Brace for Another Madoff

Politico suggests that the Obama Administration is concerned that during the current financial turmoil matters may become even more destabilized by the surfacing of additional frauds.  One commentator noted that there was probably "another Bernie Madoff out there."  Possible evidence? 

• Are there other firms out there with unblemished quarterly records? Yes. According to research done for Politico by Morningstar Inc., there are 1,684 hedge funds that have disclosed their results for the past 20 consecutive quarters. Of those, Morningstar found that 34 have never reported a down quarter in the past five years. And of those 34, at least seven funds, or their parent firms, are in some way connected to the Madoff scandal as investors in Madoff’s operation. That leaves 27 firms that have a five-year track record of gains and no known connection to Madoff.

To the extent that additional frauds surface and hedge funds rest at the center (either as the perpetrators of the fraud or as depositors with advisors who commit the fraud), it is worth remembering that on this issue the Securities and Exchange Commission tried to be proactive.  It adopted a rule that required hedge funds to register with the agency and file reports about its activities. 

What happened to the rule?  The DC Circuit, the circuit full of political appointees who are often too toxic to get appointed in their own circuit (and who often want to attract the attention of those looking for prospective Supreme Court nominees), struck down the modest rule.  Why?  Parsing through the contorted reasoning of the decision, the panel largely objected to increased government regulation of the markets.  In other words, it was less about law and more about an excessive deference to the market place.  That philosophy explains in large part why we are in the current mess.

Comments

[Doug Cornelius]

Although the rule was modest, it was in conflict with the language of the Investment Advisers Act and the relationship between the general partner of an investment fund and its limited partners.

"The adviser does not tell the investor how to spend his money; the investor made that decision when he invested in the fund. Having bought into the fund, the investor fades into the background; his role is completely passive. If the person or entity controlling the fund is not an investment adviser to each individual investor, then a fortiori each investor cannot be a “client” of that person or entity." Goldstein v. SEC

Congress could easily change the Act to change the definition of client. The SEC stepped beyond its powers when it promulgated the Hedge Fund Rule.

I am not saying that the Hedge Fund Rule was good or bad. Just that it was beyond the SEC's powers under the Investment Advisers Act. Madoff apparently registered in 2006 because of the Hedge Fund Rule. That registration did not seem to make a difference.

As a compliance professional, I am expecting that Congress will make some changes to this in the near future.

[J.W. Verret]

Don't forget that Bernie Madoff was registered as an investment adviser.