Commentary: “Scapegoating” the Hedge Fund Industry by Michael T. Jackson

The majority of the blame for the current financial mess should be placed on the U.S. Government, especially the Federal Reserve and the Securities Exchange Commission (SEC) for failure to comprehend or exercise their regulatory responsibilities. Targeting the hedge fund industry is a ploy by the government -- an attempt to leverage common misconceptions and create a scapegoat for the SEC and regulatory failures. Pushing for legislation that imposes additional regulations on the hedge fund industry may make good press for Washington, but the result will have long term damaging effects on our financial system.

"Scapegoating" the Hedge Fund Industry By Michael T. Jackson

April 2, 2009
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The majority of the blame for the current financial mess should be placed on the U.S. Government, especially the Federal Reserve and the Securities Exchange Commission (SEC) for failure to comprehend or exercise their regulatory responsibilities. As is the nature of politicians, however, the culprits have been busily casting about to find others to blame. Clearly, the financial industry also shares some responsibility, specifically the large banks that were packaging and selling junk assets. Washington though, as usual, would like to direct blame at hedge funds. This has been demonstrated by recent events, including the Hedge Fund Transparency Act, the summoning of the most successful hedge fund managers to Washington to testify before Congress, and the current push to reinstate the uptick rule.

The Hedge Fund Transparency Act would require hedge funds to register and disclose more information to regulators. However, more than half of the industry is already registered. According to Hedge Fund Research, about 55% of U.S. hedge fund firms have voluntarily registered with the SEC. These registered funds manage the majority (almost 71%) of U.S.-based hedge fund capital. Globally, firms registered with the SEC manage 60% of the $1.4 trillion in hedge fund assets.[i]

The new administration and members of Congress believe that The Hedge Fund Transparency Act will help solve the financial crisis by bringing tighter scrutiny of the hedge fund industry. There is scant evidence, however, that SEC registration will prevent thieves from stealing. Registration did not help Madoff clients from loosing their money. In fact, SEC registration probably helped Madoff, since prospective clients assumed the SEC was doing its job and performed less due diligence.

Senator Charles Schumer (D-NY) speaks of a lack of regulation as a major contributor to the crisis. I believe that it would be more correct to say that a lack of effective and competent regulation was the major contributor to the crisis. Plenty of regulation already exists. A 2008 study, conducted by the Heritage Foundation, reported that “appropriations for federal regulatory agencies increased 44% from 2001 to 2007, with a corresponding 41% increase in staff positions”. [ii] Additional reactionary regulation, such as reinstatement of the uptick rule, will only serve to make the financial industry less efficient and hurt the economy in the long run.

Why are hedge funds getting targeted? There are many reasons, with the two most obvious being:

• As hedge funds are the least understood sector of asset management, they are easier to blame, and therefore make good scapegoats.
• Regulators need to save face in light of multiple failures to uncover major frauds. By finding a scapegoat, the government can appeal to the U.S. public at large and take advantage of the perception that hedge fund managers exacerbate distressed situations for their own financial gain; totally ignoring the fact that they serve a vital role in capital allocation and market liquidity.
  

As the retired founder and CEO of the San Francisco-based registered investment advisor EGM Capital, I am painfully aware of how regulatory agencies waste resources by focusing on political agendas and overlooking the serious frauds. In my case, after an extensive investigation lasting longer than one year, the SEC found a single hedge fund trade that, although correctly handled according to our hedge fund client agreement, should have been allocated differently under the Investment Advisors Act. The SEC public relations machine trumpeted this as a major victory, in spite of the fact that the trade was reversed, and was totally immaterial (less than 1/3 of 1%) in relationship to the profits delivered to clients that year. In the case of Frank Quattrone, the SEC was responsible for criminal charges being brought which could have landed Quattrone in jail for 20 years. Instead of spending time catching genuine crooks, the SEC and the Justice Department probably spent tens of millions of dollars, along with thousands of man hours, on this case. Luckily, Frank Quattrone had the financial resources, time and energy to fight off the SEC, but clearly at a high emotional and financial cost.

A serious problem facing hedge funds, due to constraints imposed by the SEC, is that hedge funds are not allowed to publicly solicit investors or advertise what they do to the general public. This has led to a one sided view of the industry, resulting in a widespread misunderstanding of hedge funds by Main Street and the media. Lack of knowledge combined with the extraordinary earnings of the top hedge fund managers (well publicized by the press), and finger pointing by Washington, has made the term “hedge funds” the equivalent of a four letter word. With many other financial institutions, large compensation payouts have been based on fictitious profits, whereas most hedge fund managers receive their compensation based on a share of real profits.

Historically, when there has been volatility in financial markets, attention has turned to the role played by hedge funds. However, it is important to note that hedge funds only manage around $1.4 trillion, amounting to less than 3% of bank holdings. [iii] Clearly, since hedge funds are usually forerunners in identifying new trends, and weeding out the failing companies, their market impact tends to be far greater than their share of the market.

Conclusion

Targeting the hedge fund industry is a ploy by the government to save face. It is an attempt to leverage common misconceptions and create a scapegoat for the SEC and regulatory failures. Pushing for legislation that imposes additional regulations on the hedge fund industry may make good press for Washington, but the result will have long term damaging effects on our financial system. The role played by the hedge fund industry in the current financial crisis is relatively minuscule compared to the major role played by Washington, the banks and the mortgage industry.

ABOUT THE AUTHOR:

Michael T. Jackson founded EGM Capital and successfully built a family of hedge funds focused on investing in publicly traded U.S. emerging growth companies. Under his guidance, Jackson grew the firm from a modest beginning in 1986 to approximately $1.2 billion in client assets in 2001. As EGM Capital built one of the best performance records in the hedge fund industry, Jackson’s own professional success was featured in the book Investment Visionaries. Retired since 2002, Mr. Jackson concentrates on philanthropic activities and personal investments.

[i] HFR Media Reference Guide. Hedge Fund Research, Inc. 1/20/2009.
[ii] Examiner.com. Editorial: Regulation is the problem, not the answer. Mar 31, 2008. [http://www.examiner.com/a-1311111~Regulation_is_the_problem__not_the_answer.html]
[iii] Principles and Best Practices for Hedge Fund Investors, Report of the Investors’ Committee to the President’s Working Group on Financial Markets, January 15, 2009.

Source: Michael T. Jackson

HedgeCo Q&A Interview: Former EGM Capital Chairman Michael T. Jackson on SEC Registration

Advice for CEOs of Newly Registered Hedge Funds: Pay Close Attention to Compliance Regulations

Interview with Michael T. Jackson

March 30, 2006
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HedgeCo Q&A with Michael T. Jackson, the retired chairman and CEO of the San Francisco based registered investment advisor EGM Capital Corporation.

Six years ago, Michael T. Jackson was preparing for a much-deserved retirement. The firm he founded, the former EGM Capital, had successfully built a family of hedge funds focused on investing in high-quality, publicly traded U.S. emerging growth companies. Under Jackson’s guidance, the firm grew from a very modest beginning in 1986 to approximately $1.2 billion in client assets in 2001. As EGM built one of the best performance records in the hedge fund industry, Jackson’s own professional success was featured in the book Investment Visionaries alongside the creative thinkers behind Intel, Apple and Cisco. Then, a single trading allocation put the firm and its soon-to-be retired CEO in the crosshairs of the SEC.

In this candid Q&A interview, Jackson tells his side of the story as a case study for newly registered hedge funds, and offers a word of advice to these CEOs now faced with the challenge of increased SEC oversight.

HedgeCo: The SEC settlement was the result of a single trading error in one of EGM’s hedge funds. In your view, what specifically happened?

Jackson: The SEC found that in November 2000 EGM mistakenly oversold a biopharmaceutical stock that was held in several client hedge fund accounts, resulting in an unintended short position. When the transaction took place, most hedge funds were not regulated by the SEC, however EGM was registered since the firm had conducted an investment advisory business prior to founding its hedge funds. After the error was discovered, EGM covered the short at a loss of approximately $404,000. EGM treated the erroneous trade as a normal transaction, and allocated the loss to hedge fund accounts that held the oversold stock. However, SEC investment advisor regulations, when applied to a hedge fund, lead to the exclusion of certain transactions. Clearly, if the transaction had taken place in a non-hedge fund account, EGM would have handled it differently since EGM was familiar with SEC regulations.

At the time of the transaction, I was transitioning into retirement and looking forward to spending more time with my wife and family. My focus at EGM was directed toward new product development and long-term portfolio strategy. The firm was managed day-to-day by an operating committee which reported to the Board and was chaired by EGM’s President. All trades for the hedge fund in question were made by three portfolio managers, two of whom had to sign off on each transaction, and one of whom was the Chief Compliance Officer. I was not directly involved in the placing or booking of the trade, and EGM’s approach to the trade settlement was in accordance with the hedge fund agreements with its clients. Rather than continue to engage in an expensive legal battle, EGM and I signed a settlement agreement in April 2005 for violations under sections 203(f) and 203(k) of the Investment Advisors Act. The agreement was settled without admitting or denying liability.

The total extent of the settlement was no association with a registered investment adviser for nine months and a fine of $75,000. At the time of the settlement, I was retired. After more than thirty-four successful years in asset management and many accolades from our clients, the settlement, while minor, was not a welcomed event at the end of a career built on integrity and trust, as well as outstanding investment returns.

HedgeCo: Was there any financial motivation for EGM to allocate the trade the way it did?

Jackson: The transaction was handled exactly as I believed the partners would expect. The understanding of the hedge fund partners was that all trades made for the hedge fund would be included in the hedge fund, regardless of whether they were a profit or a loss.

The hedge fund strategy in which the transaction occurred had invested assets of over $500 million. The total loss on the transaction was approximately $404,000 but only approximately $326,000 after EGM’s and my interests were taken out. Relative to the hedge fund profits earned in 2000, the loss on the transaction was less than 1/3 of 1 percent of the well over $100 million in partner profits that year.
From another perspective, the advantage gained on the transaction by EGM was less than 1% of the firm’s profits earned in 2000, the majority of which was paid out in yearend bonuses to employees. None of these numbers suggest that there was a financial motivation behind the firm’s handling of the transaction.

HedgeCo: Was there any recourse or legal channel you could pursue?

Jackson: Despite an extensive audit which failed to uncover any other SEC regulation mistakes, a no-fault settlement and relatively small fine seemed to be the only course to a timely solution. To engage the SEC legally is to damage your reputation, regardless of the outcome. In addition, there were pressing family health problems that needed my immediate fulltime attention. Importantly, I was led to believe by legal counsel that the SEC would keep any comments in a press release within the bounds of the no-fault settlement language, and I could refuse settlement if that were not the case. The opposite turned out to be the reality.

HedgeCo: As of February 2006, the SEC began requiring registration under the Advisers Act of certain hedge fund advisers. Under this new regulatory framework, firms with 15 or more investors and at least $25 million in assets under management must, among other regulations, designate a chief compliance officer, implement formal compliance policies and monitor and retain all client communications. Based on your experiences, what advice can you offer these newly registered firms?

Jackson: These rules were passed by a slim 3-2 majority vote. In a dissenting SEC commissioner’s words, “It is the wrong solution to an undefined problem using an ineffective examination model.” This tells me it will be a tedious process for newly registered hedge funds to get up-to-speed on the compliance policies.

As hedge fund firms adjust to heightened regulation, their chief executives should give extra attention to team oversight and trade handling procedures. They must realize the importance of this segment of their business – company compliance procedures should receive equal, if not greater, daily attention as the investment side of the business. CEOs of hedge funds face a clear increase in personal and business risk, and must take meaningful steps to protect themselves.

We are living in a highly charged environment for all corporate executives. High profile scandals at mutual funds and public companies like Enron and WorldCom have paved the way for the SEC’s move into the hedge fund space. To some degree, EGM and I may have been the victim of the SEC's drive to bring hedge funds under their regulation. In my case, when the SEC announced the settlement they also took the opportunity to sensationalize the matter without regard to the fact that the settlement was agreed to on a no fault basis. I know I’ve led a professional life that I can look back on with great pride, and have always been dedicated to the best interests of my clients. All hedge funds should strive to do the same.

Source: HedgeCo.Net