In the increasingly lawless world of hedge funds, there are few cops.
The big Wall Street institutions that execute and process trades for hedge funds generally have no duty to stop -- or even be on the lookout for -- potential abuses, experts said.
Securities regulators are also of little help, adopting a hands-off attitude to the supposedly sophisticated investors in these offshore funds for the rich and famous. The
Securities and Exchange Commission
usually gets involved long after damage to the investor is done, as was recently the case with Michael Lauer's Lancer Management Group and Beacon Hill Asset Management.
The lax oversight of the $500 billion hedge fund industry is one reason few fault anyone but Scott Sacane for the bizarre trading activities of his $400 million Durus Capital Management hedge fund. Sacane has been under fire since disclosing two weeks ago that his Durus fund "inadvertently" acquired huge equity stakes in two small health care companies:
sued Sacane over his trading Tuesday.)
While it's too soon to say whether the out-of-control trading at Durus was the result of manipulation, incompetence or a combination of both, the episode should serve as another reminder that investing in a hedge fund requires a huge component of investor vigilance.
Securities lawyers and other hedge fund managers said it's difficult to lay blame for Sacane's trading at the feet of either
, the two firms that served as Durus' prime brokers. Even though both firms processed trades for Durus and lent the fund money so it could buy stocks on margin, experts say it's generally not the responsibility of prime brokers to keep tabs on their customers' trading activities.
"Generally they have no obligation," said Ron Geffner, a partner with Sadis & Goldberg, a New York firm that represents a number of hedge funds. "It ultimately comes down to the responsibility of the manager."
First, it's possible that Goldman and UBS, both of which declined to comment, had no idea that Durus had amassed a 77% stake in Aksys and a 33% equity position in Esperion. That's because even though all of Durus' trades were cleared by Goldman and UBS, it's likely that Durus executed them through a myriad of brokerages, stock exchanges and electronic communications networks. With so many brokerages executing trades, it would be all but impossible for any single firm to detect an unusual trading pattern at a hedge fund.
Second, even if one of Durus' brokers spotted something fishy in its Aksys or Esperion trading, it's doubtful the firms would be required to do anything about it unless a prime broker was an active participant in a hedge fund's wrongdoing or malfeasance.
"It's not easy to hold a prime broker responsible for the frauds of hedge fund managers," said Scott Berman, a partner with Brown Rudnick Berlack & Israels, who represents a number of hedge fund investors who are suing their former managers.
Simply put, the job description of a prime broker doesn't include serving as a market watchdog. Rather, it's seen by regulators and the courts as largely a "ministerial" job.
Of course, it's a ministerial job that can generate big fees for a Wall Street firm. In the second quarter, Goldman's securities services division, which includes its prime brokerage operation, generated net revenue of $279 million, up 6% from a year ago.
Those hefty fees also make an inviting target for investors and their lawyers who think the current laissez-faire approach toward monitoring hedge fund activities lets prime brokers off the hook too easily.
In fact, one investor in Lauer's Lancer hedge fund is looking into whether there's enough evidence to pursue a claim for damages against
Bank of America
, which served as Lancer's prime broker. Last month the SEC charged Lauer with engaging "in a scheme to overinflate the performances and net asset values" of Lancer's three investment funds.
But with Lancer in bankruptcy, it's doubtful the investors in Lauer's $1 billion hedge fund empire will be able to recoup their losses. And given the presumption that prime brokers aren't liable for the sins of their customers, most lawyers concede it will be difficult to blame Bank of America for Lauer's alleged misdeeds.
Berman, who represents several Lancer investors, said a determination about whether investors can sue the North Carolina-based bank will have to wait until an SEC-appointed receiver finishes its investigation into the reasons behind the hedge fund's collapse.