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November|December 2005
Behind the Hedge By David Skeel
The Enemy Among Us By Geoffrey Gagnon
A Blueprint for the Future By Daniel Brook
Viagra Natural By Brendan I. Koerner
Artfully Made-up By Erika Kawalek

Behind the Hedge

In the untamed world of hedge funds, rigged deals and manipulated markets help the wealthy thrive while ordinary investors wither.

By David Skeel

IN LATE 2004, RICHARD C. PERRY, a former investment banker at Goldman Sachs who runs a hedge fund called Perry Corporation, did something rarely seen in the shrouded world of hedge fund operators: He publicly disclosed an investment. Perry purchased 26.6 million shares (9.9 percent) of Mylan Laboratories, a drug maker that had recently offered $4 billion for a competitor, King Pharmaceuticals. Curiously, Perry also arranged then to sell his Mylan stock a few weeks later—for the same price he paid for it. Between the purchase and the sale, Mylan shareholders were scheduled to vote on the King acquisition. This peculiar arrangement prompted another major Mylan shareholder, financier Carl Icahn, to claim that Perry was trying to "rig" the vote on the Mylan acquisition.

And, in fact, he was. Perry's stratagem was a clever form of vote buying. To understand what he was up to, it helps to know one more thing: Perry also owned seven million shares of King Pharmaceuticals, and he bought many of them after the Mylan deal was announced. So he stood to make roughly $28 million from his King shares (the difference between what Perry paid for them and what Mylan was offering) if the acquisition went through. And he could help it go through by voting his 26.6 million Mylan shares. In other words, Perry owned the stock just to make sure that the deal got done, and in a close vote, 9.9 percent of the company could easily make the difference.

So what's wrong with that?

Like all sorts of elections, shareholder votes work best when each voter has a stake in the common enterprise. Villagers choosing a mayor presumably care about the candidates' stances on taxes. Shareholders considering a merger care about the deal's effect on the price of their stock. When voters' interests are tied to the future of the village or the company, as the case may be, they tend to make better decisions. But Perry didn't care what happened to Mylan. He didn't care if the price of its stock dropped, as often happens to the stock of an acquiring company, because he already had a deal to sell his shares at the price he paid for them. He also didn't care whether the King deal would weaken Mylan's business. Lousy deals burn stockholders and waste money, however, and hurt the economy and everyone who depends on it. Multiply Perry's behavior by the thousands of shareholder votes that occur every year at thousands of companies, and that's a lot of potentially lousy deals supported by major shareholders advancing narrow interests—and a lot of potential damage to the economy.

Perry's scheme fell apart after Icahn sued him, but it was only one of many tricks that hedge funds use to squeeze profits out of every corner of the market, with potentially ruinous consequences. For the most part, those tricks are entirely legal. The funds are unregulated, private pools of capital that can put vast sums of money almost anywhere they like, so they wield tremendous financial power. With an estimated $1 trillion under management, they are thought to account for half of all trading on the New York and London stock exchanges. In 1998, the impending collapse of the hedge fund Long-Term Capital Management, whose investments then amounted to over $100 billion and whose long and short hedge positions were valued at $1.25 trillion—equal to 5 percent of the entire global market—might have triggered a worldwide financial crisis had the Federal Reserve not orchestrated a bailout. And hedge fund success—if success means profits, no matter the source—can be as damaging to the economy as failure. Hedge funds have done fabulously well for their investors by manipulating shareholder votes, cornering the market for United States Treasury notes, controlling the debt of companies in bankruptcy, or, as in the recent mutual fund scandals, buying and selling stakes in mutual funds after the close of trading. But they have been cheating the rest of us, and it could get worse.

Hedge fund misbehavior looks ominously like the edge of the next wave of financial scandals. While many top executives of Enron and WorldCom—and the investment bankers and accountants who advised them—have been punished or soon will be, the scandals they perpetrated never prompted a thorough rethinking of how American markets should work, and how best to preserve the markets' integrity. After 25 years of deregulation in financial, airline, and other industries, a high-velocity, service-oriented economy has given the wealthiest Americans more money than ever. They are pouring it into hedge funds, whose whiz-kid managers are guided by an overriding principle: Multiply the money, any way you can.

THE FIRST HEDGE FUND WAS STARTED IN 1949 BY ALFRED WINSLOW JONES, an American magazine reporter and former sociologist born in Australia. As a staff writer at Fortune magazine, he wrote a story, "Fashions in Forecasting," that inspired him to try the stock market himself. With $100,000 to work with, he and four friends devised a two-part investment strategy. First, they borrowed additional funds so that they could invest far more than they had. Known as leveraging, it's the same technique used to finance the takeover of companies and is not all that different from borrowing money to buy a house.

The true innovation was the second part of Jones's strategy. He picked not only stocks he expected to increase in value, but stocks he expected to decline. He sold the expected losers "short," meaning he agreed to sell them on a future date at the current market price. So if the stock dropped, he could buy it at the lower future price, sell it to the buyer at the current price as agreed, and profit from the difference. His contract to sell the stock short meant that he had to buy at the future price even if he turned out to be wrong and the stock rose. But by betting that some stocks would rise and others fall, Jones "hedged" his position—hence the term "hedge fund"—reducing the effect that a sudden change in the general stock market would have on his investments. He made a lot of money being right more often than being wrong.

A 1966 Fortune article, "The Jones Nobody Keeps Up With," reported Jones's spectacular returns—325 percent over the previous five years, 670 percent over the previous 10—and brought hedge funds to the attention of American investors. In the two years following the article, the number of hedge funds soared from a handful to 140. But their growth paled in comparison with the rise of mutual funds, private pools of capital that were not subject to the same limits on the number and wealth of their investors. Anyone could invest in mutual funds, and a lot did in the 1970s and '80s, when many companies stopped paying retirees through pension plans and instead adopted 401(k) plans, which offered employees various options for investing in mutual funds.

Over the past decade, though, hedge funds have roared back. The prospect of earning hundreds of millions of dollars in fees each year lured top investment bankers from Wall Street to hedge funds in Greenwich, Conn., and Palm Beach, Fla. At the same time, financial windfalls from a booming economy left thousands of the wealthiest Americans looking for places to put their money. The bankers and the wealthy met initially in hedge-fund bliss.

Individuals are no longer the only ones who sock away a million or two in the funds. The best customers are often nonprofits, pension funds, and other institutions. After watching former investment banker David Swensen put a sizable share of Yale University's $15.2 billion endowment in various hedge funds and earn outsized returns, financial advisers at Notre Dame, Princeton, and other colleges and universities followed suit. And the reputation of hedge funds for earning high returns in down times has made them even more attractive since the bursting of the dot-com bubble and the economic troubles of recent years.

The numbers tell the story. From about 300 in 1990, the number of hedge funds rose to nearly 6,000 in 2001 and is currently estimated at 8,000 or 9,000. Assets under management in hedge funds increased from $39 billion in 1990 to $550 billion in 2001 to almost double that today.

HEDGE FUNDS ARE BEST UNDERSTOOD BY WHAT THEY ARE NOT. They are not regulated. To oversimplify slightly, a hedge fund is like a mutual fund that has been designed to avoid four federal laws that generally require investment funds and their advisers to identify fund officers and holdings and to submit to Securities and Exchange Commission oversight.

The first law is the Investment Company Act of 1940. The 1940 act does not apply if the hedge fund has fewer than 101 investors. In 1996, Congress added a second exemption, waiving off the 1940 act if the investors are "qualified purchasers." A qualified purchaser needs $5 million if he is an individual and $25 million if it is an institution, but a hedge fund can theoretically have as many qualified purchasers as it wants. (In reality, the maximum is 499, for reasons that will become clear in a moment.) The thinking behind the exemptions is that a few friends, family members or wealthy investors who are financially sophisticated don't need the regulatory protections of the 1940 act, safeguards like restrictions on risky investments and limits on performance-based fees. Most funds choose the second exemption, because it allows them to tap a much larger group of investors.

Hedge funds can avoid the next two laws, the Securities Act of 1933 and the Securities Exchange Act of 1934, by staying private and small. The extensive disclosure requirements of the 1933 act kick in only if the fund seeks money from the general public rather than from investors who are "accredited," meaning each has more than $1 million in net assets or earns more than $200,000 a year. And under the 1934 act, the fund doesn't have to file regular disclosure statements like quarterly financials if it isn't listed on a stock exchange and if it has fewer than 500 investors (which explains the limit of 499 qualified investors described above). Again, the thinking is that a few well-to-do friends and family members don't need the protections of the securities laws.

The fourth law, the Investment Advisers Act of 1940, requires fund managers to tell the SEC how they're investing and to follow the commission's rules. But the act applies only if the manager has more than 14 clients and promotes himself to the public as an investment adviser. The trick here is in the definition of "client." The SEC says the term can mean an entire investment fund. Rather than counting investors, in other words, the commission will, until a new rule goes into effect in early 2006, treat the hedge fund itself as the client.

Avoiding these four laws allows most hedge funds to operate in secrecy and, unburdened by investment restrictions or the cost of public disclosure, do almost anything they want. Their options include hedging, the practice that Alfred Winslow Jones pioneered, but many funds don't hedge. Some focus on major corporate deals like the Mylan-King transaction and make money by predicting a deal's effect on a company's stock. Others use mathematical models to exploit blips in the prices of stocks, bonds, or other securities. Still others buy "distressed debt"—bonds and other obligations of companies in financial trouble. The funds pay a small fraction of the debt's face value, betting it will be worth more if the company's fortunes turn.

When funds hedge, they can do it in ways that Jones never dreamed of—playing the currency markets, for example. If a hedge fund owns an asset that will be worth less if Thailand's currency declines—stock in a Thai company that needs steel and other material from abroad, for example—it can enter a currency contract in the futures market to recoup the difference between the Thai baht's current value and its value in six months, assuming the baht ends up falling. Hedge funds can also use the same contract to bet on the baht's future, even though they have no assets tied to the baht and no desire to hedge. The strategy is risky, though, since currencies are notoriously volatile. The risks rise when hedge funds are heavily leveraged and bet with lots of borrowed money. That's when the danger of collapse—and damage to the economy—is highest. Unfortunately, managers have every incentive to take those risks and more.

THINK BACK TO ENRON, WORLDCOM, and other companies at the center of recent scandals. Most had celebrity CEOs paid primarily with stock options. The options offered eye-popping rewards if the company's stock went up but no penalty if it dropped. Enron CEO Kenneth Lay, for example, exercised stock options in 1999 and 2000 for a total profit of $167 million. The executives did whatever they could to pump up the stock, from gambling with company assets to cooking company books. To gain the Wall Street support that would keep their stock prices climbing, the superstar CEOs set targets for growth in their companies' earnings of 15 to 20 percent a year, which were generally far too high to sustain through above-board practices. A study by Dutch economist Kees Cools suggests that the higher the earnings targets (the average "fraud" company in his study aimed for 18 percent, the nonfraud company 7 percent) and the more an executive's pay consisted of stock options, the greater the chance a company would commit financial fraud. A study by Jared Harris and Philip Bromley at the University of Minnesota shows that 20 percent of companies with CEOs who received 92 percent or more of their pay in options had cooked books within five years.

The situation with hedge funds is remarkably similar. Although investment strategies vary widely, the method of paying fund managers is uniform. Unlike mutual fund advisers, who generally get a percentage of the money they manage—for a $200 million fund, the standard fee is 1 percent, or $2 million per year—a hedge fund manager usually receives 20 percent of his fund's profits, plus 1 to 2 percent of its assets under management. The 20 percent fee is a legacy of Jones's original hedge fund, and last year it helped the top 25 hedge fund managers earn, on average, a whopping $251 million, according to one estimate. But the fees, together with lavish claims about performance, create the same kinds of incentives that led to corporate scandals.

There are many honest and successful hedge fund managers, but the combination of minimal oversight, performance-based compensation, and extravagant earnings expectations has encouraged lots of aggressive behavior and some outright fraud. Bayou Management LLC, a Stamford, Conn., hedge fund, stands accused of looting hundreds of millions of dollars while claiming steady, above-market profits. When the story broke last summer, it was treated as an unsettling, relatively isolated incident. But in the past five years, the SEC has brought 51 fraud cases against hedge fund managers. Many of the cases involved managers who duped investors with exaggerated earnings claims. For example, Conrad Seghers of Integral Investment Management, a biologist who turned to day-trading, persuaded the Art Institute of Chicago to invest $43 million in two funds that "generally combined safe cash holdings with stocks and riskier index options," according to Seghers, "in a way that he could guarantee profits of 1% to 2% a month in flat or rising markets." Seghers quickly squandered $20 million of the museum's money on ventures like his business partner's Internet startup. In other cases, hedge fund managers siphoned money from investors by lying about the funds' profits. West Palm Beach, Fla., hedge fund KL Group recently closed following charges that it had reported false rates of return—70 percent and 40 percent for the past two years—when, in reality, the fund was losing money.

Although these cases involved misbehavior blatant enough to detect, it's often hard to tell whether reported profits are real, because the sophisticated financial contracts that hedge funds invest in are so difficult to value. Currency contracts, for example, are often accounted for at current market value, even though their actual value cannot be known for some time. The complexity of financial contracts provides cover for lots of other sins, too, including tactics for evading regulations and rigging markets. The letter of the law has not caught up with many of these sins, whose victims often are not investors in hedge funds but ordinary stockholders and others with a stake in fair markets and a healthy economy—people like the shareholders of Mylan Laboratories.

When a hedge fund like the Perry Corporation votes shares that it has already committed to sell, and when it votes them to advance its interests in a target company, it does not violate the law. But it acts unethically to the detriment of its fellow shareholders in the acquiring company. In fact, the worse the deal is for those shareholders, the more the hedge fund stands to gain. To use the Mylan-King example, let's say King's stock trades at $30 a share when Mylan offers $50 for it. If the market thinks the deal will be bad for Mylan, it will be skeptical about the deal's chances of going through and will value King's stock at, say, $40, well below Mylan's offer price. If the market thinks the deal will be very bad for Mylan, it will be even more skeptical and will value King's stock at $35, tops. So if Perry can buy King's stock at $35 rather than $40, Perry stands to make more money.

Carl Icahn and Mylan foiled Perry's scheme, and it is one of the only confirmed examples. But vote buying by hedge funds is probably common. The practice first surfaced when the technology company Hewlett-Packard and the computer giant Compaq proposed to merge in 2001. Walter Hewlett, the son of one of the founders, waged a vigorous campaign against the merger, and many Wall Street experts criticized the deal as bad for HP. But HP shareholders narrowly approved the merger, and there is evidence that hedge funds tipped the scale through aggressive vote buying. It turned out that Hewlett and the Wall Street critics were correct, and the principal proponent of the merger, former Hewlett-Packard CEO Carly Fiorina, stepped down last year as the merged company continued to flounder.

Forcing bad deals to go through can cause surprisingly widespread damage. Consider the effect on the millions of Americans who invest billions of dollars in mutual funds. Mutual funds typically hold a broad cross section of stocks, and the big ones own shares in most of the nation's 500 largest corporations. Those companies do thousands of deals each year, some good, others bad. The bad ones eventually damage a company's performance and lower the price of its stock. Vote rigging of the Perry sort ensures that more bad transactions will happen, which means that the overall value of mutual funds will drop.

Vote buying is hardly the only way that hedge funds use their financial muscle in the markets. In May 2005, Citadel Investment Group, a Chicago hedge fund, reportedly bought and held an estimated $8 billion worth of a single issue of 10-year U.S. Treasury notes—over half the amount readily available in the market. Other investors couldn't find enough notes to buy. That doesn't sound like a big problem, but it was ruinous for people who had purchased futures contracts. The contracts obligated them to sell notes to a buyer at a specified date in the future, presumably at a profit. But they couldn't fulfill their obligations, particularly at prices they had forecast, in part because Citadel held so many notes and would make them available only at exorbitant prices. Whatever its intentions, Citadel appears to have profited handsomely. Hoarding notes can be a method for manipulating the market, and it is reminiscent of the way robber barons like Jay Gould cornered markets in the 19th century, with one important difference. Gould played both sides, contracting to sell assets in the future and then hoarding them to drive up their value, a practice that would be illegal today. When a hedge fund like Citadel holds lots of notes, it acts entirely within the law, though its behavior can be disruptive to the markets.

In bankruptcy situations, hedge funds routinely throw their weight around by combining vote buying and hoarding techniques. To reorganize its business and get out of bankruptcy, a company needs the approval of each class of creditors: banks, bondholders, or suppliers that have loaned it money, for example, or firms that hold mortgages on its buildings. Approval comes when creditors holding two-thirds of a class of debt agree. If a hedge fund buys enough debt of a particular class, it can control the class's vote and, for example, pressure the company to quickly sell most of its assets rather than restructure and save its business. The effect—all perfectly legal—is to put the troubled company at the mercy of the hedge fund's scheme for short-term profits.

Sometimes, though, the law catches up to the scheming. The greed and power of hedge funds played a major role in the mutual fund scandals that broke in late 2003. Eliot Spitzer, the attorney general of New York, alleged that mutual fund managers allowed favored investors to engage in rampant "market timing" and "late trading." Market timers buy or sell stakes in mutual funds when the fund's price is based on stale information. Say a mutual fund owns shares in an Asian company, and their value soars on favorable economic news. Anyone who can buy into the mutual fund before it has a chance to update the value of the Asian company's stock pays less than the stake is worth. Most mutual funds promise investors not to allow market timing, but it is not technically illegal. Late trading, on the other hand, is illegal. Late traders buy or sell mutual-fund shares after 4 p.m., when trading is supposed to stop and the share price is locked in. Late traders can profit by taking advantage of new information that is not reflected in the share price.

Hedge funds—particularly Canary Capital Partners, the fund that Spitzer exposed first—were able to do most of the market timing and late trading, because they used their financial power to cut deals with mutual fund managers. Typically, a hedge fund manager would promise to make a sizeable investment in a mutual fund, thus increasing the mutual fund's management fees, if the mutual fund manager permitted the hedge fund to buy and sell shares rapidly (so it could take advantage of stale valuations) and after hours (so it could do late trading). The SEC claimed that one mutual fund adviser, Fred Alger Management, developed a formula for how much a hedge fund would have to invest to qualify for a specified amount of market timing.

A hedge fund that uses privileged access to market time or late trade essentially steals money from mutual fund investors who pay full price for their stakes and aren't handed the same opportunities for quick profits. Long-term investors are hurt because they must share their gains with the in-and-out market timers and late traders and because mutual funds must keep a substantial portion of their holdings in cash to handle the timers' and traders' frequent withdrawals. By one estimate, market timing alone costs ordinary mutual fund investors $4.9 billion a year.

But there is a cost greater than lost dollars for all these practices, including vote buying and bond hoarding. It is the danger that investors will lose confidence in the markets because the markets are rigged. "People will not entrust their resources to a marketplace they don't believe is fair," an American Bar Association task force said 20 years ago in a study of insider trading, "any more than a card player will put his chips on the table in a poker game that may be fixed." The same holds true today. If investors' faith in the integrity of the markets is shaken, some will pull their money out, meaning less money will be available for American corporations to invest in ways essential to the nation's prosperity. Investors will also be unwilling to pay as much for stocks or bonds in initial or subsequent public offerings, making it more difficult for companies to raise money for expansion or the creation of new technologies and products. The effect on the markets, and on the American economy, would be devastating.

None of the widespread misbehavior of hedge funds should come as a surprise to the SEC. The commission conducted two major studies of hedge funds in the past six years: a 1999 autopsy (done with other agencies) of the near collapse of Long-Term Capital Management and a 2003 study of the proliferation of hedge funds and increasing allegations of hedge-fund fraud. The Long-Term Capital study determined that some hedge funds take enormous risks by investing borrowed money, and the 2003 study found that some hedge funds occasionally exploit their freedom from disclosure to defraud investors. But both studies stressed that the system was not broken and did not need major reform, although the 2003 study recommended that the funds be regulated as investment advisers. Not until the mutual fund scandal broke did the SEC take what Frank Partnoy, a securities law expert at the University of San Diego and a former derivatives trader, describes as its first "baby step" of reform.

THE BABY STEP WAS THE CLOSING OF A LOOPHOLE, the one that hedge fund managers used to avoid regulation under the Investment Advisers Act of 1940. In place of the fiction that a hedge fund manager's client is the fund itself, the new rule treats each investor in a fund as a client. Managers of hedge funds with more than 14 investors—virtually all funds—must register with the SEC by February 1, 2006. Once within the SEC's orbit, hedge fund managers must provide basic details about their qualifications and backgrounds, their funds' holdings, and the investment strategies they pursue.

Even this simple reform did not come easily. The hedge fund industry aggressively resisted registration, pelting the SEC with letters warning that any regulation would prompt hedge funds to move offshore, beyond the commission's reach. The industry opposes any further regulation, and with the confirmation last summer of business-friendly Congressman Christopher Cox as SEC chairman, hedge funds are confident that they will get their way.

Despite industry threats, hedge fund tricks like vote buying, late trading, and market timing are harmful enough to require a response. Late trading can be policed more aggressively, and market timing can be discouraged by penalizing funds that make repeated purchases and sales of mutual-fund shares in short periods of time. Vote buying is much harder to stamp out. The most obvious solution would be to disqualify the votes of any shareholder who had entered into a contract that protected him from changes in the price of the stock he voted. This solution is easier described than achieved, though. Perry was required to disclose his stake in Mylan only because he held more than 5 percent of Mylan's stock. But the disclosure was vague, saying only that Perry had entered into hedging transactions with Bear Stearns and Goldman Sachs—and hedge funds aren't required to disclose purchases of less than 5 percent of a company's stock. If the SEC wants to stop vote buying, it must create stricter disclosure standards—like a requirement that funds reveal any contract that puts them in conflict with the interests of the company and other shareholders—and the courts must be willing to disqualify votes that do not appear to have been cast in the best interests of the company.

Unfortunately, as each hedge fund trick is exposed and, in some cases, eliminated, the pressure to find other ways to cheat will grow, because the funds are expected to give investors rates of return so high that they are difficult to achieve without cheating. The new registration requirement is a start, but it is not clear that simply learning about the names, holdings, and general strategies of 8,000 hedge funds will allow the SEC to police them. As long as the pressure to take unreasonable risks and to show outsized returns continues, the basic integrity of the markets, and the investments of millions of Americans who think they have nothing to do with hedge funds, will be in danger.

David Skeel is the S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law School and the author of Icarus in the Boardroom.

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