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Sleazy business slick operation

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That is the industry I am not so proudly a part of: Investment Banking. Read the below from Scott Fearon’s book, so true.

HEDGED

After all my talk of Wall Street types making poor investors, you might think I would keep my money strictly in index funds. But that’s not case. I’m proud to say that, unlike some of my peers in the business, I keep almost all of my money in my own hedge fund. I’ve also made a practice of putting a little bit into other hedge funds, as well, usually ones that are just starting out. I know what it’s like trying to get a new venture off the ground, so I like to help people out. Some of these newcomers wind up earning great returns for me. Others, not so much.
In 2005, I invested $100,000 with someone who lived near me and went to the same church I (occasionally) attend. He seemed like a smart, straight-shooting guy. He was affable and confident in his abilities, so I figured, Why not give him a chance and see what he could do?
It turned out what he could do was separate me from my money.
I’d always heard about the sleazy tricks fund managers use to fleece their investors. But I’d never been on the business end of any of them personally until I signed over that money to my former friend.
The first thing that worried me was that he bought a lot of dodgy green energy companies brought public by an investment bank run by a Silicon Valley promoter named Laird Cagan. We’re talking about pure “story” stocks, companies whose only assets were a couple of engineering PhDs and—maybe—a patent or two. To be honest, I was ready to write my investment off when I saw those stocks in the audited financials. But to my pleasant surprise, my friend’s picks actually did pretty well. By early 2008, only a couple years after I’d signed over my 100K to him, my stake had more than tripled, at least on paper.
I met up with my friend that summer, and I told him that while I was thrilled with his performance so far, I didn’t feel good about the direction of the markets. This was a few months after Bear Stearns had crashed and burned. Things were getting dire, and I urged him to start shorting stocks, something he had always been reluctant to do.
“You’re running a hedge fund,” I said. “Now’s the time to start hedging.”
He gave me a bashful smile and shook his head. “You’re right—the markets are looking iffy, Scott,” he said. “But, trust me, we’ve done our homework. The companies we own are going to keep going up even if everything else crashes.”
You can probably guess how I reacted to his optimistic prediction. The next day, I wrote him an email requesting a $150,000 redemption. With the way things were looking in those days, what I really wanted to do was take everything out of his fund and put it under the nearest mattress. But I figured withdrawing that much would at least allow me to get my money back, plus a nice 50 percent return. As for the rest, I was ready to sacrifice it on the altar of my friend’s naiveté. That is, until he had the nerve to refuse my redemption request.
After not hearing from him for an entire week following my first email, I wrote him by snail mail with my banking details and instructions for wiring the money. Two days later, a letter arrived in the mail—and what a letter it was. My friend’s fund was quite small as far as hedge funds go. He only had about $7 million under management. But what he lacked in size, he made up for in chutzpah.
“As you know,” he wrote, “the timing of making a distribution to you is a function of complying with the appropriate ratio of retirement funds to non-retirement funds in the fund—no more than twenty-five percent of the fund can be invested in retirement accounts. Since we are very close to this ratio, I will have to attract new investors that are non-retirement accounts in order to maintain the proper ratio before I can make a distribution to you.”

SPIKED

In 2010, the owner of the Cleveland Browns tried to take his money out of a hedge fund, only to be told that a provision in his investment contract prevented redemptions that amounted to more than 20 percent of the fund’s assets. That was a serious problem because, as it turned out, he was the only investor in the fund! So, according to that provision, because the managers of the fund had done such a poor job of attracting other investors, the Browns owner was obligated to keep his money in their hands . . . forever!
No, Franz Kafka did not come back from the dead and go into the investment business. This was a fund managed by a perfectly respectable husband-and-wife team with Ivy League degrees and extensive experience in the financial world.* Unfortunately, those kinds of credentials do not guarantee success or integrity. The Browns owner sued the couple, and a judge ordered the return of his investment.

*Peg Brickley, “Cleveland Browns Owner on Offense Against Hedge Fund,” Wall Street Journal, March 8, 2011.
If you’ve never invested in a hedge fund, or at least tried to pull your money out of one, this passage probably sounds like a bunch of nonsense. That’s because it is. Like a lot of hedge fund managers, my friend had placed an absurdly long ninety-day waiting period on redemptions. But even that was not enough for him. Even with three months’ notice, he still couldn’t or simply didn’t want to come up with my money, so he concocted this bunkum about maintaining a percentage of retirement accounts under management. Unfortunately, this has become standard practice in my industry. It’s shocking how many hedge funds “gate” their investors by inventing all kinds of legalese excuses to refuse redemptions.
In his letter to me, my former friend not only politely refused to give me back my own money, he also served notice that, if and when he did get around to giving it back to me, he was planning to do so, at least in part, in the form of securities. Now, that might have been acceptable if he were talking about shares of easily tradable companies like AT&T or Intel. But as I’ve already said, my friend owned some pretty sketchy stocks—and a lot of them were about as liquid as Death Valley in the middle of July. I sent him a very blunt email informing him that I was not going to be pleased if he gave me stocks instead of cash. So, what did he do? He stuck me with a bunch of illiquid positions—specifically, over ten thousand “legend” shares of a company known at the time as AE Biofuels (stock symbol: AEBF).
If you don’t know what legend shares are, they are stocks given or sold to insiders, and they almost always come with restrictions on when or how they can be sold. The AE Biofuels shares my friend gave me weren’t allowed to be traded until late December of that year. So not only did I have to wait three months to get my money out of his fund, I then had to wait another three months to turn the shares he gave me into cash. I was so angry about getting a bunch of unsellable stock, I immediately demanded another $100,000 from him. This time, he responded with ten thousand in cash and another 19,400 legend shares of, you guessed it, AE Biofuels. That meant I now owned a total of 30,114 shares of more or less worthless pieces of paper.
Here’s the thing about legend shares: companies are required to notify the public when a bunch of them are about to come onto the market, and the minute they do so, the stock price almost always crashes. When I received my first batch of AE Biofuels shares in September, they were trading for around $7. By early December, after I’d gotten the next slug of them, the price was down to $3.35. Then, on December 10, the company noted in an SEC filing that “a significant number” of legend shares were about to become eligible for sale. Not surprisingly, investors sold off AEBF in droves. By the time I was legally permitted to try to offload my holdings, the price was down to, get this, 42 cents!

PERFORMANCE ENHANCEMENT

It hurts to lose tens of thousands of dollars. It hurts a lot, especially when my friend’s own legally audited reports said I had actually made hundreds of thousands. But there are always risks when you make a new investment. And it’s not like I can’t afford to lose some money. I can. What galls me is how easy it was for him to screw me over and how routine this behavior is in the financial world.
There are countless tricks that brokers and money managers have mastered to pad their stats and separate their clients from their money. New ones get invented all the time. Back in the dotcom days, fund managers would stash hot IPO shares they’d get from brokerage houses into separate, personal accounts. More recently, managers have been paying top dollar for “research” from so-called expert networks of current and former employees at public companies—research that almost always includes blatant inside information on things like pending earnings reports. This is what got hedge fund manager Steven Cohen in trouble in 2013. It also brought down the multibillion-dollar Galleon Group fund in 2009.
The only limits on these kinds of shenanigans are the depths of shady managers’ imaginations and the shallowness of their morals. In other words, there are no limits. We’re talking about people who possess a very dangerous combination of character traits: they’re intelligent, unscrupulous, and greedy. Not all of their schemes involve out-and-out theft or clearly illegal behavior. But they’re still a long way from kosher.
One of the things that still gets me riled up about my experience with my former friend is that, to receive all those worthless AE Biofuels shares, I had to open up my own personal brokerage account. I still haven’t sold them, and to this day they are the only stocks in that account. It just about makes me sick when I get my statements every month. You may be wondering why opening an account would be so upsetting for me, and why I haven’t put any other stocks in there to offset those terrible AEBF shares. The answer is, it’s a matter of principle. As I said, besides my occasional investment in other hedge funds, I keep almost all of my money in my own fund. I’m very proud of this fact, not only because it means I’m willing to risk my own wealth on the trades I make for my investors but because it shows that I’m not engaging in probably the oldest and most popular bit of legerdemain in my business: front running.
Imagine you’re a money manager with a couple hundred million dollars of other people’s capital at your disposal. Now imagine that you’re planning to buy a large stake in Acme Incorporated, which is running $10 a share. You think it’s going higher, so you decide you’re going to put $5 million of your clients’ money into it. But before you do that, you call up your own personal broker and you say, “I would like ten thousand shares of Acme Inc.,” and then you wait until your own trade is done before you pull the trigger on behalf of your mutual fund or your hedge fund.
Now, a $5 million buy is inevitably going to bid up Acme Inc., at least in the short term. Maybe it’ll only go up a couple cents if Acme happens to be a larger, more liquid concern. But if it’s a less-frequently traded stock, that investment could lift the price as much as a few dollars. Whatever it is, you watch the tape until you figure that the bump from your fund’s investment has maxed out, then you quietly call your personal broker again and tell him to unload your stake. Let’s say in Acme’s case, the stock rises one whole point before you cash out. Congratulations—you just made $10,000 in a matter of hours. And all you had to do for it was make a few phone calls.
Front running has been out of control for a long, long time—and nothing’s changed. There are guys in my industry, guys I know personally, guys who are some of the most prominent citizens in the Bay Area, who have been front running for decades. The father-in-law of a prominent Northern California politician was an infamous front runner. It was probably the worst-kept secret in Marin County. Everybody knew he was pocketing hundreds of thousands, maybe even millions, by using his clients’ funds to juice up his own trades. But nobody gave a damn.
Front running might seem like a victimless crime, but it’s far from it. How can anyone be sure front runners are making the best trades for their investors? Who’s to say they aren’t buying stocks based on how susceptible they are to rising on a big buy order? They might actually be buying into terrible companies that have no chance of succeeding in the long run. If the stocks sink, why should a front runner care? They’ve already made their cut. And what about all the honest investors out there who are scouting stocks based on old-fashioned things like earnings and growth? If you’ve got fund managers out there jacking up share prices with millions of dollars in other peoples’ capital purely for their own benefit, those metrics mean less and less. Pretty soon, the whole financial system gets warped. Money management isn’t about finding quality investments anymore, it’s all about short-term gains. And it’s not about assessing and managing risk because there is no risk for a front runner! They’re virtually guaranteed a profit. That’s called a rigged game, and it’s the exact opposite of what a fair and free market is supposed to be.
There is a more fundamental reason why I care about shady practices like front running in my industry. It has to do with simple fairness and professionalism. As money managers, our customers trust us with their livelihoods, the wealth they have built to sustain themselves and their families. We charge them enormous amounts of money in fees in exchange for the promise that we will do everything we can to safeguard that wealth and grow it as much as possible. But that’s not what happens. It seems like more and more people in my business see their clients’ money as a convenient pool of assets they can exploit to grow their own wealth. Even more shockingly, this attitude is not limited to individual fund managers. Like a bad video on the internet, it’s gone viral and infected the entire system—even the biggest, most prestigious firms.
Have you ever wondered why so many mutual funds—and a good deal of hedge funds now, too—have a so-called family of funds? Seriously, take a look at the marketing materials for your average mutual fund company. It’s probably got a catalog of funds longer than the wine list at the French Laundry (which, if you haven’t had a chance to eat there, runs over a hundred pages). There’s a good reason for this, and it stems from that old inconvenient truth about the financial industry: asset size is the enemy of return.
As companies bring in more and more investment capital, their performance inevitably declines. But do they stop taking on more assets? Of course not. They just start another fund and give it a catchy new name like their “Dynamic Growth Fund” or some such BS. As a smaller, leaner fund, this new entity has a chance to reap much larger returns. Fund managers often make sure this happens by transferring winning trades from larger funds to these newer, smaller ones. They then market the hell out of those newer funds by touting their astounding returns until those funds, too, get too big to keep posting great stats. Then, rinse and repeat—they start the whole cycle again.
But what about the new funds that don’t do well? There are plenty of those. And companies have a sure-fire strategy for dealing with them: they shut them down and erase them from their books. It’s called survivorship bias, and it happens all the time. A fund goes south and starts to post poor results, so the bosses step in and—bingo, bango—it goes down the Wall Street rabbit hole, never to be heard from again. They either wipe it out entirely or they merge it into other, better-performing funds. Of course, the investors in that fund don’t get their money back or anything. Those losses aren’t imaginary for them. But if you read the mutual fund company’s marketing materials, it’s like the fund that lost them their money never existed.

G(R)IFTED

The thing that really gets me about guys like my former friend the hedge fund manager, and way too many others in my industry, is that they present themselves as pillars of their communities while they’re secretly scamming their investors. The only reason I trusted my friend with my money in the first place was that he came off as a decent family man. I assumed that someone who seemed so wholesome would manage my money responsibly. That assumption was wrong.
Another way sleazy money managers burnish their reputations is by spreading huge amounts of money around to charities and other worthy causes. That was one of Bernie Madoff’s main MOs, and it worked for him for decades. No one wanted to believe that such a generous philanthropist was a complete fraud.
A few years ago, I attended a fund-raiser for a school I helped found for disabled kids. It’s a great event that we throw every year. We always start off with a silent auction and then we bring on some entertainment. That year, both Dana Carvey and Robin Williams were scheduled to perform. Before the auction could even get started, the singer Sammy Hagar, of all people, jumped on stage and declared that he and his buddy Larry Goldfarb were each going to donate $50,000 right then and there so that we could skip the auction and go right to the show. Larry was a local hedge fund manager with a reputation for partying with rock stars like Hagar and writing out big checks to charities. The audience applauded wildly, and Larry came on stage to take a bow. We were all thrilled at his classy, selfless gesture . . . until we found out the money he gave the school wasn’t exactly clean. In 2011, Larry was busted for dipping into his clients’ funds to bankroll his own pet projects and investments, including stakes in real estate ventures and a record company (remember, he liked to hang out with rock stars).* Some of Larry’s investments actually made large returns, but he neglected to share those profits with the people who had made them possible—his investors.
Laird Cagan, the investment banker who fed my former friend those iffy green energy stocks, is a big-time donor to charity, too. Thanks to his generosity, the soccer stadium at Stanford University is named after him. But at least one of his gifts hasn’t worked out so well for the people who received it. In 2007, Laird gave $1 million in stock to his hometown of Portola Valley to help finance a new town center. What a guy, right? Wrong. It’s hard to believe, but Laird pulled the same game on his city as his pal pulled on me. The stock was restricted, and the town couldn’t legally sell it until 2012. By then, it was worth a grand total of $60,000.†

*“SEC Charges Bay Area Hedge Fund Manager with Misappropriating ‘Side Pocketed’ Assets,” SEC press release, March 1, 2011.
†Bonnie Eslinger,
“Portola Valley Wants to Dump Donated Stock After Watching It Lose $940,000 in Value Since 2007,” San Jose Mercury News, July 19, 2012.
Hedge fund managers do this, too. They’ll shut down money-losing funds, only to reopen them months or years later. This allows them to bypass high-water mark provisions in their investment agreements so that they can charge the standard 20 percent performance fee before they fully recoup prior-year losses. Another classic trick is to squirrel away bad investments in larger accounts so they won’t affect the returns as much as they would have in smaller vehicles. This practice was so common in my area of Marin County, people used to call it the 101 Allocation after the main freeway here. Fund managers would shove their losing investments into big institutional accounts and put their winners into smaller funds—often the ones they themselves and their friends and family had invested in. Then, as the saying went, they’d be out the door and on Highway 101 by 1:01 p.m.
Tricks like allocation and front running have been around for a long time, and they’re still quite popular. You might think someone in the regulatory sector would, I don’t know, regulate these behaviors. But agencies like the Securities and Exchange Commission (SEC) aren’t just outmanned and outgunned by Wall Street; they’ve essentially abdicated their responsibilities for overseeing my industry. Sure, they make occasional headlines for busting a few blatantly bad actors like Larry Goldfarb and Bernie Madoff, but these cases are the proverbial exceptions that prove a rule. The vast majority of Wall Street’s scams not only go unpunished, but many of them are allowed to continue out in the open without the faintest threat of prosecution.
About ten years ago, I got a voice mail from a woman working for a well-known and well-connected boutique brokerage in Arkansas. She said they were arranging a PIPE (private investment in public equity) for Stonepath Group Inc. (stock symbol: STG), a troubled freight forwarder. A PIPE is a last-ditch funding mechanism for failing companies in which batches of discounted shares are sold to big investors like hedge funds. They almost never save the companies from bankruptcy, but they often wind up lining the pockets of shady money managers. At the time, Stonepath’s stock was trading for $3, but the woman said that if I bought into the PIPE scheduled for a week later, I could purchase shares at a significant discount. She concluded her message with an astonishing bit of doublespeak: “By listening to this voice mail, you are now in receipt of nonpublic information and are thus prohibited in trading on the company’s stock. But if you do decide to use this information to your benefit, it is not our role nor is it in our interest to question your decision.”
I couldn’t believe what I had just heard. Here was a complete stranger leaving me inside information on my voice mail, then all but winking and nodding at me as she invited me to use it. Why would she do such a thing? Because the entire PIPE process depends on guys in my position doing exactly what she was supposedly telling me not to do—using that inside information to make a fast profit.
Here’s how it works. Brokerages like the woman’s employer call up hedge fund managers all over the country and invite them to participate in an upcoming PIPE. The fund managers immediately short the stock of the company involved. Then, a week or so later, when the PIPE occurs, they buy in at the discounted price and use those exact shares to cover their positions. It’s the easiest money you can possibly make. The fact that it’s completely and unquestionably against the law doesn’t matter one scintilla to anyone involved—not to the brokerages arranging them, not to the money managers profiting from them, and, unfortunately, not even to the regulators who are supposed to stop them.
Over the years, I’ve received several invitations to profit on inside information during PIPE deals. But that voice mail from the woman in Arkansas was so egregious, I decided I had to do something about it. I got the contact info for an SEC lawyer from a friend of mine, and I called the guy from my room at the Hyatt in Monterey during the American Electronics Association Conference. When I told him about the message I’d received and how rampant the PIPE scam had become, he wasn’t at all surprised about it.
“We’re aware that some people have been covering short positions on PIPE offerings,” he said. I’m not sure, but it sounded like he stifled a yawn midsentence.
“Are you planning on doing something about it?” I asked.
The lawyer let out a sigh. “Look, I’m going to be straight-up with you. Do you know what I make every year?” Before I could hazard a guess, he gave me the answer: “A buck twenty-five.”
“Okay, you make $125,000 a year. That’s not exactly minimum wage.”
“No, it’s not. But the guys shorting these PIPE deals make millions.”
“But your job is to regulate those guys and enforce the law.”
“Sure it is. But when it comes to things like this, that’s a lot harder than it seems. The investigation would take years. They’d hire ten different lawyers and fight me every step of the way. And in the end, we’d be lucky if they wound up paying a small fine.”
“Let me just make sure I understand what you’re telling me,” I said. “I just informed you that I have a licensed broker on tape giving me inside information and practically begging me to use it, but you don’t plan to pursue the matter?”
“No,” he stated flatly. “I do not.”
“So all these people breaking the law are just going to keep getting away with it?”
He paused for a moment before answering.
“Yes, Mr. Fearon. I’m afraid they are.”

Written by amitdipsite

December 4, 2017 at 8:36 am

Posted in Uncategorized

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