Does regulation prevent fraud? The case of Manhattan hedge fund.

• Author: Kurdas, Chidem

Moves to enhance and expand regulation almost invariably follow financial disasters. Losses trigger calls for government action, especially when fraud is suspected. Not only policymakers, but also the media and the wider public see regulation as the natural remedy, perhaps because people tend to view financial debacles through the metaphor of misbehaving children in need of adult supervision. When you examine a real-life episode, however, the presumption that stricter regulation would have prevented the debacle is difficult to maintain. Instead, what emerges is a pattern of misperceptions and misjudgments, behavioral characteristics that apply to regulators as much as to the rest of humanity and indicate a need for better awareness of mental biases, not bureaucratic overlay.

A case in point is the failure of Manhattan Capital, a hedge fund firm. The manager, Michael Berger, misled his clients and lost several hundred million dollars of their money. This incident is particularly germane in that the U.S. Securities and Exchange Commission (SEC) used it in 2004 as part of a justification for greater regulatory control over hedge funds.

A hedge fund resembles an expensive restaurant run by a skilled chef who caters to the well heeled. By U.S. law, only people or organizations that meet certain wealth and income standards may invest in a hedge fund; the rest of us are legally limited to the less-diverse menus that mutual funds offer. Hedge fund investors are either wealthy individuals who invest their own money or, more commonly, professionals who act for others. Such people search for novel ways to get higher returns. Manhattan Capital's clients were among these sophisticated, seasoned investors with big chunks of capital to deploy. They recognized the vagaries of markets and money managers. Seemingly reasonable decisions nevertheless metamorphosed into a comedy of errors.

Hedge funds have been described as a regulatory arbitrage--a way to get around the high cost of regulation imposed on other financial organizations (Ely 1999, 248). Though subject to laws and regulations, they are freer than their mass-market cousins, mutual funds, and hence a prime target for policymakers interested in tightening the reins. As evidence that hedge fund investors need more protection, the SEC cited the Manhattan Capital example, among others. This SEC effort eventually failed, but the 2007-2008 downturn in real estate and credit markets gave rise once again to a movement to expand the government's authority over financial markets and organizations, including hedge funds. Because regulatory frenzy arises every time another fiasco occurs, the lesson of Manhattan Capital will likely remain relevant for a long time to come.

Managing a Hedge Fund

A fund is simply a pool of money, typically with no office or staff of its own. An adviser or manager creates this legal entity, develops its investment program, and hires service providers to perform its necessary tasks: brokers to execute its trades, a custodian to hold the assets, an administrator to prepare financial documents and keep investors informed, and an auditor to vouch for the statements.

Thus, Michael Berger, the owner of the management firm Manhattan Capital, set up and controlled Manhattan Investment Fund (U.S. SEC 2000). He hired an administrator and an auditor, both Bermuda affiliates of big accounting companies. Through a small, Ohio-based firm called Financial Asset Management (FAM), whose owner he knew, he gained access to the services of Bear Stearns & Co., which became the fund's prime broker and custodian of its assets. A prime broker lends to client funds and serves as the main conduit for clearing their trades. FAM acted as introducing broker and received payment for placing the trades Bear Stearns executed (figure 1).

In combination, such service institutions function as a private supervisory network, an alternative to public regulation. Investors expect service providers to act as an external check on managers. Some managers voluntarily register with the SEC, becoming subject to closer supervision as registered investment advisers, but Berger did not register. Although he lived in New York during the time he managed Manhattan Fund, almost all his clients were non-Americans who showed no interest in having the SEC oversee their investments.

The private safeguards have one notable weakness. The manager picks the service providers and can fire them. For a fund administrator, a successful fund manager is a valuable client who can easily take his business elsewhere. Therefore, administrators tend to defer to managers. But large operations that cater to many funds, such as the prime brokerage arm of Bear Stearns, are independent of any single manager. If a fund has a diverse set of small and large service providers, at least some of them will be effective watchdogs. Although the manager puts together this structure, a hedge fund's clients can inquire about and even inspect the service providers.

At the time Berger started to raise capital in 1996, he believed that the U.S. equity market was overvalued and about to take a significant fall. He therefore advocated an investment program that consisted of short selling U.S. stocks. Most mutual funds bet that the prices of securities will go up, hoping to buy low and sell high. Short selling, a less widely practiced and more complicated type of trade, reverses the order by betting that a price will go down--one sells high first by borrowing shares from a broker and buys low later to replace them. Many hedge funds combine the two kinds of trade in a strategy called equity long-short.

According to Manhattan Fund's December 1995 offering memorandum, it belonged to this category of fund. As that document emphasized, borrowing shares imposes a short-term liability: the securities have to be returned to the broker by a designated date. By borrowing stocks, a trader can sell securities of greater value than the capital he controls, but if a bet goes wrong, the loss is correspondingly large. Moreover, short selling carries greater risk than a conventional long trade simply because share prices can go up without bound. When you buy a stock, the most you can lose is whatever you paid for it, whereas when you short sell, there is no such maximum. Short-selling losses can "increase rapidly and without effective limit," as Manhattan Fund's prospectus put it. These hazards are familiar to hedge fund investors.

Berger advocated his program of borrowing and selling stocks in a weekly newsletter that he sent to clients and would-be clients during the fund's lifetime. His bearish view of the market was well known; in interviews and comments to the media, he repeatedly warned of an imminent slump. His idea attracted investors, and he succeeded in raising about $600 million over a period of almost four years. With this capital, he did what he told people he would do. By all evidence, he had confidence in his forecast and strategy. Not only did he invest the capital he raised, he threw in his own savings as well. His business was later described as a Ponzi scheme, but in fact it was a real investment operation. Week after week he told his clients that he would try to profit from short selling overvalued shares--which is exactly what he did.

From the standpoint of a dedicated bear like him, sell signs kept multiplying in the late 1990s--that is, the stock market soared. The pattern, he thought, resembled the 1920s. It followed, to his mind, that a crash was waiting to happen. "Many of the economic and technical conditions that existed before the crash of 1929, exist once again today," he argued. "When so many circumstances follow a similar path, logically the consequences have to be similar" (Berger 1997, 1). He was not alone in casting doubt on the stock boom. Federal Reserve chairman Alan Greenspan expressed concern about excessive exuberance in 1996, and another Fed official, governor Laurence Meyer, warned against high

prices. Yet money flooded into equities, pushing prices up. Even shaky businesses continued to gain. Berger had to explain to his clients why the decline he predicted was delayed. He came up with an impressively prescient account.

Although companies were reporting strong performance, giving shareholders reason to be euphoric, the rosy earnings reports were not to be believed. "Extraordinary and exotic accounting practices are being exercised to maximize earnings and minimize any shortcomings," Berger wrote several years before Enron and other accounting scandals broke (1998, 1). He identified a number of ruses to which company officers were resorting, all of which became well known later. "Cookie jar" fake businesses were created to conceal declines in earnings. One-time charges and write-offs were used to get the cost of acquiring new firms off the balance sheet, thereby exaggerating reported earnings. Among the companies he identified as engaging in dubious practices were Tyco and WorldCom, whose chief executives were later convicted of financial crimes.

Berger zeroed in on employee stock options, which had become a large part of compensation, but were not included in the costs. He estimated that the earnings of even the top one hundred U.S. companies were overstated by more than 40 percent. All this was obvious to him by 1997; in his newsletter, he repeatedly railed against what he saw as deceptive corporate tactics, describing "all imaginable forms of balance sheet cosmetics." He assured his clients that the mania could not last much longer, that reality always catches up with unrealistic expectations--and the numbers behind the bonanza were, literally, unreal.

At the time, however, attempts to bring up the issue were futile. Regulators showed no interest, even though Berger's repeated warnings suggested that anyone willing to look could see the sleights of hand. Debates about accounting questions and stock...