Journal of Investment Compliance

Hedge fund information depository: a case study of a pre-emptive solution to fund manager fraud : Table of Contents

Majed R. Muhtaseb — Sun Jun 21 14:15:05 BST 2009

Abstract:
Purpose – The objective of this research is to educate investors and hedge fund industry stakeholders about a hedge fund manager's alarming activities prior to recognition of the fraud by the authorities. The lessons serve as red flags to stakeholders in the hedge fund industry such as prime brokers, auditors, administrators, accountants, custodians and government regulators, and especially investors conducting due diligence on hedge funds. A far-reaching proposal is for the industry to found a hedge fund information depository (HFID) where participants/stakeholders provide information on any hedge fund on a regular basis. Such an information clearing-house would facilitate a long overdue timely communication among hedge fund industry constituents. The services would be available for a fee. This service elevates transparency in the hedge fund community to an unprecedented level and could ultimately mitigate a manager's fraud. Design/methodology/approach – A major hedge fund fraud case, Lancer Management Group, is used an example and application of HFID. Findings – Investors in the Lancer funds lost more than $500 million. In the case of Lancer, there were several “alerts” or “triggers” many months before the actual filing of the SEC complaint against the fund. Hedge fund manager fraud could be mitigated through the establishment of the information depository. Had the depository been in place, some Lancer funds stakeholders could have made different decisions. Research limitations/implications – Some hedge fund industry stakeholders may reluctantly join HFID. Researching the willingness of hedge fund industry stakeholders to join HFID would be a good extension of the current research. Practical implications – Had a third party become aware of the alerts, this third party could have made a different investment decision. Most importantly, this depository would allow all the hedge fund industry stakeholders (accountants, administrators, auditors, marketers, prime brokers, custodians) to contemporaneously communicate with one another. Originality/value – The approach and the solution are both unique. In addition, the topic is very controversial and timely, yet few business professionals explore research projects on fund manger fraud. HFID would be of great value to hedge fund industry stakeholders, especially investors.

Internal control reporting regulation: a law and economics perspective : Table of Contents

Matthew A. Zolnor — Sun Jun 21 14:15:05 BST 2009

Abstract:
Purpose – The purpose of this paper is to analyze the efficiency of the internal control reporting (ICR) requirements imposed by Sections 302 and 404 of the Sarbanes-Oxley Act of 2002 (SOX). The lessons learned are then applied to the current financial crisis. Design/methodology/approach – The Coase Theorem is applied to the events leading up to the collapse of Enron and the enactment of SOX. The paper then analyzes the efficacy of the various examples of ICR regulation, both pre- and post-SOX, noting the ways in which they effectively mitigate transaction costs and the ways in which they over-regulate. Findings – US investors continue to invest in foreign markets despite the fact that those markets maintain less demanding ICR requirements than those required by Section 404. Moreover, investors do not respond negatively to Section 404 disclosures. The research demonstrates that Section 404 does not provide useful information in the minds of investors. Considering Section 404's ineffectiveness and the burdensome costs it imposes on reporting companies, it is clear that Section 404 is an example of over-regulation and should be repealed. Practical implications – The transaction costs that caused the collapse of Enron and the enactment of SOX bear strong similarities to those causing the more recent subprime mortgage crisis. The lessons learned from the enactment of SOX Section 404 are directly applicable to the current financial crisis and should be noted moving forward. Originality/value – By utilizing a law and economics perspective, the paper more clearly demonstrates how Section 404 is an example of over-regulation and draws links to the current economic crisis.

Tax consequences for investors in hedge fund frauds : Table of Contents

Roger D. Lorence — Sun Jun 21 14:15:05 BST 2009

Abstract:
Purpose – The purpose of this paper is to consider the appropriate Internal Revenue Service (IRS) tax filings for individual and fund-of-fund (FOF) investors who have incurred losses from hedge fund fraud. Design/methodology/approach – The paper describes the types of losses investors have suffered; explains the types of relief the IRS provides; recommends the steps investors should take in filing claims; discusses special issues for FOFs, recoveries from the Securities Industry Protection Corp. (SIPC), treatment of litigation expenses, and recent IRS guidance; and provides a sample tax-claim calculation. Findings – For defrauded investors, two types of relief may be available: filing a tax return for the taxable year in which the fraud is discovered to claim an ordinary loss from theft for the entire adjusted basis in the fraudulent investment; and filing for refunds of tax erroneously paid in prior years on income fictitiously reported by the Ponzi scheme. Originality/value – The paper provides timely guidance from an expert on tax issues related to hedge funds. Readers need to be aware that resolution of many issues discussed here is uncertain and the subject may be characterized as a “moving target”.

Litigating disciplinary proceedings against the SEC and FINRA: it sometimes pays : Table of Contents

Brian L. Rubin, Christian J. Cannon — Sun Jun 21 14:15:05 BST 2009

Abstract:
Purpose – The purpose of this paper is to determine with statistics whether respondents should litigate or settle enforcement actions with the SEC or FINRA. Design/methodology/approach – All SEC administrative and FINRA litigated decisions from October 1, 2007 to September 30, 2008 were reviewed to see, among other things, how often the staff succeeded in proving its charges and, when it did, what penalties were sought and awarded. The approach is empirical, designed to inject meaningful quantitative data into the decision of whether to litigate. Findings – The research shows, among other things, that respondents rarely win on liability but are usually successful in persuading SEC ALJs or FINRA panels to impose substantially lower sanctions than the staff sought. Research limitations/implications – The primary limitation is that it is usually not known what terms were offered to settle cases by the staff prior to the complaint being filed. Practical implications – The implication is that respondents in SEC and FINRA cases should consider more carefully whether to litigate rather than settle. Originality/value – The statistics in the study are new and provide new evidence confirming prior years' studies. Any potential SEC or FINRA respondent would be interested in the statistics presented here.

As fraud schemes proliferate – are you the next investor to crash and burn? : Table of Contents

Ken Evola, Nicole O'Grady — Sun Jun 21 14:15:05 BST 2009

Abstract:
Purpose – The purpose of this paper is to educate investors on the red flags of Ponzi and other fraud schemes and due diligence measures. Design/methodology/approach – The paper examines ways in which fraud is executed in Ponzi schemes and then highlights practical precautions every investor should take to prevent being a victim. Findings – The research outlines specific red flags that the investors in the Madoff Ponzi scheme and other fraud schemes might have recognized and others in the future should recognize to prevent being the next victim. These red flags are consistent in most Ponzi schemes and investors should institute due diligence in examining their investment firm or manager. Practical implications – Investors should be wary of their investment manager and pay attention to the warning signs that they could be involved in a Ponzi scheme. They should insist on seeing detailed audit information and not hesitate to ask questions. Originality/value – The paper will be of interest to a wide range of individual and institutional players in the investment community who in light of recent events are concerned about being investment fraud victims.

SEC permits mutual funds to use a summary prospectus and updates statutory prospectus requirements : Table of Contents

Robert A. Robertson, Joseph P. Kelly II — Sun Jun 21 14:15:05 BST 2009

Abstract:
Purpose – The purpose of this paper is to examine SEC rule amendments that permit a mutual fund to use a three- or four-page “summary prospectus” to satisfy statutory prospectus delivery obligations and amendments to a fund's statutory prospectus requirements that require key information in a standardized order at the front of the document. Design/methodology/approach – The approach is to explain the SEC's regulatory changes to the basic mutual fund disclosure documents designed to help investors choose among the more than 8,000 mutual funds. Findings – The investing public's use of the internet for fund research and fund transactions has made it possible for the SEC to take a “layered” approach to disclosure documents, providing an investor with a short-form document and making available more detailed information on fund web sites. The SEC will likely follow suit with other documents and updated compliance requirements. Originality/value – The paper will assist fund legal counsel and compliance professionals: to comply with the new statutory prospectus requirements; and to determine whether the summary prospectus is an appropriate disclosure document for a particular fund.

Summary of selected FINRA regulatory notices and disciplinary actions, January-March 2009 : Table of Contents

Henry A. Davis — Sun Jun 21 14:15:05 BST 2009

Abstract:
Purpose – The purpose of this paper is to provide excerpts of selected Financial Industry Regulatory Authority (FINRA) Regulatory Notices and Disciplinary Actions issued from January to March 2009 and a sample of disciplinary actions during that period. Design/methodology/approach – The paper provides excerpts from FINRA Regulatory 09-12, Auction Rate Securities; 09-13, Threshold for Single Arbitrator Cases; 09-14, Trading Ahead of Customer Limit Orders; 09-17, Investigations and Formal Disciplinary Actions. Findings – The SEC has defined reporting requirements for settlements of customer disputes involving auction rate securities, raised the threshold for single arbitrator cases to $100,000, approved alternative means for calculating minimum price-improvement obligations that firms must provide to trade ahead of customer limit orders, and provided guidance on its enforcement process to improve transparency into its regulatory framework. Originality/value – These are direct excerpts designed to provide a useful digest for the reader and an indication of regulatory trends. The FINRA staff is aware of this summary but has neither reviewed nor edited it. For further detail as well as other useful information, the reader should visit www.finra.org

Group of Thirty issues road-map for financial reforms : Table of Contents

Sun Jun 21 14:15:05 BST 2009

Abstract:
Purpose – The purpose of this paper is to summarize the Group of Thirty's recommendations and explain how they relate to other concurrent financial market regulatory initiatives in the USA, UK, and Europe. Design/methodology/approach – The paper summarizes the report's four core recommendations, describes how they relate to recent reports by the US Treasury Department, the US Chamber of Commerce, and Committee on Capital Markets Regulation, and discusses how they may signal the direction of forthcoming domestic and coordinated international regulation. Findings – Momentum has been building for consolidation, increased oversight, and international coordination of the legal and regulatory framework that governs the financial industry. The report has an unabashedly pro-regulatory agenda. Originality/value – The paper provides helpful reference on the current direction of international financial institution regulation

President's working group on financial markets: best practices for the hedge fund industry : Table of Contents

Richard A. Goldman, Robert C. Leonard, Matthew Anderson Gray, Steven G. Vecchio — Sun Jun 21 14:15:05 BST 2009

Abstract:
Purpose – The purpose of this paper is to summarize two separate reports on best hedge fund industry practices issued on January 15, 2009 by the Asset Managers' Committee and the Investors' Committee of the President's Working Group on Capital Markets. Design/methodology/approach – The paper provides a detailed summary of the two reports. Findings – The Asset Managers' Committee Report sets forth a standard of best practices for the hedge fund industry aimed at reducing systemic risk and fostering investor protection. It recommends that hedge fund managers adopt comprehensive best practices in all aspects of their businesses, including the following five key areas: disclosure; valuation; risk management; trading and business operations; and compliance, conflicts and business practices. The Investors' Committee Report sets forth guidelines intended to “enhance market discipline, mitigate systemic risk, augment regulatory safeguards regarding investor protection, and complement regulatory efforts to enhance market integrity”. The Report provides recommendations to investors for evaluating hedge funds and overseeing hedge fund investments within a portfolio. It is divided into: a Fiduciary's Guide aimed at assisting plan trustees, banks, consultants and others with portfolio oversight responsibilities, in determining whether a hedge fund investment would be suitable for the organization they represent; and an Investor's Guide aimed at providing recommendations to investors who have decided to add hedge funds to their investment portfolio. Originality/value – The paper provides a concise, informative guide by experienced securities lawyers with hedge fund expertise.

Facing the financial crisis: Bank of Italy's implementing regulation on hedge funds : Table of Contents

Gabriella Opromolla — Sun Jun 21 14:15:05 BST 2009

Abstract:
Purpose – This paper sets out to describe the Bank of Italy's implementation regulation on hedge funds pursuant to Law Decree No. 185 of November 9, 2008, the so-called Anti-Crisis Decree aimed at stabilizing the Italian economy during the current financial turmoil. Design/methodology/approach – The paper defines the criteria for hedge funds, actually known as “speculative funds,” under Italian law; explains provisions under Law Decree No. 185 for a hedge fund to respond to redemption requests, sell assets if necessary, and create side-pockets if necessary. It defines side-pockets as closed-end funds and describes their purpose, operation, and set-up procedures. The paper also explains the criteria for defining assets as illiquid and transferring them to side pockets. It also discusses approval procedures for amendments to hedge fund rules and the implications of the new regulation. Findings – The Anti-Crisis Decree and the Bank of Italy's implementation regulation are among measures to ensure transparency, the orderly conduct of trading, and the protection of investors; their ultimate impact is uncertain. Originality/value – The paper provides a concise summary of hedge fund regulations by an attorney with experience in the Italian financial markets.