The SEC's New Approach to Fraud

By Jesse Hamilton

A new government system for spotting securities fraud is bearing fruit. Over the past month the Securities and Exchange Commission filed four fraud cases against three hedge funds and six people for misconduct, including improper use of assets, fraudulent valuations, and misrepresenting returns. “Hedge fund managers depend on valuation and performance for both their compensation and marketing,” says Bruce Karpati, co-chief of the SEC’s asset-management enforcement unit. “These managers have either manipulated performance or engaged in other falsehoods in order to line their own pockets at the expense of investors.”

The actions are a product of the agency’s initiative to build cases on data analysis instead of relying on tips. “We take a look at performance by comparing funds against their peers and then apply qualitative factors, including looking at experience, assets under management, their regulatory history, and whether they’ve been in trouble before,” Karpati says.

In the most recent enforcement action stemming from the program, the SEC on Dec. 1 filed a lawsuit against Michael R. Balboa, former portfolio manager for the now defunct $844 million Millennium Global Emerging Credit Fund. The lawsuit alleges that he and Gilles De Charsonville, a broker at Greenwich (Conn.)-based BCP Securities, along with an unidentified third person used overvalued securities positions to “generate millions of dollars in illegitimate management and performance fees.” Balboa was also arrested and charged with securities fraud, according to a criminal complaint unsealed in federal court in New York on Dec. 1. Balboa, 42, of Surrey, England, will plead not guilty and “intends to defend the charges,” his lawyer, Joseph Tacopina, says. An attorney for De Charsonville, 49, of Madrid, didn’t immediately respond to a request for comment.

Adam J. Wasserman, a New York attorney at Dechert who works with hedge funds, says fund managers could have concerns if achieving unusually good returns—“doing their job well”—sprouts a red flag at the SEC. “People invest in hedge funds because they expect better returns over time,” Wasserman says. “You don’t want traders and their funds to fear being successful.”

In a speech to the Consumer Federation of America on Dec. 1, Robert S. Khuzami, the SEC’s enforcement director, likened the program to former New York City Mayor Rudy Giuliani’s so-called broken windows approach to crime fighting, which operated on the theory that targeting routine violations would curtail major crime. “If you stop people when they commit small infractions,” Khuzami said, “they are less likely to graduate to bigger ones.”

The bottom line: Using data mining to spot suspicious activity, the SEC has filed four fraud cases against three hedge funds and six people in the past month.

Hamilton is a reporter for Bloomberg News.

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Investment Fraud "Secrets": How To Avoid Becoming a Victim of Investment Fraud

Exchange-Traded Funds Said to Face U.K. Fraud Prosecutor Review

July 05, 2011, 12:04 PM EDT By Lindsay Fortado and Kevin Crowley

July 5 (Bloomberg) -- U.K. fraud prosecutors are reviewing how exchange-traded funds are marketed and whether they have the tools to prosecute any wrongdoing in the industry, a person directly involved with the probe said.

The Serious Fraud Office, which prosecutes white collar crime, hired a consultant to interview bankers and lawyers to determine whether there is a risk that sales of the products may involve criminal conduct in the future. The Financial Services Authority and the Bank of England’s Financial Policy Committee have warned of a lack of transparency in the ETF market.

ETFs are exchange-listed products that mirror indexes, commodities, bonds and currencies and allow investors to buy and sell them like stocks. They grew more popular in the aftermath of the 2008 selloff that wiped $37 trillion from global equity markets because they carry lower fees than other funds, require lower initial investment than futures, can be traded throughout the day and cover most indexes.

Terry Smith, chief executive officer at London-based inter- dealer broker Tullett Prebon Plc, has said the products often fail to track the underlying asset whose behavior they’re designed follow, are exposed to the risk of a provider going bankrupt and are vulnerable to heavy short-selling.

Question Marks

“From the investor’s point of view, I think there are question marks over whether synthetic ETFs really are appropriate for all types of the retail marketplace,” FSA Chief Executive Officer Hector Sants said June 24.

Sam Jaffa, a spokesman for the SFO in London, declined to comment. Rachel Cohen, a spokeswoman at the FSA, declined to comment other than to refer to Sants’s previous remarks. No specific companies or products have been targeted in the probe at this point, the person said.

“There are a lot of myths surrounding ETFs,” said Alan Miller, founder and chief investment officer of SCM Private, which manages ETFs. “The average ETF has higher levels of transparency, better performance and lower risk than the average mutual funds.”

All the synthetic ETFs that Miller holds are 110 percent collateralized, he said. That compares well with the transparency of the absolute return fund sector, which has “shocking” transparency, said Miller, who is the former chief investment officer of New Star Asset Management Group Plc.

At a meeting of the interim FPC in June, the group warned that FSA bank supervisors should “monitor closely the risks associated with opaque funding structures, such as collateral swaps or similar transactions employed by exchange-traded funds,” according to a record of the meeting.

Mimic Performance

ETFs are typically designed to mimic the performance of gauges such as the Standard & Poor’s 500 Index. Unlike mutual funds, whose shares are priced once daily after each trading session, ETFs are listed on an exchange where shares are bought and sold throughout the day. Global ETF assets grew to $1.37 trillion as of February from $74.3 billion in 2000, according to BlackRock Inc., the world’s biggest money manager.

The SFO began a wide probe in 2009 into whether banks sold credit-default swaps and structured-finance products, including collateralized debt obligations, with flawed valuations. The review didn’t result in a prosecution, and the agency wants to ensure that it is more prepared if there is a crisis in the ETF market, the person said.

The SFO is looking more closely at ETFs because they have similar characteristics to the CDOs that helped spark the financial meltdown in 2008, according to the person. Like CDOs, the quality of the underlying assets in synthetic ETFs can be unclear and there is the potential for firms to mis-sell assets that are being heavily short sold, the person said.

SFO director Richard Alderman is seeking legislation that would create a corporate criminal liability that would enable prosecutors to enforce fraud laws against companies or banks, the person said.

--Editors: Anthony Aarons, Steve Bailey

To contact the reporter for this story: Lindsay Fortado in London at lfortado@bloomberg.net; Kevin Crowley in London at kcrowley1@bloomberg.net.

To contact the editor responsible for this story: Anthony Aarons at aaarons@bloomberg.net; Edward Evans at eevans3@bloomberg.net.

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