STOCKGATE TODAY
An online newspaper reporting the issues of Securities Fraud

Follow the Money - To where?  November 14, 2006
Dave Patch

The Securities and Exchange Commission expects to be stepping up the enforcement cases against hedge funds shortly according to SEC Director of Enforcement Linda Thomsen.  Thomsen divulged such interests at a securities conference held in New York earlier this week.

According to Thomsen, Regulators have learned to "follow the money and these days the money is in hedge funds, so the potential for abuse, the potential for securities law violations is there because there is so much money there."

While these comments could be considered a step in the right direction by the investing public, who have otherwise been highly critical of the SEC's commitment to hold accountable the highly connected Wall Street white-collar criminals, Thomsen's comments also left open the possibility that the SEC Enforcement Division is still missing the rest of the white-collar crime playing field.

Attending the conference in New York was NYSE's enforcement chief Susan Merrill who also chided in on concerns over hedge fund fraud.  Merrill agreed with Thomsen that the hedge funds were a ripe area of opportunity for securities enforcement.

But Merrill expanded on her concerns over hedge funds citing the possibility that prime brokerage, the member firms responsible for taking on the hedge fund order flows, could also be accountable if they failed to detect the illegal activities of the funds.  

Who's on First?  

Back in early 2004 the NASD passed a reform to short sale Rule 3370.  The intention of the rule change was to place compliance responsibility of the non-member firm [unregistered firm] on the member firm [registered firm] in the execution of a short sale into the US markets and close down a loophole that existed between US and non-US securities laws.  The rule was intended to insure that trades executed in to the US met the standards of trade in the US and that members firms applied their compliance standards upon the non-member firms.

In the case of an unregistered hedge fund, there are no laws that require the fund to maintain supervisory or compliance programs.  The hedge funds have fought registration because they are against taking on the financial burdens of putting such protective measures in place.  These funds are unregulated at this level and thus operate without audit by the securities regulatory operations.  But as an unregistered member, the funds must execute trades through a member firm and that would be the prime brokerage.

With responsibility of all trades executed by a hedge fund befallen upon the prime brokerage firms compliance operations, illegal trades executed for or by a hedge fund place the accountability squarely at the doorstep of the prime broker.  There is no "if" scenario in the thought process as Ms. Merrill would lead the public to believe.  Enforcement "could" should be enforcement "will".

Thomsen says, "Follow the money".  

Prime Brokers get the money, and lots and lots of it.  A single hedge fund can generate hundreds of millions of dollars in commissions to the prime broker for trade executions throughout the year.  A single hedge fund was cited as providing upwards of $200 million in trade commissions in a single year. With such significant funds to be made, prime brokers will consider to allow such illegal trading to slip through because of the commission they receive for executing that trade and how that impacts the bottom line.

Heck, the regulators have ignored this potential conflict because a growing bottom line for Wall Street means a more robust and growing US capital market. Money talks and how much louder can you get that a steady growth of the financial services sector.

The role of the prime broker is to help hedge funds manage their trades with multiple firms and also provide lending, portfolio reporting and custodial services, among other things.  For regulatory enforcement to dismiss this venue as a serious opportunity would be a crime in itself.

How much money is involved?

Revenue from prime brokerage operations totaled some $7.5 billion in 2005, according to estimates from Sanford C. Bernstein & Co. Most prime brokerage revenue comes from fees charged on stock loans and financing, with trading commissions making up a smaller portion.  Those numbers will have increased in 2006.

Today, several hedge funds have filed lawsuits against several of the prime brokerages for charging a lending fee in a short sale transaction when there was no lending to be done.  The short sale executed by the prime broker, on behalf of the hedge fund, resulted in a fail to deliver at the settlement date because the share to be lent by the prime broker to the purchaser never existed to settle the trade.  The result of such fraud was that of allowing excessive dilution, and manipulation of the value of the security shorted as well as the profiting off a service not performed.

It was such dilution and manipulation in the marketplace, illustrated by an increasing level of failed trades at settlement date, that prompted the NASD to review and ultimately change Rule 3370 calling the lapse a loophole in existing laws.

None of this should come as a surprise or news to Thomsen, the SEC, or the self-regulatory agencies that police the major markets.  The concerns of prime brokerage abuses and the concerns of the prime brokerage conflicts between compliance and revenue generation has been a standing topic of water cooler conversation since the prime brokerage business was created in the early 1980's.

So who is on first? I don't know but the SEC and SRO's had better stop playing around trying to decide who may be accountable and start understanding the laws and the dynamics of the markets to start taking names of the white-collar criminals.  Wall Street business practices have been left unattended for far too long and the delays in attention have only created a more powerful union of criminals that is becoming increasingly harder to find guilty of anything.

Follow the Money; start by following the $27 Billion in bonuses this year handed out on Wall Street and maybe you can find a few that cut corners to secure these obnoxious levels of compensation.

For more on this issue please visit the Host site at www.investigatethesec.com .
Copyright 2006