kerviel's manager of anomalies concerning Kerviel that were detected during routine reviews.
4. Kerviel's manager had an overly tolerant attitude toward intraday trading activities. Such trading by Kerviel was "unjustified" given his assignment and lack of seniority as a trader, the report noted. It was this intraday trading that gave Kerviel a context for carrying out his illegal trading activities.
5. The operations environment was critically chaotic. A "chronically" understaffed middle-office operations group, combined with fast growth and a rapid multiplication in the number of products, contributed to a chaotic operations environment, which made it easier for Kerviel to conceal his activities.

In addition, the report indicated that Kerviel may well have had an accomplice in-house an assistant who helped enter the hinky transactions. Kerviel has said repeatedly that other traders at SG followed the same practices, and that he has been made a scapegoat for others' failings in addition to his own.

Then how many "hidden" rouge traders were still staying at the bank?

Tipping

I have some friends working in the Big 4 accounting firms and investment banks. They often complain that they have been prohibited to buy many good companies listed on SEHK because such companies are their auditing or due diligence clients. However, there are always people willing to take the legal risk.

Last week SEC alleged that from summer 2006 through fall 2007, James E. Gansman, a former partner in Ernst & Young's Transaction Advisory Services department, tipped his friend Donna Murdoch about the identities of at least seven different acquisition targets of clients who sought valuation services from his firm. Murdoch was a registered securities professional and managing director of a Philadelphia-based broker-dealer and investment banking firm.

Gansman misappropriated the information about pending acquisitions on numerous occasions in breach of a duty of confidentiality owed to E&Y and its clients. Murdoch used the non-public information to trade in the securities of the target companies; to tip her father, who also traded; and to make recommendations to two others, who traded as well.

This insider trading case involves "tipping" - just like the case of the HK famous banker David Li. I always wonder whether the tipper has obtained any real benefit by tipping his friend to "get rich quickly".

Investment Banking Malpractices

Investment banking is a dream job of many people. Even investment bankers are highly paid, they are too greedy to earn even more by cheating their clients.

FINRA recently fined GunnAllen Financial, Inc. US$750,000 for its role in a trade allocation scheme conducted by the firm's former head trader, as well as for various Anti-Money Laundering (AML), reporting, record-keeping and supervisory deficiencies.

In 2002 and 2003, the firm, acting through Rivera, the former head trader, engaged in a "cherry picking" scheme in which Rivera allocated profitable stock trades to his wife's personal account instead of to the accounts of firm customers. Rivera garnered improper profits of more than US$270,000 through this misconduct. Rivera was barred in December 2006. Kelley McMahon, Rivera's supervisor, was suspended for six months from association with any FINRA-registered firm in any principal capacity and fined $25,000, jointly and severally with the firm.

In connection with the firm's investment banking business, prior to March 2005, GunnAllen never put any stock of a company on a restricted or watch list even though the firm was conducting investment banking business with these companies. During the same period, GunnAllen failed to inform its own compliance department of the investment banking activities in which the firm was involved.

GunnAllen also failed to report to FINRA that its parent firm had entered into a consulting contract with an individual who had been previously barred by FINRA. In addition, the firm was sanctioned for:

• failing to preserve e-mails and instant messages;
• failing to implement an adequate AML compliance program; and
• supervisory and complaint reporting deficiencies.

Supervisory deficiencies included a failure to ensure that markups and commissions charged on equity transactions were reasonable. In reviewing markups on equity transactions, the firm did little more than ensure that commission charges did not exceed 5%.

Breach of Placing Guidelines

In a bull stock market, placing is not just a profitable business for brokerage houses, but also a temptation to personal trading through secret accounts.

SFC recently reprimanded Wintech Securities Ltd and fined it $450,000 by finding that:

• Wintech failed to act in the best interests of market integrity when a number of Wintech staff, including a former director and responsible officer (Tsap Wai Ping), subscribed for shares and received their allocations in an IPO through the accounts of two clients;
• the allocations breached the Placing Guidelines for Equity Securities under Appendix 6 of the Main Board Listing Rules, where no consent was sought or given for an allocation to directors or employees of a placing agent.

Apart from hiding his IPO subscription, Tsap had also:

• signed new client agreements as a witness when he was not present at the time of execution by the clients; and
• accepted instructions from an unauthorised third party to withdraw funds from a joint client account without receiving any valid withdrawal instruction from the clients or properly verifying the clients' signatures.

Tsap has been banned from re-entering into the industry for one year and fined $180,000.

Back to the basics - If the account opening process is robust enough, there would not be so many loopholes for improper personal trading.

AIG Distribution

In many misconduct cases of the financial industry, the wrongdoers are penalized but the victims (investors) may not be adequately compensated. Could the regulatory system be enhanced to offer more investor protection?

Still remember the accounting scandal of American International Group (AIG) a few years ago, which caused the former CEO Greenberg to step down from AIG?

On 9 Feb 2006, SEC filed a complaint alleging that from at least 2000 until 2005, AIG materially falsified its financial statements through a variety of sham transactions and entities and that AIG reported materially false and misleading information about its financial condition. On 17 Feb 2006, the court entered a final judgment against AIG, to which AIG consented without admitting or denying the allegations in the complaint and paid a total of US$800 million on 3 Mar 2006 (US$700 million in disgorgement and US$100 million in penalties). On 14 Jun 2007, the court entered an order authorizing SEC to establish a Fair Fund to include all of the funds paid by AIG.

On 14 Apr 2008, the U.S. District Court for the Southern District of New York approved a distribution plan for the Fair Fund. The court-appointed Distribution Agent will administer the distribution of the Fair Fund to eligible current and former shareholders of AIG.

The AIG distribution is expected to be completed by the beginning of 2009. The funds are on deposit in the court's registry earning interest. Potentially eligible claimants include:

• Any person or entity that purchased AIG common stock during the period from 8 Feb 2001 to 31 Mar 2005 who (1) sold at a loss on or after 14 Feb 2005; and/or (2) held after 31 Mar 2005.
• Any person or entity who purchased certain AIG-affiliated fixed-income securities during the period from 8 Feb 2001 to 31 March 2005 who (1) sold on or after 24 Mar 2005; and/or (2) held after 31 Mar 2005.

The Sarbanes-Oxley Act of 2002 provided the SEC with authority to increase the amount of money returned to injured investors by allowing civil penalties to be included in Fair Fund distributions. Prior to SOX, only disgorgement could be returned to investors.

Is it a role model for Hong Kong?