Hedge Fund Hoax

Though created to “hedge against risk” and maximize gains through aggressive and advanced investment strategies, one recent hedge fund lawsuit against a prominent investment company may undermine confidence in this fundamental function of hedge funds. In September of last year, the Securities and Exchange Commission brought formal charges against Walter V. Gerasimowicz, Meditron Management Group, LLC (MMG) and Meditron Asset Management, LLC (MAM), for misusing client hedge fund assets from September 2009 through September 2011. 

Gerasimowicz, a well established and highly successful New York City investment strategist, is the owner of both MMG and MAM. The SEC’s charges against the three respondents allege all parties played a role in siphoning millions of dollars from their hedge fund client, Meditron Fundamental Value/Growth Fund, LLC. In its Order, the SEC alleges the money was used to keep Gerasimowicz’s failing contracting company, SMC Electrical Contracting, afloat as it dealt with bankruptcy proceedings. Nearly 80% of Meditron Fund’s assets were transferred to SMC over a two year period, in disregard of their client’s investment interests. Gerasimowicz and MAM maintained their claims that MAM held a diversified portfolio and allegedly withheld information regarding their investment deviations, even though these deviations contradicted their stated investment strategies. 

 Over the two year period of the respondents’ alleged shenanigans, Gerasimowicz sent Meditron Fund investors quarterly statements that neglected to show the company’s “investment” in SMC. Furthermore, the Investment Advisers Act of 1940 requires financial statements relating to client funds to be prepared and audited in accord with GAAP, by a PCAOB approved public accountant. Financial statements were prepared by Gerasimowicz, not a public accountant, before being dispersed to clients and audited statements were subject to lengthy, year long delays before completion.

Additionally, the respondents allegedly recruited new MAM and MMG investors and misled current clients by misrepresenting MAM’s assets at $1.1 billion. Though the respondents claimed they were working to minimize risk, their payments to SMC did anything but. The SEC found that third party investors with full knowledge of SMC’s situation were hesitant to invest in the company and could not be maintained unless Gerasimowicz himself personally guaranteed repayment of their financing. The SEC’s Order also alleges that the respondents neglected to perform any valuation analysis of their “investment” of Meditron Fund’s assets in SMC. 

Gerasimowicz, Meditron Management Group, and Meditron Asset Management are alleged to have violated various sections of the Securities Act of 1933, the Securities and Exchange Act of 1934, and the Investment Advisers Act of 1940. The judge on this matter is set to issue an opinion no later than 300 days from the Order’s date of service.

HOUSE PASSES HISTORIC FINANCIAL REGULATORY REFORM BILL

On Friday, December 11, 2009, the House of Representatives passed the Wall Street Reform and Consumer Protection Act. This is a comprehensive piece of legislation aimed at responding to the worst economic crisis since the Great Depression. This legislation seeks to address the many causes that led to the crisis, including predatory lending and unregulated derivatives.

Among the many reforms included in the Act are the creation of two new federal agencies. The Consumer Financial Protection Agency (CFPA) is an independent federal agency solely devoted to protecting Americans from unfair and abusive financial products and services. The Financial Stability Council will be made of of regulators that will identify financial firms so large, interconnected, or risky that their collapse would put the entire financial system at risk. This Council would have the power to break up these financial companies even when healthy if it is believed they pose a risk to the financial system.

The Act also focuses on various areas which are aimed at minimizing systematic risk. Although not a comprehensive list, the Act:

• Establishes an orderly process for shutting down large, failing financial institutions like AIG or Lehman Brothers in a way that ends bailouts and prevents adverse effects spreading to the rest of the financial system.
• Enables regulators to ban inappropriate or imprudently risky compensation practices, and requires financial firms to disclose incentive-based compensation structures.
• Strengthens the SEC's powers so that it can better protect investors and regulate the nation's securities markets.
• Regulates the $600 trillion over-the-counter (OTC) derivatives marketplace by requiring all standardized swap transactions between dealers and "major swap participants" to be cleared and traded on an exchange or electronic platform. A "major swap participant" is defined as anyone that maintains a substantial net position in swaps, exclusive of hedging for commercial risk, or whose positions create such significant exposre to others that it requires monitoring.
• Incorporates the tough mortgage reform and anti-predatory lending bill the House passed earlier this year. This legislation outlaws many of the industry practices that led to the subprime lending boom.
• Requires registration of hedge funds by forcing all advisers to private pools of capital to register with the SEC. These advisers will be subject to systematic risk regulation by the Financial Stability regulator.

Large financial companies will be greatly affected by the Act. Not only will there by additional restrictions on operations, but the firms will be charged billions of dollars in new fees as a result of the creation of a fund to pay for future failures of large financial institutions.

For more information, the House Committee on Financial Services issued a press release which can be found here. A Wall Street Journal article addressing the Act can be found here.

OBAMA'S PLAN FOR THE SEC: GIVETH AND TAKETH AWAY

In an effort to prevent another economic meltdown, President Barack Obama recently proposed the most sweeping financial regulatory system overhaul since the Great Depression. Many thought Obama's plan would strip the SEC of its powers and hand over control to the Federal Reserve. Since its inception, the SEC has been charged with regulating stock markets and the securities industry, including enforcing federal securities laws and regulations. As of recent, the SEC has come under harsh criticism, with some believing it was responsible for missing the signs of the impending financial crisis of 2008.

Initial reports of Obama's plan to reorganize the financial sector indicated that the SEC may take a backseat role in its financial market oversight. However, under Obama's plan, the SEC will retain most of its market power and and gain new tools to protect investors. Specifically, the SEC will be given oversight over the hedge fund industry. In addition, the SEC will be gain more authority over the enforcement of company disclosures, along with more exhaustive enforcement sanctions to ensure compliance with securities laws.

Although Obama's plan will give the SEC more expanded market power, the plan also recognizes the SEC's failure to properly oversee the country's largest financial firms, many of which collapsed under the SEC's supervision during the financial meltdown of 2008. Accordingly, Obama's regulatory overhaul will relinquish the SEC's power over these large financial firms, and instead will name the Federal Reserve as the supervisor and regulator of these firms to help prevent another collapse.

It is important to note that the new Obama plan is merely a proposal to overhaul the regulatory system. The fight in Congress is only beginning, as the Obama administration now tries to draft a bill that will give Obama the votes necessary to sign legislation on his proposed changes, which he hopes to accomplish by then end of 2009.