The SEC’s New Crackdown on Hedge Funds is Pointless

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Hedge fund crackdowns are on the rise, but do they really matter?  Even impressive conviction rates and the seizure of hundreds of millions in illicit earnings may mean little to hedge funds, much less the public.


Don’t tell that to the Wall Street Journal, which printed the following headline–“FBI Sweep Targets Big Funds”—as Friday’s above-the-fold cover story.  The piece highlighted arrests made after an inside information trafficking sting identified employees of several technology and financial companies.  It is the latest in several dozen similarly-themed stories the Journal has run in the past six months.


The most recent offender: WSJ’s “criminal-club”

The alleged scheme involved at least 7 individuals, and netted a reported $78M for all parties involved.  Specifically, a reported $62M was “earned through tips provided by a Dell employee to a former Dell worker who spread the information among his friends in at least five investment firms, including three hedge funds”, according to Manhattan U.S. Attorney Preet Bharara.


Among those involved were SAC Capital Management, Level Global Investors, and Diamondback Capital Management (the latter two of which are both run by prior managers of the former).   The exposé called attention to the not-in-any-way-new method of making illegitimate money: sharing secret information with your friends.


But, what does prosecuting fraud to the tune of $50M at a time really mean to a multi-billion dollar hedge fund?  The sums in question may sound astronomical to the general public, but consider this: for a $10B hedge fund, $50M represents just one half of one percent of assets under management.


This isn’t to say that the hedge funds want to be scrutinized, or that securities fraud and information trafficking aren’t wrong.  Those with something to hide do fear investigation, and directly accused individuals stand to lose the most.   Yet, deal-level transgressions rarely pose a threat to individual funds, much less the industry as a whole.


Take Diamondback…

Despite longstanding allegations tying it to the racket, Diamondback struck a deal to have charges dropped.  Specifically, it paid $3M in settlements to the SEC to settle civil insider trading charges and will surrender another $6M to the Justice Department for illegal profits related to the information trafficking.  It also supplied information that incriminated some of its co-defendants, thus assisting the authorities in their case.  But, Diamondback is a $5B fund, so the combined $9M fine it will pay only represents 0.18% of funds under management.  That’s the equivalent of someone worth $1M having to pay a fine of $1,800.


So, what about its reputation? Diamondback admitted partial fault in a letter to investors that said a review by the firm’s own lawyers had found past wrongdoing by no more than two former employees (though a third had been accused).  But, per George Canellos, director of the SEC’s regional office in New York, Diamondback’s actions are nearly commendable:  “[The settlement with Diamondback] appropriately sanctions the misconduct while giving due credit to Diamondback for its substantial assistance in the government’s investigation,” said Canellos in a statement printed in the Washington Post.


The message is clear: hedge funds with good PR reps and money in the bank to solve their problems are well-positioned to climb out of hot water.  Offending employees are fired.  Fines are paid.  Conciliatory statements are issued. And the funds get back to business.



The real agenda

So, why are the feds going after hedge funds if not to signal that there will be seriousness penalties for corruption?  And why not focus on the Bernie Madoff and Jon Corzine ilk, which involve billions in missing investor money?


The answer is simple (and twofold).  It’s good PR; and hedge fund victories provide a temporary (but satisfying-enough) distraction from what many Americans wish the authorities would focus on instead: the banks.


“Since late 2009, the government has secured 56 guilty pleas or convictions out of 63 people charged with insider trading,” reads the aforementioned Wall Street Journal article.  Indeed, the most written-about financial misconduct cases since the fall of Lehman Brothers in late 2008 have focused disproportionately on hedge fund activity.


But, is this arena of justice of interest to the public?  After all, most of the public cannot identify with hedge fund investors, who often have millions of dollars in personal funds at stake.  Could this be a ruse to signal the effective handling of widespread financial corruption?  And if it is, how long will it last?


William Black, of the blog “New Economic Perspectives” asked a similar question in December, saying “The SDIs are the financial institutions that are so large that the administration fears that their failure will cause a new global crisis…There is no indication that the SEC intends to use [trade pattern identification technology] to spot fraudulent SDIs…There is no indication that the WSJ reporters asked why the SEC was failing to use its system where it was most needed…Why isn’t the SEC’s top priority the systemically dangerous institutions (SDIs)?”


It’s the $64 trillion question, one we think we know the answer to but sometimes wish we didn’t: as long as political an corporate finance remain intertwined, the outlook for justice is bleak.

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