Academic journal article Independent Review

Does Regulation Prevent Fraud? the Case of Manhattan Hedge Fund

Academic journal article Independent Review

Does Regulation Prevent Fraud? the Case of Manhattan Hedge Fund

Article excerpt

Moves to enhance and expand regulation almost invariably follow financial disasters. Losses trigger calls for government action, especially when fraud is suspected. Not only policymakers, but also the media and the wider public see regulation as the natural remedy, perhaps because people tend to view financial debacles through the metaphor of misbehaving children in need of adult supervision. When you examine a real-life episode, however, the presumption that stricter regulation would have prevented the debacle is difficult to maintain. Instead, what emerges is a pattern of misperceptions and misjudgments, behavioral characteristics that apply to regulators as much as to the rest of humanity and indicate a need for better awareness of mental biases, not bureaucratic overlay.

A case in point is the failure of Manhattan Capital, a hedge fund firm. The manager, Michael Berger, misled his clients and lost several hundred million dollars of their money. This incident is particularly germane in that the U.S. Securities and Exchange Commission (SEC) used it in 2004 as part of a justification for greater regulatory control over hedge funds.

A hedge fund resembles an expensive restaurant run by a skilled chef who caters to the well heeled. By U.S. law, only people or organizations that meet certain wealth and income standards may invest in a hedge fund; the rest of us are legally limited to the less-diverse menus that mutual funds offer. Hedge fund investors are either wealthy individuals who invest their own money or, more commonly, professionals who act for others. Such people search for novel ways to get higher returns. Manhattan Capital's clients were among these sophisticated, seasoned investors with big chunks of capital to deploy. They recognized the vagaries of markets and money managers. Seemingly reasonable decisions nevertheless metamorphosed into a comedy of errors.

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Hedge funds have been described as a regulatory arbitrage--a way to get around the high cost of regulation imposed on other financial organizations (Ely 1999, 248). Though subject to laws and regulations, they are freer than their mass-market cousins, mutual funds, and hence a prime target for policymakers interested in tightening the reins. As evidence that hedge fund investors need more protection, the SEC cited the Manhattan Capital example, among others. This SEC effort eventually failed, but the 2007-2008 downturn in real estate and credit markets gave rise once again to a movement to expand the government's authority over financial markets and organizations, including hedge funds. Because regulatory frenzy arises every time another fiasco occurs, the lesson of Manhattan Capital will likely remain relevant for a long time to come.

Managing a Hedge Fund

A fund is simply a pool of money, typically with no office or staff of its own. An adviser or manager creates this legal entity, develops its investment program, and hires service providers to perform its necessary tasks: brokers to execute its trades, a custodian to hold the assets, an administrator to prepare financial documents and keep investors informed, and an auditor to vouch for the statements.

Thus, Michael Berger, the owner of the management firm Manhattan Capital, set up and controlled Manhattan Investment Fund (U.S. SEC 2000). He hired an administrator and an auditor, both Bermuda affiliates of big accounting companies. Through a small, Ohio-based firm called Financial Asset Management (FAM), whose owner he knew, he gained access to the services of Bear Stearns & Co., which became the fund's prime broker and custodian of its assets. A prime broker lends to client funds and serves as the main conduit for clearing their trades. FAM acted as introducing broker and received payment for placing the trades Bear Stearns executed (figure 1).

In combination, such service institutions function as a private supervisory network, an alternative to public regulation. …

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