Trimming Fraud From Hedge Funds

New SEC proposals hope to prevent hedge fund fraud.

Ever since the Madoff fiasco, Congress and the public have demanded action to prevent something like it from happening again. Yesterday, Securities and Exchange Commission Inspector General David Kotz responded in a letter to Congressman Paul E. Kanjorski (D-PA), the Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises. Kotz outlines four steps the SEC proposes to prevent fraud in hedge funds and other investment companies. Some of these ideas are very good, while others probably won't do much.

A Better Bounty System

My favorite is the idea to ramp up the bounty system and apply it more generally to fraud. I like this one so much that I may devote an entire post on it later today. So I won't say a lot here. But the idea that private individuals would have an incentive to be part of the network to catch white color criminals is the best idea out there. It's the people in the trenches who will be the first to notice suspicious activity -- not government regulatory bodies.

Custodians For Hedge Funds

Another good suggestion is to amend the Investment Advisers Act of 1940 to require hedge funds to use independent custodians. Mutual funds already do this, so this change would require the same of hedge funds.

It's a little unclear if having a custodian would imply that registration is required for all hedge fund investors. Hedge funds wouldn't like that, because their investors like their privacy. Whether that should be required is a separate debate. But if the custodian requirement didn't include their investors' registration, then the insignificant cost it would pose to a hedge fund seems pretty uncontroversial to me.

Here's why this suggestion matters, from the letter:

This custodian requirement essentially removes the ability of an investment adviser to fraudulently use the proceeds invested by new investors to make payments to old investors.

In other words, it prevents Ponzi schemes. Sounds good to me.

Investment Officers To Certify Due Diligence

The Sarbanes-Oxley Act of 2002 requires certain executives to certify that some reports are accurate. If they lie, they go to jail. This new suggestion would apply that logic to investment advisers, including hedge funds, but take it a step further:

We would recommend imposing a requirement of certification by senior officers of registered investment advisers that shows they conducted adequate due diligence in connection with investments.

I find this one a little puzzling, because my guess is that Madoff would have been happy to sign that. His crimes already resulted in the maximum prison sentence available, so I'm a little unclear what having his signature on some other false documents would really have helped. This idea does not bother me, but I'm not convinced that anyone who truly wants to commit fraud would find this to be much of an obstacle.

Scrutinize Hedge Fund Accountants

I understand the letter to say that, currently, the Public Company Accounting Oversight Board does not have much power to review the audit reports created for hedge funds by their accountants. The SEC would like to change that:

. . . we would recommend that the legislation clarify that the PCAOB oversight be extended to audit reports prepared by a registered accounting firm which provides reports for investment advisers, investment companies and other registered entities, as well as registered broker dealers.

You might have noted that there was no Arthur Andersen in the Madoff fiasco like there was for Enron. That's because his accountant was a little guy that nobody knew or cared about. He worked out of a small storefront in Rockland County, NY. Of course, now he has been arrested and faces charges. But since the accounting for investment companies like hedge funds, especially smaller ones, does not necessarily require one of the Big-4 accounting firms, those accountants probably didn't hit the SEC's radar screen.

Again, I don't think that this is a bad idea. I see no harm in it. However, I used to work for a large accounting firm. I was a consultant, not an accountant, but I worked on quite a few due diligence assignments, several involving fraud. I learned one very important lesson there: if an extremely smart person is completely determined to commit fraud, it's very, very hard to catch him. So if you have someone good enough at cooking his books, even a good auditor may miss it. That's why I think solutions like higher bounties are better. You need someone with knowledge of the fraud to have a high incentive to come forward, because others might not find it before it's much too late.