Hedge Funds Have Finally Pressed their Luck Too Far

The past two weeks has been a time of reckoning for the hedge fund industry. While Bear Stearns continues to try and salvage a hedge fund that invested in risky sub-prime mortgage using $20 billion of debt, the details of Amaranth’s dubious commodities strategy has become public via a Senate report. Both confirm what we already knew: the hedge fund industry puts individual investors at risk both directly and indirectly. Here’s how:

* Pension funds are heavily invested in hedge funds
* The minimum requirement to invest in many funds is now as little as $25,000 with many smaller individual investors getting involved
* Many funds target commodities and their bets are so large that the monthly gasoline, electricity, heating oil, bill goes up
* Funds are leveraged with so much debt, that if a collapse occurs the economy can be sent into a recession (See Long Term Capital Management)

So is the answer regulation? Maybe, but hedge fund managers are a smart bunch. Over regulation may cause them to sink deeper into the abyss and trade in secret “dark pools” more frequently than they already do. On the opposite spectrum, it is clear that under regulation, or no regulation, as is the current environment, puts more than just those invested in a hedge fund at risk.

Transparency is one answer. A hedge fund’s style and strategy should be transparent so that if any “style shift” occurs without the consent of the investors and regulators, the fund is penalized and subject to a lawsuit. Consider for the moment what Amaranth’s investors would have said if they were told that their money was going to be used to borrow billions of dollars which will then be invested over a lightly regulated exchange into enough gas futures contracts that it could manipulate the price to its benefit on the backs of ordinary citizens struggling to pay their utility bills.

Many of the hedge fund investors who I’ve been in touch with would shake their heads in disgust. Lifting the veil on what fund managers are actually up to and its effect on small investors and even families living check-to-check, would add a much needed level of scrutiny. If that doesn’t work, let’s revisit the use of the stockade.

Politicians Get a Black Mark over Blackstone

Its funny how supposedly populist politicians act when they are forced to make a decision that would do some good for the little guy. This thought came to mind as I was reading the coverage of the impending Blackstone IPO and the immense windfall of riches that CEO Steve Schwartzman and his colleagues will receive. They apparently have exposed a tax loophole that has garnered a lot of press recently. The main focus has been whether or not the IPO windfall should be taxed at the corporate rate of 35 percent or a special rate of 15 percent reserved for partnerships, among other tax code minutiae.

And while Wall Street sends its legions of lobbyists to the Capitol to influence a potential bill that could slice private equity profits nearly in half, other interesting underlying themes arise. Namely: the questionable tax record of Senator Charles Schumer and whether or not private equity has reached its peak.

To address the tax situation, Senate Finance Chairman Max Baucus and his Republican colleague Charles Grassley are leading the charge to close the supposed loopholes. Interesting, however, was Schumer's reaction to the bill, who also sits on the Senate Finance Committee. Though he normally favors taxing the "rich," his comments suggested that on this one, he's on the fence at best. The woman who would be president, Hillary Clinton is equally perplexed.

Schumer's office's official position according to reports is that the Senator is "taking a careful look at the legislation." Senator Clinton's office followed suit. The reason for indecision is that Steve Schwarzman is one of their richest constituents as well as major <http://www.opensecrets.org/indivs/search.asp?key=H9VHC&txtName=Schwarzman&t
xtState=(all%20states)&txtCand=Schumer&txtAll=Y&Order=N> donor of tens of thousands of campaign contribution dollars. Forgetting Senator Clinton for a second, on the surface there is nothing wrong were it not for Schumer's hypocritical votes to tax the investor class by lumping them into the "rich" category.

For example he opposed the 2006 tax cut package, including a two-year extension of the reduced 15 percent tax rate for capital gains and dividends, currently set to expire at the end of 2008. If you're wondering exactly how deeply this will affect individual investor's wallet, economist John Rutledge in an interview estimated that raising the dividend rate alone, "would reduce the value of the S&P 500 stocks by between 5% and 8.5%, roughly a $500 to $700 billion decline in the wealth of the 52% of American households that own stock."

Schumer has also voted against repealing the marriage penalty and against lowering all individual income tax rates. One would have thought based on his record a tax specifically targeted at billionaire private equity barons would be a no-brainer for Schumer. The fact that he is hesitating shows that Schwartzman's donations are having their desired affect.

Furthermore, this isn't the first time Schumer has changed his stripes when it comes to taxing the super rich. He was able to insert a <http://www.nysun.com/article/33000?access=805807> special tax break into an unrelated bill for a wealthy New York developer named Robert Congel - also a donor - that funded a mega-mall in Syracuse New York with tax-exempt bonds.

Chuck Schumer's record consistently shows that when it comes to the uber-wealthy New Yorkers, tax breaks and loopholes are ok, but tax cuts that would help middle and upper class investors are not. I ask you, who needs a tax break more: the billionaire or the "thousand-aire" who has a mortgage and a portfolio just barely large enough to retire on?

And speaking of leaving ordinary investors high and dry, though I am certainly no investment guru, it seems like the Blackstone IPO is a dumb investment to begin with. It can be argued that private equity has reached its peak and returns are poised to decline. Why else would private equity barons be looking to cash out and subject themselves to new taxes and regulatory scrutiny?

Further, with cheap financing on the decline, deals are going to become more expensive and less profitable. Making matters worse, undervalued acquisition targets are dwindling so where is the growth potential?

Unfortunately the sales and marketing geniuses on Wall Street are going to rally investors big and small into buying Blackstone shares. And in five years I'm quite sure Steve Schwartzman and his cronies will still be <http://online.wsj.com/article/SB118169817142333414.html?mod=hpp_us_pageone>
eating cracked crab that goes for $400 per claw and hiring out Rod Stewart to play private shows while ordinary investors will be stuck wondering what happed to their Blackstone stock.

Down in Washington, Senator Schumer will be wondering how to tax the poor saps.

Supreme Investor Injustice?

The full scale assault on investors’ rights continues with the Supreme Court ruling that the antitrust rules, which govern U.S. corporations, don’t apply to securities industry firms. Specifically, they are referring to tie-in requirements that forced investors to agree to pay excessive commissions and expenses in order to have access to hot IPO stocks. As a former Federal Trade Commission (FTC) lawyer, I know this area well. Under antitrust laws, a firm cannot “tie” the sale of a desirable product to an undesirable product…apparently unless you are a multi-billion dollar Wall Street brokerage firm.

The Court’s rationale is rather pitiful. They claim this issue is the jurisdiction of the SEC because the securities industry is so complex that the court system won’t be able to understand what is and isn’t allowable under the law. But the SEC has shown time-and-time again that they will side with the brokerages to limit their exposure. I guess the billions in quarterly profits isn’t enough?

Unfortunately, it’s going to get a lot worse for investors before it gets better. Two other cases are likely to be heard by the Supreme Court featuring the investors of two companies: Tellabs and, of course, Enron. In Tellabs, the CEO is alleged to have deceived shareholders by his upbeat comments about the company’s performance when in fact, the situation was dire. Sound familiar?

The S.E.C. has not surprisingly taken the opposite side of the investors suing Tellabs. What it all boils down to is a perfect storm for investor rights. While the SEC and the Supreme Court are limiting the liability for laws already on the books, the Paulson committees are seeking the change laws to more favor Wall Street and Corporate America.

So what’s an investor to do? At the risk of sounding exceedingly grim, I’d say stick your money under the mattress until Congress get’s involved. Unfortunately it’s going to take another Enron blow-up for that to happen.

Mandated Arbitration is the Only “Choice” for Investors

Finally Ira Hammerman, general counsel of the Securities Industry and Financial Markets Association (SIFMA), and I agree on something. “Arbitration is not perfect,” Hammerman said in a recent report, “but it is a more efficient way for customers to voice their claims.”

Hammerman and I recently appeared on a North American Securities Administrators Association (NASAA) panel together and this is almost assuredly where our shared opinions on securities industry regulations end. The ability to find common ground on arbitration reform will be put to the test this week when the House Committee on the Judiciary will hold fast-tracked hearings tomorrow to expose how the process has morphed into a protective shield for Wall Street against investors ripped off by their brokers.

The hearings will be held one day prior to the full release of an influential study showing that investors recovered only about 34 percent of claims based on a review of 14,000 arbitration cases filed with the NASD and NYSE from 1995 through 2004. More alarming is the fact that Wall Street’s three largest brokers – Merrill Lynch, Citigroup and Morgan Stanley – only paid damages in 38 percent of cases filed against them, according to the study compiled by a Wake Forest professor and securities arbitration attorney.

The reasons for the disparity are simple and well known. The main reason investors do not fare well in mandated arbitration is that it is required that one of the three arbitration panelist must be an industry representative. Immediately, the chips are stacked against the investors. It’s akin to getting up to bat with one strike against you.

Furthermore, many times the so-called “public arbitrators” are former financial services employees, thus they are not truly representative of the public at large, as is mandated. The NASD and NYSE have frankly done a poor job recruiting a pool of arbitrators that is truly representative of American investors. The pool of available arbitrators at the NASD and NYSE is neither deep, nor does it reflect the diversity of backgrounds which we see in our jury pools around the country. To be blunt, arbitration panels are composed largely of older white men and lack proper representation by women, African-Americans, Latinos or Asian-Americans.

There are plenty of other reasons for reform, but we still must tread carefully and consider only ideas that are in the investor’s best interest. Senate Judiciary Committee Chairman Patrick Leahy (D-Vt.) and fellow committee member Russell Feingold (D-Wis) recently sent a letter to the SEC arguing that investors should have a greater choice in resolving legal disputes with brokerage firms; they argue that investors should be able to choose the court system.

Though their interest in reforming securities arbitration is commendable, this part of their thinking is flawed. Less experienced attorneys may encourage their clients to pursue Wall Street firms in court where they will no doubt be devoured. Making matters worse, long drawn out litigation is extremely expensive. It will be difficult for an investor who has lost his or her life savings to find an attorney willing to absorb the costs of a long protracted case. More likely the attorney will have to bill by the hour.

The arbitration process on the other hand, is designed to be an expedient and low cost forum of dispute resolution, and many attorneys take cases based on a contingency fee so their interests are completely aligned with an investor’s. But we still must fix the system.

Rest assured the industry and its lobbyist will fight tooth-and-nail against reforms by any means necessary. They will argue that recent studies, including the one mentioned above, don’t account for settlements. This position is so flawed its silly and regulators should not be boastful of such matters. The number of settlements is actually driven by the fact that the disparity of the existing system forces investors into unsubstantial settlements.

Investors, advocates, regulators and attorneys actually have more common ground on the issue of arbitration reform that some seam to think. If we work together to fix the system, and limit the number of large expensive court cases, everyone wins and Wall Street will continue to be the cash machine it always has been.