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Hedge-Fund Fraud Is `Emerging Threat,' McNulty Says

Date: Friday, July 7, 2006
Author: Robert Schmidt, Bloomberg.com

July 7 (Bloomberg) -- Fraud in the $1.2 trillion hedge-fund industry poses an ``emerging threat'' to investors, the head of the Bush administration's task force on corporate crime said in an interview.

Deputy Attorney General Paul McNulty said the potential for wrongdoing in the lightly regulated investment pools makes them ripe for scrutiny by prosecutors, regulators and investigators. The corporate-fraud task force is also studying the scandal involving backdating stock options for executives, he said.

The task force will discuss hedge-fund fraud at its next meeting at the end of this month, McNulty said. ``There's been some interest in the media recently on hedge funds, and that would be a good example of an emerging threat that we would want to talk about and ensure that we are handling,'' he said.

McNulty's comments signal that the task force, formed as investor confidence plummeted after the accounting scandal at Enron Corp., is looking for new targets rather than winding down as some critics have suggested it should. While stocks have rebounded since the task force's creation and federal prosecutors have obtained 1,063 convictions or guilty pleas, investigating white-collar crime remains a priority, McNulty said.

``The corporate-fraud task force is alive and well,'' he said. ``The need for it in our view is still very clear and strong.''

Private Partnerships

Hedge funds are private investment partnerships that are exempt from most regulation because they cater to sophisticated investors and institutions. Some officials say the funds should be more closely watched because they increasingly manage money for small investors, mostly through pension funds.

The Securities and Exchange Commission brought 29 civil cases against hedge funds in 2005, up from 10 in 2002. Several fund companies have collapsed amid fraud allegations in the past year, including Stamford, Connecticut-based Bayou Management LLC and Atlanta-based International Management Associates LLC, which managed the investments of a number of current and former professional football players.

Last month, a federal appeals court in Washington threw out SEC rules requiring hedge funds to register with the agency and undergo inspections of their books and records.

The corporate-fraud task force this month also will look into the growing scandal over backdating corporate executives' stock options to increase payoffs, McNulty said.

Pay Incentive

``That one has the potential of being categorized as an emerging threat,'' he said.

Granting stock options to executives gives them an incentive to increase their own pay by boosting the company's stock price. Options give holders the right to buy shares at a set price. Once the options vest, usually over a period of several years, they can be exercised and the holder pockets the difference between the set price and any increase in the market value.

Backdating options to a time when the stock price was at a low point increases the chances they will be profitable.

Some ``emerging threats are new and different, but backdating is an example of just a good old-fashioned lie,'' McNulty said.

At least 60 companies have started internal investigations or are being probed by the SEC and federal prosecutors for possible irregularities in dating options and in disclosing the grants to investors.

Unreasonable Leverage

McNulty, in the June 29 interview, also defended a Justice Department policy that the U.S. Chamber of Commerce and the American Bar Association say gives prosecutors unreasonable leverage to force companies to settle cases brought by the government.

The policy, outlined in a 2003 memo by then-Deputy Attorney General Larry Thompson, gives companies credit -- and potentially a lesser penalty -- if they reveal confidential conversations with attorneys and cut off legal fees for employees under investigation.

A federal judge last month ruled that the attorney-fee tactic violated the rights of former KPMG LLP executives being tried on charges of selling illegal tax shelters. McNulty said he disagreed with the ruling.

``As of today, that is the policy of the department and it will remain that way until we reach a decision that it should change in some way,'' he said.

Still, McNulty said the Justice Department is ``willing to listen'' to the business groups' complaints and entertain their suggestions for revising the policy.

``We believe it's important to get these things right and we want to be responsible with the use of our authority,'' he said.

Created in 2002

President George W. Bush created the corporate-fraud task force in 2002, ordering a crackdown on financial crime in response to the accounting fraud at Enron that shook investor confidence. Task force members include the Treasury secretary, director of the Federal Bureau of Investigation and chairman of the SEC.

Along with McNulty, the task force has or will soon have several recent additions, including incoming Treasury Secretary Henry Paulson, SEC Chairman Christopher Cox and Reuben Jeffery, chairman of the Commodity Futures Trading Commission. The group crafts policies on pursuing corporate crime and coordinates investigations.

McNulty, 48, who was confirmed by the Senate for his current post in March, took over the task force at a time when business groups led by the Chamber of Commerce are urging the Justice Department and the SEC to rein in investigators and some critics say the task force has outlived its usefulness.

Past Its Peak

``On the corporate-fraud side, we've already hit the peak and we're coming down off that peak,'' said William Mateja, a former Justice Department attorney who worked with the task force and is now a partner at the Fish & Richardson law firm in Dallas. ``There are cases left to do. But as far as from a policy standpoint, I see the task force's job as completed.''

McNulty said the task force won't be shut down during his tenure, especially because millions of Americans use the stock market to save for retirement and their children's education.

``We think the message has gotten out loud and clear, but that doesn't mean we shouldn't keep watching,'' he said. ``This ultimately is an environment that is enticing to those who are subject to excessive greed.''

When the task force identifies an emerging threat, it usually will consider whether more regulation is needed and whether agencies investigating wrongdoing are properly coordinating their efforts and using their resources, he said.

To contact the reporter on this story:
Robert Schmidt in Washington at  rschmidt5@bloomberg.net.