• It's Here!

    Etf Pro

    Get the big financial market moves right, bullish or bearish with Hedgeye’s ETF Pro.

  • It's Here


    Identify global risks and opportunities with essential macro intel using Hedgeye’s Market Edges.

The Efficient Regulator Hypothesis – The SEC Beats The Index Funds


He Hate Me – Mary Schapiro And The Extreme Regulatory League




Brush Up Your Shakespeare – The Efficient Shylock Hypothesis



Value Proposition

It’s been a busy week for SEC Enforcement Chief Robert Khuzami.

It started when the CEO and the former Chief Compliance Officer of Value Line agreed to a settlement that will cost them $45 million and see them barred from the industry and from holding executive positions in public companies (4 November, SEC release 2009-234, “SEC Sues Value Line Inc. And Two Senior Officers For $24 Million Fraudulent Scheme”).

The SEC Order covers activity spanning the period from 1986 through 2004, during which time Value Line, as adviser to the Value Line Funds, ran a self-dealing bonanza called the “commission recapture program.” 

“Value Line arranged for one of three unaffiliated brokers to execute, clear and settle the Funds’ trades at a discounted commission rate of $.02 to $.01 per share.  Instead of passing this discount on to the funds, Value Line had the unaffiliated brokers bill the funds $.0488 per share and then ‘rebate’ $.0288 to $.0388 per share to VLS.”  This arrangement resulted in VLS receiving “over $24 million in bogus brokerage commissions.”  Please note that the scammers were paid substantially more than the brokers who facilitated these transactions.  A penny here, a penny there...

Here’s why we particularly like this outcome.  It shows Khuzami as a thorough and serious practitioner in the public sector, winning big settlements that actually make a difference.

Here’s why we don’t like this outcome.  Who on earth was responsible for auditing Value Line for the past 23 years?

The alleged activity started in 1986 and ran for eighteen years.  It did not take the SEC two decades to build its case.  Is there another allegation of massive SEC failure lurking beneath the surface?  Judge Rakoff (of whom more below) did well to reject the SEC’s rush to settle the B of A case.  We would be well served to see his insistence on full transparency applied across the board.  Indeed, it may be unavoidable.  We get the sinking feeling that the SEC has done nothing since the days of Arthur Levitt.  In Wall Street’s Monkey Years, that’s a long, long time.

Somebody Up There Hates Me

Does Mary Schapiro stare in the mirror each morning troubled by the thought that God might be out to get her?  It seems nothing short of divine orneriness that the first massive Enforcement case brought on her watch should be assigned to none other than Judge Jed Rakoff, who has already shown the Commission the back of his learned hand in the Bank of America settlement.

Here’s our theory on the BofA settlement: We give Schapiro credit for brilliant political maneuvering.  Realizing she could never force full clarity through the layers of political protections built up around Ken Lewis, Schapiro rushed through a clearly flawed settlement.  Knowing that Judge Rakoff would reject it, Schapiro stage-managed the political coup of the year by getting clarity forced upon the case, while continuing the tough political balancing act that brought her to this high position.  Fantasy, you ask?  Chairman Schapiro has been around a long time.  We wouldn’t put it past her.

Now, however, the stakes are significantly higher, and Chairman Schapiro may not be in a position to finesse this one.

There was much sound and fury at Friday’s press conference, with assurances of more arrests to come, and a highly articulate Enforcement Director Khuzami telling the world in no uncertain terms that the Bad Guys are on notice.

We think Khuzami is not the kind of Enforcement official to go off half-cocked.  Our immediate take on the Rajaratnam arrest was that Khuzami is too good to go public with anything less than a slam-dunk case.  The SEC, its credibility already shredded beyond repair, can’t risk a billionaire perp walk unless it’s a dead cert.

But as the saying goes, Man proposes, and God disposes.  And in the judicial lottery, God disposed the case that could make or break the future of America’s regulatory system into the hands of a judge who has a very noisy bee in his judicial bonnet over the SEC’s disregard for its own highest brief, which is to ensure the integrity of the marketplace.

In America, plaintiffs get two bites at the apple.  The ability of injured parties to bring both criminal and civil cases is an odd legal structure, not standard in the rest of the world.  It played well with OJ Simpson, who was not convicted in the criminal trial but was found against for substantial damages in the civil trial.  The higher standard of Reasonable Doubt in a criminal case is designed to protect against prosecutorial abuse, while the broader Preponderance of Evidence applied in civil cases protects the interests of the injured by bringing the jury’s decision down to common sense.

Enter the SEC, which has a mandate to keep the markets clean – in other words, to rout out criminal activity – but does not have the ability to bring criminal prosecutions.  Typically, the SEC teams up with the US Attorney’s office to run cases which are filed together, but prosecuted separately.  The criminal case generally precedes the civil case, for a number of reasons.

First, if a criminal conviction is won, or a plea bargain struck, that takes the bad guys out of circulation with immediate effect, and saves time and taxpayer dollars.

But there are tactical reasons for bringing the criminal case first, not the least of which is the extensive discovery process in a civil case, which enables the accused to see every shred of evidence that will be used against them, and gives defense counsel time to prepare.

One of the uglier outcomes of the SEC two-step occurs when the government loses the criminal case, and the Commission starts all over again with a civil case.  This is tremendously disruptive to the lives of the defendants who, having gone through months of grueling hearings where they spent millions of dollars on representation, now must start from scratch with a different standard of proof.  In addition, in order to fully prepare their case, the SEC often does not even bring the civil suit until many months after the criminal case is closed.  Defendants often have to cool their heels for a year in between winning in criminal court, and being dragged into civil court.

As far as batting average goes, the SEC is about a .500 player when it comes to insider trading.  This means it wins half the cases it brings.  It also means it loses half of them.  If we were looking for a lawyer to represent us, we would not settle for someone who lost half the time.  Why should the taxpayers have to finance this kind of performance?  And isn’t the most important marketplace in the world entitled to better? 

We think Congress must create clearer standards for insider trading, and give the SEC more resources to attack specific cases.  It is political cowardice to saddle a regulatory agency with a messy, unclear set of standards, then excoriate them for not winning more convictions – but then, cowardice is the bread and butter of politics.

We do not go so far as some who say that insider trading is a positive process, because it gets more information into the system.  We can’t take that position seriously – and we find it troubling that editorials masquerading as reportage have found their way into the pages of the mainstream press suggesting that insider trading is good for the markets. 

As just one example, the Wall Street Journal ran a piece in their weekend section (24 October, “Learning To Love Insider Trading”) that claims insider trading makes markets more efficient by getting the information into the price of the stocks in question.  This is linguistic legerdemain.  “Efficient” markets do not mean “better” markets, or “fairer” markets.  Rather, the Efficient Market Hypothesis posits that all available information is reflected in the price of a stock at any given moment.  But note that all information being “reflected” does not mean the stock in question is trading at the “right” price, but only at the price that all current buyers and sellers agree to.  At best, in market efficiency, the “real” price comes out eventually, but it can be a long-drawn process, which is why Market Efficiency looks best when paired with that other academic standard, Buy And Hold.

There has been a flurry of articles lately on the Efficient Market Hypothesis as a culprit creating the conditions precedent for the latest market meltdown.  It is true that the institution of the MBA and the PhD economist lend a patina of academic credibility to the business of buying and selling pieces of paper using other people’s money.  But it is a substantial reach from an academic paper by a Chicago PhD to the series of miscalculations, mistakes of fact, negligence in oversight, and occasional outright lies that connect a busted mortgage on a single-family home in Western Pennsylvania to the 40% decline in your 401K.

Market efficiency, then, does not guarantee fairness.  That is the job of our lawmakers and regulators.  Our market model is based on a guarantee of equal access.  If all available information is embedded in a stock’s price, then it is the job of the individual investor or analyst to tease it out and determine whether the stock is priced correctly.  Those who are better at understanding information will profit.  Those who use information not available to the rest of the marketplace violate a fundamental principle of the system.  The American capitalist model is predicated on fairness, and we believe we have the right to demand that of the System and its participants, as well as of the theoreticians who support that system. 

American capitalism, predicated on guaranteed opportunity, abhors the notion of guaranteed outcome.  Information that finds its way unnoticed into a stock’s price will yield a superior outcome – in the form of financial reward – for those able to identify it first.  In this form, the efficient market is like a vast field where we know there is a buried treasure.  If we all dig, someone will find it.  All who come with shovel in hand are willing to accept the risk that someone else may find the treasure.  Everyone has an equal chance of being disappointed.

Misappropriating corporate information is stealing the treasure before the official start of digging season.  We do not agree that insider trading adds to even a hypothetical form of Market Efficiency, as the information does not immediately enter the price of the stock.  It is not available to any normal means of accessing market information.

Those who argue that corporate information belongs to the corporation, that corporations should be permitted to define the parameters of treatment of such information, fail to take into account the fundamental point that market information belongs not to the company or its agents, but to the marketplace.  We should be leery of making intellectually feeble leaps such as tying the SEC’s defeat in the Mark Cuban case to the allegations surrounding Octopussy and his ring of informants.  Insider trading, of the type alleged in the current case, is not Fraud on Google, or Fraud on Intel.  It is Fraud on the Markets.

The integrity of our marketplace rests on disclosure.  The economics of the marketplace stipulate that a public company is worth more than a private company because of public availability of information.  We are all in favor of smart people outsmarting less smart people, whether in the form of algorithmic statistical arbitrage, high-frequency trading, or developing proprietary models to project earnings more accurately than the competition.  But it is dangerous to allow the misappropriating of information to be sold to the public as a Greater Good.  It is not.

We understand that the US Attorney’s office and the SEC had not yet fully coordinated their information, when they learned that Rajaratnam was planning to leave the country.  Fearing he had gotten wind of the pending indictment and was about to vanish, they nabbed him and perp-marched him out to the full complement of news media and TV cameras.

Playing their part in the legal minuet, the SEC filed their formal complaint along with the US Attorney.  In it, they referenced wiretap records which, because of the haste triggered by Rajaratnam’s arrest, they had not yet seen.  Figuring they would run the standard give-and-go, the SEC assumed the US Attorney would start with the criminal case, giving the Commission time to backtrack and fill in the blanks.

But then along came Judge Rakoff and said in essence, you filed your case, now bring your case.  This seems to have thrown the SEC team for a loop.  It appears they tried to get a stay, entering into a convoluted deal with the defendants’ counsel wherein the defense would petition the court for a 90-day continuance, in return for which the SEC would share the wiretap information with the defense.  Judge Rakoff didn’t go for that either.  As of this writing, both the US Attorney’s criminal case, and the SEC’s civil case are set to go forward. 

Adding a further level of complexity is the sheer number of individual scams alleged.  The SEC’s case indicates that many roads lead to Galleon, but a significant number completely bypass the hedge fund and its employees.  It will be a tough prosecutorial balancing act to keep all the players in the courtroom, and there is always the risk that a setback in one case might lead to the unraveling of others. 

One thing is for sure: there is no regulatory, legal or legislative structure that can prevent bad people from doing bad things.  Both the Value Line case and the metastasizing insider cases revolving around Galleon include key participation by those designated as guardians of the system. Compliance officers and lawyers lie at the heart of these massive fraud allegations, which reaffirms the verity that our system needs both a robust framework, and robust enforcement.

Judge Rakoff has thrown down the gauntlet to the SEC.  What’s at stake is nothing less than the credibility of our marketplace, and the SEC’s ability to guarantee that credibility.  If the SEC stumbles along, plays .500 ball, and comes up with a slapdash settlement, based on hasty legal work, the country and the markets will be the worse for it.  For those who, like Harry Markopolous, have stated that the SEC “should die,” this will be a good outcome.  For those who believe the SEC is a necessary entity that needs a serious retooling, it would be devastating to see this high-profile case go by the boards.

The game is on.

We think Khuzami is the man for this job.  He is plenty tough.  He spoke highly of his legal team and, given what we know to be his standard for performance, he may not be exaggerating.  We think Chairman Schapiro, for all the political pressure she has to deal with, is putting together an admirable team.  For the sake of our markets, we sincerely hope the new SEC Enforcement team will be equal to the challenge.

Hail, Mary!

The SEC has announced its new head of the New York Office of Compliance Inspections and Examinations (3 November, Release 2009-231, “Norm Champ Named Associate Regional Director For Examinations In SEC New York Regional Office”).  Norm Champ will be taking over the Commission’s highest visibility compliance examinations position, and we are delighted that Chairman Schapiro has snagged such an outstanding executive for this job.

Champ’s academic credentials include Princeton (summa cum laude), a Fullbright Scholarship at King’s College, London, and a Harvard law degree (cum laude).  He left the law firm of Davis Polk & Wardwell to serve as General Counsel at Chilton Investment Company, a major global hedge fund operator.  This is a real win for the Commission.  Champ brings to the job a world-class mix of background, experience and operating knowledge of the markets.  Like his predecessor in the job, Tom Biolsi, Champ has the operating knowledge of the markets to know where the Commission should be looking – and where they should not be wasting their resources.  We even suspect Mr. Champ may have the intestinal fortitude to push past the bureaucracy and actually get things done.  We applaud Chairman Schapiro on this appointment. 

With hires like Robert Khuzami, and now Norm Champ, Chairman Schapiro gives us reason to hope that the SEC may one day be able to do its job.  Talk about leveling the playing field.

Brush Up Your Shakespeare

O, what a goodly outside falsehood hath!

                   - Shakespeare, “Merchant of Venice


The Wall Street Journal featured Yale economist John Geanakoplos (3 November, “Crisis Compels Economists To Reach For New Paradigm”) whose work focuses largely on the nature of collateral, a critical yet under-studied component of the financial marketplace.  The article attributes Geanakopolos’ focus to an insight gained from reading Shakespeare’s “Merchant of Venice”, which is focused on “collateral, with the money lender Shylock demanding a particularly onerous form of recompense if his loan wasn’t repaid.” 

Professor Geanakoplos’ work appears to be vitally important to the current economic debate, and we hope it will be brought out of the lecture hall in included in a meaningful way in future discussion.

But the article got us musing.  For “Merchant” holds more fundamental and broad-ranging messages for America today.

“Merchant of Venice” and “Othello” are Shakespeare’s only plays set in Venice.  In Shakespeare’s intellectual world, the Republic of Venice enjoyed a fabled status, along the lines of an idealized New York City.  It was a free city-state founded on principles of commerce.  It guaranteed equal treatment of its citizens and equal access to its financial markets, business and international trade.

In both of his Venetian plays, Shakespeare tests the limits of the ideal society’s tolerance by planting in their midst – and in a role as savior of their way of life – an outsider who is foreign to their culture in every respect.  Both Shylock and Othello are culturally, racially, and religiously foreign to their adopted city.  When the clash of cultures erupts Venice, rather than stay true to its stated principles, reverts to a base type and crushes them both.  Both plays are about the clash between policy and reality, about what happens when a society’s legal protections are put to the test in an existential crisis. 

To quote a line variously attributed to Henry Louis Gates, Jr. and H. Rap Brown, “When white folks say “justice’, they mean “just us white folks’”.

 “Merchant”, once a staple of high school literature classes, has fallen on hard times because of misplaced political correctness.  But the failure to engage on difficult social phenomena such as racism is the surest guarantee they will be perpetuated. 

A serious reading of the play shows Shylock to be the most flexible and fascinatingly protean character in the Shakespeare canon.  There is literally no wrong way to depict Shylock, and the character has been played to great success as a hero, a villain, a clown, a tragic figure, a man of noble spirit, a conniver, a Moses-like lawgiver, a dastard, and a fool.  Even a cursory study of Shakespeare’s life and times reveals that his own Catholic family suffered religious persecution at the hands of England’s then-dominant Protestants – indeed, his wife’s cousin was publicly executed for being a Jesuit.  Hardly the recipe to turn the subtlest observer of human nature into a bigot.

Shakespeare’s misunderstood masterpiece has much to teach us today, as our society transitions from a bastion of equal opportunity to a Goldmanocracy.  The promise of equal treatment and equal access was written on a piece of paper that is becoming increasingly inconvenient in the current environment.  We look for it soon to be declared irrelevant.

America is The Forgotten Man.  Our money is out of money.  Our markets are out of credibility.  Our political system is rotten.  Washington sends flu vaccine, not to our schools, but to Goldman Sachs.  Our Treasury Secretary, like a stockbroker who has just wiped out his best customer, begs the world to “give us one more shot.”  Washington pumps trillions of dollars to Wall Street, which proceeds to pay all-time record bonuses.  While true unemployment ramps up to 17%, Washington masks reality with bogus statistics like “jobs saved.”  The newsmedia, instead of cogently revealing all this for public debate, are a hate-mongering shriek-fest, and we increasingly suspect that our next door neighbors are stocking weapons in their cellars.  When we are come to pay our pound of flesh, shall we be required to deliver it wrapped in the Constitution? 

If you prick us, do we not bleed?

Moshe Silver

Chief Compliance Officer