Wall Street Sucks

Strong title to this one, and a bit tongue in cheek – the investment industry is critically important and doesn’t always suck. But some individuals within it sure do. The WSJ reported that the SEC is investigating several hedge funds and a regional broker-dealer for trading ahead of material non-public information – in this case, a brokerage analyst’s unreleased and very negative report on an insurance company in 2003. Names have been redacted to avoid the time and expense of nonsensical legal threats from the parties involved, and issuer information was redacted to avoid any alleged appearance of a securities recommendation (good grief!):

At issue in the civil suit and the SEC investigation is a research report by [an] analyst [at a] a Memphis, Tenn., investment firm…[who] initiated his coverage of [the company] on Jan. 17, 2003. His report said [the company] was $5 billion short of the reserves it should have been holding to cover potential insurance claims, and rated it "underperform." It also said the company’s strategy of acquiring troubled property and casualty insurers had backfired, saddling the company with assets that would have to be written down, potentially erasing most of shareholders’ $2 billion of equity in the company…

Documents in the case reviewed by The Wall Street Journal, primarily emails and instant messages submitted as exhibits by [the company], show that some of the hedge funds knew of Mr. [Analyst's] report more than a month before it came out.

On Dec. 11, 2002, a [hedge fund A] executive wrote the hedge fund’s founder, [hedge fund A founder], saying he had heard from another hedge fund that Mr. [Analyst] was going to issue a research report rating [the company's] stock "underperform" and warning about a reserves deficiency, according to a court exhibit.

A week later, Mr. [hedge fund A founder] forwarded an email to [hedge fund B guy] at [hedge fund B], a New York hedge fund founded by [hedge fund B founder]. The email, written by another [hedge fund A] employee who said he had talked to Mr. [Analyst], said the analyst "was more critical of [the company] than I’ve ever heard a sell side analyst … everything from underwriting to accounting to honesty," according to a court exhibit.

On Jan. 16, 2003, a [hedge fund A] executive wrote Mr. [hedge fund A founder], saying he had just talked with Mr. [Analyst]. "[H]is piece that rips [the company] apart is supposed to be published tomorrow…"

Trading records obtained by [the company] through discovery in the lawsuit show that [hedge fund A] put on a $5 million "short" position, or a bet against [the company's] shares, in the month after Mr. [hedge fund A founder] learned of Mr. [Analyst's] report, including $2.5 million the day before the report came out, a [company] attorney…said during a September court hearing.

[Hedge fund A] attorney…disputes that account. He says [hedge fund A] reduced its short position after receiving information about Mr. [Analyst's] views in mid-December and increased its…short position by "a modest amount" on Jan. 16, but did so before the email about the report’s pending release. He declined to provide specific figures, and the trading records aren’t part of the public court file.

In other words, at least one of the funds that acted on this information made almost all of its short sale gains in the days and weeks preceding the release of the report. And when the report was issued, they closed out their trades and booked their profits, made all the tidier by the market’s reaction to the report. If the funds (or the fund advisor(s)) had conducted the research internally and acted upon it for the benefit of all of its clients, that would have been fine. But they cannot trade on a broker dealer’s report before it’s released. That’s cheating***. And as in any other pursuit, cheating enriches some at the expense of the game itself. In this particular case,  individuals within the investment industry – some high profile ones at that – were perfectly willing to sacrifice some of the industry’s social and political capital for their own benefit (at least $2,000,000 for ‘hedge fund A’ by our estimates, and an astronomical annualized rate of return). As a fellow professional, this kind of BS is infuriating.

We’d note a couple of other things. First, the SEC investigation was sparked by e-mails uncovered in the discovery process related to the insurer’s litigation against the parties involved. It should take a bit less than that to uncover and investigate this kind of nonsense, shouldn’t it? Second, short sellers are staunch defenders of their craft, as they should be. But in [hedge fund A founder] they’ve lost one of their most public and influential voices. This could also undermine their attempts to get regulators and exchanges to renounce curbs on short sales. All of that said, we would point out that this kind of unseemly behavior is not limited to hedge funds, much less short selling funds. Anyone with access to material nonpublic information is going to be sorely tempted, and there’s plenty of evidence to indicate that the use of inside information is still common (unfortunately, it seems as though private individuals are the ones most frequently targeted for prosecution, rather than the professionals who know how to cover their tracks). Investment professionals simply have to make the right choice, which is to respect the game, even when it means less money in your bank account. Anyone who can’t do that should be banned for life. Like incentives, disincentives matter.

***Even if [hedge fund A] already had an existing short position in place, they should have restricted further activity and sought legal counsel on next steps (we assume they at least sought legal advice on the issue after it came to their attention – if not, their conduct is that much more damning). In fact, even if [hedge fund A] had never traded in the company, the fact that its founder and chairman would forward an internal e-mail containing material nonpublic information to another fund is simply mind boggling. It certainly implies a culture of entitlement – entitlement to a different set of rules than the rest of us, that is. Incredibly – but perhaps not surprisingly, the more we learn about human behavior – ‘hedge fund A’ appears to have done very well for its clients over the years based on solid analysis. In other words, it didn’t need to filch $2MM ahead of the market. It just couldn’t say no.

An admonition to our fellow investment practitioners – cut the bull, play by the rules, and respect the game. We’ll all be better for it.  

URLs: 

http://online.wsj.com/article/SB123449787320481341.html (subscription required)

http://www.cnbc.com/id/26789044