Hedge Funds, Plagued by Fraud, Need More Scrutiny, Senate Told

Date: Wednesday, June 28, 2006
Author: Bloomberg.com

une 28 (Bloomberg) -- Hedge funds, fresh off a court victory that struck down new regulations imposed on them, came under fire in the U.S. Senate where witnesses said the $1.2 trillion industry was rife with fraud.

``Is federal law enforcement adequately protecting the nation's capital markets and their participants from the risk of manipulation and fraud'' by hedge funds? former U.S. Securities and Exchange Commission lawyer Gary Aguirre said in written statement accompanying his testimony. ``The answer is no.''

Aguirre, 66, took center stage at the Senate judiciary hearing in Washington with allegations that his investigation of alleged insider trading by Pequot Capital Management Inc., a $7 billion hedge fund, was stymied by political pressure. He said he was fired after pushing to question John Mack, chairman of Morgan Stanley. Pequot has denied any wrongdoing. Morgan Stanley says Mack was never contacted by the SEC about Pequot.

The clamor on Capitol Hill came five days after the U.S. Court of Appeals for the District of Columbia Circuit threw out SEC rules that required many hedge funds to register and submit to routine inspections. The court said the regulations were arbitrary.

The industry, which has long fought any regulatory efforts, is exempt from most federal oversight because the funds are meant for institutions and sophisticated investors with a net worth of at least $1 million.

After listening to testimony from Connecticut Attorney General Richard Blumenthal, several financial analysts, representatives for hedge funds and companies who claim they were victims of fraud, Senate Judiciary Committee Chairman Arlen Specter said he was convinced the industry needs scrutiny.

`Too Powerful'

``Hedge funds are too big and too powerful, too much area for abuse, not to have some oversight,'' said Specter, a Pennsylvania Republican.

Some state officials and the SEC have argued that the funds need to be more closely watched because they increasingly appeal to small investors. The funds also can have a disproportionate effect on securities markets because they trade so often.

Separately, U.S. Representative Barney Frank of Massachusetts, the senior Democrat on the House Financial Services Committee, said he will introduce legislation to reverse the appellate court decision and give the SEC authority to regulate hedge funds.

Blumenthal, whose state is home to many of the largest hedge funds, urged the judiciary committee to step into the ``black hole'' that was created by last week's court decision. If Congress doesn't act, Blumenthal warned, states will.

``Right now hedge funds are in a regulatory void without any disclosure or accountability,'' he said.

Jurisdiction Question

Specter fended off complaints from the Senate Banking Committee that the judiciary panel doesn't have jurisdiction over hedge funds. The banking committee, which generally is charged with handling financial regulation, plans to hold hedge- fund oversight hearings before August.

Senator Charles Schumer, a member of both committees, said the judiciary hearing ``raises a yellow flag of caution'' because it treads on the banking committee's turf. The judiciary panel doesn't have the financial and market expertise that the banking committee does, he said.

Hedge funds are designed to make money whether financial markets fall or rise. They can use leverage to help boost gains and they can sell short, or borrow securities and immediately sell them with the hope of buying them back at a lower price.

Defending Hedge Funds

Joseph McLaughlin, an attorney who represented the industry, said the investment pools help markets by providing liquidity, or the ability to quickly trade securities. The funds allow investors to spread out risk and further diversify portfolios, McLaughlin said.

``The hedge-fund industry and policy makers currently face an important challenge, namely to preserve the benefits offered by hedge funds while addressing legitimate investor protection and market integrity issues,'' McLaughlin said.

Paul Roth, a hedge-fund attorney at the Schulte Roth & Zabel law firm in New York, said in an interview that having states regulate the industry would be ``the worst of all possible worlds.''

He said the SEC and the industry ``need to sit down'' and decide what they can do to compromise and ``satisfy each other's requirements.''

New York lawyer Marc Kasowitz, who represents clients who contend they were victims of hedge-fund market manipulation, said they ``spread rumors and falsehoods'' and conduct ``orchestrated campaigns to communicate egregiously false information'' to the marketplace.

Mack

``The effects of these campaigns have been devastating to the companies, employees and investors,'' he told the committee.

Aguirre said a Morgan Stanley compliance official asked the SEC last year whether his probe involved questioning Mack, who was about to be named chief executive officer of the New York- based securities firm.

``Are you going to proceed against Mr. Mack? If so, we are going to have problems and don't think he can step in as CEO,'' Aguirre said, quoting the official, Eric Dinallo, who no longer works for the firm.

``Over the next seven days, I saw this investigation come to a grinding halt,'' Aguirre said. He was fired in September.

Mack became CEO of Morgan Stanley last June.

``No one has provided any evidence that Mr. Mack has engaged in any wrongdoing, and Mr. Aguirre provided none today,'' said Jeanmarie McFadden, a Morgan Stanley spokeswoman.

The SEC has declined to confirm or deny any investigation of Pequot, and spokesman John Nester said today the agency had no immediate comment on the hearings.

Heller Financial Takeover

Aguirre, a plaintiff's lawyer in Southern California before working at the SEC for less than a year, claimed he investigated Pequot for allegedly making millions from insider trading. Profits included $18 million from General Electric Co.'s $5.25 billion acquisition of Chicago-based commercial lender Heller Financial Inc. in 2001, perhaps with the help of a tip from Mack, he alleges.

``Mr. Aguirre has still failed to produce a shred of evidence to support his unfounded allegations against Pequot,'' said Jonathan Gasthalter, a spokesman for the Westport, Connecticut-based hedge fund.

To contact the reporter on this story:
Robert Schmidt in Washington at  rschmidt5@bloomberg.net;
Katherine Burton in New York at  kburton@bloomberg.net