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SEC Charges Execs with Fraud at Fannie & Freddie

Following up on our September post "Big Bucks, No Whammies?" about the SEC's apparent inaction on the wells notices they had served to the execs of Fannie & Freddie. We write to report that Whammies finally came with  Friday's headlines . The SEC brought fraud charges after all, not just against Daniel Mudd, former CEO of Fannie Mae but also five others now charged with deliberately misleading government officials about the extent of their subprime exposure.

The NYTimes explores the charges in greater detail and there are new reports that an FBI investigation into the same conduct is underway which means the guys could face criminal charges.    Following the SEC announcement speculation had already begun that Mudd would soon step down as CEO at Fortress Investment Group (FIG).

“Can you really run a trading and investment firm with a guy accused of fraud in the corner office?”   a Fortress employee was reported to have asked.  Apparently not when the accusations become official. (UPDATE:  Mudd took leave as CEO of Fortress on Wednesday December 21)

Mudd has been on the board at Fortress since 2007,and was appointed CEO of Fortress when he left Fannie amid scandal after the bailout in 2008 Fortress is a publicly traded hedge fund which recently introduced new subprime mortgage bonds onto the market.... 

Big Bucks. No Whammies?

Tick Tock. Tick Tock.  In a scenario reminscent of the classic game show Press Your Luck.  It appears Former Fannie Mae CEO Daniel Mudd  may get a reprieve  courtesy of new Dodd-Frank stopwatch.  Mudd was put on notice March 11th that he could face regulatory action for his role in misrepresenting the underwriter's subprime exposure to investors and government agencies.  But Dodd-Frank amendments enacted last year introduced a 180 day time limit compelling Commission staff  to "either file an action or provide notice to the Director of the Division of Enforcement of its intent to not file an action,” within 180 days of the Wells Notice. 

The probe centers on his time at Fannie Mae and his role in creating the subprime debacle that would shock the country and the world.  But given the radio silence, observers wonder if  new admendments that were intended to make the agency more proactive in handling such cases have backfired.   

An alternate theory is that the inaction is related to reports that the SEC is winding down its investigations of Fannie & Freddie the NY Times reported that Fannie settlement talks were underway and fraud charges would likely be dismissed.  

As we explore more in the Pomerantz Monitor this month.  Fannie & Freddie Conservator the FHFA  also announced in early September that they'll seek to recover $196 billion in new actions against 17 banks for misrepresenting CDO risks to the underwriters.

For his part, Mudd has shown little remorse.  His failure, he said, was only that he could not maintain the “delicate balance,” required to meet such expectations.   Since taking over the CEO position at Fortress Investment Group Mudd's appetite for subprime has continued unabated.  In May, the publicly traded hedgefund unveiled subprime bond Springleaf acquired from AIG.  They  even managed to secure triple A rating from S&P after that agency had downgraded US treasury securities. 

So far, for Mudd its big bucks, and no whammies. 

NYC Pensions May Join in Hedge Fund Trend

The pension funds for New York City firefighters, police and civil employees are currently contemplating investments in hedge funds for the first time.  To that end, the city comptroller has recently sought out proposals from hedge fund consultants, which he will be receiving through August 9th.  Should the city funds decide to open their portfolios to hedge fund investments, they would be joining a larger trend that has pension funds increasingly putting their money into alternative investments.  For example, the California State Teachers’ Retirement System (“CalSTRS”) has credited its recent bump in returns to a shift of its assets towards alternative investments, including hedge funds.  Similarly New Jersey’s state pension fund has recently considered expanding the percentage of assets it allocates to alternatives, especially hedge funds.

The NYC funds’ consideration of hedge funds also occurs at a time when hedge funds are facing a shifting regulatory environment.  Most prominently, the Dodd-Frank Financial Reform Bill enacted last week requires hedge fund advisers to, depending on the size of their funds, register with either the SEC or their home state regulators.  The interplay of these new regulations with pensions’ increased participation in hedge funds  is sure to be an interesting area to watch in the coming months.

From the Pages of The Pomerantz Monitor: Hedge Funds Secretly Engage in “Total Return Equity Swaps” to Gain Seats on CSX Board

The August issue of The Pomerantz Monitor reports on the questionable tactics successfully used by hedge funds to gain seats on the CSX board. For years, two offshore hedge fund groups, The Children's Investment Funds and the 3G Funds, have wanted to buy CSX, one of the largest railroad systems in the U.S. But CSX was not interested. So the two fund groups recently launched a proxy contest seeking, among other things, to place five directors on the 12-person CSX board, to pave the way for an acquisition.

FINRA To Replace NASD and NYSE Regulation

In case you missed it, the Securities and Exchange Commission has given final regulatory approval to the consolidation of the member firm regulatory functions of the National Association of Securities Dealers, Inc. and NYSE Regulation, Inc., a wholly-owned subsidiary of New York Stock Exchange LLC. The consolidated organization will be known as the Financial Industry Regulatory Authority.  This means that we all get to learn a new acronym --- “FINRA.”

The consolidation of functions into FINRA is intended to help streamline the broker-dealer regulatory system, combine technologies, and permit the establishment of a single set of rules governing membership matters, with the aim of enhancing oversight of U.S. securities firms and enhancing investor protection.  We hope it works that way.

FINRA will operate under SEC oversight. It will be responsible for regulating all securities firms that do business with the public, including those that provide services related to professional training, testing and licensing of registered persons, arbitration and mediation. FINRA also will be responsible, by contract, for regulating The Nasdaq Stock Market, Inc., the American Stock Exchange LLC, and the International Securities Exchange, LLC. Finally, FINRA will be responsible for operating industry utilities, such as trade reporting facilities and other over-the-counter operations. NYSE Regulation, Inc. will continue to be responsible for the regulatory oversight of trading on the NYSE.

SEC Tries to Regulate Hedge Funds

The Securities and Exchange Commission voted unanimously last week to adopt a new antifraud rule under the Investment Advisers Act.  The SEC hopes that this new rule will allow it to bring fraud-related enforcement actions against investment advisers of hedge funds, private equity funds, venture capital funds, and mutual funds.

The SEC’s ability to regulate such persons has been the subject of recent debate, and the SEC’s action is an attempt to firmly establish its role as regulator of these increasingly important types of investments.  While we support the thrust of the new rule, we find the Commission’s accompanying statements about the need for investor protection to have an element of tragic irony.  This is the same SEC, after all, that found itself on the losing end of an internal Bush Administration fight about whether to file a brief in the Supreme Court in support of the proposition that those who knowingly participate in a scheme to deceive investors should be held liable under the securities laws.

Against the backdrop of that stain on the SEC’s reputation, here is what the SEC says about the new hedge fund rule:

“The rule will give the Commission an important tool to help us police this market — to deter misconduct and to call to task those who breach their obligations to investors."

The new rule will make it a fraudulent, deceptive, or manipulative act, practice, or course of business for an investment adviser to a pooled investment vehicle to make false or misleading statements to, or otherwise to defraud, investors or prospective investors in that pool. The rule will apply to all investment advisers to pooled investment vehicles, regardless of whether the adviser is registered under the Advisers Act. Under the new rule, a pooled investment vehicle will include any investment company and any company that would be an investment company but for the exclusions in Sections 3(c)(1) or 3(c)(7) of the Investment Company Act.

SEC Takes Heat for Limiting Access To Hedge Funds

As you may know, in 1982 the SEC determined that in order to invest in hedge funds an investor must have at least $ 1 million in net worth. Recently, the SEC proposed adding a requirement that a hedge fund investor also have $2.5 million in investments.  According to the SEC, this type of financial litmus test is the best way to ensure that only sophisticated investors take the risks associated with hedge fund investment.

According to a recent CNN article, those implicitly deemed “unsophisticated” by the SEC didn’t take kindly to the proposal.  In fact, such investors sent numerous comments to the SEC complaining that they are perfectly capable of looking after themselves and that they don’t need the SEC to determine who is, and is not, capable of investing in hedge funds. Click here for a link to the SEC’s comments.

What we find most interesting about this entire debate is the underlying premise of the SEC’s proposal. The SEC seeks to remedy the problems associated with hedge fund investment – which are primarily caused by the lack of transparency -- by limiting the number of hedge fund investors.  We, in contrast, would argue that simply demanding more transparency from hedge funds is a more logical, and effective solution.  As the investor comments make clear, you don’t have to be rich to be smart.  We would only add that being smart does you no good without adequate information.

Is SEC Rule 13f-1 Unconstitutional?

Phillip Goldstein, the hedge fund manager who successfully challenged the SEC's hedge fund registration requirement, has now set his sights upon SEC Rule 13f-1.  In a filing last week with the SEC, Goldstein claims that Rule 13f-1, which requires institutional investors with more than $100 million in US-listed equities under management to report their holdings each quarter, is an unconstitutional "taking." 

Goldstein notes that institutions spend millions of dollars generating investment ideas, which many closely guard as trade secrets.  By placing those ideas in the public domain, Goldstein argues, SEC Rule 13f-1 violates the Fifth Amendment's takings clause.  That clause states:

"nor shall private property be taken for public use, without just compensation."

Goldstein also argues that Rule 13f-1 serves no legitimate regulatory purpose.  The legislative history indicates that Section 13(f)(1) of the Securities Exchange Act of 1934, under which Rule 13f-1 was promulgated, was intended to enable the SEC to analyze the effects of institutional trading on securities markets.  However, according to Goldstein, the rule was never used for that purpose.   

Blodget Blames Amaranth Disaster on Traders With Nothing To Lose

In an article written in Slate Magazine, former telecom star Henry Blodget put in his two cents as to the root causes of hedge fund disasters such as Amaranth’s $6 billion lost wager on energy prices.  According to Blodget, the crux of the problem is that young traders are expected to make large and risky bets with other peoples’ money.  A trader in a hedge fund is posed with the following options: 1) make conservative investments and get fired for not generating enough profits for the fund; or 2) take risky bets and either make huge bonuses when those bets pay off—or get fired for losing billions of the fund’s money.  In either scenario, the trader gains nothing by investing conservatively.  If the employee loses his job, there will be another hedge fund that will snatch him up to make trades on its behalf.  The bottom line, according to Blodget, is that as long as hedge fund employees are not trading with their own money and funds demand exorbitant returns, a trader has nothing to lose by betting the house on risky investments.

To read Blodget’s article, click here.

SEC Takes Another Shot At Hedge Fund Regulation

After its latest attempt to regulate the burgeoning hedge fund industry was overturned by the U.S. Court of Appeals for the District of Columbia, the SEC has decided to go back to the drawing board.  Concluding that an attempt to appeal the court’s decision was “futile”, the agency will now focus on drafting a new rule.  SEC Chairman Christopher Cox said the SEC will propose an antifraud provision that would deem hedge-fund investors to be “clients” of the fund. The SEC has the authority to regulate investment advisors, but advisors with a small number of clients are exempt from such regulation.  Previously, the SEC and federal courts have considered each hedge fund itself, rather than the investors within a fund, to be a fund manager's client.  By designating an investor as a “client” of a hedge fund, the Commission would effectively be eliminating the exemption from regulation that these funds currently enjoy.

For a link to the SEC’s press release, click here.