Jake Zamansky's Blog

WexTrust Capital Investigation Eerily Similar to Peter Dawson’s Long Island Fraud

2008-08-15T14:00:00.005-04:00

For as sophisticated as today's financial gurus claim to be, the old-fashion Ponzi scheme is still alive and well. Indeed, the SEC filed a major case against WexTrust Capital (a Chicago-based private equity firm), its partners and various investment affiliates, that allegedly ripped off an estimated 1,200 investors, mainly from the Jewish Orthodox community. In response, Zamansky & Associates has launched its own investigation in order to return funds back to investors.

It is estimated that WexTrust Capital, and one of its main partners, Joseph Shereshevsky, may have defrauded their investors by as much as $100 million, which the SEC alleges was diverted to cover personal expenses, among other expenditures. According to the SEC's complaint,

"Defendants have been fraudulently raising money in the various offerings, each of which purportedly is for a particular investment, without disclosing that funds raised were actually being used to pay prior investors in unrelated offerings and to make unauthorized payments to fund the operations of the Wextrust Entities, which were operating at a deficit. An internal Wextrust combined "balance sheet" shows that as of December 31, 2007, Wextrust Entities "borrowed" at least $74 million from the LLC entities and also "lent" at least $54 million to various LLC Entities. The Defendants are raising money and commingling funds in contravention of specific representations in private placement memoranda that investor funds will be used for specific investments in real estate or other assets identified in offering memoranda."

All together, the SEC alleges that WexTrust Capital conducted at least 60 private placement offerings and created approximately 150 entities in the form of limited liability companies or similar vehicles. Throughout the process, the SEC alleges, WexTrust Capital partners didn't disclose material information, never purchased properties it promised to investors and paid themselves profitably. WexTrust Capital allegedly committed a litany of violations of U.S. Securities laws.

Indeed, this is the classic Ponzi scheme strategy and eerily similar to Zamanky & Associates' pending case in Long Island court involving Peter Dawson, a now jailed investment advisor who ripped off dozens of retirees. Among the similarities between the Dawson case and that of WexTrust Capital are:

Both situations are examples of affinity schemes: WexTrust Capital targeted members of the Jewish Orthodox community and specifically, those that attended the B'nai Israel Congregation. Mr. Shereshevsky was close with the Rabbi who vouched for him regularly, according to the Wall Street Journal. By the same token, Peter Dawson targeted members of the East Meadow Methodist Church, and had close ties with its Pastor.

Investor borrowed against his home: According to the Journal, at least one investor, and potentially others, borrowed against his house in order to invest in WexTrust Capital.

Managers of WexTrust Capital and its affiliates enjoyed lavish lifestyles, as did Mr. Dawson, by allegedly fraudulent means.

And basically both Mr. Dawson and Mr. Shereschevsky and WexCapital, commingled funds, which is a fancy way of robbing "Peter to pay Paul." For example, in the SEC's report under "The Block III Offering Fraud," WexTrust Capital did the following:

Block III Mines & Minerals, LLC ("Block III") is a Virginia limited liability company organized to make a loan to and acquire an interest in a Namibian company, Deva Investments (Pty), Ltd., which owns the exploration and mining rights in a group of diamond mines in Namibia known as Block III.

Block III Managers, LLC, a Virginia limited liability company, is the manager of Block III. Block III Managers is wholly-owned by Brandon Investments, and that Brandon Investments is a wholly-owned subsidiary of Wextrust.

Defendants Byers and Shereshevsky, together with Defendant Wextrust and Brandon Investments, controlled the issuer, Block III.

Block III issued a private placement memorandum dated March 22, 2007 (the "Block III PPM") seeking to raise $11 million from investors. The Block III PPM represents that the proceeds of the offering will be used as follows: (a) $4.5 million would be used for new equipment and operating capital, (b) $1.5 million would be used to fund a reserve for a purchase option on two other mines, (c) $1.75 million would fund an operating reserve, $300,000 would pay legal and operating expenses, and (d) approximately $2.95 million would be paid in fees to Wextrust and Wextrust Securities. Moreover, the operating agreement attached to the Block III PPM specifically limited the use of funds to expenses related to Block III.

These representations were false. Moreover, the Defendants knew, or were reckless in not knowing, the representations were false. Almost immediately after the money was raised, Defendants diverted the proceeds to unauthorized uses.

The Wextrust balance sheet shows that $3,990,910 of proceeds raised by Block III Mines & Minerals LLC was diverted to Wextrust Entities.

Defendants Wextrust Securities acted as a placement agent in the Block III offering.

The Block III PPM describes Shereshevsky as a "principal and integral part of Wextrust", and states that Shereshevsky was "instrumental in the founding of Wextrust Securities". The Block III PPM fails to disclose Shereshevsky's prior felony conviction. Defendants Byers and Shereshevsky knew, or were reckless in not knowing, of Shereshevsky's conviction.

Defendant Shereshevsky and his wife received transaction based compensation of $249,577, or approximately two percent of the funds raised by Wextrust Securities, in connection with the Block III offering. The Shereshevskys also received $750,000 in bonuses in connection with the Block III offering.

WexTrust Capital's Troubles

Its likely WexTrust Capital will attempt to defend itself by saying that investments simply went south and it's "buyer beware." But the SEC's evidence points otherwise. For example, Mr. Shereshevky emailed a business partner which showed they both were aware that their activities were fraudulent:

"Please remember one thing. That although I always take care of you and myself, my goal in this thing as I have always told you from day one, is to get [W]exTrust out of all the s---- before the end of 09 or 10 at the latest. that is my primary concern. We have faced it until we made it for long enough and now we must clean it up."

Mr. Dawson pleaded guilty and is serving a sentence of five to 15 years; a sentence provided to him only after helping investor recover their money. At least at this point, the SEC has only filed civil charges. Shereshevsky and his Chicago partner affiliated with WexTrust Capital were arrested earlier this week and face criminal charges. The WexTrust Capital partners could be looking at much longer sentences if they choose to fight the charges.

WexTrust Capital Investors: What's Next?

Naturally, the investors in WexTrust Capital are asking simply, "where's my money now and how do I get it back?" In the Peter Dawson case, most of the funds were squandered. It's unclear at this point whether any of WexTrust Capital assets are retrievable, but in all likelihood even the assets that are liquid won't amount to a full recovery for the allegedly defrauded investors.

The key in recovering money is to ferret out solvent firms that potentially aided and abetted the fraud, or at least were in the position to stop it. In the Dawson case, we are suing banks, mortgage brokers, mortgage lenders and other firms, which Mr. Dawson himself alleges were participants. This takes an extensive amount of research and investigation, but if you follow the money in all likelihood there are places that can be found were recoverable money exists.

Investors in the WexTrust Capital scheme are likely feeling a whole host of emotions. It's important to have hope, be patient, and communicate regularly with an attorney.

WexTrust Capital and Peter Dawson: What are the lessons for investors?

Perhaps the over arching lesson in these two cases is due diligence. According to the SEC's complain, Mr. Shereshevsky had a prior history of investment-related fraud:

"In March of 1993, Shereshevsky was arrested for bank fraud, among other things. In June 2003, Shereshevsky pleaded guilty in the Southern District of New York to one felony count of bank fraud. He was sentenced to time served, 24 months supervised release and ordered to pay restitution in the amount of $38,797.90, which judgment was satisfied on February 15, 2005."

Even if the investment advisor is a member in good standing at investor-affiliated organizations, such as a church, synagogue or rotary club, a full due diligence investigation should be conducted.

And then there is the age old adage: if something is too good to be true, it probably is.

What the Auction Rate Securities Settlement Doesn’t Do

2008-08-14T11:56:00.001-04:00

The New York State Attorney General and the other regulators participating in the auction rate securities (ARS) settlement talks are surely to be commended for their action and diplomacy. Auction rate securities clearly were fraudulently marketed to investors and without the regulatory pressure and investigations; there would be no light at the end of the tunnel. And lest anyone think Wall Street is owning up to its mistakes, know the real reason banks have come to the table are the potentially ruinous emails and evidence that would have surfaced had an investigation continued. The emails that surfaced at Merrill Lynch and UBS showing ARSs were sold to unsuspecting investors while internally it was clear the market was poised to collapse is the tip of the iceberg in all likelihood.

But putting Wall Street’s disingenuous generosity aside for the moment, based on details of that have emerged, it seems to fall short of true retribution for the fraud which occurred…and I’m not referring to Goldman Sachs’ apparent non-participation.

First off, though it appears that brokerages will be buying back auction rate securities over the course of the next year, clients that suffered consequential damages are left out in the cold. Many of our clients were not able to close on transactions such as homes and tuitions because of the ARS market’s collapse. Non-profits were not able to meet their philanthropic obligations as well. Cases seeking to recover these consequential damages are likely to continue in arbitration.

Secondly, ARSs were fervently pitched to corporations as “cash equivalents,” so many very sophisticated CFOs and comptrollers tied up their free cash flows in these securities. Payrolls were missed, financing opportunities passed by and business operations were hampered. These claims will likely proceed as well.

Thirdly, some investors were able to sell their ARSs in the secondary market, usually at steep losses. It’s currently unclear whether they will be compensated for their losses.

And importantly, many angry investors moved their accounts to other firms; and burned brokers, switched firms because their brokerages pressured them into buying and selling auction rate securities. This seems to be a grey area as well. For example, if an investor left Merrill Lynch after getting ensnared in its ARS offerings, and moved his/her account to competitor, it is unclear whether that investor will be made good.

Finally, it appears that Wall Street will be customarily let off the hook by not admitting any wrong doing. At the very least, senior managers who oversaw the ARS market and were responsible for its marketing should be held responsible.

Indeed, when the dust settles on the auction rate securities settlements, its likely Wall Street’s problems won’t go away. As they say, the devils in the details.

Hedge Fund Losses Could Lead to Style Drift

2008-08-13T15:03:00.002-04:00

Reuters reports on key indexes pointing to large losses by hedge funds in the month of July - and likely for the foreseeable future. The reasons are that many hedge funds that were highly leveraged are receiving margin calls. And a great many firms are being hammered by a combination of falling commodity prices and rising financial stocks, which pressured popular bets in the opposite directions.

As liquidity dries up and prime brokerage lines shrink, we are likely to see more hedge fund managers going outside the box and making riskier, more speculative plays. If these investments diverge from the style or strategy disclosed to investors when they joined the hedge fund, more and more lawsuits based on style drift and fraud (failure to disclose) could be filed by investors.

Investors are entitled to a certain amount of transparacy based on the originally disclosed investment strategy - if the strategy changes, investors should be given an opportunity to either withdraw or consent. Simply baiting and switching is unacceptable and likely will lead to lawsuits. Amarath is viewed as exhibit A. The fund said it was employing a presumably safer multi-strategy approach, but in fact the managers made huge bets in natural gas.

One of the major differences between a claim against a hedge fund and a claim against a brokerage firm is that in many instances the hedge fund investors must file the lawsuit in court instead of through FINRA’s arbitration proceedings. On the surface that is a disadvantage, but given hedge fund managers propensity for secrecy, such a public dispute could lead them to act quickly and make investors whole.

The Decision to Sue a Financial Advisor is not so Cut and Dry

2008-08-07T08:02:00.003-04:00

A recent Money Magazine columnist, who carries the nom de plume of “The Mole” and is an undercover financial planner, wrote a column entitled “Should I sue my advisor?”

“The Mole” relates a common situation where a broker is asked to review another broker’s performance and finds that unsuitable investments were made and excessive fees were charged. Indeed, many of the cases referred to Zamansky & Associates’ are from these “second” brokers, who are often the best ones to determine whether the previous advisor abused the client, yet as The Mole asserts, only a qualified securities arbitration attorney should be trusted with this advice.

But I do disagree with The Mole on some of his/her points. The Mole writes that “the award is typically a small fraction of what's requested, sometimes not enough to cover the cost of the suit.” Many lawyers, including our firm, take cases on a contingency or success fee basis so that if there is a successful arbitration or more commonly a financial settlement, only then are legal fees incurred. In other words, the financial interests of the aggrieved investor and his/her counsel are aligned.

Secondly, The Mole takes a look at disclosure documents, such as the investment advisory agreement and the prospectus, and sees the fine print as iron clad. True enough, while arbitration panels will be presented with disclosure documentation, that’s not dispositive of a case. Securities arbitration panels will hear testimony from both broker and client and make judgments based upon the credibility of the witnesses. If an arbitration panel thinks that a broker made a material misrepresentation to a client, the fact that documents contain disclosures may be ignored by the panel which could issue a monetary award against the broker. Furthermore, where a broker has a number of customer complaints on their record, arbitration panels may find it more likely abuse has occurred.

The Mole and I may disagree on some things, after all he’s a financial planner and I am a securities arbitration attorney, but we both agree that the best policy is to not buy a “financial product or [do] business with an adviser unless you understand what you're buying and what you're paying in total fees.”

Merril Lynch's Microwave Ovens

2008-08-04T11:48:00.001-04:00

The focus on Merrill Lynch these days is on its tattered balance sheet, namely the more than $30 billion in mortgage-related assets it wrote down last week for some 22 cents on the dollar. Given that Merrill valued these toxic assets at 36 cents on the dollar just weeks ago underscores the severity of the mess Wall Street has created. Even a veteran executive like Merrill CEO John Thain has absolutely no clue how to value the assets on his company’s books.

But Mr. Thain has another formidable problem. It is the mind-boggling allegations outlined in the administrative complaint Massachusetts regulators filed Thursday outlining with impressive clarity how Merrill Lynch deceived its clients into believing that auction rate securities were safe cash equivalent investments when in fact they were inherently quite risky. If a significant portion of Merrill’s brokers and retail customers take the time to actually read the complaint, they will be outraged by how badly Merrill's management betrayed them.

The Massachusetts complaint, impressively written in language that a layman can easily understand, makes clear that Merrill was badly conflicted when selling auction rate securities to its retail customers, some of whom I represent. The firm reaped a hefty $90 million in profits in 2006 and 2007 underwriting these securities for their corporate customers and priced them at interest rates ultimately advantageous to them.

The interest rates on these securities reset at weekly or monthly auctions and were typically slightly higher than an investor could receive from a money-market fund. The little understood risk was that Merrill was artificially propping up the auction rate market and that if an auction ever failed, investors would get stuck holding essentially illiquid long-term bonds carrying relatively low rates of interest. Merrill’s mortgage-related problems eventually prevented the firm from propping up the auction rate market; almost overnight its retail clients were stuck holding low-interest bonds with long-term maturity dates.

“Time after time, when confronted with conflicts of interest, Merrill Lynch was consistent in that it placed its own interests ahead of its investor clients (emphasis mine),” the administrative complaint charges.

With more than three decades of experience representing individual investors who have been wronged by their brokers, it comes as no surprise to me that Merrill put its interests ahead of those of its clients. And to be fair, other brokerage firms also have been accused of deceptively selling auction rate securities to their clients. But the Massachusetts complaint against Merrill also reveals the firm’s lack of regard for both the letter and spirit of previous regulatory agreements it has entered into and provides yet another appalling example of conflicted research.

According to the complaint, Frances Constable, a manager director responsible for overseeing Merrill’s auction rate securities desk, was allowed to compromise the integrity of Merrill’s fixed-income research by demanding that a less-than-sanguine report about auction rate securities be retracted. Merrill’s research department acquiesced and issued a new report positively characterizing auction rate securities as “a buying opportunity.” Merrill cannot claim that Ms. Constable was acting without the complicit approval of her superiors; Ms. Constable sent an email to her bosses written entirely in capital letters outlining her planned course of action.

Another damaging email was sent by Ms. Constable to an associate on November 26 when the firm was clearly worried about the firm’s increasing inability to peddle auction rate securities to its unsuspecting clients: “The gloves are off and we are not concerned about issuer perception of [Merrill Lynch’s] abilities and the competition. Gotta Move these microwave ovens!!”

Conflicted research is nothing new at Merrill. In 2001 the firm was party to a global $1.4 billion settlement after former New York Attorney General Eliot Spitzer uncovered emails showing that then Merrill analyst Henry Blodget was touting stocks he privately believed were “pieces of crap.” As part of the settlement, Merrill agreed to ensure the independence of its equity research department from its investment banking operations. Shockingly, a Merrill spokesman defended Ms. Constable’s actions by saying the Spitzer settlement didn’t preclude communications between Merrill’s sales and fixed-income research analysts.

Artificially propping up its auction rate securities also underscores the disregard Merrill has for regulators. On May 31, 2006, the SEC's Division of Enforcement issued a news release trumpeting that it had settled with 15 broker-dealer firms, including Merrill Lynch for what essentially amounted to rigging the auction rate securities market between January 2003 and June 2004. The penalty: a paltry fine totaling $13 million, of which Merrill’s piece was an insignificant $1.5 million.

To the credit of Massachusetts regulators, they are seeking to force Merrill to make their retail clients whole on the auction rate securities they were duped into buying. But if the Commonwealth’s regulators are truly bent on forcing Merrill to reform, they will insist that any settlement require Merrill to admit wrongdoing, thereby making it considerably easier for their clients to seek redress in securities arbitration for additional losses they sustained because of the unexpected illiquidity of their investments.

The fallout for Merrill's brokers could also be significant. The complaint alleges that brokers who questioned the safety of auction rate securities were stifled and there is strong evidence that they may not have known or understand the inherent risks of the securities they were selling to clients. Merrill's brokers could suffer considerable reputation damage if a significant number of clients file claims against them.

Perhaps most damaging of all is that Merrill's brokers must now accept the hard reality that management ultimately regards them as nothing more than microwave oven salesman.

Banks Stocks the Next Tech-Bubble?

2008-07-29T12:55:00.003-04:00

It comes as no surprise that the subprime/credit crunch crisis has led to an increased level of securities class action filings. Research firm Cornerstone just released a report which shows the financial sector was the target of the most filings with 63 in the first half of 2008 alone. The research is an indication that many believe there are disclosure issues which led to inflated stock prices.

But another area of concern is that brokers made speculative plays in these stocks on behalf of their retail clients. Sensing a bottom, many brokers loaded up theirclients with stocks like Citigroup, Merrill Lynch and even Bear Stearns. Trying to catch a falling knife is not an appropriate recommendation for an investor with amoderate or conservative risk profile and we are seeing such complaints become more common.

Clearly, brokers fell asleep at the wheel on two levels: there was no reasonable basis for expecting the financial services industry was finished with its subprime write-downs unless they were duped nor was there any reasonable basis for many investors to buy financial stocks during the past year and a half.

During the tech-bubble, we filed many claims on behalf of investors whose brokers pushed them into bottom fishing for tech stocks that were rightly beaten down. This is another example of Wall Street’s history repeating itself.

Needless to say, any broker who recommended buying bank stocks in the past year and a half should be prepared to explain their rationale in an arbitration hearing.

FINRA Pilot Arbitration Program is a Step in the Right Direction

2008-07-25T09:48:00.001-04:00

Yesterday FINRA announced a pilot program to do away with the financial services industry participant in arbitration panels. Rather, all three panelists will consist of an investor’s peers.

FINRA is to be commended for at least putting a toe in the water towards arbitration reform. Studies have shown investors believe that the panels are bias against them. And the statistics supports this.

This is long overdue but a pilot program is hopefully just the beginning. Rather than a small pilot program this should be rolled out on a wholesale basis.

There will be a surge of investor claims in the wake of the sub-prime/credit crisis, so leveling the playing field for investors should continue to be one of FINRA’s main focuses.

Frank Quattrone’s Utopia

2008-07-25T09:42:00.001-04:00

I’m quite sure everyone will take Frank Quattrone’s recent comments about returning to his glory days of conflicts between research and investment banking at face value, but at the risk of indulging his attempt at a comeback I’ll address his flawed reasoning. Mr. Quattrone believes barring Wall Street’s research analysts from participating in investment banking deals is the reason the U.S.’ IPO market share has decreased. Not so.

Among the reasons there are less IPO’s are these:

Ø Stock exchange listing fees are way too high

Ø Document filings and compliance is expensive (not necessarily a bad thing in my opinion)

Ø Global corporations have chosen to list on their home country’s exchange

Now is not the time to scale back regulation especially when it pertains to conflicts of interest. Exhibit A is the ratings agencies. Many CDO’s and mortgage backed securities received coveted AAA bond ratings due in a large part because of a conflict between the need to generate fees from Wall Street and independent, reliable research.

The one point Mr. Quattrone is spot-on about is the fact that many of Wall Street’s best research analysts have migrated to the buy-side. The stark difference in opinion about Lehman Bros. David Einhorn had versus Wall Street shows just how wide the gap is. Frankly, the only folks that trust Wall Street research are small retail investors and injecting tech-bubble conflicts will only exacerbate the problem.

Needless to say, Mr. Quattrone’s utopia would only serve to enrich him and his ilk.

Mr.Cuomo: ARS Investors Don't Need a Spitzeresque Settlement

2008-07-23T16:52:00.002-04:00

After learning that New York Attorney General Andrew Cuomo is set to bring charges against UBS related to their marketing of auction rate securities, I am of mixed emotions. On the one hand I am pleased that the scandal is resulting in complaints, but I am only cautiously optimistic that the charges and potential settlement will be in the investors’ best interest.

Don’t get me wrong, Mr. Cuomo’s action is certainly welcomed and clearly warranted. Auction rate securities were pitched to investors as cash equivalents and liquidity risks were hidden, which is why I was particularly pleased to see that Mr. Cuomo could file charges against individuals at UBS and seek a broad resolution for investors whose money is tied up in the ARS permafrost.

But a resolution is only as good as its terms and I have reservations that an eventual settlement won’t go far enough. Specifically, it is typical for Wall Street to settle these types of matters without admitting guilt or acknowledging responsibility. Wall Street steadfastly bargains for this because it limits their liability to investor claims. Recall that Eliot Spitzer’s global Wall Street settlement included this “out” clause and many investors lost arbitration claims because of it.

Another common occurrence during the Spitzer regime was Wall Street scapegoating. So long as Mr. Cuomo targets individuals, he should follow the trail as high as it leads and not allow Wall Street’s top brass to sacrifice a few bit players.

Moreover, a resolution that simply makes UBS customers “whole” also is a mistake. For many months ARS holders were prevented from participating in more lucrative investments and making large purchases, such as homes, automobiles and tuition payments. It is reasonable that they should be awarded damages for those lost opportunity costs. And finally, some investors are facing legal fees which should be paid for by UBS.

A UBS settlement could serve as a case study for other ARS investigations. Cuomo and other State securities regulators are investigating Citigroup, Merrill Lynch, J.P. Morgan Chase, Goldman Sachs, Wachovia and many other institutions for similar practices.

We’ve been through the era of headlines, photo-ops and slaps on the wrist. Mr. Cuomo has an opportunity to substantively alter the way in which Wall Street markets its products.

As I said, I am cautiously optimistic.

The Hapless Members of Citi’s ELKS Club

2008-07-21T16:10:00.001-04:00

It’s only a hunch, but experience tells me you can soon expect to be reading a lot about “ELKS” and other structured investments in the business press.

The name evokes images of a hardy, austere and stable animal able to withstand the harsh elements of the forest. But not in this story. For some Citigroup customers, ELKS might conjure images of a broker who duped you into buying risky securities that were inappropriate with your investment goals.

Citi’s ELKS (equity linked security) product is a risky derivative instrument where an investor is offered a specified return on a structured security tied to an individual stock. Providing the stock maintains a minimum value, the guaranteed return is paid. If the stock ever falls below the minimum value (sometimes around 80 percent), the ELKS immediately convert into shares of that stock. Then if the price of the underlying stock declines, the investor could receive a stock worth much less than the initial investment.

Here’s the catch: ELKS offer potentially higher returns, but the downside risk is unlimited if the stock goes south. If the underlying stock happens to dramatically increase in value, the investor only gets the guaranteed return.

For Citigroup, it’s a classic case of “heads I win, tales you lose.” The bank charges investors an upfront commission to buy ELKS and likely earns additional profits through hedging. Not surprisingly, brokerage firms were aggressively peddling structured derivative products like ELKS to unsophisticated retail investors a few years back, prompting FINRA to warn member firms of concerns that customers didn’t understand the inherent risks.

There’s evidence that FINRA’s warnings weren’t heeded. I represent a retired couple over 80 whose Citi broker last year bought $300,000 worth of ELKS on their behalf. The ELKS were highly unsuitable for retirees simply looking to preserve capital. The highly volatile stocks my client’s ELKS were derived from included Yahoo!, Cemex and Sandisk. The couple has lost nearly a third of their principal as the underlying stock’s value plummeted.

Admittedly, I have only encountered one ELKS case so far, but many brokerages firms peddled similar products using monikers such as PACERS, STRIDES, SPARQS, and ELEMENTS. Some commentators were critical of me when I sounded the early alarm about auction rate securities, but that warning proved quite prescient. Recall, that the SEC uncovered wrongdoing in the ARS market in 2006, but the activity persisted. Sadly, I can’t help but suspect that the experience of my elderly clients with ELKS is not an isolated incident.

Stay tuned.

“My Take” on the SEC posted on BusinessWeek.com

2008-07-21T15:49:00.003-04:00

A few weeks ago I sent a comment to BusinessWeek’s senior editor and blog contributor Diane Brady agreeing with an item she posted that questioned the usefulness of the SEC’s charges against former A.I.G. CEO Hank Greenberg. I was asked to elaborate on my position by BusinessWeek.com for their outside contributor column, “My Take,” which was posted last week.

I focused my essay on drawing attention to what I believe are the more crucial issues for the SEC’s including the collapse of Bear Stearns, the continuing inadequacy of equity research, investment banking fees and credit default swaps. Moreover, the SEC should work to alter Wall Street’s compensation structure in order to be aligned with the goals of its customers. To read my essay, please click here.

As it turns, my commentary struck a cord (or a nerve) with a great many BusinessWeek.com readers and it became one of highest trafficked and commented articles on their website. BusinessWeek.com editor-in-chief John Byrne was kind enough to memorialize the accomplishment with a blog post of his own.

Clearly I am not alone in my position that our financial regulators need to do a better job of looking after individual investors and instituting substantive change on Wall Street.

Cioffi and Tannin's Indictment: Good News for Investors

2008-06-19T18:25:00.001-04:00

Ralph Cioffi and Mathew Tannin, the former managers of the Bear Stearns' hedge funds that collapsed last year, were indicted today. The SEC also filed civil charges today as well. I appeared on CNBC this afternoon to discuss whether the evidence will be enough to show "intent" and whether criminal charges were warranted. The answer is a resounding yes to both questions, especially given Tannin's "smoking gun" email from his personal account to Cioffi's wife's email account where he frets over the funds future performance just days before making upbeat comments to investors. Cioffi's withdrawal of $2 million from the funds before the collapse appears to provide evidence of his "intent".

The criminal and SEC developments could bode well for investors seeking recovery of losses through the arbitration process. Tannin and Cioffi will be called to testify in arbitration hearings before their criminal trials take place and likely will exercise their Fifth Amendment rights against self incrimination. Attorneys can ask the arbitration panel to take what's called an "adverse inference", which means panelists can assume that if the defendants answered the questions, rather than pleading the Fifth, the answers would have adversely affected their interest.

It should be noted that JP Morgan has put aside billions of dollars for litigation costs when it acquired Bear Stearns.

Keeping Callan and Gregory in the Lehman Tent

2008-06-12T15:03:00.002-04:00

It’s standard practice for Wall Street firms to retain executives tied to extensive financial losses and persistent questions about accounting practices, particularly if there is the likelihood of lawsuits. So I note with great interest that that Erin Callan and Joseph Gregory, who today “resigned” respectfully as CFO and COO of Lehman Brothers, will remain at the embattled firm, at least for now. Ms. Callan will rejoin the firm's investment banking division in an unspecified “senior capacity,” and Mr. Gregory will stay with the company in an “undefined capacity.” Suffice it to say, Callan and Gregory aren’t getting promotions.

It’s doubtful that Lehman is retaining the tarnished executives out of sheer loyalty. More probably, it’s out of concern for the litigation that will no doubt ensue. Company lawyers prefer to have all the major participants responsible for activities leading to litigation in the corporate tent, thereby having some measure of control over the proceedings. Throwing Callan and Gregory to the wolves could put their legal interests at odds with Lehman’s.

The irony of Ms. Callan returning to investment banking must also be noted. During her previous tenure there, Lehman took public both Fortress Capital and Och-Ziff and IPOs that certainly didn’t serve investors well. Since their respective public offerings, Fortress lost 56 percent of its value and Och-Ziff some 25 percent of its value. As I noted earlier, Lehman was also responsible for orchestrating Wachovia’s highly questionable takeover of Golden West.

Perhaps Ms. Callan had no involvement with the aforementioned deals. But given her track record as CFO, Ms. Callan’s return to Lehman’s investment banking group somehow doesn’t inspire further confidence in Lehman’s deal making prowess.

Lessons From Lehman

2008-06-10T15:01:00.003-04:00

I’m still trying to make sense of Lehman’s disclosure yesterday that it will post a whopping $2.8 billion loss in the second quarter and raise $6 billion in equity by selling shares at a 20% discount to book value, but one lesson is already readily apparent: the best and brightest analysts aren’t working at the major Wall Street brokerage firms.

Lehman’s projected loss amounts to $5.14 a share, a mind-boggling deficit given that Wall Street analysts were expecting a loss of no more than $1.28 a share. Lehman’s planned fund raising will dilute the holdings of existing common shareholders by 30 percent.

As best I can tell, the loss gives some credence to warnings by hedge fund manager David Einhorn, who repeatedly has charged that Lehman hasn’t adequately marked down some of its assets. While it isn’t entirely clear to me that Lehman plans to write down some of the assets whose value Mr. Einhorn has questioned, the hedge fund manager was indeed correct in predicting a massive earnings train wreck. As Mr. Einhorn so elegantly puts it: “(Lehman) just raised $6 billion of capital that they said they didn’t need to replace losses they said they didn’t have.”

Individual Lehman shareholders should be concerned how Mr. Einhorn – who has a short position on Lehman’s stock – knew with such certainty that the company’s asset values would have to be aggressively written down. Admittedly, it’s quite possible that Mr. Einhorn is just way smarter than the Wall Street analysts who cover Lehman’s stock and is better versed on how to read a balance sheet. But Mr. Einhorn’s public statements indicate that he based his analysis on Lehman’s valuation methods, which possibly suggests we are dealing with basic accounting issues.

Lehman previously maintained that Mr. Einhorn’s criticisms had “no basis in fact.” The merits of that defense are increasingly hard to believe.

Don Quixote and ARS Investors

2008-06-09T16:33:00.004-04:00

Recent articles in The Boston Globe and Bloomberg underscore how Wall Street firms woefully favor their own interests at the expense of individual investors.

According to a report in today's Globe, UBS Financial Services warned some of its big investment banking clients of looming problems in the auction rate securities (ARS) market three months before the market for these securities collapsed. Nevertheless, the firm continued marketing the securities as cash equivalents to unsuspecting individual investors.

Adding insult to injury, the Globe and Bloomberg report that UBS, Bank of America, and Wachovia along with others are preventing their clients from unloading auction rate securities at a loss saying – are you ready for this? – it isn't in their clients' best interests!

In an ideal world, it would be nice to believe that Wall Street firms are actually trying to do right by unsuspecting investors whose brokers assured them that auction rate securities were cash equivalents. But Bryan Lantagne, the securities division director for Massachusetts, offers Bloomberg a more compelling explanation:

"By allowing customers to sell at a discount, the banks allow customers to establish damages."

Richard Stahl, a retired New Hampshire car dealer, is one of the auction rate securities victims caught in limbo. The 73-year-old UBS client wants to sell some $650,000 worth of auction rate securities, but UBS won't let him.

"I feel like Don Quixote fighting windmills," Mr. Stahl told the Globe.

Sadly, Mr. Stahl, compared to taking on Wall Street, Don Quixote had it easy.

Lehman’s Investment Banking Prowess

2008-06-06T09:06:00.004-04:00

The ways of Wall Street never cease to amaze me.

You might think that a company responsible for orchestrating one of the biggest M&A banking debacles in recent memory, the reputational damage would be quite severe. Think again. In justifying his upgrade of Lehman’s stock, Merrill Lynch analyst Guy Moszkowski cites Lehman’s “very strong global franchises” in various areas, including investment banking.

Investment banking?

Lehman has “bragging” rights for Wachovia’s failed 2006 acquisition of Golden West Financial, a major California thrift and mortgage lender. Analysts estimate that Wachovia could rack up more than $10 billion in losses on Golden West’s $122 billion mortgage portfolio. The botched acquisition is said to have cost Wachovia CEO Ken Thompson his job earlier this week.

Fortunately for Lehman, the brilliant investment banking minds behind M&A deals that go south aren't called to task. So kudos to Dealbreaker for taking note of Lehman’s additional contribution to Wachovia’s financial woes.

When Companies Doth Complain Too Much

2008-06-05T15:52:00.006-04:00

I was taken somewhat aback when I read how Lehman Brothers responded to an inquiry about allegations made by short seller David Einhorn. “We will not continue to refute Mr. Einhorn’s allegations and accusations,” an unnamed spokeswoman told The Wall Street Journal. "Mr. Einhorn cherry-picks certain specific items from our quarterly filing and takes them out of context and distorts them to relay a false impression of the firm’s financial condition which suits him because of his short position in our stock. He also makes allegations that have no basis in fact with the same hope of achieving personal gain."

It’s understandable that Lehman would vehemently deny Mr. Einhorn’s allegations questioning the firm’s accounting. However, the statement seems a tad personal, particularly since Mr. Einhorn has made no secret of his short position. Lehman’s essential public defense appears to be that Mr. Einhorn’s allegations are wrong simply because he benefits handsomely if they are right.

I’m not going to take sides on this one, as I’m not privy to all the facts. Still, Lehman’s seemingly personal attacks on Mr. Einhorn hardly inspire confidence if history is any indication.

Back in 2001 a young reporter at Fortune named Bethany McLean began questioning the accounting of a then highly revered Houston-based company called Enron. Jeffrey Skilling, the company’s then chief executive, called her unethical for failing to do more research. And Kenneth Lay, Enron’s former chairman, complained to Fortune’s editor that McLean was relying on information provided by a short seller who wanted to drive down the price of the company’s stock. Turns out, that short seller had good reason to be short on the stock.

Then there were the attacks by L. Dennis Kozlowski when he was the CEO of Tyco International. In response to a report by David Tice questioning Tyco’s accounting, Mr. Kozlowski said he was outraged by the “false and baseless” report. ''There is no risk that investors will wake up one day and find out'' that ''there's something wrong with the way we've been recording revenue or the way we've been recording margins.'' Mr. Tice, too, was also a short seller.

Finally, there was the press release Calpine International issued on August 27, 2004 attacking a report by an independent research firm called Rate Financials questioning Calpine’s accounting. The release said the report was riddled with “flagrant, misleading and inaccurate allegations.” Sixteen months later Calpine filed for bankruptcy.

For the sake of the public markets, I truly hope that Lehman ultimately defies a disturbing trend that suggests a possible inverse relationship between reality and the vehemence of a company’s denials.

Making Sense of David Einhorn vs. Lehman Brothers

2008-06-05T09:50:00.005-04:00

One of the sad lessons that most individual investors fail to learn is just how badly the stock market is stacked against them. Yes, there are rules that supposedly ensure a level playing field, but those rules become meaningless when some of the players are decidedly smarter and know how to play the system to their financial advantage. The market uncertainty about Lehman Brothers Holdings affords a textbook example.

Lehman’s stock plummeted earlier this week in the wake of a Wall Street Journal story saying the firm is “considering” a common stock offering that would be dilutive to shareholders. The precipitous decline was no doubt welcomed by David Einhorn, a hedge fund manager who is short Lehman’s stock and has been quite vocal in his attacks questioning the transparency of the brokerage firm’s financials. Mr. Einhorn’s repeated public slamming of Lehman Brothers reportedly has contributed to the decline in Lehman’s stock price.

Mr. Einhorn has made some extremely damning allegations about Lehman’s accounting practices. He questions some large, unrealized gains Lehman booked in the first quarter that helped goose up the firm’s earnings. The gains were on illiquid securities for which there are no public markets, which means Lehman’s management can assign values at its own discretion. As if that alone isn’t enough of a red flag, Mr. Einhorn also charges that Lehman has given him conflicting explanations of its valuation process. To boot, Mr. Einhorn says Lehman has not properly disclosed or written down various complex debt securities, including $6.5 billion of CDOs. Lehman vehemently denies Mr. Einhorn’s allegations, saying they have “no basis in fact.”

I’m in no position to evaluate Lehman’s earnings statements, and I have no reason to question them. But I also am not quick to accept that Mr. Einhorn’s allegations have no basis in fact. The short seller’s claim that Lehman has placed an artificially high valuation on illiquid securities is eerily familiar. There were similar allegations that Bear Stearns priced artificially high the illiquid assets in its subprime hedge funds before those investment vehicles collapsed. A recent comment by Sy Jacobs, a hedge-fund manager who correctly predicted the subprime mortgage crisis, also cannot be ignored. “Just because we got saved from what would have happened that Monday if Bear went down doesn’t mean we are saved from all the forces that conspired to get Bear Stearns to the brink in the first place,” Mr. Jacobs told Barrons.

I also note a comment by star banking analyst Meredith Whitney about Lehman CFO Erin Callan in the May 17th issue of the Journal: “(Callan) is going out on a limb to provide more transparency in Lehman’s earnings, business and strategy.” On Monday, Ms. Whitney predicted Lehman would report a second quarter loss after earlier predicting a profit. The sudden about face possibly suggests that Lehman’s transparency wasn’t quite as clear as Ms. Whitney originally believed.

The reality is there is so much market turmoil and uncertainty today that it is no longer possible to accurately value many of the assets the major brokerage firms have on their books. As Standard & Poor’s analyst Diane Hinton has noted, “We’re in a market environment where sometimes perception becomes reality.” At the moment, it appears that a short seller on Lehman’s stock appears to have the upper hand in shaping the company’s market perception.

And that, folks, is the sad state of the public markets in this Country.

The Piety of Henry Blodget

2008-05-27T09:40:00.003-04:00

Henry Blodget and I have a history, there’s no denying that. Back in 2001 I sued him and his former employer Merrill Lynch for fraudulently touting tech stocks that Mr. Blodget privately confided were “POS,” “pieces of junk” and “pieces of crap.” My case caught the attention of former New York Attorney General Eliot Spitzer and ultimately led to the $1.4 billion global settlement and Mr. Blodget’s lifetime ban from the securities industry.

Although countless investors lost hundreds of millions of dollars because of his bogus research reports (and he was allowed to keep most of the millions of dollars he was paid to write them), Mr. Blodget has refused to fade from the limelight he once enjoyed. He has successfully transformed himself into a prolific journalist, penning commentaries in august publications such as the New York Times and running various websites including Clusterstock, which specializes in stock research. Given his disgraced past, that takes real cajones.

Last week Clusterstock launched a mild broadside at yours truly, questioning my transparency though essentially conceding the merits of my argument regarding a blog post I wrote on some failed Citigroup hedge funds. The site says Mr. Blodget agrees that “it is possible” that I’m correct in speculating that Citi’s brokers were likely instructed to market the collapsed hedge funds as conservative investments “but he would like see evidence of this.”

Mr. Blodget understands full well how the game is played, particularly since Merrill’s brokers dutifully peddled his research to clients, even when they began to openly question the integrity of his analysis. Furthermore, the Wall Street Journal recently quoted a Smith Barney broker as saying, “"That's why they bought it," said the broker whose clients, many of them wealthy retirees, invested in the Falcon fund. "These kinds of clients weren't looking for a home run."

Interestingly, Mr. Blodget remained mum on my comment that Citi was positioning its own brokers as fall guys, when in all likelihood they were merely following the direction of the company’s wealth management executives. I’d expect this comment to strike a particular nerve given that Mr. Blodget took the fall for Merrill’s conflicted research while his senior managers was given a free pass. As I noted in my earlier post, Wall Street’s senior executives almost never are held accountable for the wrongdoing under their watch.

Finally, there is Mr. Blodget’s issue with my transparency:

Since Zamansky is taking a stand for "transparency," Blodget thinks it might also have been appropriate for Zamansky to disclose that he is in the business of suing companies based on allegations like the ones above.

Setting aside the irony of Mr. Blodget requesting transparency, my interests in the Citi hedge fund post were patently obvious. But in deference to Mr. Blodget’s new found piety, I must point out that in my blog post I referenced angry calls from investors who are my clients. If that wasn’t clear enough, my biography is clearly posted on Seeking Alpha, a financial blog aggregator which is where Mr. Blodget originally saw my post. And finally, my blog post first appears on my law firm’s website.

Most people in the industry know - Mr. Blodget certainly one of them - that I represent investors who have been harmed and abused by Wall Street.

Suffice to say, I never thought I’d see the day when I’d be holding myself accountable to Henry Blodget. Perhaps that explains the pigs I’ve just seen flying past my office window.

Falcon Falling: Citi’s Hedge Fund Litigation Problem

2008-05-20T14:17:00.003-04:00

I’m no expert on public relations, but I’d expect the flacks at Citigroup would go to great lengths to avoid maligning the firm’s Smith Barney brokers. But the financial giant’s public defense for peddling risky proprietary hedge funds to wealthy clients seeking conservative investments implicitly undermines either the integrity or the competency of the firm’s brokers.

“Our disclosures and marketing material sufficiently outlined the inherent risk in the funds and their leveraged strategies,” an unnamed spokesman said in a statement issued to the Wall Street Journal regarding the firm’s Falcon and ASTA/MAT hedge funds, which have lost about 75 percent of their value in the past year.

Oh really? Well if the disclosures were so sufficiently outlined, then how come I’m getting calls from outraged clients who vehemently insist they bought into the hedge funds because they were repeatedly assured by their brokers that the funds were extremely low-risk investments? Smith Barney brokers themselves apparently are even willing to acknowledge that these assurances were given. I quote verbatim here from the Wall Street Journal:

Citigroup brokers and fund managers assured prospective investors that the new hedge funds were low-risk, with Falcon likely to post losses of no more than 5% a year in the worst-case scenario, according to people familiar with the situation.

“That’s why they bought it,” says a Smith Barney broker whose clients, many of them wealthy retirees, invested in the Falcon Funds. “These kinds of clients weren’t looking for a home run.”

Investors rely on the overtures of their brokers, who fashion themselves as financial consultants or advisors, not highly compensated salespeople. “We make money the old-fashioned way. We earn it” – as Smith Barney used to say.

Unfortunately, most brokers don’t have the training or the acumen to understand highly complex and sophisticated financial instruments. So they dutifully rely on the representations given to them by their superiors, who are richly compensated for moving the products out the door.

Herein lies the vicious circle: Citigroup concocts inherently risky funds for its brokers to sell to their wealthy clients that generate handsome fees for the firm and commissions for its brokers. The brokers are told to market the fund as a “conservative” investment, notwithstanding that fact that the funds are so levered that a few ticks the wrong way causes the house-of-cards to collapse. The brokers mimicked the company’s recommended sales pitch to their clients and successfully wrangled hundreds of millions of lucrative assets.

Citigroup, understanding that it has a significant legal liability on its hands, publicly insists that company sufficient disclosed the risks when it marketed the funds. If that was truly the case, the brokers who marketed the funds will deservedly be held legally accountable for failing to educate their clients about the obvious risks.

But more than likely, many of the Smith Barney brokers who marketed the funds themselves were likely led to believe the funds were in fact “low risk.” At a minimum, there was a lack of due diligence. Now that markets are under pressure, Citigroup wants to shift the onus of blame to its brokerage force, rather than hold its wealth management executives accountable. Blaming the folks who followed orders - rather than the ones who gave them - is the way Wall Street works.

Calling for an Investor's Bill of Rights

2008-05-08T16:27:00.003-04:00

While the presidential candidates have been aggressively courting homeowners with mortgages under duress, they seem to care little for the rights of individual investors. As today's New York Times points out, these are grim days for investors who have fraud claims. Recent Supreme Court decisions including "Tellabs" and "Stoneridge", which as we've blogged about previously, have raised the bar for what constitutes fraud and limited third party liability (i.e., investment banks, law firms, accounting firms, etc. that are alleged to have contributed to fraud).

That's why I believe an investor's bill of rights should be on the table. Candidates can sign-on or reject its provisions – at least then we would know where they stand. Among the provisions I suggest are:

Right to an SEC which protects investors: Only SEC commissioners who actually accept the agency's mission of protecting investors (rather than cozying up to Wall Street interests) should be nominated.

Right to fair arbitration hearings: The first step towards balancing the arbitration process is to eliminate the industry panelist on three-member arbitration panels. An arbitration panel should consist of individuals who are conflict free and representative of the universe of American investors.

Right to tax-free awards: In many cases, claimants are required to pay taxes on arbitration awards, punitive damages and attorney's fees. To me, this rubs salt in an aggrieved investor's wounds.

Right to an honest broker: If a broker has three or more arbitration awards against him or her, it's clear that they are abusive towards their customers. I propose a "three-strikes-and-you're-out" rule. After the third award, a long-term suspension should be levied.

Proxy rights, executive compensation and other important investor issues should be considered as well.

And since we are on the topic of presidential candidates and Supreme Court decisions, they should pledge to balance the court's anti-investor bias. Its fine to say that you are for the traditional interpretation of the Constitution as Senator John McCain has, but one must focus on how that affects investors – both big and small.

The Supreme Court has reversed over 70 years of case law which expanded investor rights in securities cases. Enough is enough. The next Supreme Court nominee should not be confirmed if he or she shows disdain for investor rights.

One additional note on the aforementioned New York Times article: while it does a good job of explaining new hurdles for investor lawsuits, it doesn't cover arbitration. Many investors – institutional and individual – are better suited by filing claims against brokerages using FINRA-sanctioned arbitration proceedings. Though the deck is still stacked, investors certainly fare better than in class actions especially in light of the recent Supreme Court decisions.

Candidates: Let's see where you stand.

Senator Grassley and the SEC

2008-04-23T12:40:00.002-04:00

It’s well known to anyone with experience representing individual investors that the SEC is shamefully ineffective when it comes to regulating the major brokerage firms. To wit: the SEC might have prevented the collapse of the auction rate securities market. The agency knew of extensive wrongdoing in the marketplace as far back as 2006, but instead of mandating a wholesale cleanup and imposing extensive fines, it chose to let Wall Street off with barely a wrist slap.

It also can be argued that the SEC might have prevented the collapse of Bear Stearns. It’s publicly known that the SEC dropped an investigation of Bear’s valuations of collateralized debt obligations just months before the firm collapsed. We now know those valuations weren’t worth the paper they were printed on.

Sen. Charles Grassley, the ranking member of the Senate Finance Committee, admirably and justifiably wants to know why the SEC dropped its Bear investigation. But according to today’s Wall Street Journal, the SEC responded to the Senator as if he was just a reporter.

“The commission does not disclose the existence or nonexistence of an investigation or information generated in any investigation unless made a matter of public record in proceeding before the Commission or the courts,” the SEC responded in a letter.

It doesn’t take a rocket scientist to figure out what’s going on here. The SEC’s decision to close its Bear investigation represents yet another monumental agency failure. The agency knows full well that Congress will be outraged if the truth about its failure to protect investors becomes publicly known. Let’s hope that Senator Grassley is sufficiently outraged by the SEC’s response and continues to aggressively pursue this matter. The findings won’t be pretty, but maybe it will finally lead to some real – and much needed – regulatory reform.

Auction Rate Securities Compensation: Peanuts or Icing on the Cake for Brokers?

2008-04-09T14:35:00.002-04:00

Dow Jones (no link available) touches today on an issue I’ve covered in my blog often: Wall Street’s compensation tied to the auction rate securities (ARS) market. Wall Street is claiming that “they picked these products because they offered higher yield for investors than other cash-like products, not because they generated fees for brokers.”

When compared to stocks and mutual funds, the compensation to brokers is marginal. However comparing ARS investments to mutual funds and stocks is flawed; a better comparison is to other so-called “cash equivalents” such as Treasury’s and money-market funds, which as Dow Jones states, “pay little to nothing.”

Whether the fees were as marginal as Wall Street claims remains debatable. One broker, Dow Jones reports, earned $5 for every $25,000’s worth of ARSs he sells plus a “trailer,” which is an annual fee of about 0.12 percent. That fee structure is consistent with our understanding.

But here’s the twist: we’re getting calls from corporations and high net worth individuals with $100 million invested in ARSs. Under this scenario, the broker would have earned a trailer/annual fee of $120,000 or more from this ARS client alone. If this client would have been placed in Treasuries, the fees would have been drastically lower. Peanuts? Or nice ten percent boost to a broker earning $1 million annually?

Admittedly it seems counterintuitive to me that a broker would risk his or her prized high-net worth and corporate clients by placing them in ARSs when they sought cash equivalents. Though I’d never underestimated Wall Street’s “need for fees,” it’s plausible that brokers were themselves duped by their own firms.

Here’s why:

A broker's Wall Street employer is paid for managing an ARS auction by the issuer - usually around one percent of the total securities auctioned. So, for example if a municipality issues $300 million worth of auction rate securities, the firm that manages the auction earns $3 million. Numerous auctions were being held daily so these fees racked up. Since the market is estimated to be $330 billion, conservatively Wall Street raked in over $3 billion in fees. An extra few hundred million - to borrow a quote from Jeffrey Skilling - is enough to “juice earnings” at least. And the manager overseeing a firm’s auctions' compensation is likely tied to the amount of fees generated too.

The auction fees could be a reason why ARSs were pitched so heavily to investors. Some brokers were at best naïve participants. But ignorance, while blissful, is not a justifiable argument. A broker has a fiduciary responsibility to inform a client of an investment’s risks. It doesn’t take an economist to realize that along with ARS’s higher returns there are greater risks, particularly liquidity. Clients should have been made aware that at any given time, Wall Street could pull out of the bidding process and freeze the market, instantly turning what was a highly liquid asset into a 30-year, low interest fixed rate bond.

I simply don’t buy into the argument that fees did not factor into the decision to put clients into ARS. Fees were small in comparison to other investments…ok…but clearly enough of an incentive to feed Wall Street’s greed machine.

Fortune's Must Read Articles on the Wall Street Bailout

2008-04-07T16:36:00.003-04:00

If you don’t subscribe to Fortune, I strongly recommend forking out five bucks and buying the latest issue on how to fix Wall Street. Bethany McLean’s column alone is well worth a Lincoln.

Ms. McLean, who is best known as the reporter to first sound the alarm about Enron, revisits a McKinsey & Co. report issued approximately a year ago saying that regulatory burdens were hindering the competitiveness of the U.S. markets. These lines are worth quoting verbatim:

“McKinsey wrote that over-the-counter derivatives “help foster the kind of continuous innovation that contributes heavily to financial services leadership.” (Tell that to Bear Stearns.) McKinsey also complained that higher capital requirements for U.S. banks would put them at a “competitive disadvantage.” (Hello, Citigroup!).

Ms. McLean notes that the McKinsey report was backed by New York Senator Chuck Schumer, who now believes that more regulation is needed. Ms. McLean is extremely charitable; she might also have noted that the folks at McKinsey also celebrated Enron for that company’s innovation before it collapsed as well.

Shawn Tully’s article “What’s Wrong With Wall Street and How to Fix It,” is a first-piece of expository journalism and deftly explains the inner and conflicted workings of Wall Street. His explanation of the reckless risks Wall Street firms take with leverage is especially impressive: According to Tully, since 2002, the leverage of the five biggest Wall Street firms, measured by assets as a multiple of equity, jumped to 41 from 30. That means if a firm’s portfolio is leveraged at 33 to 1, it takes a mere 3% drop to wipe out its entire capital.

Mr. Tully admirably reports as fact an open secret that has long been known: Wall Street firms use intelligence they get from executing institutional client trades for their own trading benefit. The “intelligence” is euphemistically known as “color.” Mr. Tully says the rise of automated trading makes it easier for big institutional clients to trade anonymously, but experts in algorithmic trading I’ve spoken with say that’s not necessarily the case. Still, I commend Mr. Tully for his insightful piece of analysis.

Finally, legendary columnist Allan Sloan weighs in with a commentary that if every American taxpayer were required to read, Congress would be forced to clean up Wall Street once and for all.

Still, I have one quibble with Fortune’s latest issue: It doesn’t examine the formidable obstacles individual investors face getting retribution for Wall Street’s wrongdoing. The subject matter could easily fill an entire issue.

Paulson Proposal Neglects Individual Investors

2008-04-01T11:30:00.001-04:00

By any measure, Paulson’s plan shows a certain disregard for individual investors, who have suffered the brunt of Wall Street’s extensive wrongdoings of the past few years. The plan neglects the pressing need to bolster investor protections for individual investors and threatens to usurp the authority of state regulators, who have a very impressive record of pursuing Wall Street wrongdoing. The plan’s only beneficiary is Wall Street, which has long wanted more streamlined regulation because it would ease their regulatory burdens.

Another area that Paulson neglected to cover was investor arbitration, which many have argued favors brokerage firms. It would have been helpful for him to propose reforms that would level the playing field for investors who are required to arbitrate disputes with their brokers.

But there also needs to be in place a regulatory mechanism that protects investors from wrongdoing before it occurs. Though in theory I have no problem with the creation of a “supercop” role for the Fed, Congress should insist that the expanded agency have a very senior investor advocate with extensive powers and authority. This advocate should have bona fide credentials representing individual investors and not be someone with close ties to Wall Street firms.

Finally, state regulators should continue to be allowed to regulate Wall Street firms doing business within their borders. State regulators such as state attorney generals have an important role to counterbalance federal regulators.

Ironically, I’m in Washington today to attend the North American Securities Administers Association (NASAA) annual meeting, an organization comprised of state regulators. I know I don’t have to tell you the dominant topic of conversation. NASAA’s comments on Paulson’s plan can be seen here.

Rx for Cleaning up Wall Street

2008-03-30T20:31:00.001-04:00

Wall Street is finally getting its comeuppance judging by all the calls for more regulation. As a sign of how big an issue it has become, the Presidential candidates have announced reform-minded plans. But I wonder if they are truly keyed-in with all these supposedly "sophisticated" instruments that are commonplace on Wall Street, many of which precipitated the current economic malaise.

However sophisticated Wall Street shenanigans have become, the crisis itself is quite easy to comprehend: Wall Street these past few years has quietly created largely unregulated shadow markets that even the brightest minds in the universe can't value. Lest you think I'm spouting mere hyperbole, consider the following admissions:

Alan S. Blinder, a former vice chairman of the Federal Reserve and an economics professor at Princeton, admits that even he has only a "modest understanding" of complex derivatives and "if you presented me with one and asked me to put a market value on it, I'd be guessing."

Major Wall Streets banks use a metric known as value-at-risk (VAR), which measures how much money their traders could potentially lose on a given day. At the end of last year, Citigroup's VAR was $191 million, nearly double from a year earlier. But as noted by research firm Audit Integrity, Citigroup's VAR figures don't even include the bank's exposure to collateralized debt obligations – which the bank admits "are tough to value." CDOs were responsible for nearly $20 billion in investement-banking losses last year for Citi.

Oppenheimer analyst Meredith Whitney lowered her earnings estimates for several major U.S. banks, including Citigroup, for the 30th time on Wednesday and warned "we are confident this will not be our last reduction in 2008."

It is almost beyond my comprehension how any company, particularly major financial institutions, took on such a dizzying degree of credit exposure they readily admit can't be quantified. Byron Wien, chief investment officer at hedge fund Pequot Capital, perhaps best explains how this came about. "These are ordinary folks who know a spreadsheet, but they are not steeped in the sophistication of these kind of models. You put a lot of equations in front of them with little Greek letters on their sides, and they won't know what they're looking at."

Some legislators are just now waking up to the magnitude of the problem and talk is brewing on Capital Hill about the need for regulatory reform. Senator Schumer's op-ed in the Wall Street Journal is indicative of Washington's reactive stance. Though I've been a critic of Mr. Schumer's in the past, his suggestions are all sound. Risk, regulatory consolidation, transparency and getting a handle on Wall Street's shadow markets (such as the $516 trillion global derivatives market) are all critical issues.

Even Jamie Dimon, J.P. Morgan's CEO, has grudgingly conceded there is a need for more regulation. "We have a terribly global world and, over all, financial regulation has not kept up with that."

However, couching recommendations with worry about global competition sets the stage for a classic Congressional cop-out. And simply creating more regulations and oversight won't protect investors from Wall Street's pervasive wrongdoings. There has to be a radical philosophical overhaul on the part of regulators in their oversight of the major Wall Street firms. America is badly in need of watchdogs that will bark with a vengeance and are willing to impose meaningful and painful punishments when Wall Street firms run afoul of regulations, as they frequently do.

Take the conflicted research scandal. Although Wall Street firms routinely peddled research to investors they knew was woefully bogus, they were allowed to settle the matter for a measly $1.4 billion. That didn't even amount to a wrist slap.

Or consider the collapse of the auction rate securities markets. The SEC uncovered considerable wrongdoing in this market as early as 1996, but imposed an insignificant $13 million penalty on 15 firms. Not surprisingly, the wrongdoing not only continued it actually escalated, and countless individual investors were left holding the bag.

In a letter to the nongovernmental Basel Committee of Banking Supervision, S.E.C. chairman Christopher Cox attributed the collapse of Bear Stearns to "a lack of confidence, not a lack of capital." That may be true. But had the S.E.C. intervened more aggressively when Bear Stearns' mortgage-backed hedge funds began imploding last June, regulators could have imposed measures that perhaps could have ensured a measure of confidence and staved off the firm's collapse.

Wall Street is dominated by some of the smartest people in the world. Regretfully, most of these people are driven by unadulterated greed and typically put their own interests ahead of the clients. This greed is now wreaking havoc on the lives of ordinary Americans and has badly hurt our economic standing in the international community. Its high time Wall Street was held accountable for their actions.

It's Time Wall Street Answered to Main Street

2008-03-20T16:47:00.004-04:00

Ever since the Curbstone Brokers traded stocks outside the NYSE in the 1800s, its always been a dog-eat-dog world on Wall Street. In today’s market where thousands of hedge funds managed by glorified day traders are answering to sophisticated investors craving alpha, eating one’s own is as common as it ever was.

And today the financial press is full of articles covering investigations into whether false rumors spread by short sellers caused catastrophic damage to major financial institutions...sometimes the very same institutions that executed their trades. Bear Stearns stock price has been on a roller coaster ride and extremely aggressive put options are being investigated by the SEC:

Betting on a 57% decrease in Bear Stearns stock in nine days is very unusual, Todd Salamone of Schaeffers Investment Research told the Wall Street Journal. The Wall Street Journal claims that over 25,000 of such contracts as of last Thursday. The insinuation is the traders were manipulating the market either through insider trading or spreading false rumors.

It’s not illegal for traders to talk amongst themselves, but it is if the information is knowingly false. Regulators will have a hard time proving their case especially because well-lawyered hedge fund managers can expertly operate on the edges of legality.

The persistence of rumors however, should not be remembered as the only reason for Bear Stearns’ collapse. More likely, Bear Stearns is a case of managerial hubris, an utter failure to manage risk multiplied by unreasonable leverage and a culture of greed perpetuated from the top down. How else to explain the firm’s bulls-eye position among the myriad of Wall Street scandals of the past 20 years?

Bear Stearns is a scandal. Market manipulation by hedge funds is a scandal. In my mind, the potential intersection of the two underscores the need for regulatory consolidation, which Barney Frank (D-MA) has put on the table. It remains to be seen what shape the regulatory landscape may take given Wall Streets highly paid and effective lobbyist. But our current system of self-regulation, the light-touch of the SEC and forcing competitors to play by different rules has proven ineffective. The wave of greed on Wall Street and its tornado effect on Main Street is too strong for such a hands-off approach.

Consolidation may only be half the solution. The corporate scandals of Enron, WorldCom, etc. and the criminal trials in their aftermath sent a message to board members and CEOs alike: accounting fraud will not be tolerated. Thorough federal investigations should be next for Wall Street and if wrongdoing is found, perpetrators should be prosecuted to the fullest extent of the law.

The message would be clear: Wall Street exists for Main Street, not the other way around.

JP Morgan Buys Bears Stearns: Assets Less “Liabilities”

2008-03-17T11:36:00.003-04:00

The shocking news that JP Morgan is buying Bear Stearns for the price of $2 per share has many people scratching their heads. Currently Bear Stearns stock isn’t even trading that low. However if you examine the amount of litigation costs and arbitration claims that JP Morgan inherits, it seems a little more reasonable. JP Morgan has announced it had to set aside $6 billion “pretax for litigation, losses on sales of Bear assets and back-office and other consolidation expenses.”

In my mind, Bear Stearns’ spectacular fall underscores the firm’s reluctance to cooperate with other Wall Street brokerages and its unreasonable treatment of investors. Bear Stearns famously neglected to cooperate with the bail out of Long Term Capital Management (LTCM). And more recently, after the firm’s two now collapsed hedge funds were discovered to be on the brink last summer, Bear Stearns stonewalled all attempts by its lenders to inject liquidity into the spiraling funds.

Ironically, it was J.P. Morgan Chase that encouraged Bear Stearns to act, according to a meeting recounted by a Wall Street Journal story from last June:

An hour and a half into the meeting, John Hogan, head of risk management for J.P. Morgan's investment bank, raised his hand. "With all due respect, I think you're underestimating the severity of the situation," he said to Mr. Cioffi and his boss, Bear Stearns Asset Management Chief Executive Richard Marin, according to people who were there. The funds "needed to figure out" how to meet their margin calls, he said, and if that meant bringing in funding from the parent company, "we recommend you do that."

Many attendees were puzzled by Bear's apparent unwillingness to bail out the struggling fund, according to people who were there. After the meeting, these people say, there was sympathetic talk about Mr. Cioffi, a loyalist to the firm who seemed to be getting no help in return, and grumbling over memories of the Long-Term Capital Management crisis.

That afternoon Steve Black, J.P. Morgan's co-chief of investment banking, put in calls to Bear co-presidents and chief operating officers, Mr. Spector and Alan Schwartz. "Is Bear going to stand behind your asset-management company?" he asked Mr. Schwartz, according to people who were briefed on the conversation. Mr. Schwartz said he'd get back to Mr. Black.

An hour later, he called and said that on the advice of Bear's lawyers, the firm wasn't going to get involved, these people said. A spokeswoman said Mr. Schwartz couldn't be reached for comment.

Given its historically self-interested approach to investor crises, this deal could be a positive for individuals with arbitration claims against Bear Stearns such as Zamansky & Associate’s clients. At the least the buyout avoids a Bear Stearns bankruptcy.

Perhaps at most, J.P. Morgan may not have the same motivation to impede investors from recovering losses due to the unscrupulous management of the hedge funds that we now look back at as the beginning of the end for Bear Stearns.

Carlyle Group and Wall Street Firms: Different Strokes for Different Folks

2008-03-14T15:32:00.002-04:00

When the market for auction rate securities collapsed a few weeks back, not one of the big Wall Street firms offered to help their clients deal with the fallout. Although the clients were told that the securities were cash equivalents, they were in fact bonds that carried a significant amount of risk. Countless individuals and institutions are now experiencing a severe cash crunch.

So the attitude of David Rubenstein, co-founder of the Carlyle Group, provides a sharp study in contrasts. Mr. Rubenstein has announced his firm will compensate investors for losses sustained due to the collapse of its $22 billion mortgage-backed securities fund the firm launched just seven months ago.

“We have stood behind our products in the past and we are working on ways to address the losses that are being suffered by investors,” Mr. Rubenstein told the FT.

While it remains to be seen exactly what kind of compensation Mr. Rubenstein will offer investors to soften their financial blows, it’s commendable that he at least pays lip service to the idea of making his investors whole. That kind of talk is completely foreign to Wall Street firms.

Auction Rate Securities Taken Up By Congress

2008-03-11T16:40:00.002-04:00

Tomorrow Barney Frank (D-MA), Chairman of the House Financial Services Committee, will hold hearings into the municipal bond market. After reading the press release, it appears most of the hearing will be dedicated to the “impact on state and local governments and other municipal bond issuers as the current credit crisis worsens.” It is my hope however that a significant portion of the hearing will be dedicated to questions pertaining to the financial services industry’s auction rate securities (ARS)-related conflicts of interest and the manner in which these instruments were peddled to investors.

On the third panel will be Martin Vogtsberger, Managing Director and Head of Institutional Brokerage, Fifth Third Securities, Inc. on behalf of the Regional Bond Dealers Association. Given the allegations against the industry, he is certainly in a hot seat.

One of the specific issues that Congress should raise is whether the industry is living up to its own “best practices” put out by the Securities Industry and Financial Markets Association, including Wall Street’s self-obligated promise to educate “investors as the material features” of auction rate securities including disclosure regarding auction procedures, conflicts of interest, liquidity and other risks. It seems clear the industry fell down and did not meet this minimum standard.

To wit, after Wall Street was caught rigging the ARS market the SEC conducted industry-wide enforcement action imposing fines upon the violators. And clearly this didn’t stop Wall Street from taking advantage of its conflicted position. For example Wall Street failed to disclose when they were making bids on ARSs, which would have provided investors an indication of the ARS market’s true liquidity and risk. Likely Wall Street propped up the market so that firms could continue to charge underwriting and auction fees to ARS issuers, which includes local government and municipalities. It was apparently typical for banks to charge a one percent underwriting fee to issuers then hit them up for a .25 percent fee to manage the auctions.

Furthermore, Wall Street pitched these instruments as “cash-equivalents,” a position not even corporate CFO’s can take, but as the New York Times aptly points out in Sunday’s business section, ARSs are far from cash.

The combination of Wall Street’s insatiable appetite for ARS fees coupled by a shameful marketing program to support the market blinded brokerages from their fiduciary responsibilities.

Chairman Frank, the ball is in your court.

When Wall Street Exploits A Charity

2008-03-09T06:00:00.003-04:00

Having represented investors who have been wronged by Wall Street for more than three decades, I've seen a lot of scandalous activities. But nothing outrages me more when a brokerage firm seeks to exploit a charitable group. Sadly, I'm dealing with yet another egregious instance, this one involving the peddling of auction rate securities to a charitable foundation in Ohio.

The charity is called the Joffe Foundation, which was founded by Steven N. Joffe, a renowned Cincinnati opthamologist and a pioneer in laser-vision correction surgery. The foundation regularly makes donations and commitments to provide funds on an ongoing basis to support various charities and causes, including low-income patients in the US in need of laser vision correction; AIDS prevention; high school educations; and surgeries to correct cleft palates in children in South Africa and Ghana. Because of its ongoing funding commitments, the Joffe Foundation made clear to its broker at UBS Financial Services that it needed to keep its funds extremely safe and liquid.

But the foundation's UBS broker wasn't content having the organization park its money in a simple money market account. Instead, he encouraged it to purchase auction rate securities, which he assured Dr. Joffe were "the equivalent of cash" and could be liquidated within a few days if necessary.

Auction rate securities are long-term government or corporate bond instruments where the interest rates are set at weekly or monthly auctions. As long as there are investors willing to bid on the bonds, they are indeed liquid investments paying higher rates of interests than money market accounts. The problem is that if there aren't enough investors to buy the bonds, the auctions fail. Investors holding the paper are suddenly stuck with a long-term note with a "penalty" interest rate predefined by the bond's issuer.

Making a market for auction rate securities was a highly lucrative $330 billion market for the big Wall Street firms, including UBS. But the balance sheets of the big firms have been badly impaired because of the collapse of the mortgage-backed securities market (a crisis of their own doing), so they no longer have the wherewithal to support the auction rate market. That's why the market for auction rate securities has dried up.

Acting on his broker's insistence that auction rate securities were as good as cash, Dr. Joffe agreed to allow UBS to invest the foundation's entire $1.35 million. UBS invested all the money in various ARS series or issues of preferred stock in the Eaton Vance Limited Duration Fund, thereby increasing the Joffe Foundation's risk because all its auction rate securities investments were tied to that fund.

The auction for the Joffe Foundation's securities failed on Feb. 15, so all its cash is locked up indefinitely. Although the penalty interest rates of failed auction rate securities can sometimes go as high 17%, the penalty rate on the Joffe Foundation's paper is a measly 4.97%. That makes it incredibly unlikely that anyone will buy the paper before it matures. Moreover, the Eaton Vance fund itself carries enormous potential risk of principal loss.

As a result of this debacle, the Joffe Foundation cannot make a committed $100,000 donation to laser vision correction patients, nor fund its ongoing commitments. The foundation also needs cash to fund the salary of its administrative assistant.

Zamansky & Associates has already filed an arbitration claim on behalf of the Joffe Foundation, but it will take some time before it can be heard. You might think that UBS, which likely earned tens of millions of dollars peddling auction rate securities, would do right for a worthy charity and rescind the fraudulent and unsuitable investments so the foundation can honor its donation commitments, but unfortunately you would be badly mistaken.

Merger Meltdown: $29.5 billion!

2008-03-03T15:14:00.003-05:00

That is the amount Sprint Nextel wrote down in the fourth quarter largely because of the failed melding of Sprint and Nextel Communications three years ago. It turns out the merger news release headline touting the “unmatched asset mix” was an unusually prescient investor warning: the companies have struggled mightily merging their technologies, according to the New York Times.

Another dozy from the merger’s announcement: “We will have the resources to develop and deploy compelling, differentiated services by unleashing the combined strengths of the two companies, each of which is recognized as a product and network innovator. This is a pro-competitive combination that will provide customer choice and create exciting new opportunities for all of our constituencies."

Guess what? All that unleashing did indeed spark lots of customer choice. Sprint Nextel expects to lose 1.2 million subscribers this quarter and possibly more in the second quarter. It lost more than 1 million customers in 2007.

Sprint Nextel’s write down comes just weeks after Alcatel-Lucent’s staggering $3.8 billion write-down relating to the merger of Alcatel and Lucent just one year ago. According to the Wall Street Journal, Alcatel and Lucent “underestimated the cost of ripping out and replacing customers' old equipment as it combined two overlapping product lines.”

Here’s what’s bothering me: Media stories announcing mergers dutifully mention the investment bankers involved in the deals, often a quid pro quo for the bankers leaking news of the deals in the first place. But when problems with these deals begin to surface, there is nary a mention of the investment bankers responsible.

So what exactly do investment bankers do to warrant the tens of millions of dollars in fees they command? For starters, one would expect that as part of their due diligence reviews they help determine whether there might be formidable problems merging the operations of competing technology companies. Okay, maybe it’s unreasonable to expect them to understand the underlying technologies of their clients. They might also be expected to gauge whether the managements responsible for making the deals work have the requisite competence, but you know what they say about biting the hand that feeds you.

The sad truth is that no one really knows exactly what value investment bankers add because the reality is that ultimately they don’t really add value. As Andrew Ross Sorkin noted in his column last week, it’s generally taken as a given that most mergers fail. So it really doesn’t matter what investment bank conducts an M&A due diligence review because all the optimistic assumptions invariably prove to be wrong anyway.

As an aside, I don’t understand the obsession over the so-called League Tables, which focuses on which investment bankers do the biggest or the most deals. A more valuable table would be the investment banks responsible for doing the worst deals. As a public service, I’ve put together a representative list:

1991: AT&T and NCR Corporation

Goldman Sachs and Dillon Read advised NCR and Morgan Stanley advised AT&T

1998: Daimler-Benz and Chrysler

Goldman Sachs and Deutsche Bank advised Daimler-Benz and Credit Suisse First Boston advised Chrysler

1999: Mattel and The Learning Company

Goldman Sachs advised Mattel and Merrill Lynch advised The Learning Company

2001: AOL and Time Warner

Salomon Smith Barney advised AOL and Morgan Stanley advised Time Warner

2001: Hewlett-Packard and Compaq

Goldman Sachs advised HP and Salomon Smith Barney advised Compaq

2005: Sprint and Nextel

Lehman Brothers Inc. and Citigroup Global Markets advised Sprint and Goldman Sachs & Co., Lazard Freres, and JP Morgan advised Nextel

2006: Alcatel and Lucent

Goldman Sachs advised Alcatel. And JPMorgan and Morgan Stanley advised Lucent

Alt-A Mortgage Class the Next Shoe to Drop?

2008-02-29T17:04:00.003-05:00

For credit rating purposes, the class above subprime is known as "Alt-A". It is likely Alt-A bonds is the next shoe to drop… that is if it hasn't already.

Issuances of Alt-A mortgages has tumbled, according to a Dow Jones report, however, "the mortgages still made up 28 percent of all mortgages originated in the quarter, the same level as two years earlier." The lending industry's continued appetite for these loans is still alarmingly high considering Alt-A delinquencies are rising at a rapid pace:

After 18 months, Alt-A loans originated in 2006 had a delinquency rate of 4.71 percent, versus 1.97 percent for such loans from 2005 and 1.07 percent for 2004. The trend for 2007 loans is even worse than 2006, suggesting last year could be "the worse ever for the Alt-A market," S&P said.

This is terrible news for hedge funds, fund-of-funds and individual investors that have billions invested in Alt-A bonds. In 2006 alone $400 billion Alt-A loans were originated and likely sold to investors.

The fall-out of a collapse in this market will likely mirror that of the subprime loan market. Amidst the subprime rubble, allegations of hidden risks and omissions have been commonplace as well as accusations that Wall Street unloaded toxic subprime debt on unsuspecting investors. We could see a similar legal landscape in the near future.

According to our sources, Alt-A investments were pitched in a comparable fashion as subprime. Brokers and managers told clients Alt-A investments were backed by secure assets and were steady gainers, unlike tech stocks of the late 90s. Alt-A securitized investments in reality are backed by loans requiring little documentation regarding salary and other assets that would determine a consumer's credit worthiness. The phrasing is interesting: "Alt-A mortgages typically got to borrowers whose credit is deemed good enough to forgo proof of claimed assets or income."

Analysts are also eyeing the Alt-A market suspiciously. In a Marketwatch story from earlier this month, Mark Adelson, head of structured finance research at Nomura Securities International, calls "Alt-B" products:

"The Alt-A market has absorbed and disguised a portion of the subprime space," he said. "You can debate how to define these loans, but many have ended up being an Alt-A product with subprime deficiencies…"In the past few years, Alt-A loans were made to weaker and weaker borrowers and the sector expanded downward along credit spectrum," he said. "In doing that, you draw up into the Alt-A space some of the problems that are affecting the subprime space."

In other words, "Alt-A" isn't simply the next subprime, it could be subprime.

Financial Regulators Missed the ARS Market, But That’s Par for the Course

2008-02-28T11:19:00.002-05:00

I can’t help but note the irony of David Brown, executive director of the New York State Dormitory Authority, lambasting Wall Street for allowing the collapse of the auction rate securities market.

“As a whole, this is not the finest hour of the investment-banking community,” the Wall Street Journal quoted Mr. Brown as saying. Auction dealers “are refusing to make a market in the securities, saying publicly the product is dead and everyone has to get out of it,” then recommending debt restructurings “where they will earn yet another investment banking fee.”

I applaud Mr. Brown for sounding his criticisms, as I already have voiced the same concerns. But let’s be honest here: As a whole, this also isn’t the finest hour for regulators and some former prosecutors, including Eliot Spitzer, who served as New York’s attorney general before being elected governor.

Mr. Brown was a deputy attorney general under Mr. Spitzer. He was the person who spearheaded a probe of mutual fund trading abuses that ultimately resulted in some $3 billion in fines. There’s no questions that is a severe penalty, but regulators gave a pass to the executives ultimately responsible for the wrongdoing. To Mr. Spitzer’s credit, he at least took some action to punish the mutual fund industry for its improper market timing trading; the practice was well known and reported in 1997 by then Wall Street Journal reporter Charlie Gasparino (no link available), who quoted SEC officials as saying they would investigate the matter. The agency did nothing until Mr. Spitzer stepped in.

But imposing fines on Wall Street firms has hardly proven to be a deterrent for Wall Street, particularly since most of the penalties are puny to begin with. The SEC in 2006 charged 15 Wall Street firms with wrongdoing relating to auction rate securities and let them off with a $13 million fine, which didn’t even constitute a wrist slap. So no one should be surprised that some of the wrongdoing continued. Wall Street executives regard regulatory and prosecutorial fines as simply the cost of doing business.

Wall Street cannot be reformed until regulators and prosecutors begin taking legal action against the top executives at the major firms. Most, if not all, the top Wall Street executives knew about market timing and it’s highly unlikely there weren’t aware of the wrongdoing taking place in the auction securities market. Federal prosecutors have done an impressive job garnering convictions of CEOs and other top executives at companies involved in wrongdoing; if Mr. Brown laments Wall Street’s ways, his criticisms should also be directed at the SEC and Mr. Spitzer.

Auction Rate Securities Round-Up

2008-02-20T15:43:00.005-05:00

The financial media is moving the needle forward with regard to the auction rate securities crisis. Both the New York Times and Dow Jones have interesting takes today:

Floyd Norris reports that auctions continue to fail and that municipalities as a result will likely pay more to borrow money. The article reports that that some auctions - such as those issued by leveraged municipal bond funds - are in dire straits.

Dow Jones reports that as far back as 1992, auction rate securities triggered arbitration panels to award claims to investors. An arbitration panel awarded an investor group $2.2 million siding with them over Goldman Sachs who allegedly hid the risk associated with ARSs. A second, separate arbitration award was later granted to an investor with similar claims.

Arbitration awards as far back in 1992 are significant. Recall that it wasn’t until 2006 that the SEC made its illusionary attempt to reform the auction rate securities market. With evidence of alleged widespread bid rigging and arbitration awards due to inadequate risk disclosures, regulators turned a blind eye to what has developed into a $350 billion debacle.

Auction Rate Securities: A Scandal Made Possible by the SEC

2008-02-19T16:29:00.008-05:00

The SEC's Division of Enforcement has never been considered a tough minded regulator. But the collapse of the auction rate securities market underscores just how frighteningly ineffective the division really is.

On May 31, 2006, the SEC's Division of Enforcement issued a news release trumpeting that it had settled with 15 broker-dealer firms for what essentially amounted to rigging the auction rate securities market between January 2003 and June 2004. Here's an excerpt from that release:

The SEC order finds that, between January 2003 and June 2004, each firm engaged in one or more practices that were not adequately disclosed to investors, which constituted violations of the securities laws. The violative conduct included

allowing customers to place open or market orders in auctions;

intervening in auctions by bidding for a firm's proprietary account or asking customers to make or change orders in order to

prevent failed auctions, to set a "market" rate, or to prevent all-hold auctions;

submitting or changing orders, or allowing customers to submit or change orders, after auction deadlines;

not requiring certain customers to purchase partially-filled orders even though the orders were supposed to be irrevocable;

having an express or tacit understanding to provide certain customers with higher returns than the auction clearing rate; and

providing certain customers with information that gave them an advantage over other customers in determining what rate to bid.

The release also noted:

Some of these practices had the effect of favoring certain customers over others, and some had the effect of favoring the issuer of the securities over customers, or vice versa. In addition, since the firms were under no obligation to guarantee against a failed auction, investors may not have been aware of the liquidity and credit risks associated with certain securities (emphasis mine). By engaging in these practices, the firms violated Section 17(a)(2) of the Securities Act of 1933, which prohibits material misstatements and omissions in any offer or sale of securities.

In justifying the paltry $13 million fine the SEC imposed, a spokesperson said the agency "considered the amount of investor harm and the firms' conduct in the investigation to be factors that mitigated the serious and widespread nature of the violations." In particular, the firms voluntarily disclosed the practices they engaged in to the SEC, upon the staff's request for information, which allowed the SEC to conserve resources.

With the advantage of hindsight, it's clear that the SEC never understood the inherent and significant damage that was created by brokerage firms rigging the auction in the first place. It's also worth noting that if Wall Street firms simply cooperate with the SEC that partially justifies a wrist slap. Finally, if SEC still mistakenly believes that the their "cease and desist" order prompted the big brokerage firms to warn investors of the risks in buying auction rate securities, I have some clients they should definitely meet.

Auction Rate Securities: An Investor Scandal of Significant Proportions

2008-02-19T16:19:00.004-05:00

Our office has been flooded in recent days with inquiries from panicked investors who have suffered incredible harm because of the collapse of the auction rate securities market. All these investors vehemently insist they acquired auction rate securities because their brokers advised them they were as good as cash but would pay higher interest rates than government treasury bills or FDIC-insured savings accounts. Firsthand accounts from investors are posted on Dealbreaker, available here. Now that the market for auction rate securities has all but dried up, these investors can no longer make good on routine financial commitments such as monthly mortgage and credit card payments.

Although we are still sifting through mounds of evidence in preparation of filing our first claims, here is what we have already determined:

The investors we represent have provided irrefutable evidence that their brokers assured them that auction rate securities were as good as cash. Although Wall Street firms can cite some boilerplate warnings in their offering materials, they clearly marketed auction rate securities as being risk free, liquid investments. And indeed they were risk free, as long as Wall Street firms were willing to provide liquidity to prop up the market.

And therein lays the magnitude of this scandal.

One of the egregious blind spots of individual investors is they rarely take the time to understand the financial incentives behind the products Wall Street sells them. Underwriting or serving as a broker-dealer for auction rate securities was a hugely profitable business for the big brokerage firms, garnering them millions of dollars in fees. In addition to peddling auction rate securities to individual investors, the brokerage firms also bought these securities for their own proprietary accounts, yet another whopping conflict of interest.

And true to form, the big brokerage firms got caught manipulating the market. In May 2006, the big brokerage firms agreed to pay more than $13 million to settle SEC charges they were sharing confidential information between January 2003 and June 2004. The SEC said the violations were "serious and widespread."

The Big Four accounting firms clearly understood the inherent risks of auction rate securities. A year after the SEC settlement, the Big Four accounting firms warned their corporate clients to classify auction rate securities in their portfolios as "investments" rather than "cash equivalents." As of yet, we have found no evidence of any brokerage firm offering similar counsel or warnings to their clients.

The credit crunch that was sparked by the sub-prime mortgage mess – for which investors can also thank the big brokerage firms – has impaired the balance sheets of the big brokerage firms, so they no longer have the flexibility to provide liquidity and support for the $350 billion auction rate securities market. (Note to individual and corporate investors: the interests of a brokerage firm always take precedent over yours.) The repercussions and the extent of the fallout is not yet fully understood; in addition to individual investors that have been impaired, an untold number of corporations will likely be forced to join Bristol-Meyers Squibb ($270 million write-down) in taking massive write-downs relating to the auction rate securities on their books.

Merrill Lynch already has been sued by one of its corporate clients for peddling auction rate securities. Rest assured, when all the facts about the auction rates securities market are known and understood, the legal fallout could quite possibly be more formidable and damaging than Wall Street has ever before experienced.

Bear Stearns & Ralph Cioffi: Breaking Up is Hard to Do

2008-02-13T07:30:00.001-05:00

We've obtained the termination "Form U-5" filed by Bear Stearns regarding the now departed portfolio manager, Ralph Cioffi, who guided the two hedge funds specializing in investing in mortgage backed securities into the abyss. My prior blog post anticipated this filing.

The document discloses Cioffi left the firm under a "mutual agreement" with Bear Stearns effective November 28, 2007. The U-5 further states that in June 2007 the firm initiated an internal investigation into Cioffi's "role and conduct" in the failed funds and that "in addition, Federal and state regulators and law enforcement are also investigating" the same hedge funds and "similar issues".

Bear Stearns clearly wanted an amicable departure. Often when firms are under investigation they look to scapegoat others. In this instance, Bear Stearns has a strong interest in keeping Cioffi "on-the-reservation" given the firm's exposure to allegations of fraud in criminal and civil proceedings. The firm stands to benefit so long as their interest and Cioffi's are aligned. Therefore Bear Stearns doesn't have any incentive to include "negative" disclosures which could shed light into how the hedge funds collapsed.

This is stark contrast to allegations that Wall Street firms use Form U-5 to defame departing employees in order to scapegoat them for firm-wide wrongdoing or prevent them from competing on a fair level. I actually have clients that allege Bear Stearns did just that when the firm struck a $250 million settlement with the SEC over mutual fund market timing. The sordid tale was chronicled by Forbes in a story entitled "Fall Guys".

The message is that on Wall Street, you get the "kid-glove" treatment if you're either a Wall Street CEO, or as with Cioffi, the firm needs a friend for upcoming litigation.

My Subprime Litigation Speech

2008-02-08T16:07:00.000-05:00

As previously posted about, I just wrapped up a speaking engagement sponsored by Bloomberg and Eversheds. To see my full remarks, click here.

The Impending Subprime Litigation Tsunami

2008-02-06T17:20:00.000-05:00

Tomorrow I will be participating in a panel discussion hosted by Bloomberg News and Eversheds, one of the world's largest law firms. The conference is entitled "Sup-prime and global credit symposium: What will happen in 2008". Other participants include Matthew Allen, partner in the insurance and reinsurance group at Eversheds, Dr. Andrew Hilton, director of the Centre for the Study of Financial Innovation, Rolf Tolle, Franchise Performance Director at Lloyd's of London, Michael Fallon, MP for Sevenoaks and member of the Treasury Select Committee and Mark Gilbert, a Bloomberg news financial columnist.

I was asked to provide a view of the potential litigation. Here's what I will tell them:

The world is in for an unprecedented litigation tsunami. Subprime isn't the new dot-com, it's in a whole other class altogether. Wrongdoing is likely much more pervasive and egregious and claims will reach into the multi-billion dollar range. Already there are over 32 class actions filed against mortgage lenders, originators, and Wall Street brokerages alone and multiple civil and criminal probes.

There is one thing in common with the tech-bubble: investors were left holding the bag. I'll be posting my full remarks later this week.

Moody's Finds Religion: Too Little Too Late

2008-02-06T17:06:00.001-05:00

It was announced that Moody's is weighing a new 21-point scale for rating structured finance securities. The firm is also considering adding a warning label that acknowledges the ratings' limitations. While I welcome any reforms that can prevent another subprime collapse, this to me falls into the too-little-too-late category.

Furthermore, the market for securitized financial instruments has all but dried up, so it's unclear to me what benefit the new system will have. In reading the news, I couldn't help but recall the asbestos litigation and subsequent regulation which required certain buildings to contain the phrase. CAUTION: ASBESTOS. HAZARDOUS. DO NOT DISTURB WITHOUT PROPER TRAINING AND EQUIPMENT.

My suggestion for the ratings agencies: "CAUTION: PURCHASING THIS SECURITY COULD GREATLY REDUCE YOUR PORTFOLIO."

Harvey Pitt on Individual Investors: Let Them Eat Cake

2008-02-01T16:46:00.000-05:00

Former SEC chairman Harvey Pitt was no champion of individual investors. Pitt was in charge of the agency when the former New York Attorney General put the SEC to shame and took the lead in exposing Wall Street's conflicted research. Pitt was also among the regulators who signed off on Spitzer's wrist-slapping $1.4 billion global settlement.

So I guessed I should not have been surprised to hear Mr. Pitt tell CNBC viewers today that the Supreme Court's recent Stoneridge decision, which prevents investors from suing all parties involved in a fraudulent transaction and not just those who directly initiated it, would have no bearing on investors seeking legal recourse relating to the subprime mortgage meltdown. Mr. Pitt said that there were already enough primary violators to sue.

Mr. Pitt is badly mistaken. The Stoneridge decision will adversely affect the legal recourse available to subprime investors, as many potential avenues for discovery – where "smoking guns" are often discovered &ndash are now closed. My guess is that if CNBC had also asked Mr. Pitt about the Supreme Court's Tellabs decision, which requires "a strong inference of fraud" before a class action suit can be certified, he wouldn't have had any issues with that ruling either.

Credit Mr. Pitt at least for one thing: at least the regulatory lightweight's longstanding indifference to the issues and concerns of individual investors remains intact.

FBI's Subprime Investigation and Cuomo's "Martin" Move

2008-01-31T13:52:00.000-05:00

If the legal departments at our nation's major financial services firms weren't nervous before, they certainly are now. According to news reports, the FBI is looking into potential subprime crimes by 14 companies as part of a wide ranging investigation into the troubled mortgage industry. Apparently they have been doing so since the Spring of 2007. Reading through the tea leaves, the FBI might find that risk disclosures were hid from investors and ratings agencies as well as mortgage lenders and brokers falsifying information on loan applications, among other potential wrongdoings.

The FBI inquiry is extremely important because rather than pursuing these cases civilly through the SEC, we could see federal criminal indictments and jail time. The Feds were successful in prosecuting corporate criminals at Enron, WorldCom, and Adelphia and they have the requisite knowledge and experience to pursue wrongdoing in the subprime mortgage arena.

This is in stark contrast to Eliot Spitzer's strategy who was content to use photo-ops and wrist slaps and call it justice. Mr. Spitzer's performance will hopefully not serve as a case study for the current New York Attorney General, Andrew Cuomo. This is not to say he didn't learn anything from Mr. Spitzer. Attorney General Cuomo apparently is threatening to use The Martin Act to aggressively pursue a case against Wall Street, which also was Mr. Spitzer's legal club of choice.

This is an important development. The Martin Act is quite broad in its scope and can be used to indict a company for virtually anything. No Wall Street firm has ever survived an indictment, so Cuomo will likely garner some settlements. Let's hope that unlike Mr. Spitzer, Mr. Cuomo is hell bent on truly reforming Wall Street and that any settlements involve penalties that might actually serve as painful deterrents to future wrongdoings.

Sub-Prime Crisis and the Ratings Agencies

2008-01-29T16:06:00.000-05:00

Sub-Prime Crisis and the Ratings Agencies

Back in August, Fortune ran a story that took the ratings agencies to task for their role in the subprime mortgage crisis. A noted investor named Jim Chanos, the head of Kynikos Associates, acknowledged he had a short position in Moody's stock: "If the rating agencies will downgrade only when we can all see the losses, then why do we need the rating agencies?"

If what I read in the Sunday Business Section is true about Attorney General Andrew Cuomo's investigation and the participation of Clayton Holdings, a company based in Connecticut that vetted home loans for many investment banks, then Mr. Chanos is due for a windfall (he's already at least more than doubled his money). Apparently Clayton Holdings has provided extensive documentation to the attorney general's office in exchange for immunity that shows investment banks allegedly knew many of the loans it was packaging for unwitting investors were more risky than was disclosed. Early on in the subprime crisis when I filed the first hedge fund investor arbitration claims against Bear Stearns, we made the similar allegations regarding the firm's failure to disclose risks.

More shocking is the allegation that the investment banks never turned Clayton's due diligence reports over to ratings agencies. Instead, according to the article, "in these disclosures, underwriters typically said that loans that did not meet even lowered lending standards, called exceptions, accounted for a "significant" or "substantial" portion of the loans contained in the securities, but they offered little hard, statistical information that Clayton promised prosecutors it would provide as evidence."

Wall Street's selective disclosure to the ratings agencies is only half the story. My question is, should the ratings agencies even need such information? I thought the ratings agencies did their own due diligence. If this story is accurate, what value-added are the ratings agencies providing if they aren't able to perform their own analysis?

Later on in The New York Times story, Raymond W. McDaniel Jr., the CEO of Moody's says of the investment bank's reports: "Both the completeness and veracity was deteriorating." My question to Mr. McDaniel is how could Moody's possibly award ratings to securities based on incomplete information?

Ordinarily we would just let market forces deal with such failure. However firms like Moody's, Standard & Poors, and Fitch are granted special competitive advantages because they are part of a select group of eight companies designated as Nationally Recognized Statistical Rating Organization (or "NRSRO"). Based on their record, the government should not be protecting them. If there was more competition the ratings might be more predictive and less expensive. Maybe if investors had gotten their hands on Clayton's reports they would have never invested in the first place.

The fact is ratings agencies have become lagging indicators. Mr. Chanos knows this better than anyone. He was an early short-seller of Enron after investigating the firm and finding accounting irregularities. It wasn't until mid-October of 2001 that three credit-rating agencies started to warn investors of Enron's deteriorating condition, and not until Nov. 28, just days before Enron filed for Chapter 11 bankruptcy protection, that they lowered their debt ratings below "investment grade."

If the only service ratings agencies provide is assigning some combination of the first four letters in the alphabet to a security, then maybe they can be replaced by a smart preschooler.

Chairman Waxman’s CEO Compensation PR Stunt

2008-01-23T09:15:00.000-05:00

Next month, Congress will be schlepping in the former chief executives of several financial services firms damaged by the subprime crisis to question them about their compensation packages. House Oversight and Government Reform Chairman Henry Waxman (D-Calif.) has sent letters to Angelo Mozilo, CEO of Countrywide Financial, Charles Price, former CEO of Citigroup and Stanley O'Neil, former CEO of Merrill Lynch. According to reports Chairman Waxman intends to ask them why they "stand to collect tens of millions of dollars in severance payments and other compensation," even as their current and former companies are losing billions of dollars in the subprime mortgage meltdown.

It's certainly understandable to perceive these golden parachutes as obscene. Mr. Mozilo is supposedly getting more than $110 million on top of the $47 million he got last year, while Countrywide Financial erased billions of dollars in shareholders equity. Mr. Prince is allegedly getting more than $29 million in "accumulated benefits" and supposedly even received a bonus for 2007. Mr. O'Neal walked away with more than $161 million in "accumulated benefits." Citigroup and Merrill together have written down more than the GDP of most third world countries.

By any measure, paying these men hundreds of millions of dollars for their recent performance is not justified – which is exactly why Mr. Waxman is calling in the wrong people. It should instead be the corporate board members overseeing the compensation committees that should explain the payouts. Maybe executive compensation consultants hired by corporate boards should face questioning too, such as Hewitt Associates of Lincolnshire, Illinois, and Mercer Human Resources, which were involved in the decision to give Dick Grasso over $100 million. The ones who accepted authorized pay shouldn't be flogged.

The individuals Chairman Waxman should have sent letters to include Harley Snyder, CEO of HSC, Inc., John Finnegan, Chief Executive Officer of The Chubb Corporation and Alan J.P. Belda, Chairman and CEO of Alcoa, who chaired the compensation committees of Countrywide, Merrill Lynch, and Citigroup, respectively. Hopefully not lost on Chairman Waxman would be the fact that all these men hold the title of CEO. In this elite fraternity, sometimes one hand washes the other. For example, Mr. O'Neil was just named to the board of Alcoa. It would of course be too obvious of a conflict for Mr. Prince to serve on Alcoa's board, so Mr. Belda got the next best thing. The point is, those holding the power don't have the motivation to change the status quo.

Chairman Waxman needs to get to the source of the problem which lies squarely with the board of directors and compensation committee members. Not holding them accountable is like patching a leaky roof with duct tape every time it rains. Unfortunately, without their presence next month's hearings are the equivalent to nothing much more than a witch hunt wrapped-up in a PR stunt.

If Chairman Waxman was truly interested in relating compensation to performance, why stop at publicly held companies? He should call in sports stars like Alex Rodriguez, Carl Pavano, and Albert Belle, notoriously over-paid underperformers. I know what you're thinking. Congress holding hearings with professional baseball players sounds ridiculous, doesn't it?

Front Running and Institutional Investors

2008-01-22T12:21:00.000-05:00

A few years ago there was a Long Island restaurant that served the most deliciously yummy foods and desserts, all of which were labeled as being ridiculously low in calories and fat. The lines extended out the door. But one night a local television station reported that its testing revealed the restaurant's food was in fact incredibly high in calories and fat. The restaurant issued an apology and reverted to a healthy menu focused primarily on salads, but barely anyone would frequent the place. The trust was gone and the restaurant closed.

You would think that institutional money managers, who have a fiduciary responsibility to their clients, would also avoid doing business with any firms that engaged in organized wrongdoing and ripped them off. But that certainly doesn't appear to be the case. There have been repeated incidents where major Wall Street firms reportedly have traded in advance of major trades they were asked to execute for their institutional clients. This practice, known as front running, gives brokerage firms an unfair advantage because they have insider knowledge that a pending block order will likely cause a significant price swing.

The SEC reportedly is investigating whether Merrill Lynch was front running orders placed by Fidelity Investments, the massive mutual fund operator. If the allegations prove true, it won't be the first time Merrill Lynch has been nailed for this infraction. In 1995 the firm was fined $10,000 and censured by the American Stock Exchange for "the practice of profiting on advanced knowledge of a planned transaction." The piddling fine didn't even cover the losses incurred by Merrill's client and could hardly be considered a major deterrent. Whoever coined the phrase "crime doesn't pay," never worked on Wall Street.

But let's not just pick on Merrill. Front running has long been suspected as a widespread practice at all the big brokerage firms. Yet institutional money managers continue to route the bulk of their trades through them, rather than support the various independent boutiques that have sprung up in recent years offering very sophisticated algorithmic trading capabilities. One of the reasons is that the big brokerage firms offer their institutional clients equity research, but we know that most of that research is hardly worth the paper it's printed on. Another major reason is simply fear: In the words of one institutional money manager, "no one is going to get second guessed for routing an order through Goldman Sachs."

Rest assured, even if the SEC finds that Merrill was front running Fidelity's orders, nothing much will come of it. The matter will be settled by Merrill agreeing to pay a relatively insignificant penalty without admitting any wrongdoing. It will, of course, get to keep most of its ill-gotten gains. The SEC neither has the resolve, or the resources, to take on a big Wall Street firm.

It's about time mutual fund boards acted responsibly and begin questioning how trading in the equities they oversee are executed. Customers betrayed by the Long Island restaurant weren't willing to grant a second chance, and I'm confident that mutual investors would be similarly unforgiving about having their holdings routed through institutions engaged in pervasive wrongdoing.

The Subjective Nature of Wall Street Write-Downs

2008-01-17T08:48:00.000-05:00

Fourteen billion. That's the apparent magic number for Merrill Lynch and its new CEO John Thain as formally they announced a write down of $14 billion for the fourth quarter of last year. An equally staggering number was announced by Citigroup and its new CEO Vikram Pandit, which wrote-down $18 billion for the fourth quarter. Together their losses amount to more than the Ecuadorian GDP! It is of course strategically logical for Mr. Thain and Mr. Pandit to write-down such massive losses. As incoming CEOs the losses weren't under their watch and they can ride gains to the upside. No where to go but up from here!

But what is more troubling about Merrill's and Citi's write downs is how it exemplifies the subjective nature of Wall Street's accounting methods. Just one quarter ago the write-down was $8 billion for Merrill and $11 billion for Citi. Both of those write downs occurred during the tenures of the now "retired" CEOs Stan O'Neil and Charles Prince, respectively.

I have a few questions: If the previous CEOs were still in place would the fourth quarter numbers have been the same? Did Mr. O'Neil and Mr. Prince choose to take smaller write downs in an attempt to save their jobs or is Mr. Thain and Mr. Pandit taking a bigger write down than necessary to ensure they receive the full extent of the upward bell curve? Or are you going to believe "uncertain market conditions" are to be blamed?

The point is, strategy shouldn't influence when and how much to write down losses. What Wall Street's earnings environment shows us is that a CEO may have a greater influence on balance sheet than, well… the balance sheet.

In an ideal world we would count on an independent accounting firm to honestly audit Wall Street's books. But accounting firms are anything but independent as noted by Francine McKenna, whose blog re: The Auditors covers the "Big Four" accountancies. In a recent post, she disclosed the lucrative relationship between PricewaterhouseCoopers (PwC) and Goldman Sachs. PwC has been Goldman's sole auditor since the firm went public in 1999, but they deliver a myriad of other professional services to the firm.

Writes Ms. McKenna, "This past year, total audit fees were $43.4 million, audit related fees were an additional 3.3 million and tax fees were 2.6 million. In addition, [PwC] made $19.2 million more by providing services to merchant banking and other funds managed by Goldman Sachs subsidiaries. All of these fees were for audit and tax services. By comparison to prior years' numbers, we can see that over the years, and like other large, complex, global companies, audit and related fees have grown substantially due to Sarbanes-Oxley. But the services to the Goldman Sachs funds have also been part of the package since almost the beginning and add a significant amount to PwC's overall compensation."

What Ms. McKenna delicately touched upon I will say outright: with money like that at stake an accounting firm is not incentivized to interpret accounting rules strictly and universally. More plainly, either Mr. Thain or Mr. O'Neil has some explaining to do because investors should not accept that Merrill Lynch couldn't have written down any of the $14 billion before now.

The game is clearly rigged in Wall Street's favor if a CEO has billions of dollars of leeway when it comes time to pay the piper. With such grey accounting standards, the write-downs are largely meaningless. And therein lies the lesson. When investing in Wall Street, you're on a wing and a prayer.

Stoneridge Decision is NOT Good for Investors

2008-01-16T15:00:00.000-05:00

There’s a lot of propaganda circulating about the Supreme Court’s decision in the Stoneridge vs. Scientific Atlanta case. The court completed its trifecta of anti-investor decisions by deciding that third parties (investment banks, law firms, accountants, etc) are not subject to so-called “scheme liability.” In other words, investors cannot recover losses from third parties that contributed to securities fraud.

The decision is extremely unfortunate for the investors in Enron, many of which were employees whose pensions were mostly invested in the firm’s own stock. Because there’s nothing left of Enron, they will forever be left olding the bag regardless of the fact that investment bankers helped Enron managers create sham transactions that eventually led to the firm’s collapse.

Since the Supreme Courts decision yesterday, many pundits have been echoing the arguments of the business lobby. The argument goes that the Stoneridge decision is actually good for investors because litigation expenses drive down corporate earnings. Another creative argument is that diversified investors will be both victims and beneficiaries of fraud so it evens out.

Maybe, but it is the market’s integrity that is its strength in the long run. Not holding all the market’s participants accountable for fraudulent activities essentially grants a license to steal. Not matter how you slice it, that’s bad for investors. Second of all, allowing for investors to recover losses will not harm competition or corporate earnings. Rather it will even the playing field for those companies operating within the confines of the law.

Bear Stearns Announces Third Hedge Fund Collapse; A Sign of Things to Come?

2008-01-10T09:29:00.000-05:00

Bear Stearns has dropped another bombshell announcement. A third hedge fund, the Asset Backed Securities Fund, has apparently lost so much money its no longer profitable for the bank to run it...and that’s saying something considering Wall Street’s reputation for squeezing fees out of investors. At its peak, the fund had $900 million of investor assets, which is now valued at $500 million. This brings the grand total of investor loses under Bear Stearns’ watch to well over $2 billion in three hedge funds alone.

This latest hedge fund to shutter, Bear Stearns claims, only had 0.5 percent of is assets tied to sub prime mortgage related securities. This begs the question of exactly what constituted the other 95 percent of invested assets. Were these also illiquid securities or is the market for all asset backed securities (including commercial lending) worse than anyone could imagine? No one has ever accused Bear Stearns as being a pillar of transparency, but if the market is in such jeopardy then a great many more portfolio managers may be going the way of Ralph Cioffi, the now departed portfolio manager who oversaw the other two collapsed Bear Stearns hedge funds.

My inclination is that this is partly another example of the dubious nature of Wall Street’s credit valuation methods. Bloomberg reports that the Asset Backed Securities Fund’s portfolio was valued at $900 million as late as August of 2007, but spiraled downward losing as much as 21 percent in November alone. Would August’s valuation been the same had the funds assets been valued based on more pragmatic (read: honest) method? Did the hedge fund managers’ strategy waver in any way during the funds history? And did Bear Stearns park any of its own bad assets in the funds as it is alleged they did with the other two funds under Cioffi’s supervision? These are the types of questions that investors should be asking.

They say where there’s smoke, there’s fire. And in my thirty years working on behalf of defrauded investors nowhere is that more true than on Wall Street. At Bear Stearns, there’s a raging inferno. Rest assured, we will be paying close attention and working with clients to determine the real story behind the Asset Backed Securities Fund and its spectacular losses.

The Resignation of Jimmy Cayne

2008-01-08T13:47:00.000-05:00

The resignation of James E. Cayne as the CEO of Bear Stearns comes as no surprise to anyone following the subprime crisis. Bear Stearns stands out as one of the primary securitizers of subprime mortgage backed securities and many consider the collapse of its two hedge funds this summer the spark that ignited the subprime forest fire. Since the collapse, Bear Stearns has been besieged by investor lawsuits - including those filed by Zamansky & Associates on behalf of institutional and high net worth investors - regulatory investigations and multi-billion write-downs resulting in huge losses in shareholder’s equity.

Many will praise Mr. Cayne’s leadership, and perhaps rightly so, since under his control the firm’s stock price rose from $16 to over $100. But along the way hundreds of investors have filed arbitration cases and Bear Stearns has paid out hundreds of millions of dollars in regulatory fines. Indeed, Mr. Cayne’s legacy will be difficult to spin positively.

Taking his place as CEO will be Alan Schwartz, currently serving as Bear Stearns’ president. It is my sincere hope that the leadership change will also elicit change in the way that Bear Stearns treats its investor clients and belief in strict regulatory compliance.

State Street versus Main Street?

2008-01-04T14:30:00.000-05:00

The financial press is reporting today that the State Street Corporation, which manages an astounding $2 trillion for pension funds and other institutions, has set aside over $600 million to cover legal claims stemming from clients whose investments lost money because of exposure to the securitized mortgage arena. It is certainly interesting that even a self-described conservative financial house like State Street drank the mortgage back security cool aid. While $600 million may sound like a lot of money, it's likely only the tip of the iceberg. Indeed, the rest of Wall Street should follow State Street's lead instead of stonewalling.

The cash reserves could amount to a multi-billion exposure to lawsuits brought by pension funds, municipalities, hedge funds and high net worth individuals. Given the interest of the financial regulatory community – it was reported FINRA has finally joined the action and has sent requests to more than a dozen brokerages for marketing and client account information used to steer clients toward mortgage related securities – a settlement along the likes of the $1.4 billion research/investment banking conflicts could also be in the future.

State Street Corp. is indeed where Main Street and Wall Street collide. Pension funds and mutual funds are comprised of the weekly contributions from mom-and-pop investors' paychecks. State Street allegedly took client funds that were suppose to be invested in treasuries and corporate bonds and instead invested them into the mortgage security market. After the client lost $80 million, the response from State Street will go down in annals of Wall Street's stupidest client responses ever (and that's saying something). Allegedly a State Street executive told his client that the firm "forgot there was a lot more risk in the strategy."

Clients are suing State Street under the Employee Retirement Income Security Act (ERISA), which is a relatively new legal strategy. Prior to the last year's Supreme Court decision known as "Tellabs," the standard to prove fraud was easier to meet. Unfortunately the business-friendly Supreme Court decided that a plaintiff must show a "strong inference" of fraud but didn't exactly define what that meant. Because of that risk, ERISA is being used to recoup for investor losses in this case and we will likely see its use increase.

In addition to the billions of dollars tied to litigation, Wall Street will lose billions more due to the collateral damage to brokerage reputations. Confidence in Wall Street's ability to invest honestly is shattered and no amount of rainy day funds can save that.

The Silver Lining in the Subprime Mess

2008-01-02T09:36:00.000-05:00

It’s beginning to look like 2000 all over again. The Wall Street Journal reported that the SEC alone has launched dozens of investigations tied to the subprime crisis. The investigations are eerily familiar to those that were held after that tech bubble burst in 2000 and ultimately led to the $1.4 billion global settlement.

But there is a fundamental difference this time around: some of the CEOs who oversaw the subprime mess at their respective firms – namely Chuck Prince at Citigroup, Stan O’Neal at Merrill Lynch – have already been fired. Bear Stearns reportedly is looking to replace Jimmy Cayne.

Flashback to the conflicted research probes where no CEOs – not even Sandy Weill who created the most conflicted financial conglomerate ever – lost their jobs because of Wall Street’s rampant institutional dishonesty.

Although wrongdoing is as pervasive as ever on Wall Street, it’s a progressive step forward when CEOs – and not hapless middle managers – are actually held accountable.

Awaiting the Truth about Ralph Cioffi's Departure

2007-12-19T17:30:00.000-05:00

Ralph Cioffi, the head fund manager in charge of the two collapsed Bear Stearns hedge funds, has quietly left the firm. While there are rumors that he might be setting up another hedge fund, this would be shocking given the carnage at Bear Stearns which is still being cleaned up. Well, you know what they say about doubling down on a bad bet.

A more likely reason for Cioffi's departure might have to do with the report that prosecutors are looking into Cioffi's withdrawal of some $2 million he personally invested in the funds while he was still touting them to investors. Two failed funds would be the least of Cioffi's worries if prosecutors decide to pursue a case of insider trading or some other wrongdoing.

The real interesting tidbit of Cioffi's departure will be the U-5 form that Bear Stearns is required by law to file within 30 days of his leaving, disclosing the reasons for his departure. Wall Street firms often post disparaging comments on a departing employee's U-5 in order to make it difficult to take a book of business or gain future employment. Regretfully, Wall Street believes it can now make reckless claims with immunity thanks to a New York state court ruling in June saying that a brokerage firm cannot be sued for defamation because of what it states on a broker's U-5 form.

But with regulators, prosecutors, liquidators, and investor attorneys, including myself, aggressively scrutinizing the collapse of Mr. Cioffi's funds, Bear naturally wants to avoid writing negative comments about him as that could undermine the firm's stated defense that no wrongdoing ever occurred. Still, Bear is obligated to be truthful in its U-5 disclosures, so if Cioffi's departure was involuntary, or related to regulatory or legal issues, the firm has to disclose that.

With so much on the line, you can also bet FINRA is also keeping a close watch on what Bear Stearns has to say about Cioffi. The Form U-5 is a critical part of FINRA's much touted "Broker Check" system, which has been advertised everywhere from CNBC to professional football games. A chink in the U-5 could mean a loophole in the whole "Broker Check" system.

Rest assured, I'll be reporting on Cioffi's U-5 disclosure as soon as it is filed, so let the countdown begin.

Bear Stearns Hedge Fund Insider Trading Inquiry

2007-12-18T13:17:00.000-05:00

The inquiry by Federal criminal prosecutors into whether insiders withdrew money from the collapsed Bear Stearns hedge funds was reported nationally this morning. The Feds are looking into the actions of the fund’s head manager Ralph Cioffi. People close to the investigation are saying he moved nearly $2 million from the funds just weeks before they imploded into insolvency.

Also investigation insiders are saying that Cioffi was touting the funds to investors and prospective investors while at the same time pulling his own money out. If the allegations are indeed true, then this is a situation reminiscent of Sam Waxal, the disgraced former CEO of Imclone, whose actions led to his imprisonment of seven years and Martha Stewart’s conviction and incarceration.

Insiders should never be granted preferential treatment and if the Feds’ inquiry uncovers evidence it could certainly help my clients and other investors who have filed claims against Bear Stearns.

The report of potential insider trading at Bear Stearns ironically was followed by a report from the General Accounting Office that criticized the SEC and FINRA for their record on insider trading. Under such pressure, you can be sure regulators and investigators will take the Bear Stearns inquiry very seriously.

Subprime Arbitration Claims Ring Familiar: Welcome Back Blodget?

2007-12-12T16:19:00.000-05:00

Sans research analysts secretly trashing the stocks they cover and it's the year 2000 all over again. Dow Jones Newswire reports on some of our clients whose financial advisors allegedly placed their savings into unsuitable investments tied to the speculative subprime loan market. Here's an excerpt profiling one of Zamansky & Associates' clients:

In his claim against Oppenheimer, investor Kevin Haynes, a freelance writer and editor, argues that his broker, Alvin Corwin, shifted him out of blue-chip stocks and over-aggressively concentrated his portfolio in American Home Mortgage (AHMIQ), a mortgage lender that ultimately filed for bankruptcy protection in August. Although it wasn't a "subprime" lender, American Home Mortgage offered Alt-A mortgages - mortgages offered to more creditworthy borrowers than subprime loans, but that often have adjustable rates and sometimes require little or no documentation.

When Corwin would recommend buying more shares in American Home Mortgage, Haynes, 50 years old, said he would ask "Aren't we putting too many eggs in one basket?" Haynes recalled. "He said, 'No, this is a smart play...You've got to do this.'"

As the subprime crisis widened in June 2007, Haynes, who lives in Manhattan's Financial District, met with Corwin and told him he wanted to get out of American Home and that he couldn't tolerate a large loss from such a substantial holding, the claim said. Corwin adamantly advised Haynes to keep holding onto the stock, the claim says, and Haynes did. Shortly after, the claim says, Haynes' shares dropped to $1 each and American Home filed for bankruptcy protection.

Another one of our clients was profiled in the article as well. This demonstrates a distressingly similar trend reminiscent of the dot-com bust, right down to a broker insisting, “Who ever lost money in real estate?"

This is likely only the tip of the iceberg as I've already been approached by other investors with similar cases.

The Bear Stearns/KPMG Whitewash Job

2007-12-12T09:54:00.000-05:00

I naturally attended a meeting in Wilmington Delaware today with KPMG on behalf of clients that invested in the failed Bear Stearns High Grade Structured Credit Strategies Fund. KPMG has been hired by Bear Stearns Asset Management (BSAM) to investigate the collapse and liquidate what's left of the failed financial carcass.

The so-called investigation gives me great pause for concern. First, it is BSAM, the subject of investigation, who is paying for it. Second, BSAM has paid KPMG $500,000, which KPMG believes may only be enough to produce a "preliminary report with summary findings." Knowing a big four accounting firm, this will barely cover their photocopying charges.

Surprisingly, KPMG likely won't be producing documents to investors and may only release their "summary findings."

In other words, investors will have to simply trust KPMG, who are ultimately accountable to the firm that burned them in the first place.

Rest assured, Bear Stearns' management isn't sweating KPMG's report.

Paulson's Sub Prime Plan: See You in Court?

2007-12-10T11:01:00.000-05:00

U.S. Secretary of the Treasury Henry Paulson is arguing in favor of the administration's plans for the subprime loan crisis. Two sentences from his recent Wall Street Journal op-ed in particular struck a cord with me:

By convening a large group of servicers and mortgage investors, we facilitated their work to improve their outreach and develop an industry-wide, streamlined response to struggling borrowers. Because these industry standards are the product of investor and servicer discussions, the risk of litigation should be manageable.

While many of the provisions in the plan are admirable and the overall goal of keeping Americans in their homes is something we are all striving for, I must take issue with Paulson's statement when it comes to the manageability of litigation. Put another way by Christopher Meyer, head of the Milstein Center for Real Estate at Columbia University's business school, "Everybody is going to end up suing everybody."

Investors in particular seem to be getting the short end of the stick, specifically with respect to the freezing of adjustable rate mortgages set to adjust higher. Pension fund managers, plan sponsors, hedge funds and even institutional individuals have significant investments in collateralized debt obligations (CDO) or related investments tied to subprime loans. The rate of return for many is tied to adjustable rate mortgages, which were supposed to increase as stipulated in the mortgage contract.

It's very simple: if an investor buys a security that is suppose to generate a five percent return, then if it's going to be changed, either the buyer needs to sign off or they need to be compensated for the reduction. In my mind, Paulson's plan is tantamount to a bail out of Wall Street. Wall Street contributed greatly to the housing bubble by packaging and selling toxic subprime loans to investors perpetuating their use even further, therefore Wall Street should bear the brunt of the losses due to contract renegotiations, not the investors themselves.

SEC, Spitzer: Swing and a Miss at Bear Stearns

2007-12-10T10:59:00.000-05:00

Every year in New York around this time it's tradition that the ball gets dropped. The problem is this year it has nothing to do with New Year's Eve and Times Square. Today's Wall Street Journal revealed that the S.E.C. and former New York attorney general Elliot Spitzer dropped enforcement cases pertaining to whether Bear Stearns improperly valued mortgage backed securities and in doing so, harmed investors. The investigations would almost certainly have stemmed the tide of valuation inflation currently plaguing Wall Street and protected the myriad hedge funds, institutional investors and high net worth individuals who bought the poisonous debt. Translation: They Dropped the Ball.

Two cases in particular were investigated. In one case an SEC investigator went so far as to recommend a large civil enforcement penalty against Bear Stearns. In the other Bear Stearns allegedly sold bonds it priced at 90 cents on the dollar but after it unloading them, re-priced the value of the same bonds at 30 cents on the dollar before agreeing to purchase them back. Both cases were dropped and there was no comment as to why.

The dropped investigations highlight the rampant conflicts of interest and potential for fraud between Bear Stearns and its now collapsed internal hedge funds raised in the arbitration case we filed on behalf of the investors in the hedge funds. Claimants allege that Bear Stearns was moving toxic low quality collateralized debt obligations over to the fund at inflated market values. In essence, it's alleged that among other things, Bear Stearns was artificially creating a market for this debt by using dubious "mark to model" techniques and questionable transfers. Bear Stearns will eventually have to explain how it valued these transactions.

By the same token, the regulatory community must answer for why their leadership was asleep at the wheel. Poor leadership, in fact, is one reason Wall Street is in crisis to begin with. Bear Stearns execs reward the rank and file through end of the year performance bonuses and according to the Wall Street Journal story "traders long have had a motive to inflate the value of securities because their bonuses often are tied to them."

Without any downward pressure from regulators and a culture of greed/eat what you kill encouraged by Wall Street, is any wonder that things got so far out of control?

Ben Stein's Goldman Sachs Column: Just the Facts

2007-12-04T16:29:00.000-05:00

By now, the financial blogosphere is teaming with reactions to Ben Stein's column in Sunday's New York Times about potential conflicts at Goldman Sachs related to its short positions in the collateralized mortgage obligation (CMO) sector. Most of the comments have dissected his presumptions that Goldman Sachs is an underground imperial network, ala the Russian KGB, and that research circulated by one of its chief economist, Jan Hatzius, is nothing short of "lazy" and even possibly libelous.

As an attorney, I stick to the facts and then analyze based more than 25 + years of Wall Street litigation experience. Based on the facts, I'm firmly in Stein's camp.

Fact: (Goldman Sachs) alums are routinely Treasury secretaries, high-advisors to presidents, and occasionally a governor or United States senator.

Fact: Jan Hatzius sent a letter for unlimited distribution and consumption hypothesizing that subprime mortgage crisis would get so bad "that it would affect aggregate lending extremely adversely and slow down growth."

Fact: Hatzius admitted that he left out of his doomsday scenario the likelihood of action from the Federal Reserve.

Fact: While aggressively selling risky CMOs to investors, Goldman Sachs was moving "to a considerably larger short posture."

A classic conflict of interest if there ever was one, and a nefariously sounding one at that. Rounding out the latest Wall Street conflict is another indisputable fact: Wall Street has a sordid history of harming investors through conflicted financial research targeted at individual investors. Stein actually mentioned disgraced Merrill Lynch tech-analyst Henry Blodget as proof, but it certainly doesn't begin and end with Blodget. Frankly, I couldn't decide whether I was reading classic Ben Stein satire given his shock at Goldman's audacity and influence.

Likewise we shouldn't be surprised that Goldman Sachs gets a free pass for alleged misdoings. They have never been held accountable. Take for example the Speer Leeds & Kellogg traders who were front running orders. After a menial fine it was back to business as usual and traders kept their jobs.

Stein's critics miss the only real opening to find fault in his column: that he's had his head in the sand if he thinks this is anything new.

Wall Street's Bloodletting Could Get Litigious

2007-11-26T10:51:00.000-05:00

In previous blogs about hedge funds and in various appearances on television, I've said that rich people have rights too. The same can be said of well-compensated Wall Street employees, especially those who have been fired or laid off. With the downturn in the bull market, we are set to endure a Wall Street bloodletting not seen since the 2001 tech bubble collapsed. In fact, Investment Dealers Digest is reporting that recruitment firm Challenger, Grey & Christmas estimates 140,000 employees will be laid off and this morning CNBC's Charlie Gasparino broke a story about significant layoffs and CitiGroup, one of the largest employers on Wall Street.

While there will be many who won't shed any tears over Wall Street's pain, they might not understand how many employment agreements on Wall Street are structured in the banks' favor. Nor might they understand that Wall Street firms commonly bully employees into agreeing to less than desirable terms when an employee is fired or laid off.

It's commonplace for the worker bees and managers alike on Wall Street to expect much of their compensation as a bonus. Furthermore, deferred compensation, pensions, stock options and other retirement income are regularly used in lieu of a traditional salary in the financial services industry. It's pitched as a win-win for both the brokerage and the employee but the tables can quickly turn when the going gets tough on the Street.

After 2001's layoffs, many employees were terminated shortly before receiving their end-of-the-year bonuses. They were denied much of the compensation and benefits they thought were promised. Instead, employees were coerced into waving their rights under the NASD rules (now known as FINRA) and in return received severance packages not equal to what they could have expected to earn under normal circumstances. Among other concerns, employees feared that their Form U-5's might get marked up which would result in a near banishment from ever working again in the securities industry. It's like the old godfather line: make them an offer they can't refuse.

I hope that the 140,000 Wall Street professionals who lose their jobs this go around learn from the mistakes of others. In the meantime, here's a few tips:

Generally Wall Street employees get paid a modest salary, sometimes around $100,000, and a bonus which can be in excess of $1 million depending upon the performance of the employee and the particular desk. If the performance has been good but the employer decides on a layoff, the employee may have a claim against the employer for the promised bonus.

Secondly, in an employee termination, the employer is required to file termination "Form U-5," which can be viewed by all prospective employers and customers. If an employer files a U-5 which contains false and defamatory language against the employee, the employee may have legal remedies such as seeking expungement of the false and defamatory language and possibly monetary damages.

If an employee seeks employment at a new firm and the prior employer interferes with the employee's ability to transfer his/her book of business to the new firm, the employee may have a legal right to seek damages for potential wrongful conduct.

Often an employer will make promises to induce an employee to join the firm. If an employee was made false promises, he or she may have a legal claim of fraudulent inducement of the employment relationship.

A terminated employee may have a right to compensation under the employer deferred compensation plan or stock option plan.

If an employee over 40 or female employee are terminated in a way that reflects age or sex discrimination, there may be a legal claim against the employer.

It is important to understand that these tips are general in nature. They may or may not apply to your situation, so do not rely on them in lieu of legal advice from an attorney in your area.

THE BURSTING OF YET ANOTHER WALL STREET BUBBLE

2007-11-01T11:54:00.000-04:00

The Wall Street Journal's lead editorial yesterday "Wall Street Reckoning," should be must reading for investors. It warns that while Merrill Lynch rightly came clean with its structured investment losses, "some other big banks haven't been so candid." The editorial adds: "We suspect some of the tightest white collars these days are over at Citigroup, America's largest bank and one with some of the biggest subprime exposure. Something like $80 billion worth of so-called ‘structured investment vehicles' sold in Citi's name are wobbling, yet the bank is doing all it can to avoid absorbing those losses on its own balance sheet."

The story is eerily all too familiar: A corporation plays fast and loose with the valuation of its assets hoping its "strategic investments" will finally pay off. But the real value of the investments continue to plummet and the truth must finally be revealed.

Presto, another bubble bursts.

Hocus pocus accounting played a significant role in the collapse of some dot.com companies. But the accounting shenanigans were initially touted by Wall Street. Consider an April 2000 Salomon Smith Barney reseach report on "March First," an internet and technology services company that ultimately went bust.

Over the last decade the most common valuation method for technology providers has been P/E multiples relative to the projected growth rate. However in late 1999, the investment community adopted revenue multipliers as a valuation methodology for the Internet and Technology providers...The application of revenue multiples led to record valuation metrics for some ITS providers, particularly those with fast revenue growth and limited earnings projections.

Avoiding a liquidity crisis was likely Enron's motivation when they orchestrated the Nigerian barge transaction with Merrill Lynch or when telecom firms engineered sham "revenue swaps" at the end of quarters to meet Wall Street expectations. There is no barge or revenue swaps in today's market, but there is the Paulson-blessed "super-conduit" fund that will supposedly buy up the bad debt and hopefully allow banks to avoid their day of reckoning.

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

2007-10-19T11:47:00.000-04:00

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

2007-10-16T15:10:00.000-04:00

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...

2007-10-08T12:05:00.000-04:00

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.

Paulson Committee Backtracks

2007-09-26T16:44:00.000-04:00

After standing firm on limiting (read: doing nothing) hedge fund regulation, the President’s Working Group on Financial Markets has apparently caved under international pressure...well, kind of. The Wall Street Journal reports that though earlier this year the group said current regulations were sufficient to prevent hedge funds from threatening the financial system’s stability, they will create two new advisory groups to develop voluntary "best practices" guidelines for investors in hedge funds and the managers that run them.

Apparently the pressure comes from German Chancellor Angela Merkel and French President Nicolas Sarkozy; neither of whom can be regarded as anti-capitalists. It remains to be seen whether the committee can whitewash their concerns as they have with U.S. investor advocates, given that the response will be to ask (politely I’m sure) hedge fund managers and investors to voluntarily adhere to meaningless guidelines on disclosure and due diligence.

Another issue the two subcommittees will discuss will be valuation, a lightening rod issue on Wall Street. Hedge funds love the mark-to-model method that allows them to use their own fuzzy math to determine the value of their portfolio, and consequently their 20 percent take of the returns. The more acceptable method is the mark-to-market, where a financial instrument’s value is based on the current market price.

When it comes to valuation methods, disclosures and due diligence, voluntary guidelines aren’t enough. Wall Street has been down this road before and it didn’t work. Stock analysts were supposed to adhere to best practices and we all know how that story ended. Already major hedge fund blow-ups have occurred, most notably at Bear Stearns which faces litigation, including several claims filed by Zamansky & Associates on behalf of investors. This trend is sure to continue so long as Wall Street is allowed to make up its own rules.

“Our Clients Interest Come First” – Goldman Sach’s tagline

2007-09-11T14:11:00.000-04:00

Goldman Sach’s tagline comes to mind while coming across a story in Friday’s Financial Times (subscription required). Apparently, the white shoe investment bank raked in some $300 million in profits from the $2 billion it injected into its failing Global Alpha and GEO hedge funds along with several partners including Hank Greenberg, who was just interviewed by the SEC concerning his involvement in possible wrongdoing at A.I.G. On the other hand, the investors in the hedge fund are still reeling from losing 23% of their original investment.

This situation truly is an example of “Wall Street versus America,” which is also the title of a highly recommended book written by Gary Weiss, a former investigative reporter at BusinessWeek and prominent blogger. Gary’s book dedicates several chapters on hedge funds and opens chapter nine with the following passage:

It happens when you least expect it. You may be at an alumni reunion where people are drinking too much, or perhaps you are at a party that you know you should have skipped. A “financial consultant” or “advisor” sidles up to you near the munchies, asks a few innocent-sounding questions, and purrs gently, “So…that means you are an accredited investor! Now I have at my office a numbered offering memorandum I can send right over to you for the Millennium Partners Variable-Interest Market Neutral Alpha Partners Partnership III.”

If anyone ever says that to you, take the nearest crudités and eject them firmly in the direction of the offending words. If bodily injury results – well, any jury would call it self-defense.
Hyperbole aside, Weiss’ book is actually a balanced look at alternative investment strategies and I wrote a review of it for the Daily Deal here. But whatever the advantages or disadvantages to investing in hedge funds, they are in the business to make money for themselves - first and foremost. You, the investor, are only a means to that end.

And, above all else, hedge funds fiercely guard their privacy when it comes to investment strategy. Investors in Goldman’s hedge fund likely did not have access to the minutia of the Global Alpha and GEO funds’ strategy, so they probably didn’t have any way to effectively gauge whether to pull their money out or leave it in the fund. Goldman Sachs likely did and saw an opportunity. Careful to share the risk when it comes to their own proprietary investments, Goldman was even generous enough to share it with billionaire Wall Street friends.

Low and behold the timing was brilliant and they all made money while investors on the outside are left wishing they bought into Goldman Sachs’ shares and not its hedge fund. Just another case of “Wall Street versus America.”

Dirty Laundry Stowed…For Now

2007-09-07T13:15:00.000-04:00

As I posted before, Governor Spitzer was between a rock and a hard place when it came to Darren Dopp, his aide that was placed on “indefinite” leave after the Trooper Gate story broke. Spitzer could either run Dopp off the reservation and risk him airing the Gov’s dirty laundry or hire him back and face a severe credibility question. As it turns out, the dirty laundry was scary enough to warrant rehiring Dopp, likely near his old salary of $175,000 per year.

If you flash back to August 3rd, Dopp’s lawyer did some clever public relations work and made sure reporters included in their stories that Dopp felt he was being scapegoated for the scandal and is willing to testify.

“What happened to Darren is just not fair,” said Dopp’s lawyer. “Darren is getting screwed.”

No sir. The people of New York are.

New Twist on an Old Rule

2007-08-20T17:00:00.000-04:00

Generally speaking, banks and other financial institutions extend themselves far beyond the amount of cash they actually have on hand. They keep just enough around to handle the normal influx of clients wishing to make withdraws. So there’s nothing scarier than an old fashion “run at the bank” and thats exactly what’s going on at many hedge funds these days…with a twist.

The latest hedge fund to undergo a rapid collapse is Sentinel Management Group, who describes itself as a “cash management firm.” Perhaps that’s a misnomer because once a few clients got wind of downward pressure on some of Sentinel’s investments, they started to pull out.

Apparently to fund the early redemptions, the firm made a deal with Citadel Investment Group, another secretive hedge fund. Citadel bought the most valuable of Sentinel’s investments at a major discount; some are saying as much as 30 percent.

Issuing more redemptions may have been a noble cause, but hedge funds have many different investors with different agendas. Institutional investors may have longer time horizons and are willing to sit through downturns, while high net worth individuals panic when their net worths are at stake. Such was the case with Sentinel Management. Several clients were large money management funds who didn’t take kindly to Sentinel selling its most valuable assets. Here’s the statement from one fund that had a stake in Sentinel:

"Based on what we have heard of the proposed terms, we believe that this sale occurred at discounts of up to 30% from market prices. This portfolio consisted of short term AA or better corporate bonds or US government agency bonds, as required under CFTC rules. We believe that to liquidate such a portfolio at such a discount to market value constitutes, among other things, a reckless disregard of industry fair practice responsibilities by all parties involved."

The lesson here is that an old fashion run on the bank has an equally damaging effect on hedge funds as it does on traditional banks. Furthermore, the Sentinel collapse shows that there are diverging interests at play and in seeking to appease one investor a hedge fund may be hurting another. The breaking news now is that the SEC will bring charges against Sentinel. The firm is accused of misrepresenting the true reasons for the collapse, which may not have been redemptions but excessive use of leverage.

Either way, the latest hedge fund collapse shows that the blood bath isn’t over on Wall Street. Bear Stearns, Goldman Sachs and many others likely to come show that the Wild West days are coming home to roost and investors are the ones taking the hit.

Trader Monthly Coverage

2007-08-16T16:00:00.000-04:00

CNBC’s Charlie Gasparino wrote a great story on Zamansky & Associates in the latest issue of Trader Monthly. So good in fact that it was picked up by The New York Times’ reporter Andrew Ross Sorkin on his high profile blog: www.dealbreaker.com Here’s the direct link: A Plaintiffs’ Attorney Takes His Client List Upscale

Time to Reassess Your Hedge Fund Investment?

2007-08-16T10:45:00.000-04:00

Ultra high net worth investors are understandably nervous these days about their investments in hedge funds. Whether they have a clear idea of how their money was invested or not, many are thinking it may be time to get out. More poignantly put by a guest today on CNBC, “if you don’t know what you are in, it might be time to sell.” As with any asset bubble, the dirty laundry gets aired when the market goes sour and the hedge fund industry has not escaped this trend.

For example, our clients who had investments in the collapsed Bear Stearns hedge funds allege that the fund managers misrepresented the quality of investments and risk controls in place. The troubles which allegedly surfaced when Amaranth lost a sizable chunk of its investor’s money revealed a trend known as “style drift;” when managers go outside of the fund’s stated strategy.

Unfortunately, when a hedge fund struggles often times investors are the last to know. This is because hedge funds are very lightly regulated and lack transparency. When they do struggle, a hedge fund managers’ interest is not always aligned with the investors’. The manager’s goal is to prevent a “run on the bank” and use his/her trading skills to get back to a profitable position. This is like the gambler who lost money at the black jack table but thinks the next hand will turn his luck around.

So what then, is an investor to do? Knowing redemption policies is a start. Many times an investor must inform the hedge fund of his/her intention to pull out of the fund in writing weeks ahead of time. In fact, many hedge funds require 45 days notice and redemptions are only available at the end of the month, therefore today is the earliest time a redemption can be requested. Today’s Wall Street Journal covered redemption policies and warned of pulling your money from a fund for fear of being sued by those who incurred losses by not getting out in time. This is a concern.

Secondly, investors should participate in every conference call, take notes and always ask the hard questions. Investors are entitled to honest information about a hedge fund’s investments, risk management and asset valuation methods. Investors should be extremely worrisome if any investment schemes drift away from the originally stated strategy. This could be indicative of troubled waters.

If a loss is incurred and the potential for misrepresentation and/or “style drifts,” or outright fraud exists, it’s important to act fast and consider contacting regulators and pursuing your own legal action. Sometimes the venue will be a settlement negotiation, while other times fund managers may be pursued via securities arbitration or the court system.

Remember, even wealthy investors have rights and fraud is illegal no matter who the victim is.

Bear Stearns Hedge Fund Update

2007-08-10T11:11:00.000-04:00

Bankruptcy Judge Burton R. Lifland is scheduled to rule on August 27 where Bear Stearns’ two bankrupt hedge funds will be liquidated – in the Cayman Islands or New York.

Bear Stearns wants the funds liquidated in the Cayman Islands, where the funds were incorporated. But most of the assets of the funds are based in New York, so creditors may want the liquidation to take place in Lifland’s court.

Bear Stearns knows Judge Lifland quite well. The judge earlier this year ordered the firm to pay nearly $160 million to investors for failing to properly supervise Manhattan Investment Fund, one of the hedge funds it cleared trades for. Lifland also ruled that $121.1 million of transferred payments be returned to investors with interest. If Lifland decides to keep the case in his court, he could conceivably order Bear Stearns to return the millions of dollars in collateral it seized from its failed hedge funds before they collapsed.

Bear Stearns to Its Hedge Fund Investors: Walk the Plank

2007-08-06T14:24:00.000-04:00

Today’s Wall Street Journal story on the continued unraveling of the Bear Stearns hedge funds include an easily overlooked item that deserves added scrutiny. When Wall Street executives outside of Bear Stearns pressured the firm to provide its two capsizing hedge funds with added liquidity, senior management initially balked. According to the Wall Street Journal, “Bear Stearns executives felt they shouldn’t feel obligated to lend money to a fund whose operations were separate from Bear Stearns’, and whose investors were knowledgeable about the risks.”

Forget for a second Bear Stearns’ apparent contempt for its clients, but one of the arguments we will be making on behalf of our clients who invested in these funds will be material misrepresentations of risks and investments: so investors were never truly “knowledgeable” in the first place.

Clearly rather than spend the money that usually goes into end-of-the-year bonuses, Bear Stearns preferred to throw investors overboard figuring these wealthy clients would land safely. But it doesn’t matter if you’re rich or poor, a sophisticated investor or not, you are entitled to honest information about your investments.

To view recent coverage of our case against Bear Stearns, please click here.

Spitzer’s Wall Street Playbook

2007-08-01T17:38:00.000-04:00

If there’s one thing we can be assured of when it comes to Eliot Spitzer, it’s that he’s an intelligent man with a long memory. That would likely explain the announcement to put communications director Darren Dopp on “indefinite leave” in the wake of the Joe Bruno smear scandal.

Spitzer’s sacrificial lamb actually brings to mind the Wall Street executives who escaped Spitzer’s wrath for their mutual fund market timing practices by paying menial fines and scapegoating lower level employees. The dismissed employees, some of whom are my clients, were tagged as rogue traders and will likely never work in the securities industry again. After the dust settled, it was back to business as usual on Wall Street while Spitzer sought out the next headline.

Wall Street’s strategy for weathering the market timing storm wouldn’t have been lost on a shrewd guy like Spitzer, which is probably why Dopp was placed on “indefinite” leave and not fired outright. Spitzer, and maybe Dopp himself, likely thought that once the scandal ran its course that in time Dopp would come back under the tent. But there are a few key differences between Wall Street’s scapegoating and the Dopp dismissal. First off, Dopp was not a low level employee. Likewise Dopp can’t be tagged as a rogue since he’s been Spitzer’s right hand man since the “press not prosecution” days in the AG’s office. And finally, the smearing scandal has not turned the other cheek the way Spitzer’s market timing “investigation” did.

So this leaves Spitzer in a difficult position: does he risk a guy like Dopp, who knows where the bodies are buried, wandering off the reservation or does he re-ignite the scandal by re-hiring his long time foot soldier? Frankly, it doesn’t matter because either way Spitzer’s true colors will be exposed; he’s a politically motivated man who cares not what’s in the greater good so much as destroying the opposition. If the smear scandal cause irreparable damage to Spitzer’s political fortunes, he clearly has what it takes to make it as a senior Wall Street executive.

Wall Street: The More Things Change…

2007-07-13T13:47:00.000-04:00

Two seemingly unrelated issues cropped up recently which may have more to do with one another than meets the eye. One the one hand, the Wall Street Journal reports that a Bear Stearns analyst was absurdly bullish on the sub-prime mortgage market that his bank’s proprietary trading desk, clients and hedge funds were so heavily invested in. On the other hand, the market shook when the two major bond rating agencies, Moody’s and Standard & Poor’s, finally lowered the ratings on hundreds of bonds backed by risky mortgages.

Regarding both the analyst and rating agencies, there could be conflicts that would explain the performance breakdowns, which left all those who rely on their good judgment high and dry. In the Bear Stearns case, even the most outspoken Wall Street apologist has to be questioning whether the analyst’s bullish views on mortgage back securities had something to do with the bank’s own investments. To be sure, Bear Stearns categorically denies this. The firm said in a statement of their analyst: “Gyan is a top analyst with a distinguished track record, and we stand by the quality of his work.” Even still, according to reports, Bear Stearns conveniently hired a new mortgage industry analyst and based upon how the bank treats its departing employees as shown here, if I was Gyan I’d be worried about my future on Wall Street.

Analyst conflicts are nothing new, but the latest wrinkle is the role of the ratings agencies in the collapse of the CDO market. According to a recent study co-authored by Josh Rosner, a consultant at Grahman Fisher, an investment research firm, and Drexel University finance professor Joseph Mason, ratings agencies have become too close to the deals they rate and thus have opened themselves up to liability.

The authors of the study contend that unlike traditional corporate bond rating, in structured finance deals like mortgage backed securities, “the rating agency is often an active part of structuring the deal” and would be considered an underwriter like the Wall Street bank packaging the securities bond portfolio for sale to investors.

A further conflict is that as the popularity of CDO’s grew, so did the demand for the bond ratings. The more attractive the ratings were, the more ratings requests would come in, ultimately making this sector highly profitable for Moody’s, S&P and others. Assuming the secondary market took off right after the tech bubble went bust Moody’s stock price soared from $11 in January of 2001 to a $76 high in 2007. Now the stock trades for around $60 per share.

Analysts credit the surge in Moody’s stock to the CDO/structure finance market. According to the Wall Street Journal, John Neff, an analyst at Chicago-based investment bank William Blair & Co., expects Moody's total revenue from structured finance in 2005 to have reached about $681 million, up 24% from 2004 and accounting for about half the company's ratings revenue. McGraw-Hill Chief Executive Harold McGraw III cited structured finance and the CDO market as major areas of growth for S&P.

The common thread is that conflicts are not being managed carefully enough in the financial services industry. This reflects a continued culture led by hard charging, “Greed is Good” managers; ones that the industry tries to pretend are a thing of yesteryear. Put a different way, from a view of 20,000 feet, this sure feels a lot like 2000.

Oh, and one other thought. Moody’s and S & P favorably viewed Enron bonds four days before its bankruptcy. Here’s to hoping the situation isn’t totally analogous.

Mortgage Fraud: East Coast, West Coast and Everywhere in Between

2007-07-09T19:34:00.000-04:00

Last Thursday’s Wall Street Journal discovered on the West Coast what we already knew on the East Coast: that mortgage brokers could be a key part of the unraveling of the sub-prime mortgage market. Undoubtedly there are more examples in between the two coasts and other places to lay blame, but what the article and the Dawson "mortgage fraud" case shows is how the mortgage origination business is, as Chuck Schumer puts it, is like "the wild, wild west."

Origination companies are likely getting more attention these days then they might wish. Not only is Schumer pushing for new regulations governing everything from background checks to establishing a fiduciary standard for brokers, but the New York State Attorney General’s office is looking into the matter as well.

This should come to the brokers as no surprise because they are apparently unwilling to police themselves. Statements from the National Association of Mortgage Brokers seem totally off the mark if the goal is less regulatory scrutiny. Their strategy is to point fingers: "There’s plenty of blame to go around," says Joseph Falk, the association’s legislative guru of the sub-prime mortgage collapse.

He may have a point, but there’s a reason mortgage brokers are known as "originators," so perhaps the problem originates with them.

Hedge Funds Have Finally Pressed their Luck Too Far

2007-06-25T16:44:00.000-04:00

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

2007-06-21T10:23:00.001-04:00

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?

2007-06-20T14:41:00.000-04:00

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

2007-06-11T15:39:00.000-04:00

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.

Negative Reinforcement Out; Positive Reinforcement In: Spitzer’s Got a Committee of His Own

2007-05-31T14:20:00.000-04:00

In the most unsurprising press release of the year, Eliot Spitzer announced that he too has commissioned a committee to “identify ways for New York to retain and enhance its status as a world financial capital.” Apparently the headlines Treasury Secretary Hank Paulson was receiving for his three – count ‘em – three committees were too much to pass up.

The creation of all these committees seems to ignore the powers of globalization. Of course New York has lost some of its market share because other financial centers are rapidly developing. Not the least of which is Beijing and if you think the regulatory environment in China is a good model then apparently you haven’t been reading Herb Greenberg’s blogs about the shady accounting procedures practiced at publicly traded Chinese firms. See here, here, and here. Further, more and more companies actually are choosing to list on the New York Stock Exchange. Even today, the U.K.’s largest hedge fund manager, Man Group, choose to publicly list several of its larger funds with the New York Stock Exchange.

But aside from the myth that New York isn’t a competitive financial hub, I do believe there are ways this commission can help investors and brokerages. An abbreviated list goes as follows:

     - Completely restructure securities arbitration. For specifics, you can read my previous blog here.
     - Affirm the right to use SEC Rule 10b-5 in private investor civil cases. Again, for specifics read here.
     - Encourage the NASD to adopt a “qualified” privilege rule covering information inserted into a departing brokerage employee’s Form U-5 and put an end to Wall Street scapegoating and defamation of employees. I won’t hold my breath since Spitzer in part created this problem to begin with. Need evidence? Click here.

Spitzer’s committee is to report its findings and recommendations on June 30, 2008. Hopefully after a year of spending taxpayer’s money, the committee will actually accomplish something for them and not reward Wall Street for its past misdeeds.

Cox’s True Scheme to be Revealed

2007-05-31T11:59:00.000-04:00

It finally will come to a hilt. Christopher Cox, Chairman of the SEC, has to make a decision. Is he a friend to big business and corporate interest as his record in the U.S. Congress has shown, or is he a champion of the individual investor as he claimed in his Senate confirmation hearings? We shall see well enough as he must decide whether to file an amicus brief with the Supreme Court weighing in on whether the SEC advocates so-called “scheme liability.” Scheme liability means that after a major corporate fraud is uncovered, other players who may have participated in the fraud share in the liability and may be sued under SEC Rule 10b-5.

The stakes cannot be higher. There are still many victims of dot-com-era fraud who haven’t been able to recoup their losses because the Enron’s of the world are no longer liquid. The liquidity exists with the vendors including the brokerage houses that assisted in hiding transactions, law firms that advised fraudulent deals to hide losses and accountants that swept substantial profit shortfalls under the carpet. In many cases the fraud that brought down Enron, HealthSouth, and WorldCom was the brainchild of a consultant, or at the very least was blessed by outside vendors who charged fat fees for their rubber stamps.

Chairman Cox is no fan of class action law suits and was a champion of tort reform while in Congress, which makes his decision hard to predict. Ever the optimist, I have to believe he’ll keep his promise to investors and ask the court to establish a precedent that broadens the liability to the Wall Street fraudsters that should have gone the way of Jeffrey Skilling and Bernie Ebbers in the first place. It is indeed a defining moment.

Third Times a Charm!!!

2007-05-29T14:48:00.000-04:00

No one would mistake me as a fan of Treasury Secretary Henry Paulson or his committees aimed at increasing Wall Street’s competitiveness regardless of the cost to individual investors. Not surprisingly, I was skeptical when I learned of last week’s announcement from the Treasury that it was creating yet another committee, this one with the directive to study problems in the accounting industry.

However, I must admit I was encouraged to learn that former securities chief, Arthur Levitt will be leading the new committee’s efforts. It’s no secret that Mr. Levitt doesn’t think Paulson’s concerns over Wall Street’s competitiveness hold much weight and has in fact made public comments questioning the soundness of proposals that would limit investors’ rights to sue. As Alan Murray writes in Wednesday’s Wall Street Journal “perhaps Paulson sees this as a harmless way to bring the outspoken Mr. Levitt onto the team, and soften his criticism.” Whatever Paulson’s reason for appointing Levitt as co-chairman, I’m encouraged to know that there’s at least one committee member who’s looking out for the rights of investors; not to mention, the Levitt Committee just has a nicer ring to it.

Paulson suggested in an op-ed that appeared in the Financial Times on May 17th that the committee is intended to be a public forum where “investors, advocates, and companies can present a wide range of views, engage in informed debate and provide recommendations.” In the hopes of ensuring that ordinary investors are protected, I decided to take him up on his offer and have submitted a request to Treasury Under Secretary Robert Steel to see if there’s an opportunity for my involvement. Stay tuned.

The Absent Minded Professor

2007-05-24T12:03:00.000-04:00

Columbia law Professor John Coffee seems to be unfamiliar with the classic movie, “The Absent Minded Professor” despite appearing to be the real world embodiment. To wit: on Wednesday, the Financial Time’s Patti Waldmeir wrote an article making the case that the SEC needs to combat frivolous investor lawsuits. In particular, comments from Prof. Coffee caught my eye:

“[Coffee] says current law wrongly immunizes secondary participants in fraud – such as banks and accountants. The SEC used to believe that guilt should be spread to all those who actively helped perpetrate a fraud – and it will shortly have a chance to prove whether it has changed that position.” (Financial Times May 23, 2007)

In a previous blog post, I showed that Prof. Coffee has made clear that he advocates preventing class action securities lawsuits and arbitration claims from arguing violations of SEC Rule 10b-5. He thinks the SEC should be the sole user of the so-called “Securities Fraud Rule.” This is a catch-22 for investors.

On the one hand Prof. Coffee’s tying the hands of investors by preventing the use of Rule 10b-5, and then on the other he’s admitting the SEC may not have the appetite to seek retribution against fraudsters like Enron’s bankers. Who’s looking out for the little guy then?

Further Prof. Coffee’s legal career includes helping lawfirm giant Vinson & Elkins evade punishment after they allegedly assisted former Enron CFO Andy Fastow hide illegal personal profits from offshore partnerships in order to deceive shareholders. Apparently banks and accountants who enable fraud: bad…law firms that enable fraud: good.

Absent minded indeed!!

The Wall Street Shell Game – Wanna Play?

2007-05-21T12:07:00.000-04:00

Recently, The Wall Street Journal buried a story about a settlement reached between the SEC and Morgan Stanley. The SEC found that after retail investors in their Private Wealth Management unit placed an order to buy a stock, Morgan Stanley would quote them a marked-up price, usually no more than a penny more than the stock’s actual price. According to the article, Morgan Stanley would do this on a massive scale and profit handsomely.

But that gain is likely only one of three profit centers Morgan Stanley and other major Wall Street brokerages are making off the backs of high net worth retail investor clients. The real profits exist on a much darker and sinister level. It’s known in the industry as getting a “threefer,” and the ease at which the scheme is carried out is a result of the erosion of the specialist floor broker at the New York Stock Exchange and the rise of aptly-named “dark pools.”

The easiest way to understand the “threefer” is to consider this scenario:

A major Wall Street brokerage accepts a sell order from a retail investor for 10,000 shares of a thinly traded stock. Revenue stream number one comes from the fee the retail investor must pay the brokerage to sell the stock. The brokerage then enters into what is known as “the dark pool,” where the hedge fund sharks swim. Avoiding any stock exchange or floor trader, the brokerage and the hedge fund negotiate a trade. The brokerage then marks up the stock price representing revenue stream number two and the penny markup represented in the WSJ article.

The hedge fund now sells 9,000 shares and keeps 1,000 in its own portfolio. So, the hedge fund turns back to the brokerage to execute the order via the brokerage’s pipeline to a major exchange. The hedge fund pays a fee for the pipeline to the brokerage, which completes the “threefer,” but the illicit profits don’t end there.

Why would a hedge fund make profitless trades and pay a major Wall Street brokerage for the trouble? Well, when the hedge fund buys the stock, it will be executed through a program in 1,000-share increments usually reducing the stock’s price by a few cents. Once the trade is complete, the hedge fund will ride the stock back up using the 1,000 shares it kept, sometimes increasing its stake if the arbitrage gains are significant enough. The scheme is virtually risk free and equates to a license to print money.

Worse yet, the above scenario occurs all day everyday in plain sight and is a major reason hedge funds can produce outsized returns. High net worth investors are most susceptible because their buy and sell orders are large enough to affect stock prices.

Every investor, whether institutional or retail, is entitled to the “best execution” of his or her buy/sell orders, meaning the best possible price. Institutional investors buy and selling huge positions so they are less likely to be taken advantage of because they’ll check the data.

How can a retail investor do the same? Morgan Stanley and all brokerages are actually required to disclose where a trade was executed. The rule requiring them to do so is SEC 606. The disclosure comes in the form of the confirmation document your brokerage will send to you, usually buried somewhere in the ninth or tenth item. You might see four letter acronyms representing the other market participant. Ask your broker for details on these mysterious four letter words.

If they won’t tell you or do come clean and the four letter acronyms represent a hedge fund or other firm with a proprietary trading desk, you’ve probably fallen victim to Wall Street’s secret little shell game.

So what’s the harm here? The rich-guy investor only paid a penny a share more. No harm no foul, right? Think again. The stock market is based on the principle that a stock price is the reflection of the way the market views it at a particular time. The Wall Street shell game creates a manufactured price. If there’s no guarantee that a stock is priced at market value, then the market will lose confidence, which is bad for investors big and small.

Better Late than Never: Wrap Accounts Finally Wrapped-Up

2007-05-17T11:33:00.000-04:00

Thankfully, a federal court has put an end to the free wheeling ways Wall Street treats wrap accounts, also known as the “Merrill Lynch rule,” and this week the SEC announced it will not appeal the decision. Two years ago I published this article in the “Wall Street Lawyer” arguing that the transition from commission-based brokerage accounts to fee-based, or “wrap accounts,” opened up the door for more Wall Street shenanigans. The switch-over was actually well-intended and sought to curb churning for commissions on frequent trading. But churning was replaced with other unscrupulous activities.

For example, Wall Street brokers would convince their clients to double-up assets on margin when a hot stock tip came down the pipe, then charge the 1-3 percent fee based on the client’s gross assets. So someone with a $1 million account would borrow another $1 million to increase profit on a surging tech stock. The broker then charges a fee based on the $2 million, unfairly doubling the fee. Then there’s the “hit and run” brokers who open up wrap-accounts, convince client to buy some speculative stocks and disapear while their client’s assets deteriorate.

By over-turning the Merrill Lunch rule, the court decided that brokers who offer fee-based accounts must register as investment advisors with the NASD and accept “fiduciary” responsibility for their clients. This means brokers now have to put a client’s best interest first (the horror!) and on an on-going basis monitor client trading and make active recommendations reacting to market volatility and a client’s changing risk tolerance (such as a client’s financial circumstance).

What I find most interesting in all this is the shock and horror from Wall Street. Merrill Lynch sent a memo to its legion of brokers saying that it “strongly disagrees with any action that would end fee-based accounts.” The Securities Industry and Financial Markets Association (Sifma), Wall Street’s main lobbying group, calls the decision “an outrage.” Is it so outrageous to put a client’s interest ahead of your own? Wall Street’s outrage is actually somewhat comforting. Finally they are publicly admitting that a client’s best interest play second fiddle to their own.

Paulson Committee’s “Hippocratic Method”

2007-05-16T09:25:00.000-04:00

In case anyone doubted the hypocrisy of Treasury Secretary Hank Paulson’s Committee for Capital Markets Regulation, just take a look back at an op-ed published this week in the National Law Journal by Lawrence A. Cunningham, a Boston College Law School professor and leading expert on corporate governance and securities law.

One of the overarching hot-button issues is whether Wall Street and Corporate America should be governed by a “rules-based” or “principles-based” system. Professor Cunningham writes that while on the one hand the Paulson Committee lobbies for an overarching “principles-based” system on the other when an already established principle works to their disadvantage they urge specific language and rules - distancing industry wrongdoers from liability. In other words, the Committee is trying to have its cake and eat it too.

The most egregious example is the Committee’s full scale assault on SEC Rule 10b-5. Rule 10b-5 is a well established “legal principle” that prevents firms from making “false and misleading material statements” and is the basis for which many investor arbitration claims and class action securities lawsuits are filed. While simply telling the truth might seem reasonable, the Committee wants “detailed prescriptive language” to reduce what it considers “uncertainties” with the principle. Translation: they want to make it harder for investors to prove Rule 10b-5 was violated. Committee consultants are already on the record arguing that the rule should not be used in civil trials and arbitrations whatsoever, as my previous blog points out.

Abandoning an established legal principle like Rule 10b-5 and reversing its course in favor of more stringent standards, Paulson’s committee audaciously undermines its own reasoning for deregulation. And Rule 10b-5 is only one of a slew of examples where the Committee favors rules that insulate themselves from the legal system.

Among other examples of duplicity, Cunningham cites the Committee urging the SEC “to abandon its recently stated principle that ‘materiality’ is not a strictly quantitative concept and return to the erstwhile rule that measured materiality in terms of 5 percent of income.” This legalese basically means that fraud is only truly fraud if it equates to 5 percent of a company’s income. The “materiality” argument, mind you, was one of the defense strategies employed by Enron’s Ken Lay and Jeffrey Skilling.

Choosing when and where to apply legal principles based upon the investor’s ability to recoup fraudulently incurred losses shows the Paulson committee’s true motivation is greed. Kudos to Professor Cunningham for helping to expose the Paulson Committee’s “Hippocratic Method.”

A Figment of Paulson's Imagination

2007-05-09T14:52:00.000-04:00

It’s strange that Hank Paulson and the Committee on Capital Markets would want to scale back investor protections and regulations, when the hands of the judicial branch are already tied from acting upon the securities industry’s transgressions. Take for example this op-ed by Harold Myerson in Tuesday’s Washington Post,
showing how Merrill Lynch, Barclays and Credit Suisse First Boston were granted near immunity for enabling Enron to cook the books by a Federal Appeals court, despite the judges’ opinions that the banks’ actions were less then honorable.

The decision’s highlight is what Judge James Dennis wrote in the concurring opinion: "The majority immunizes a broad array of undeniably fraudulent conduct from civil liability…effectively giving secondary actor’s license to scheme with impunity, as long as they keep quiet." In other words, you can rob the bank so long as the driver takes the fall.

The ruling revolves specifically around Rule 10b-5 which prohibits companies from making misrepresenting statements leading to the purchase or sale of securities. This rule is crucial to many class action securities suits as well as arbitration claims, so any tinkering can have far reaching implications.

The Committee on Capital Markets has remained ambiguous on its true intentions regarding 10b-5, they just want to "resolve existing uncertainties in Rule 10b-5 liability" Paulson Committee adviser, and Wall Street advocate Prof. John Coffee however has been a little more forthcoming. Back in October, Coffee mentioned to the New York Times (October 29, 2006) that, "he had recommended that the S.E.C. adopt the exception to Rule 10b-5 so that only the commission could bring such lawsuits against corporations." With arbitration and class actions out of the way, the already swamped SEC will be the last investor protection. Who benefits when that happens? Certainly not individual investors.

The real question is, where is the over burdensome legal proceedings that is the object of Committee on Capital Markets whining? With the judicial branch arguing that laws currently let crooks off the hook, it seems to be a figment of Paulson & Co.’s imagination.

Calling into Question the Committee for Capital Market Regulations True Motivations

2007-05-08T12:19:00.000-04:00

Today I spoke before the National Association of Securities Administrators Association on Wall Street’s greedy efforts to scale back Enron-era corporate and securities regulation. I’ve posted my speech here.

For the life of me, I can’t figure out how Paulson’s committee is arguing for the deregulation of reforms that are targeted at curbing their own indiscretions. To put it another way, this is like Pete Rose asking Major League Baseball to sanction gambling on games!

FACTS vs. MANAGEMENT SPIN

2007-05-04T12:30:00.000-04:00

Having been the catalyst that sparked Wall Street’s $1.4 billion settlement for conflicted research, the quality and accuracy of the Street’s equity coverage is understandably a subject near and dear to my heart. That’s why I nearly choked on my morning breakfast earlier this week when I read the following comment by Andy Kessler, a former Wall Street telecom analyst, about a Banc of America Securities analyst who had the temerity to initiate coverage on about a half dozen pharmaceutical stocks without talking to management.

Initiating coverage without speaking to management "is absolutely pointless for a money manager," Kessler opined to the New York Post.

I beg to disagree.

Disgraced analysts Jack Grubman and Henry Blodget were "tight" with the managements they covered, and we all know about the quality of their work. A more recent example is some divergent coverage on Circuit City, the once darling stock that has imploded.

An obscure research outfit called Rate Financials, which maintains a strict policy of not talking to management, warned investors about the perils of investing in Circuit City nearly 10 months ago. Meanwhile, two prominent retail analysts, Gary Balter of CSFB and "independent" analyst Dana Telsey, were touting the stock. Balter and Telsey apparently had close ties to –and apparently were blinded by -- Circuit City’s management.

Here are the facts I’ve garnered based on published news reports and some of my own research:

Rate Financials last July issued a critical report on electronics retailer Circuit City (NYSE:CC), claiming the company wasn't properly accounting for lease obligations and that earnings were generated almost entirely from the sale of extended warrantees and not from profits earned on peddling electronics. At the time, Circuit City was trading at around $26 a share.

Balter, who in September had an "outperform" rating and a $35 price target on Circuit City shares, didn’t take kindly to Rate Financials’ report after it was highlighted in a September article in the Wall Street Journal. Balter issued a critical report on Rate Financials’ analysis that included this admonition: "Circuit City stock rose 54% in 2004 and 44% in 2005. Which side of the trade would you want the sell side to be on?"

Telsey’s affection for Circuit City was disclosed in a December 14, 2006 article in Fortune magazine, where she included the retailer as being among the nine companies showing "the most near-term promise" of the 38 retailers she covers. Interestingly, Telsey on her website trumpets that she is in "front of the executive management of the most influential companies," and that she speaks "directly with the sales associates in the stores." Telsey told Fortune she had a $30 to $32 price target on Circuit City.

Investors who heeded Rate Financials’ warning fared well. Circuit City last month, announced significant decreases in earnings estimates, fired its CFO, and terminated its most experienced sales staff (presumably the staff Telsey was talking to). And guess what? Contributing to the loss were decreases in warranty sales and lease obligations. Circuit City dropped a second shoe earlier this week by announcing yet another profit warning.

Circuit City now trades at around $16 and change. Balter has cut his rating on the stock to "neutral" from outperform and now has an $18 price target. No public word on Telsey’s view on the stock.

Here are some other interesting facts worth noting.

Rate Financials apparently isn’t a one-trick pony. In August of 2005, Calpine Corp. issued a special press release denouncing a Rate Financial’s report calling into question its accounting procedures. By December, Calpine had declared Bankruptcy.

Fortune readers who acted on Telsey’s stock recommendations haven’t fared too well. Her basket of recommended stocks are up 3.3 percent since the article was published, while the S&P Retail Index is up 4.3 percent. Perhaps Telsey should spend a little less time talking to managements and sales clerks and learn how to read the fine print in publicly disclosed documents.

Sadly, Rate Financials research is costly and beyond the reach of individual investors, providing another case in point as to why the markets are stacked against them.

Evidence Grows Proving Wall Street Deregulation is Bogus

2007-04-30T14:47:00.000-04:00

I came across the latest piece of evidence that supports the regulatory status-quo on Wall Street while catching up on some weekend reading. The latest issue of Barron’s has a column from Arindam Nag which covers the impending IPO of ManFinancial, the brokerage unit of ManGroup, a powerhouse UK-based financial services firm. Interestingly, the firm’s management has chosen to list the offering on the New York Stock Exchange, as oppose to the London Stock Exchange. I guess contrary to Paulson’s Committee on Capital Markets Regulation’s arguments, the NYSE has some competitive juice left after all.

Perhaps ManFinancial’s management paid close attention to the recent study released by a group of academies, regarded as the leading authorities on foreign companies that list shares in the U.S. The study, which was covered by the Wall Street Journal, found that “investors are still willing to pay a sizable premium for foreign-company shares listed in the U.S., in return for meeting tough U.S. regulatory standards.” In other words, it’s our regulatory environment that makes our markets more competitive.

Here’s a thought: If Paulson successfully scales back regulation then will a new group form: Deregulation was Ultimately a Major Blunder, or D.U.M.B.?

The U-5 Defamation Campaign Continues…

2007-04-25T15:00:00.000-04:00

As we continue our campaign to persuade the NASD to revisit a rule originally proposed in 1998 known as “NASD Notice to Members 98-18,” that would have given securities firms a qualified privilege to information inserted into a departing employee’s Form U-5, I draw your attention to this letter I recently submitted to Jean I. Feeny, Associated Vice President and Chief Counsel in charge of the NASD’s Dispute Resolution department.

We aim to counter the recent Rosenberg v. MetLife decision, which established an absolute privilege standard in New York, by engaging the financial regulators directly. In addition to our online petition, this letter establishes that an absolute privilege standard not only is harmful to brokers and employees of securities firms, but to individual investors as well.

Significantly, I also point out that the opponents to the qualified privilege standard, namely the Securities Industry Association (SIA) and the Securities Industry and Financial Markets Association (SIFMA), in fact, supported the 1998 rule! You can view their original comment letter establishing their position here. As many parents would say of their unruly children, “give ‘em an inch and they’ll take a mile.”

Paulson Committee’s Next Target: You

2007-04-17T10:03:00.000-04:00

A front page story in yesterday’s Wall Street Journal lifts the veil on an issue I’ve been concerned about for quite some time: the replacement of shareholder class action lawsuits with NASD-style arbitration. The main proponent of this initiative is once again, Secretary Paulson’s Committee on Capital Markets Reform. How no one is truly questioning this “blue ribbon” panel’s true motivation is beyond me, but that’s a story for another day…namely when I speak at the North American Securities Administrators Association (NASAA) Public Policy Conference on May 8, 2007.

The panel’s latest proposal would allow corporations to have special shareholder elections that could require anyone owning stock in the corporation to waive his or her right to initiate or join a class action lawsuit, instead electing for individual, private arbitration hearings.

At first glance you’d think that replacing costly class action lawsuits would be beneficial, but as always, the devil’s in the details. In fact, a couple of questions come to mind: Who would participate in the arbitration panels? Where would the arbitrations take place? Would the decisions and opinions be private or would they be made public to provide precedential value? Who in the world would oversee the process and pay for it?

You can bet that the little guy won’t like the answers to those questions. The real motivation behind this proposal is to allow Corporate America to “divide and conquer” each shareholder lawsuit. It’s also an attempt to scare away smaller investors with claims of less than $50,000. After all, would you pay an attorney to argue a case where the likelihood of winning is less than 50 percent and even then, you’ll probably get a few pennies on the dollar?

It might seem a little strange for this argument to be coming from me, a securities arbitration specialist, but I think that without significant reform to the securities arbitration process, this proposal is anti-investor.

Coastal States Erode Brokers' U-5 Rights - Support our Petition to the NASD Asking for a Uniformed "Qualified" Standard

2007-04-11T07:30:00.000-04:00

As discussed in my last blog post, the New York Court of Appeals last week held that securities industry employees working in the state have no legal recourse if they have been illegally defamed on their Form U-5 by a former employer.

Think about that -- no legal recourse even though they were unfairly defamed. None. Zero. Zip.

As questionable as that outcome was, New York is not the first state to take that questionable stance. California also gives securities industry firms a free rein when it comes to an "absolute" privilege to such statements. These are the only two states to do so, probably because the other 48 know they have it absolute-ly wrong.

Elsewhere in the country, firms only have a "qualified" privilege. States like Illinois, Tennessee, Georgia, Michigan, Florida, and Oklahoma accept that employees have a right to due process and recognize that they should be able to seek legal recourse should former employers file false and defamatory statements that can ultimately serve to sound the death knell to their careers in the securities industry.

State-by-state standards make no sense. It's time for one uniform standard, for one central "playbook" that preserves brokers' rights by giving them legal recourse should they be the unfortunate victim of what essentially amounts to a corporate smear campaign.

As I recently wrote to Mary Schapiro, Chairman and CEO of the NASD, the time is now for the NASD to revisit a rule first proposed in 1998 to adopt the "qualified" privilege standard.

I hope you will join this cause and sign my online petition here.

Rosenberg vs. MetLife Decision Affirms Financial Service Firms Have an "Absolute" Privilege to U-5 Comments

2007-03-29T16:05:00.000-04:00

The Second Circuit dealt a severe blow today to the rights of anyone employed by a firm under the regulation of the NASD. In the case, Rosenberg vs. MetLife, the three of the five judges (one judge took no part) came to a majority decision that MetLife had an "absolute" privilege to the information they inserted into a departing employees "Form U-5," which is a process mandated by the SEC. The SEC requires this process to ensure that any past infractions are transparent to a new employer or the public at large.

The problem, however, is that many firms are using the Form U-5 to defame their departing employees. Many brokers who were dismissed for the mutual fund marketing timing practices were scapegoated and defamed on their Form U-5 to appease Eliot Spitzer and prevent the bank's upper management from further investigation. In other documented cases, the rationale for U-5 defamation was to prevent a departing broker from taking along his clients.

To better protect employees working in the securities industry, the NASD should revisit a 1998 rule enacting a "qualified" privilege allowing some recourse for those who have been defamed. I wrote this to NASD Chairman and CEO urging her to immediately reconsider the rule.

Schumer Shows Up to the Sub-Prime Party; Forgets Gift

2007-03-28T16:54:00.000-04:00

It’s classic Chuck Schumer: a Sunday press conference proposing some sort of legislative action to solve the crisis du jour. Sunday is typically a slow "news" day so Schumer’s remarks help the dailies fill their Monday news holes.

Sunday’s adaptation was a proposal to create a new federal system and agency to oversee the mortgage brokers and loan officers and to establish a "suitability standard" barring lenders from issuing loans to consumers who cannot afford them is a common sense approach.

But actions speak louder than words so it’s hard to take this announcement seriously. Indeed, last week, four-days prior to Schumer’s press conference, the Senate Banking Committee in which Schumer is the number two ranking Democrat, held hearings to investigate why so many sub-prime mortgage owners have found themselves facing defaults.

And after briefing his office about the dozens of Long Islanders facing mortgage defaults after receiving unsuitable loans and being victimized by their now disgraced broker Peter Dawson, I looked forward to these guys get a little comeuppance from our Senator. Unfortunately Schumer was nowhere to be found.

Banking regulators and executives from mortgage companies including Sandy Samuels, Executive Managing Director of Countrywide Finance Corp. and Brendan McDonagh, CEO of HSBC Finance Corp., provided sworn testimony about their roles in the sub-prime crisis. Senator Schumer quite literally had to opportunity to directly address the executives responsible for, according to Schumer’s own numbers, 42,000 voting constituents facing foreclosure in New York City, Nassau County and Suffolk County alone.

Did Senator Schumer have other pressing matters? As a matter of fact yes, Senator Schumer did have other things on his mind that day. He spent a good chunk of the day playing the role of partisan pit bull threatening to subpoena administration officials involved in the entirely legal sacking of U.S. Attorneys. When not riding the party line, he made time for lobbyists from the "Buffalo Niagara Partnership" and championed their request for $11 million in pork spending.

Up until now Senator Schumer has paid little attention to the mortgage market. In fact, prior to Sunday’s announcement, the only lending industry activism on his website is a 1999 press release co-announcing legislation with Jesse Jackson aimed a credit card fees. Not exactly a burning issue.

So, while Senator Schumer plays catch-up and chases headlines, Dawson’s victims will take their fight for suitability standards to the Nassau County court system. Knowing Washington’s propensity for empty promises, I like our chances a little better.

What we need now is leadership and real action in Washington, not a Senator interested in finding ways to make the nightly news.

NYSE Should Follow the Merrill Market-Timing Trail Wherever it Goes

2007-03-28T12:00:00.000-04:00

Finally the market-timing bonanza and the rush to judgment by Eliot Spitzer is coming home to roost. Yesterday a decision issued by the U.S. District Court in Manhattan rejected an appeal by Merrill Lynch which sought to vacate an arbitration decision to award $14 million to three brokers now known as the "CBS Group," who were dismissed and allegedly defamed after participating in market-timing activities while in the firm’s employ. http://online.wsj.com/article/SB117504262361851160.html?mod=todays_us_money_and_investing

This was largely a technical legal victory, but its an important step towards affirming that many of the dismissed brokers involved in market timing were scapegoated by Wall Street firms eager to appease Spitzer with minimal fines, sacrificial lambs and, of course, the ability to neither admit or deny guilt.

It should also be interesting to see how the recent investigation opened up by the NYSE into the trio’s former manager at the Paramus, N.J. branch of UBS AG shakes out. The manager was recently fined $50,000 for failing to supervise three unnamed financial advisers involved in market timing.

http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20070110/REG/701100704/-1/BreakingNews04 It doesn’t take a snoop to come to the conclusion that the CBS Group was also participating in market-timing with management’s blessing at their former employer.

It is my hope that the NYSE continues its investigation as far up the ladder as is justified even if it means more heads must roll. Clearly market-timing was not a "rogue" issue but a strategy well embedded in Wall Street’s most prestigious firms.

My Legal Quest to Hold Mortgage Lenders Accountable

2007-03-21T19:01:00.000-04:00

As an attorney with a long track record of advocacy on behalf of individual investors wronged by their brokers, I am certainly proud of every judicial victory, big or small, scored on their behalf.

However, one in particular stands out as a career-defining moment. In 2001, I filed a complaint against Merrill Lynch on behalf of a New York doctor who lost $500,000 after following firm analyst Henry Blodget's tainted stock recommendations. That complaint became the catalyst for then New York attorney-general Eliot Spitzer's investigation into conflict-of-interest abuses on Wall Street and the subsequent $1.4 billion global settlement he wrangled from the top names in investment banking.

Having trod through some of Wall Street's muck as long as I have, I thought I had seen it all with respect to so-called financial professionals taking advantage of the Little Guy. Not quite.

I've uncovered a mortgage lending scandal on Long Island that I strongly suspect is indicative of widespread fraud and dubious lending practices throughout the industry. It is my sincere hope that a related lawsuit I filed today will similarly catch the attention of appropriate prosecutors and further fuel much-needed industry reforms, this time within the mortgage lending business.

Over the last five months, my firm has been conducting its own investigation on behalf of more than a dozen Long Island and Florida working-class retirees who collectively have been bilked out of more than $100 million by Peter J. Dawson, a once high-flying "financial planner" who is currently in jail awaiting trial on grand larceny charges. It gives me great pleasure to have been instrumental in putting him behind bars.

Dawson, president of BMG Advisory Services, worked out of one of Long Island's most prestigious office buildings, which gave him a patina of legitimacy. Over the course of 15 years, he convinced dozens of unsophisticated retirees to surrender their existing variable annuity policies and mortgage their paid-off homes so that he could invest the proceeds in new annuities on their behalf. Dawson promised that these annuities would pay a higher rate of interest than their home mortgages, thereby generating additional retirement income. Dawson assured clients that his office would pay the monthly mortgage bills.

Unfortunately for those he ensnared, he didn't invest all the mortgage proceeds. Instead, he siphoned off some $100 million to support his lavish lifestyle, which reportedly included several properties and a lavish antiques collection. His victims are now in danger of losing their own homes because they have little or no income to cover their monthly mortgage payments; foreclosure may be imminent. The victims are mostly retired senior citizens, including a legally blind firefighter, an electrician suffering from Lupus, an ailing sanitation worker, and even a priest.

Although Dawson masterminded the fraudulent scheme, about a dozen other mortgage companies were active participants, including well-known outfits like Countrywide Home Loans and Washington Mutual, two of the nation's biggest home lenders; PHH Corp., a NYSE-listed company that has agreed to be acquired by an affiliate of The Blackstone Group and the financing and asset management unit of General Electric; and The First National Bank of Long Island.

No doubt these mortgage company participants will dismissively invoke Sergeant Shultz's classic "I know nothing" defense if called on the carpet. After all, there are currently no hard and fast rules or regulations requiring mortgage lenders to determine whether the loans they make are “suitable” for their borrowers. Granted, it's quite possible that none of the lenders knew that Dawson was absconding with the monies they advanced, but they had plenty of reasons to be suspect of him.

Among the warning signs:

Prior to starting his own firm, Dawson worked at various brokerage firms. Dawson's U4 form, an easily available document that lists all previous charges made against a broker, contains four customer complaints, including an allegation that he induced a customer to take out a $250,000 mortgage to invest in an annuity whose interest rate was lower than the mortgage rates. "Unsuitable investments followed," according to the complaint.

The mortgage closings for Dawson's clients were typically held at his office, or in at least one highly irregular instance, a hotel room. None of Dawson's clients were represented by an attorney. Representing the mortgage lenders at most of these closings was an attorney named Ida D'Angelo or one of her associates. Ms. D'Angelo last year was indicted for mortgage fraud by the Deputy Attorney General in charge of the New York's Organized Crime Task Force for mortgage fraud. The indictment's complaint against D'Angelo does not pertain to her activities involving Dawson's clients.

In most instances, the mortgage monies were given directly to Dawson , not his clients, which also should have raised warning signs.

By any standard, none of Dawson's clients should have been granted mortgages. They had little or no income and there was no rational reason for them to assume mortgage debt given their late stage in life, and in several instances, their poor health.

Earlier today, I filed a lawsuit asking the New York State Supreme Court to issue a declaratory judgment ordering all the defendant banks and mortgage companies to void and cancel the mortgage loans they made to Dawson's clients and to immediately terminate and freeze all foreclosure proceedings against them.

Sadly, it shouldn't take a court order to force the defendant lending institutions to do what is so abundantly the proverbial "right thing". But morals and fairness have never been the hallmarks of the U.S. banking industry, especially when there is money at stake. The Dawson case underscores why Congress should impose suitability rules on all the nation's home lenders.

Whether Dawson's victims can ultimately keep their homes is in the hands of a Long Island judge. If a declaratory judgment is granted, it will establish a valuable legal precedent and put irresponsible mortgage lenders on notice that they will be held legally accountable for their wrongdoing. More important, it could serve as the catalyst for much-needed industry reforms that will level the playing field for unsophisticated borrowers who are otherwise at the mercy of ruthless financial planners who line their own pockets at the expense of those less financially savvy.

As we saw with my client's case against Merrill Lynch in 2001, it only takes a spark to light a fire.

Securities Industry Employees’ Rights at Stake in Court Case

2007-02-13T15:22:00.000-05:00

Today, the New York Court of Appeals (New York’s highest court) will decide whether securities industry employees have a legal right to sue their employers for defamation stemming from statements made in the N.A.S.D. Form U-5, the standard termination form. The case is entitled Rosenberg v. MetLife; which will decide whether brokerage firms have an "absolute" or "qualified" privilege from defamation claims. To be sure, the stakes could not be higher for securities industry employees and securities employment attorneys.

If the Court rules in favor of a "qualified" privilege, then securities industry employees will be able to bring arbitration suits against their employers who defame them on Form U-5 and can seek expungement of defamatory language contained therein. Many times the desired affect of a defamatory or damaging Form U-5 is to blackball an employee from the securities industry and prevent him or her from moving to another firm with a book of business.

Even more distressing is the recent use of the Form U-5 to scapegoat employees who participated in mutual fund "market timing," a common trading service offered to hedge fund managers now deemed to be illegal. Many brokerages have chosen to fire and defame employees who participated in market timing to protect the firm and its senior management from prosecution and exorbitant fines.

On the other hand, if the Court decides that there is an "absolute" privilege from defamation on Form U-5, then securities industry employees will no longer be able to sue their employers for U-5 defamation or seek expungement of defamatory language.

My law firm has submitted a legal brief on behalf of the National Employment Lawyers Association (NELA) to the Court of Appeals arguing in favor of the qualified privilege standard and right to obtain expungement. To view our brief on behalf of NELA, click here.

You may also wish to review my op-ed in the November 2006 issue of Registered Rep magazine entitled "Fighting the U-5." You can access my op-ed by clicking here.

Securities industry employees and securities employment attorneys should carefully follow this case which will have wide ranging effects on all securities industry employees and the right to obtain expungement in a U-5 defamation action.

Rosenberg v. Metlife

2007-02-02T11:43:00.000-05:00

Our firm is representing the National Employment Lawyers Association as an Amicus ( or "Friend of the Court") in the Seminal case Rosenberg v. Met Life pending before New York's Highest Court which will decide the issue of whether Wall Street brokerage firms who file for a departing employee a termination Form U-5 enjoy a "qualified" or "absolute" privilege from a defamation suit.

The case will be argued February 13, 2007 before the New York Court of Appeals.

To view our Amicus brief CLICK here.

Also see our Oped on the case in Registered Rep Magazine entitled
"Fighting the U-5".

Peter Dawson's Investor Victims' Lawsuit

2006-12-28T10:55:00.000-05:00

In one of the most egregious investment fraud scams in recent history, high-flying Long Island broker Peter Dawson has allegedly made off with the savings of dozens of families, some of which were elderly and veterans. The exact amount of money Dawson may have stolen is not yet known, but authorities estimate that nearly $100 million may be missing.

I have been representing many of the victims of this securities fraud. The story broke in the New York Post and after local authorities arrested Dawson the case received significant local and national media attention. Below are links to some of the coverage this case has generated. If you think you have been a victim of Peter Dawson, click here.