Alan Hevesi's Other Skeleton in the Closet

It has now come to light that Alan Hevesi, Comptroller of New York State and outspoken critic of Dick Grasso's compensation package, has been using the considerable powers of his office for personal benefit egregiously using state funds to pay for his wife's chauffer. Missing in the reports is how he may also be a major beneficiary of "pay-to-play" agreements as the administrator of the $140 billion retirement system for state and local government employees. Indeed, Hevesi authorized a $130 million investment into a private equity firm which contributed more than $100,000 to his 2001 mayoral campaign fund.

This practice is currently legal, if not encouraged. Therefore, a logical question is where has the SEC been in stopping these practices? In 1994, the SEC passed Rule G-37, the "pay to play" rule which prohibited municipal bond underwriters from contributing to the campaigns of elected officials who may influence the award of bond underwriting contracts. This rule is widely credited with cleaning up the municipal bond industry.

However, the SEC is also responsible for regulating money managers and mutual funds. In August 1999, the SEC proposed to prohibit money managers from engaging in "pay to play". The SEC proposal would have required that money managers give up any compensation they received for managing public money for two years after the firm, its executives or agents, made a campaign contribution to an elected official or candidate who could have influenced the selection of the money manager.

The SEC federal "pay to play" rule has gone nowhere since 1999 and no one is even talking about it. The attorneys who wrote the rule have long since departed from the SEC and we were told the rule was "not finalized." The reason is obvious; the pay to play rule has no natural constituency. Incumbent politicians want to maintain all potential sources of campaign money. Money managers who benefit from pay to play like the status quo, and those who don't benefit risk retaliation if they criticize the system.

As if the latest ethics scandal surrounding Alan Hevesi wasn't proof enough that state treasurer's can't be trusted with managing a conflict between their political ambitions and fiscal responsibilities, one only has to plug in a Google search to find other examples of pay-to-play shenanigans. California State Comptroller Kathleen Connel, while serving on the boards of CALPERS and CALSTERS ($165 billion and $110 billion pension funds respectively) reportedly received over $250,000 in campaign donations from a firm doing business with the two pension funds. The ugliest example was seen in Ohio where a major fundraiser for the former Governor Bob Taft was provided $50 million of pension fund monies to invest in rare coins. Needless to say the investment went south and many of the coins went missing.

It's laughable that scandals continue to surround the administrators of public pension funds and regulators remain inactive. The SEC should revisit the "pay-to-play" rule and make the same requirements of pension funds that they do for municipal bond business. No investment advisors should receive pension fund investments if they have donated to government officials involved in the fund's administration within two years. Let's not wait for another scandal before this rule is enacted.

Securities Industry Behemoths Are Once Again Trying to Change the Rules of Arbitration

As usual, securities industry behemoths are once again trying to change the rules of arbitration to further stack the chips in their favor. This time it comes in the form of proposed changes to the NASD Code of Arbitration Procedure known as Rule 12504 and 13504. These changes will allow brokerage houses to introduce motions to dismiss in “extraordinary circumstances” prior to an arbitration panel hearing a case. The full rule change proposal can be found on the SEC’s website here.

The securities arbitration process was designed be simple, cost effective and expedient. Allowing brokerages, who of course have unlimited legal resources, to move for dismissal before an arbitration hearing opens up the opportunity for potential abuse. Attorneys will introduce motions without merit simply to increase a small investor’s legal costs and to poison an arbitration panel before they know the facts of a case. The reality is arbitration panels rarely issue sanctions.

This is another example of the systematic effort by the securities industry to stack the deck against the ordinary investor. Worse yet, it’s done under the false pretenses of reform. If the industry wanted true reform, then the NASD should be very specific about what constitutes “extraordinary circumstances.” Suitable circumstances should be limited to situations such as when the wrong defendant, or in this case broker, is named in a lawsuit. The NASD actually went back to the industry with this suggestion, but not surprisingly they wouldn’t agree to any clarification. Instead the rule gives the brokerages a carte blanch opportunity to introduce complex, time consuming motions to dismiss, which is another blow to an already damaged system.

My colleagues on the plaintiffs bar have done a good job in submitting comments opposing the rule so the SEC should reject this change out of hand. And while they are at it, the SEC should do away with the industry panelist requirement. It should be up to the ordinary investor whether he or she wants a potential industry “shill” deciding the fate of their claim.

Spitzer’s Sideline Seat to Conflicts and Insider Trading

Just in time for the AG to choose what color carpeting he wants in the governor’s mansion, The New York Times published a two part profile covering the life and times of Eliot Spitzer. I was actually called for commentary and pointed out to the reporter Spitzer’s general inadequacies when taking a case to court. I would have liked to have seen more attention paid to how Spitzer’s much ballyhooed global research settlement has also been a general failure. Not only were smaller investors left without evidence of wrong doing since no firm admitted any guilt, but the independent research industry which was suppose to take off as a result of the settlement is generally floundering. “Indy shops” are closing all the time. Do you want more evidence? Conflicts on interest in the form of “finder’s fees” are still prevalent in the financial industry. Yesterday’s Chicago Tribune explores a fuzzy line between a finder’s fee and a kickback. At the very least these fees should be disclosed.

But while there’s some semblance of investor friendly regulation for brokerages, it’s still the Wild West in the hedge fund market. The New York Time’s business reporter Jenny Anderson wrote an article for today’s paper exposing how hedge funds are making loans to companies and then placing investment bets based on the business intelligence they gain from the loan’s intentions. You don’t have to be a prosecutor to realize this is insider trading, which continues to be rampant on Wall Street to the detriment of the individual investor - perpetually the outsider looking in.

The Amaranth Hedge Fund and Legal Strategies for Its Investors

The meteoric rise and fall of the Amaranth Hedge Fund is a clear warning for investors: know your hedge fund.

Amaranth recently lost $6 billion of the $9 billion which investors poured into the fund. Most of the blame has been placed on a purported "rogue" 32 year old energy trader named Brian Hunter. Earlier in the year, Hunter made $2 billion for the fund trading natural gas but his enormous gains quickly turned to stunning losses when the market reversed.

The message of the Amaranth Hedge Fund debacle for investors is simple - be familiar with the type of investments in which your hedge fund is investing. If a hedge fund such as Amaranth bills itself as a "multi-strategy" fund but, instead, it invests heavily in a single strategy such as natural gas, it may be time for investors to head to the exit. This type of shift is called "style drift" in which the hedge fund drifts from its initial strategy which it promised to investors into some other and likely more risky strategy which was never disclosed to investors.

Investors, whether they are high net worth individuals or pension funds, are entitled to rely on representations made at the time of investment by the hedge fund as to the nature of the fund's investment portfolio. If the style or investments "drift", the hedge fund may have breached its fiduciary duty to investors and may be liable for misrepresenting the nature of the strategy employed.

"Style drift" is likely to be legal basis upon which investors sue their hedge funds for fraud and misrepresentation.

Another potential target of investor claims will be the "prime brokers" who often allow hedge funds to dramatically increase their risk by providing them with virtually unlimited leverage or margin with which to trade. The gains can be exponentially higher, but the risk to an unknowing investor may be more than is tolerable for their portfolio.

Investors are also entitled to proper supervision of hedge fund traders by hedge fund managers. To the extent that the manager-supervisor abdicated their responsibility, they may also have personal liability for the collapse of hedge funds.

Broker Defamation on Form U-5

Many Wall Street firms are engaging in an unlawful practice of filing false and defamatory Form U-5s for their departing broker and trader employees in order to "blackball" the employee from the Securities Industry. A terminated broker or trader may have a valid legal claim against their former employer for U-5 defamation. Such employees can bring their claims in arbitration for U-5 defamation and seek compensatory and punitive damages and an order from an arbitration panel ordering expungement of false and defamatory language from the employee's Form U-5.

Where a brokerage firm files a Form U-5 which contains false and defamatory language about the reason for an employee's termination or resignation, they have violated the employee's legal rights by not accurately disclosing the circumstances for the termination. Brokers bringing Form U-5 defamation claims need to establish in arbitration that the reason given by the firm for the termination (and the employee's conduct leading up to the termination) differs significantly from what actually occurred.

Often employers file false and defamatory Form U-5s against their employees in order to punish them for leaving the firm, to cover up for senior managements missteps or to hinder the ability of a former broker or trader who seeks to compete at a new firm. Where such evidence of "malice" or bad intent can be established, an employee is likely to prevail in arbitration on a claim for Form U-5 defamation.

Arbitration is the most effective and efficient means for a broker or trader to recoup back salary and bonuses, compensatory damages, a clean slate and a clear conscience.