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Hedge Funds for Investors

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Hedge Funds for Investors Chapter 6 Individual Factors: Moral Philosophies and Values Frauds of the Century Ponzi vs. Pyramid Schemes Ponzi scheme: A type of white-collar crime that occurs when a criminal—often of high repute— takes money from new investors to pay earnings for existing investors. The money is never actually invested and, when the scheme finally collapses, newer investors usually lose their investments. Ponzi vs. Pyramid Schemes Ponzi scheme: This type of fraud is highly detrimental to society Huge financial impact Displaces consumer trust in business. Despite the high-profile cases like Bernard Madoff, Tom Petters, and R. Allen Stanford, Ponzi schemes continue to be used in any industry that includes investing. Ponzi vs. Pyramid Schemes Pyramid scheme: Offers an opportunity for an individual to make money that requires effort. Usually this is in the form of an investment, business, or product opportunity This type of fraud is highly detrimental to society. The first person recruited then sells or recruits more people, and a type of financial reward is given to those who recruit the next participant. Ponzi vs. Pyramid Schemes Pyramid scheme: The key aspect of a pyramid scheme is that people pay for getting involved. Each new individual or investor joins in what is believed to be a legitimate opportunity to get a return, which is how the fraudster gets money. Unlike a legitimate organization, pyramid schemes either do not sell a product, or the investment is almost worthless. All income comes from new people enrolling. Ponzi vs. Pyramid Schemes Pyramid scheme: Direct selling businesses that employ a multilevel marketing compensation system are often accused of being pyramid schemes because of similarities in business structure, although multilevel marketing is a compensation method that involves selling a legitimate product. Charles Ponzi The original Ponzi schemer Saw way to profit from international reply coupons International reply coupon: guarantee of return postage in response to an international letter Lived a fairly opulent life outside Boston Charles Ponzi Success came from personal charisma and ability to con People trusted him because he created an image of power, trust, and responsibility Fraud exposed in 1920 Scheme was self-destructed after one year In order to give earlier investors their returns, he had to continually draw people in Tom Petters Operated the third largest Ponzi scheme in U.S. history at 3.65 billion dollars Petters Company, Inc. (PCI), Petters Group Worldwide’s wholesale brokerage firm operated the Ponzi scheme Scheme was believed to have lasted for over a decade Petters was eventually sentenced to 50 years in prison without appeal He continues to maintain his innocence, saying he did not find out about the scheme until shortly before his arrest Bernard Madoff Most notorious Ponzi scheme conductor Scheme lasted a very long time and was of great magnitude Madoff’s fraud lasted because of his respectability and reputation as a market genius Used his legitimate success and high visibility to start a second money managing business Promised consistent returns of 10-12 percent Attracted billions of dollars Appeal to invest created through exclusivity Bernard Madoff Stated strategy: buy stocks while also trading options on those stocks as a way to limit the potential losses “Split-strike conversion” Used intermediaries known as “feeders” to continuously draw new clients Feeders profited by receiving fees Money was never invested Money was deposited in banks and was moved between Chase Manhattan Bank in New York and Madoff Securities International Ltd., a U.K. corporation Bernard Madoff 2008: economy collapsed Clients requested deposits back Turned himself in to his sons He was arrested on December 11, 2008 Charged with criminal securities fraud Still had approximately $200-300 million left in the company Sentenced to 150 years in prison Fraud billed as a $65 billion Ponzi scheme Actual amount may be below $10 billion Securities and Exchange Commission (SEC) highly criticized for the fraud Insider Trading at the Galleon Group Company Overview The Galleon Group was a privately owned hedge fund firm Provided services and information about investments (stocks, bonds, etc.) Made money for itself and others by picking stocks and managing portfolios and hedge funds for investors Founded in 1997 Company Overview Company’s philosophy: it is possible to deliver superior returns to investors without employing leverage or timing tactics The company held monthly meetings Executives explained the status and strategy of each fund to investors Investors were told that no Galleon employee would be personally trading in any stock or fund the investors held Company Overview The federal investigation and prosecution of members of the Galleon Group is the largest insider trading case in U.S. history. Over two dozen people were implicated, and Raj Rajaratnam, an eccentric millionaire and head of Galleon, was convicted of 14 counts of securities fraud and conspiracy. Rajat Gupta, a man of high influence as Director of McKinsey & Co., was convicted for participating in the scheme and was sentenced to two years in prison. The investigation ushered in a new era in white- collar crime prosecution because wire taps and other techniques were used to secure convictions. Insider Trading Cases are incredibly difficult to prove because: Prosecutors must demonstrate that the defendant not only acquired insider information but also that he or she used that information to trade stock in a way that damaged a company. While regulators have passed more legislation to discourage insider trading, prosecutors are becoming more aggressive and are using strategies previously only seen against drug and organized crime rings. Hedge Funds Hedge funds A combination of assets bundled together with various strategies that minimize risk. Created as an unregistered investment management company and is meant to maximize returns while minimizing risk or exposure. Invest in a broad range of assets, including equities, bonds, and commodities. Only investors who meet criteria set by regulators can participate in hedge funds. Are not sold to the general public At its peak, the Galleon Group invested $7 billion. Hedge Funds Hedge fund managers typically invest their own money in the funds they manage Management fee Investors typically pay this fee Fee goes towards the operational costs of the fund Usually ranges from 1 to 2 percent of an investor's assets in the fund Performance fee Fee investors pay when the fund’s net asset value is higher than that of the previous year Fee is typically 20 percent of the fund's gains in a given year Example: if a client invested $100,000 and the fund earned 40 percent in one year, the additional fee would be $8,000, or 20 percent of the investor's $40,000 gain The performance fee was Galleon’s main source of revenue. The fees associated with hedge funds can generate massive wealth for hedge fund managers. Securities Fraud Because hedge funds are not sold to the general public, hedge fund managers have not been subject to the same restrictions as other investment fund advisers. After the recent financial crisis, new regulations were passed to increase government oversight and eliminate regulatory gaps between different kinds of investment funds. Securities Fraud The Dodd-Frank Wall Street Reform and Consumer Protection Act of July 2010 Require hedge fund managers holding more than $150 million to register with the SEC as investment advisers. Hedge fund managers with less than $100 million in assets are subject to state regulations. Requires hedge funds to provide information about trades and portfolios so that the Financial Stability Oversight Council can monitor and regulate systemic risk. Securities Fraud Securities fraud occurs when a person or company misrepresents or misuses information that investors utilize to make their financial decisions. The types of misrepresentation involved in securities fraud include: Providing false information Withholding key information Offering bad advice Offering or acting on inside information. In Galleon’s case, it was found to be engaging in insider trading. Other Unethical Practices Aside from insider trading, Rajaratnam and his colleagues at the Galleon Group engaged in other unethical practices Tax shelter A kind of investment that allows investors to reduce their taxable income, such as pension plans and real estate. Not all tax shelters are legal. In the Galleon case, Rajaratnam was accused of having a fraudulent tax shelter, because he hid taxable money in foreign bank accounts. Shell corporation A company that has legal status but provides no products and has few, if any, assets. Shell companies are illegal if they are used for income tax evasion or are formed to attract funding. Central Players Player and Employer Shared insider Charges/Convictions information about Raj Rajaratnam At the center of the insider Galleon trading network; pled not guilty to 14 charges of insider trading and fraud; sentenced to 11 years in prison and ordered to pay over $66 million in penalties Danielle Chiesi IBM, Sun Microsystems, Pled guilty to charges of New Castle/ Bear Stearns and AMD securities fraud; sentenced to 30 months in prison, two years of supervised release, and 250 hours of community service Roomy Khan Intel, Hilton, Google, Pled guilty to charges of Intel, Galleon Kronos securities fraud, conspiracy to commit securities fraud, obstruction of justice, and agreed to the government’s request to use wiretaps; sentenced to one year in prison and ordered to forfeit $1.5 million Copied from page 519 in Business Ethics: Ethical Decision Making and Cases Central Players Player and Employer Shared insider Charges/Convictions information about Anil Kumar AMD Pled guilty to passing inside McKinsey & Co. information to Rajaratnam in exchange for $1.75 million; sentenced to two years probation Rajiv Goel Intel Pled guilty to passing inside Intel information; sentenced to two years probation Rajat K.
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