Amelia Island, FL.: Currently Ground Zero for Hedge Fund Fraud

For over a year I’ve been scheduled to speak on hedge fund fraud at the Public Investor’s Arbitration Bar Association’s (PIABA) annual meeting at the Ritz Carlton Resort & Spa in Amelia Island, Florida. Give credit to the meeting planners for having the foresight to discuss this important issue so far in advance of the headlines garnered by the horrific collapse of the two Bear Stearns hedge funds. My presentation will focus on hedge fund fraud and how it affects investors and the market in general.

Hedge fund cases are indeed the new frontier for fraud because of their murky trading strategies, lack of transparency and ability to “smooth returns.” I’ll be laying out to my colleagues’ strategies for how to bring a case and the types of documentation important to help investor recover for losses due to fraud. The discussion won’t necessarily be limited to hedge fund managers either. The prime broker’s role in clearing trades, providing inappropriate leverage and valuation will be part of the discussion to be sure.

An interesting debate is whether these cases should be filed in court or in arbitration. I firmly believe arbitration is the proper venue. Wall Street has the ability and resources to bury a court case for years and more than likely many cases will be dismissed even prior to the discovery process. On the flip side, arbitration is quicker, efficient and an award is virtually non-appealable.

Interestingly, though I cannot at the moment give specifics, it’s becoming clear to me that regulators are primed for action. The scuttlebutt around here is that should federal authorities lack the wherewithal to curb hedge fund fraud, there are certainly others who will make it their mission to protect the interest of investors.

Bear Stearns Hedge Fund Collapse: A Veritable House of Cards

When I first disclosed in June that I planned to file investor claims against Bear Stearns and the managers of the firm’s High-Grade Structured Credit Strategies fund and High-Grade Structured Credit Strategies Enhanced Leverage fund, some pundits were immediately skeptical. They reasoned that investors should know that hedge funds are inherently risky – pay your money, you take your chance, as the saying goes. You shouldn’t seek legal redress for a bet that goes south.

Yes, there were some cryptic warnings mentioned in the fine print of the Bear hedge fund prospectuses. But many investors were deceived into believing they were actually investing in reasonably conservative funds that had the full faith and backing of the investment bank. My office has obtained documents clearly showing that investors were told the fund would be protected from market downturns through “high-quality investments.”

The Bear hedge funds were anything but conservative. Their horrific collapse is impressively chronicled in this week’s newly designed BusinessWeek. In their impressive, easy-to-understand narrative of a highly complex subject, reporters Mathew Goldstein and David Henry explain how the Bear funds should have been more aptly named “The Wing and the Prayer” funds. More than 60% of their net assets were fair valued by management – meaning they were worth what management said they were worth, not what they could necessarily fetch if there were actual buyers for the securities. (In many instances the assets were so obscure there wasn’t a ready market for them).

The growing trend of valuation abuse to goose returns to garner higher performance fees or prevent redemptions is more practiced than Wall Street would have you know. One of the paragraph’s in the BusinessWeek article says it all:

Valuation games are surprisingly common. A study this summer by Riskdata, a hedge fund risk consulting group, found that at least 30% of hedge funds that rely on illiquid trading strategies are "smoothing returns" to make a fund's performance appear less risky by evening out month-to-month volatility. The study, which was published in June, included the Bear funds among those it examined. "The Bear Stearns hedge funds had a profile that's typical of funds that smooth earnings," says Olivier Le Marois, Riskdata's chief executive officer. "Smoothing returns is very misleading."

BW also does an excellent job of highlighting an unusual – and little understood -- arrangement the Bear funds had with Barclays, which conflicted with the interest of many allegedly unknowing investors. With the advantage of hindsight, the Strategies Fund mission statement was clearly a joke.

Bear Stearns Asset Management Inc. (“BSAM®”) is focused on high value added investment solutions that span traditional and alternative assets for institution and high net worth investors. We are committed to providing our client with world-class investment management and thorough communication of both risks and returns.

Sadly, investors who trusted Bear Stearns and invested in their hedge funds aren’t the ones who are laughing.

StoneRidge vs. Scientific Atlanta: My commentary on Forbes.com...

Commentary

Roe Vs. Wade For The Securities Industry

Jake Zamansky 10.08.07, 6:00 AM ET

This Tuesday promises to be a historic day for the securities industry. At stake? The very integrity of our financial system, according to one pension fund manager. The dramatic verbiage is not misplaced. Without question, there's a lot riding on the outcome of StoneRidge Investment Partners LLC vs. Scientific Atlanta, the high-profile securities case scheduled to be heard by the Supreme Court this week.

Characterized by some as the "Roe vs. Wade for the securities industry" and others as "the most important securities case in a generation," the eventual decision will have a significant impact on whether investors in companies that commit securities fraud should be able to sue investment banks, accountants, lawyers and others who were direct "participants" in that deception. Current shareholders' rights for going after third parties that aid or abet corporate fraud are not as clearly defined as one would think.

First, a quick synopsis of the StoneRidge vs. Scientific Atlanta case: In 2000 to 2001, technology companies Motorola (nyse: MOT - news - people) and Scientific Atlanta (now owned by Cisco Systems (nasdaq: CSCO - news - people)) allegedly agreed to supply cable TV provider Charter Communications (nasdaq: CHTR - news - people) with equipment at a $20 premium over the traditional cost with the knowledge that Charter intended to account for the transactions improperly as advertising revenues (the vendors used the extra funds to buy advertising space).

These "sham" transactions inflated Charter's revenue by $17 million. When the revenue inflation came to light in 2002, Charter's stock crashed from $26.31 to 76 cents, a $7 billion loss in market cap. StoneRidge, an institutional investor in Charter, accused the two vendors of participating in a "scheme to defraud" investors and now wants the right to sue them for remediation.

StoneRidge's ability to go after the tech companies remains thwarted, however, by the outcome of a 1994 Supreme Court case known as Central Bank vs. First Interstate. The Court held that while all "primary actors"--those who were directly part of a scheme (the emphasis is mine) to defraud investors--can be sued for federal securities fraud, the "secondary actors" who aided and abetted the fraud cannot be sued. This case once again raises this all-important issue of third-party liability in securities cases, settling it once and for all.

As an advocate for individual investors, it's not surprising, I'm sure, to hear me contend that all participants who directly engage in activities to deliberately defraud investors be held liable for their actions. Whether the Court will agree with me depends on their definition of the word "scheme" under the federal securities statute.

If you look it up in the dictionary, one definition for the word has it as a synonym for an underhand plot or conspiracy. Since it generally takes two or more to plot and conspire, it could be reasonably argued that the use of the word "scheme" in the statute should allow for more than just one party (such as the investment banks, accountants and lawyers) to be labeled the "participants" in the fraud and hence be held accountable.

If the Court's strict constructionists are to be intellectually honest in their interpretation of the meaning of "scheme" liability in StoneRidge next week, it would prove a revolutionary milestone in the saga of investor rights. Shareholders would be granted a much more level playing field to target for recourse those who had targeted them for fraud.

Sadly, smart money is probably better waged on the Court reaffirming the Central Bank decision from 13 years ago, thereby remaining consistent with its general pro-business stance and previous decisions that limit lawsuits against public companies. While such a toe-the-line decision would generate sighs of relief in the boardrooms of otherwise culpable investment banks, accounting firms and law firms, it is the groans of disappointment at the kitchen tables of victimized shareholders that should ultimately resonate more loudly.

The corporate scandals of recent years may have faded from the headlines, but they are still fresh in the minds of American investors. Their confidence in Wall Street already badly shaken, shareholders need more than empty "we've changed" promises from a mostly self-regulating Wall Street to restore their trust in the system. What they need is for the Court to hold all participants in a fraudulent "scheme" just as responsible as those considered the primary actors.

The integrity of our financial system demands nothing less.

Jacob H. Zamansky, a principal in the firm Zamansky & Associates, is one of the leading plaintiff's securities arbitration firms in the country. He is a frequent contributor to Forbes.com.