[Senate Hearing 109-696]
[From the U.S. Government Publishing Office]
S. Hrg. 109-696
HEDGE FUNDS AND INDEPENDENT ANALYSTS: HOW INDEPENDENT ARE THEIR
RELATIONSHIPS?
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HEARING
before the
COMMITTEE ON THE JUDICIARY
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
__________
JUNE 28, 2006
__________
Serial No. J-109-93
__________
Printed for the use of the Committee on the Judiciary
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COMMITTEE ON THE JUDICIARY
ARLEN SPECTER, Pennsylvania, Chairman
ORRIN G. HATCH, Utah PATRICK J. LEAHY, Vermont
CHARLES E. GRASSLEY, Iowa EDWARD M. KENNEDY, Massachusetts
JON KYL, Arizona JOSEPH R. BIDEN, Jr., Delaware
MIKE DeWINE, Ohio HERBERT KOHL, Wisconsin
JEFF SESSIONS, Alabama DIANNE FEINSTEIN, California
LINDSEY O. GRAHAM, South Carolina RUSSELL D. FEINGOLD, Wisconsin
JOHN CORNYN, Texas CHARLES E. SCHUMER, New York
SAM BROWNBACK, Kansas RICHARD J. DURBIN, Illinois
TOM COBURN, Oklahoma
Michael O'Neill, Chief Counsel and Staff Director
Bruce A. Cohen, Democratic Chief Counsel and Staff Director
C O N T E N T S
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STATEMENTS OF COMMITTEE MEMBERS
Page
Grassley, Hon. Charles E., a U.S. Senator from the State of Iowa,
prepared statement............................................. 143
Hatch, Hon. Orrin G., a U.S. Senator from the State of Utah...... 2
Schumer, Hon. Charles E., a U.S. Senator from the State of New
York........................................................... 4
Specter, Hon. Arlen, a U.S. Senator from the State of
Pennsylvania................................................... 1
WITNESSES
Aguirre, Gary J., former Investigator, Securities and Exchange
Commission, Washington, D.C.................................... 16
Anifantis, Demetrios, former Client Relationship Manager,
Camelback Research Alliance, Inc., Scottsdale, Arizona......... 27
Blickenstaff, Kim, Founder, Chairman and Chief Executive Officer,
Biosite, Incorporated, San Diego, California................... 22
Blumenthal, Richard, Attorney General, State of Connecticut,
Hartford, Connecticut.......................................... 8
Boersma, Jonathan A., Director, Standards of Practice, CFA Centre
for Financial Market Integrity, Charlottesville, Virginia...... 31
Friedrich, Matthew, Principal Deputy Assistant Attorney General
and Chief of Staff, Criminal Division, Department of Justice,
Washington, D.C................................................ 6
Kasowitz, Marc E., Senior Partner, Kasowitz, Benson, Torres &
Friedman LLP, on behalf of the Alliance for Investment
Transparency, New York, New York............................... 19
Lamont, Owen A., Professor of Finance, Yale School of Management,
New Haven, Connecticut......................................... 25
McLaughlin, Joseph, Partner, Sidley Austin LLP, on behalf of the
Managed Funds Association, New York, New York.................. 20
Schilit, Howard, CPA, Founder and Non-Executive Chair, Center for
Financial Research and Analysis (CFRA, LLC), Rockville,
Maryland....................................................... 29
QUESTIONS AND ANSWERS
Responses of Gary Aguirre to questions submitted by Senator
Specter........................................................ 48
Responses of Demetrios Anifantis to questions submitted by
Senator Specter................................................ 55
Responses of Kim Blickenstaff to questions submitted by Senator
Specter........................................................ 61
Responses of Richard Blumenthal to questions submitted by Senator
Specter........................................................ 62
Responses of Jonathan Boersma to questions submitted by Senator
Specter........................................................ 65
Responses of Matthew Friedrich to questions submitted by Senator
Specter........................................................ 66
Responses of Marc Kasowitz to questions submitted by Senator
Specter........................................................ 87
Responses of Owen Lamont to questions submitted by Senator
Specter........................................................ 90
Responses of Joseph McLaughlin to questions submitted by Senator
Specter........................................................ 91
Responses of Howard Schilit to questions submitted by Senator
Specter........................................................ 96
SUBMISSIONS FOR THE RECORD
Aguirre, Gary J., former Investigator, Securities and Exchange
Commission, Washington, D.C., statement........................ 97
Anifantis, Demetrios, former Client Relationship Manager,
Camelback Research Alliance, Inc., Scottsdale, Arizona,
statement...................................................... 112
Bettis, Carr, Founder, President and Chief Executive Ofiicer, and
Donn Vickrey, Founder and Editor-in-Chief, Gradient Analytics,
Inc., statement................................................ 121
Blickenstaff, Kim, Founder, Chairman and Chief Executive Officer,
Biosite, Incorporated, San Diego, California, statement........ 123
Blumenthal, Richard, Attorney General, State of Connecticut,
Hartford, Connecticut, statement............................... 126
Boersma, Jonathan A., Director, Standards of Practice, CFA Centre
for Financial Market Integrity, Charlottesville, Virginia,
statement...................................................... 131
Friedrich, Matthew, Principal Deputy Assistant Attorney General
and Chief of Staff, Criminal Division, Department of Justice,
Washington, D.C., statement.................................... 136
Green, Stanton, Chairman, Investorside Research Association,
statement...................................................... 144
Kasowitz, Marc E., Senior Partner, Kasowitz, Benson, Torres &
Friedman LLP, on behalf of the Alliance for Investment
Transparency, New York, New York, statement.................... 151
Lamont, Owen A., Professor of Finance, Yale School of Management,
New Haven, Connecticut, statement.............................. 160
Manning, Greg, Escala Group, Inc. New York, New York, statement.. 171
McLaughlin, Joseph, Partner, Sidley Austin LLP, on behalf of the
Managed Funds Association, New York, New York, statement....... 191
Pollock, Alex J., Resident Fellow, American Enterprise Institute,
statement...................................................... 205
Schilit, Howard, CPA, Founder and Non-Executive Chair, Center for
Financial Research and Analysis (CFRA, LLC), Rockville,
Maryland, statement............................................ 210
Smith, Rich, Chief Executive Officer, Taser International,
Scottsdale, Arizona, letter.................................... 214
HEDGE FUNDS AND INDEPENDENT ANALYSTS: HOW INDEPENDENT ARE THEIR
RELATIONSHIPS?
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WEDNESDAY, JUNE 28, 2006
U.S. Senate,
Committee on the Judiciary,
Washington, D.C.
The Committee met, pursuant to notice, at 9:32 a.m., in
room SD-226, Dirksen Senate Office Building, Hon. Arlen
Specter, Chairman of the Committee, presiding.
Present: Senators Specter, Hatch, and Schumer.
OPENING STATEMENT OF HON. ARLEN SPECTER, A U.S. SENATOR FROM
THE STATE OF PENNSYLVANIA
Chairman Specter. Ladies and gentlemen, the Judiciary
Committee will now proceed with this hearing to inquire into
the adequacy of the Federal criminal statutes to deal with the
potential issues for fraud on the investments of hedge funds in
collaboration with so-called independent analysts. This is a
subject of enormous importance to the United States economy,
with hedge funds now having $1.2 trillion in assets and having
stock transactions which involve some 30 percent of what goes
on in the trading market.
There have been some high-profile civil cases which have
been brought with allegations, among other things, that hedge
funds are collaborating with the so-called independent analysts
to rig the information to make it appear that some companies
are weaker than they really are, with short-selling and the
potential for very, very substantial profits.
The Judiciary Committee has been intimately involved in the
regulatory process to the extent that it involves criminal
prosecutions in the legislation captioned ``Sarbanes-Oxley,''
so much so that Senator Leahy, when he was Chairman of this
Committee, and Representative Sensenbrenner, the Chairman of
the House Committee, were conferees. The Banking Committees
obviously have primary jurisdiction on the regulation of hedge
funds. It is squarely within their purview. The issue of the
adequacy of the criminal laws are a matter for the Judiciary
Committee, and that is why we are making this inquiry today.
Our focus will be on the adequacy of the provision of
Sarbanes-Oxley, which was reported out of this Committee since
it dealt with a criminal law, making it a violation for anyone
who knowingly executes a scheme or an artifice to defraud any
person in connection with any security or to obtain by means of
false or fraudulent pretenses any money in connection with the
purchase or sale of any security.
We have a representative of the Department of Justice and
we have the Attorney General of the State of Connecticut to
give us their thinking on this subject.
We are dealing with a subject matter which has enormous
potential to have a very, very major impact on the markets. The
case involving the Long-Term Capital Management Company was one
which illustrates the potential problems. In 1998, when LTCM
was on the verge of collapse, the New York Fed stepped in and
undertook what we call a ``facilitation,'' a rescue package of
some $3.6 billion in cash contributed by 13 private financial
institutions. You have a situation where this company, LTCM,
with $3 to $4 billion in assets, was able to leverage some $80
to $100 billion, and if there had been a fire sale of their
assets, it would have had an enormous impact on the market, and
the Fed stepped in.
Well, that is fine if the Fed can find 13 companies to step
in to stabilize the market. But it raises some very, very
important questions, especially in the context where the
District of Columbia Circuit Court has held that the SEC does
not have jurisdiction for some of the rulemaking. That is a
matter, obviously, for the Banking Committee to take up. But
the backdrop here of the applicability of the criminal laws is
very, very important.
Since this hearing was scheduled, the subject matter has
attained substantial additional notoriety with the termination
of a senior SEC lawyer, who will testify here today. We have
had the decision by the Court of Appeals for the District of
Columbia, and we have quite a heavy focus on these hedge funds.
They had been attracting investors who were very, very wealthy,
in the range of $400,000, and now we are finding people in the
$10,000 to $20,000 category. So it is a matter of great
concern, and it is very important that there be adequate
investigation and oversight by the Department of Justice and
oversight on the Department of Justice by this Committee if we
need any new laws.
My red light just went on, so I will yield to my
distinguished colleague, the former Chairman of the Judiciary
Committee, Senator Hatch.
STATEMENT OF HON. ORRIN G. HATCH, A U.S. SENATOR FROM THE STATE
OF UTAH
Senator Hatch. Well, thank you, Mr. Chairman. I want to
thank you for holding this hearing today. I know there has been
some discussion about our Committee's jurisdiction here, and I
want you to know that, in my opinion, our jurisdiction is
clear. We have oversight responsibilities for the Department of
Justice. Ultimately, the Senators on this Committee are the
ones responsible for writing and amending our Nation's criminal
law.
In 2002, the President created a Corporate Fraud Task
Force. It is chaired by the Deputy Attorney General and
includes U.S. Attorneys, the heads of DOJ's Criminal and Tax
Divisions, and representatives from the law enforcement
community and government agencies, including the SEC. That task
force is responsible for investigating corporate fraud, and we
are responsible for determining whether DOJ is doing its job
and whether we have provided them with the tools to do their
job.
Unfortunately, because of my schedule this morning--we have
markups in both the HELP and Finance Committees, and one of my
bills is being marked up this morning. Of course, I am a member
of both of those as well, and I will not be able to attend all
of this hearing, as much as I would like. But if I leave early,
I do not want anybody to mistake that I am doing that for a
lack of commitment to investigating this issue. I think that it
is critical that we do so.
I am pleased that Mr. Friedrich is here to testify today
about the structure of the Corporate Fraud Task Force and its
past successes. I think that the many successful prosecutions
that he details are testament to the priority that the
President and the attorneys at DOJ have given these cases.
Market confidence and ultimately the health of our economy
depends on them. There is no denying those successes.
Now, I know that he cannot speak to ongoing investigations,
but in reading your testimony, it seemed to me that there was a
general reluctance to discuss, even in a general way, the
Department's capability to investigate and prosecute what we
are here today to discuss: the relationship between hedge funds
and so-called independent analysts.
We all know that hedge funds are a powerful force in our
financial markets. It is critical that the power and influence
that hedge funds have attained be exercised responsible, and we
need to be sure that our laws that we give to the law
enforcement authorities are effective and adequate to ensure
that the substantial power of hedge funds is not abused. This
is of particular concern because hedge funds are so lightly
regulated and operate largely in secrecy.
I am not necessarily calling for new regulations here. In
fact, I have real questions about whether we should. But we
need to monitor this field and make that our markets have the
integrity that our investors need to continue investing and
maintain our vibrant economy.
DOJ has an important role to play here. Mr. Friedrich, as
you explain in your testimony, the Corporate Fraud Task Force
maps out a strategy and identifies best practice. I have a
number of questions. Do you have the tools that you need? How
often do you meet? Are you incorporating U.S. Attorneys only
from major financial centers or also from nontraditional
locations? After all, we are going to hear today about an
alleged fraud that began not in New York but in Arizona. And I
know that in my State of Utah, the issue of hedge funds and
corporate fraud has become such an issue that the State
legislature went into a special session to address the issue.
And as you know, DOJ and SEC work closely in these cases, but
sometimes, as I read the testimony today, I get the impression
that if somebody asked both agencies who was ultimately
responsible for initiating these investigations, they might
just point fingers at each other.
Now, I want to be clear about what we are not trying to get
at through this hearing. This is not a hearing about naked
shorting. It is most certainly not a hearing to drag anyone's
name through the mud. And this is not a hearing that challenges
hedge funds as a whole or the practice of naked shorting in
general.
As our friends in the press have continually reminded us
since the hearing was called, there is nothing wrong with
short-selling. We do not need to be reminded again. The market
trend is upward, and it is good to have some pessimists around
who keep prices honest and help to maintain market balance. We
also know that shorters were well ahead of anyone in
discovering that there were problems at Enron. And nobody is
attacking this activity in general.
As Mr. Kasowitz has noted, though he does represent a
number of clients who alleged harm through market manipulation
and short-selling, he does represent hedge funds in a variety
of matters. These are legitimate investment vehicles, and I do
not doubt that, for the most part, they are acting on the up
and up. Yet hedge funds are the Wild West of our financial
markets. There are 11,500 hedge funds. They are highly
profitable to their managers and largely unregulated, more than
all the stocks listed on the Stock Exchange, as I view it. They
may be a small piece of the market, but they are growing. And
because of their volume of trading and the commissions that
they represent, they are an increasingly powerful member of the
financial community.
Well, there is a lot more I have to say, but my time is up.
Let me just put the record of my statement in the record, Mr.
Chairman.
Chairman Specter. Without objection, Senator Hatch's full
statement will be made a part of the record.
Senator Schumer. Mr. Chairman?
Chairman Specter. Who is seeking recognition?
Senator Schumer. I am, Mr. Chairman.
Chairman Specter. Well, in that event, I will ask you if
you would care to make an opening statement.
Senator Schumer. I would indeed, Mr. Chairman.
Chairman Specter. Proceed.
STATEMENT OF HON. CHARLES E. SCHUMER, A U.S. SENATOR FROM THE
STATE OF NEW YORK
Senator Schumer. I thank you, Mr. Chairman. Good morning,
Mr. Chairman and members of the Committee. As the only member
of this Committee also on the Banking Committee, I would like
to bring a different perspective to today's hearings.
First of all, Mr. Chairman, as you said, I support the
jurisdiction of this Committee to hold hearings on legal issues
raised by any industry, including the investment industry. But
the very title of this hearing--''Hedge Funds and Independent
Analysts: How Independent Are Their Relationships?''--raises a
yellow flag of caution.
From the written testimony submitted by many of the
witnesses, it is clear that this hearing will focus on a broad
range of regulatory issues facing the hedge fund industry. For
starters, what are hedge funds? Just last week, the U.S. Court
of Appeals negated the SEC's hedge fund registration rules
because the agency's definition of a hedge fund was not
adequately supported.
Experts continue to disagree over what it is or is not,
what a hedge fund is or what a hedge fund is not. Should hedge
funds be regulated?--an issue we have discussed at great length
in the Banking Committee. And a separate issue, does short-
selling benefit markets?
The bottom line, in my judgment, Mr. Chairman, as one who
sits on both Committees, is that many of these issues are best
addressed in the Banking Committee. The Banking Committee has
exclusive jurisdiction, as they have asserted in a letter sent
to the Committee yesterday afternoon. I am going to read the
letter and ask unanimous consent it be added to the record.
Chairman Specter. Without objection, the letter will be
made a part of the record.
Senator Schumer. Thank you. This is a letter--short--from
Chairman Shelby and Ranking Member Sarbanes.
``Dear Senators Specter and Leahy: We understand that the
Judiciary Committee will hold a hearing tomorrow on hedge fund
advisers and independent equity research analysts. While we
appreciate your interest in these important participants in the
capital markets, we are writing today to note that the
operation and regulation of both hedge funds and stock analysts
fall within the exclusive jurisdiction of the Banking
Committee. Furthermore, our jurisdiction over these areas is
well established and clearly delineated by Senate rules. This
Committee''--the Banking Committee--''has held numerous
oversight hearings in the past year on both hedge funds and
Wall Street analysts, and we intend to continue this active
oversight for the remainder of the 109th Congress and beyond.''
Not only do the Banking Committees--and the letter is now
in the record. Not only does the Banking Committee have
exclusive jurisdiction, but it also has the critical expertise
needed to examine these very complicated financial market
issues. I worry that today's hearing will not afford us the
benefit of the views and expertise of many of the critical
Federal agencies charged with overseeing and enforcing our
Nation's security laws. I understand that Mr. Blumenthal, my
friend and a man I have great respect for, will be making
claims that there should be additional regulation of hedge
funds. Those arguments should absolutely be heard, but they
should be heard before the Banking Committee, which has
exclusive and relevant jurisdiction. And we should hear the
views of the relevant regulators and the people in the industry
who might disagree with those views so we could come to a fair
and adequate conclusion.
Though the Department of Justice undoubtedly plays an
important role in securities enforcement, without the expert
views of the SEC as principal regulator or other members of the
President's Working Group on Financial Markets--Treasury,
Federal Reserve, CFTC--this Committee is not likely to get a
full and complete picture, complete view of the way in which
participants in the capital markets operate legally and
ethically.
Thank you, Mr. Chairman.
Chairman Specter. Thank you very much, Senator Schumer.
We turn now to our first witness, Matthew Friedrich,
Principal Deputy Assistant Attorney General and Chief of Staff
of the Criminal Division of the Department of Justice;
previously had been an Assistant United States Attorney in the
Eastern District of Virginia; served as a member of the Enron
Task Force and co-counsel in the first two criminal cases tried
as part of the Enron investigation; a graduate from the
University of Virginia, the University of Texas School of Law;
clerked for District Judge Royal Ferguson in the Western
District of Texas.
Thank you for coming back to testify before this Committee,
Mr. Friedrich, and we look forward to your views.
STATEMENT OF MATTHEW FRIEDRICH, PRINCIPAL DEPUTY ASSISTANT
ATTORNEY GENERAL AND CHIEF OF STAFF, CRIMINAL DIVISION,
DEPARTMENT OF JUSTICE, WASHINGTON, D.C.
Mr. Friedrich. Thank you. Good morning, Mr. Chairman and
members of the Committee. On behalf of the Department of
Justice, I want to thank you for inviting me here today to
testify about the Department's ongoing efforts to combat
corporate and investor fraud. The Justice Department
appreciates the Committee's concerns, and I look forward to
discussing this issue with you today.
Prosecuting corporate and investor fraud is more than just
enforcing the rules. It is about protecting the reliability,
integrity, and transparency of American markets. Investing,
after all, is a measure of trust. Investors generally will not
put their money into companies or markets that they do not
trust. Thus, in the global competition for investor dollars,
market integrity is essential to the strength of our economy.
It is a competitive edge that can bring with it new investment,
new capital, and new jobs.
Conversely, and as we were all reminded during the
corporate scandals of 2001 and 2002, instances of corporate
fraud put us at a disadvantage in that competition because,
simply put, fraud is bad for business. Lack of investor
confidence leads to weak markets and job loss. I am sure that
concerns like these were paramount in the minds of members of
this Committee in passing the landmark Sarbanes-Oxley
legislation in 2002. You gave those of us in the front lines of
prosecution new tools to use in our efforts against corporate
fraud.
We have utilized the tools which you have given us, and we
are grateful to you for them. For example, since the inception
of Sarbanes-Oxley, more than 53 defendants have been charged
with securities fraud under Section 1348 of the Act.
Additionally, through fiscal year 2005, we have issued five
indictments involving violations of the certification
provisions of Section 1350.
I would note that the importance of the certification
provision of Sarbanes-Oxley, however, is not measured solely by
indictments. Section 1350 has had an enormous deterrent effect
on corporate fraud, which ultimately is one of the primary
purposes of this powerful law.
As you know, and as Senator Hatch referred to earlier, the
focal point of the Department's efforts in this arena is the
President's Corporate Fraud Task Force. The task force is
chaired by the Deputy Attorney General and includes members
from the U.S. Attorney community, the head of the Criminal
Division, and a broad array of Federal law enforcement and
regulatory agencies, including the FBI and the SEC.
From its inception in 2002 through this past December, the
task force has obtained over 1,000 corporate fraud convictions.
As to corporate officers, the task force has convicted 92
corporate presidents, 82 CEOs, 40 chief financial officers, and
17 corporate counsel or attorneys. In the Enron investigation
alone, 34 individuals were charged, and 25 convictions to date
have been obtained. Two of those recent convictions came last
month. On May 25th, a Houston jury found Enron's top two
executives, Kenneth Lay and Jeffrey Skilling, guilty of
committing one of the largest financial crimes in history.
As you know, in December of 2001, Enron, which was then one
of the ten largest companies in the United States, collapsed
into bankruptcy. Thousands of employees lost their jobs,
investors and retirees lost billions of dollars in savings, and
the investing public began to seriously question the integrity
of our financial markets. During the 4-month trial earlier this
year, the Department presented 22 witnesses, including many
former top Enron executives who pled guilty to Enron-related
crimes. These executives testified that at an Enron run by Lay
and Skilling, the company's image and stock price were valued
above anything else at any cost. The defense presented over 25
witnesses of their own, which included weeks of testimony from
both Lay and Skilling.
The jury ultimately found that Lay and Skilling
orchestrated a conspiracy to inflate profits artificially, to
hide millions of dollars in losses, and misrepresent the true
nature of the company's finances through misleading statements,
omissions, half-truths, and lies.
As one newspaper reported on the eve of trial, ``The
implications of the outcome of this case are sure to be felt
far beyond the courtroom. Most people in the white-collar world
would agree that Enron is the Granddaddy of all frauds in the
last two decades. How this comes out is a test of the limits of
what the corporate community will tolerate in business
practices.''
The verdict also had a closer and more personal impact on
the victims, some of whose reactions were carried by the press.
``Justice has been served,'' said Roger Boyce, who worked
in Enron's plant building business. ``I'm satisfied with the
verdict, but I'm happy for all of us employees and retirees
that a just verdict has been reached.'' And, Mr. Chairman, for
our prosecutors and agents who labored in bringing that trial,
I am sure that there is no more fitting reward than comments
like that from a victim.
In summary, I can tell you that our work in combating
corporate fraud is both continuing and vigorous. We are working
with our law enforcement colleagues at State, local, Federal,
and international levels. We are partnering with the SEC and
the FBI, and we are doing many of those things using the
impressive arsenal of new laws contained within Sarbanes-Oxley.
Our corporate citizens are stepping up to the plate to follow
the new rules created by Congress.
Mr. Chairman, on behalf of the Department of Justice, I
would like to again thank you for having the opportunity to
testify today, and I will be happy to answer any questions
which you may have.
[The prepared statement of Mr. Friedrich appears as a
submission for the record.]
Chairman Specter. Thank you very much, Mr. Friedrich.
We turn now to the distinguished Attorney General of the
State of Connecticut, Richard Blumenthal. Previously he had
been in the Connecticut State Senate and the State House of
Representatives and the United States Attorney for Connecticut.
He served as a law clerk to Supreme Court Justice Blackmun, was
an assistant to former Senator Abraham Ribicoff and an aid to
then-Presidential Assistant Daniel Patrick Moynihan; Phi Beta
Kappa graduate from Harvard University and from the Yale Law
School, where he was an editor of the Yale Law Journal, a
prestigious position. Thank you for again joining us, Attorney
General Blumenthal, and the floor is yours.
STATEMENT OF RICHARD BLUMENTHAL, ATTORNEY GENERAL, STATE OF
CONNECTICUT, HARTFORD, CONNECTICUT
Mr. Blumenthal. Thank you very much, Mr. Chairman, and to
you, Senator Hatch, and to Senator Schumer, for being here
today and for your leadership in having us address this
critically important topic. I speak today as a former
prosecutor, as United States Attorney, former Federal
prosecutor, and I want to congratulate and thank the Department
of Justice for the prosecutions that have just been discussed
by my co-panelist and for its initiative and intense and
successful action in that area.
Let me address the precise question that has been raised by
this Committee. I strongly urge and believe that penalties
should be strengthened for the kind of manipulation that has
been alleged involving hedge funds, in effect, shorting and
distorting, using supposedly independent analysts that are
really independent in name only. Right now the penalties, in my
view, are inadequate. They are inadequate in a monetary sense,
certainly, and in my testimony, I have recommended that there
be a civil penalty of treble damages imposed for this kind of
manipulation and deceptive practice as well.
I believe that the susceptibility of the markets is
particularly acute where hedge funds are involved and
supposedly independent analysts because hedge funds can engage
in short-selling, unlike other institutions, they operate in
secret, and the supposedly independent analysts may be beholden
to them as a result of very substantial fees that they receive
in connection with the supposed custom reports that are meant
to be unbiased but may not be. And I want to stress, borrowing
a phrase from Senator Hatch, that there is nothing wrong with
short-selling. It can be a very constructive and positive
technique in the market. There is nothing wrong with hedge
funds. By and large, they are operated honestly and
effectively, and Connecticut is home to many of them.
But there is a need for stronger scrutiny and oversight,
and the Goldstein decision, which I think brings us to a
turning point, a really critical juncture in this area, really
makes absolutely certain the need for some kind of
Congressional action. And it should be to establish a new
framework of regulation that encompasses hedge funds, which
previously had been unregulated. The Goldstein decision turns
on a very narrow and technical point--namely, the definition of
``client''--that could be easily clarified by the Congress or
perhaps by the SEC. But the point is that States will fill the
void that the court of appeals has created. Right now hedge
funds are in a regulatory void without any disclosure or
accountability. The absence of transparency and Federal
inaction or inertia will invite State action. And under our
State statutes in Connecticut, which track the Federal
statutes, we could easily amend our laws, as could other
States.
Federal action and regulation is vastly preferable because
the Federal Government can bring to bear the expertise as well
as authority and uniformity that is so important in this area
to assure credibility and trust in the markets. But States must
consider their own regulatory standards, perhaps modeled on the
SEC rules, achieving the same goals of disclosure and
accountability. And if Federal agencies abandon the field, as
they have done at other points in history, in other areas of
regulation, then States will join forces, as we have done in
joint legal action, to act separately or together to
proactively protect our consumers.
Let me conclude simply by saying that the recommendations
that I have included are simply an opening shot or a beginning
shot in this debate that post-Goldstein I think will be very
much in the fore. And whether it is in this Committee, which I
believe has clear authority over the criminal areas that are
involved, or in the Banking Committee, I hope that the States
are given a role in this debate.
Thank you.
[The prepared statement of Mr. Blumenthal appears as a
submission for the record.]
Chairman Specter. Thank you very much, Attorney General
Blumenthal.
Senator Grassley could not be here this morning. He is
Chairman of the Finance Committee and is otherwise engaged. But
he asked that this statement be put into the record.
Senator Grassley says, ``Chairman Specter, I am pleased
that you are holding this oversight hearing on hedge funds and
independent analysts. I share the Chairman's concern regarding
corporate fraud and integrity in the marketplace. The
allegations we are hearing today remind me of the Enron debacle
where positive accounting information was fabricated and
disseminated about the company to increase the value of its
stock. This Committee held hearings on Enron's fraudulent
partnership and accounting practices, and we passed legislation
included in Sarbanes-Oxley that strengthened the criminal
prosecutions of persons who defrauded investors in publicly
traded securities. The Sarbanes-Oxley law also included a
provision that I offered''--Senator Grassley--``with Senator
Leahy providing whistleblower protection to individuals who
raised concerns about fraudulent activity.''
``All in all, I felt the Sarbanes-Oxley law had done much
to assist Federal regulators to prosecute illegal activity and
to keep our financial markets on the up and up. But maybe we
did not go far enough. The wholesale fabrication of information
and collaboration with market players to pull down the price of
stock sounds suspect to me. In my mind, this kind of market
manipulation seriously distorts the integrity of the financial
marketplace, and everyone--that is, everyone except the bad
actors--loses.''
``So what is independent analysis? Is research ever
independent? Is there enough scrutiny of this kind of activity,
or do we need more disclosures and safeguards in the trade? I
want to make sure that the Department of Justice and SEC are
being aggressive in their investigations of alleged wrongdoing.
I want to make sure that they are doing everything in their
power to protect investors and the public from fraudulent
activity and manipulation of the marketplace. I want to find
out whether the Department of Justice has a need for more tools
or resources to get the job done. The stakes are high because
so many are impacted by fraudulent market information--pension
plans, small investors, seniors, ordinary workers, and their
families. So we need to support our enforcement agencies in
their efforts to clean up the market and make sure that we have
enough tough laws in place, not just to punish but to deter
these bad actors.''
Mr. Friedrich, starting with you on the 5-minute round of
questions, we are not looking at the regulatory approach. That
is for others, and regulations obviously are very important.
But there is nothing like a criminal prosecution. Criminal
prosecutions may have a questionable effect on violent criminal
conduct or barroom killings or a variety of street crimes where
motivations are hard to understand. But when you deal with the
corporate community, when you deal with white-collar crime,
criminal sanction is very, very effective, much more effective
in a regulatory scheme which may or may not be imposed. When it
is imposed, not a whole lot happens except filing of a report
or perhaps a civil proceeding or perhaps a fine within the
regulatory scheme. But a jail sentence means a lot, especially
to thoughtful white-collar criminals.
You went over a litany of corporate fraud convictions that
you have had. How about on hedge funds? Have there been any
convictions by the Department of Justice on hedge funds or the
so-called independent analysts going to the allegations which
are current now about collusion and market manipulation?
Mr. Friedrich. Senator, I am not aware of any closed cases
that deal--or publicly reported cases that deal with that
specific issue as between hedge funds and analysts. The
Department has done some prosecutions in the area of hedge
funds. Two I can think of offhand. In September 2005, the
Southern District of New York had a couple pleas--
Chairman Specter. You have done some prosecutions on hedge
funds?
Mr. Friedrich. Yes.
Chairman Specter. Have there been jail sentences?
Mr. Friedrich. My understanding is that as to the one
closed case, there was a jail sentence.
Chairman Specter. Well, would you please provide that
information to us? On a hearing dealing with Department of
Justice enforcement of criminal actions against hedge funds, I
would have thought that would have been at the top of your
agenda to tell us what you have done.
Mr. Friedrich. Senator, the case that I was referring to
involved the prosecution of two executives, I believe it was
Bayou Capital Management in the Southern District of New York.
If you would give me a moment, I can give you some more detail
on that.
Chairman Specter. Well, provide it in writing. There is a
limited amount of time, and I want to turn to Attorney General
Blumenthal. But give us the detail, if you will, please, as to
what prosecutions have been brought in this field. And I do not
want to ask you in open session about investigations, but we
have oversight authority on pending matters. Would you please
provide us on a confidential basis what the Department of
Justice is doing on current investigations?
Mr. Friedrich. I can provide you information as to the
cases that are publicly reported as to closed cases. I am not
aware that I am free to provide, even in a confidential format,
information about pending cases.
Chairman Specter. Well, take a look at the testimony in the
confirmation of Deputy Attorney General McNulty and our
discussion about our authority to get into pending cases and
give me a response on that.
Mr. Friedrich. Yes, sir.
Chairman Specter. Attorney General Blumenthal, you say you
would like to see some treble damage cases. I would be
interested in your evaluation of the efficacy of treble damages
against wealthy companies or wealthy individuals contrasted
with a tough jail sentence behind bars?
Mr. Blumenthal. Well, clearly, Senator, I agree with you
wholeheartedly that incarceration has a much stronger impact,
both in terms of deterrence and also a message to the public,
than does any fine or monetary penalty. The case that involved
the Bayou group, in fact, I think illustrates that idea because
the two individuals there, Samuel Israel and Daniel Marino,
might not have engaged in the massive fraud that caused the
criminal prosecution by the Department of Justice. Excellent
work done by the FBI and the Department of Justice. But the
kinds of sentences in these cases, Bayou and--
Chairman Specter. What were the sentences?
Mr. Blumenthal. Well, I don't know that they have been
sentenced yet. The prosecutions themselves, as Mr. Friedrich
said, resulted in guilty pleas in December of 2005. Bayou is a
Connecticut case, and I think that certainly the kinds of
deterrent effect that you have discussed have much greater
weight if there are criminal penalties. And that is true
generally in the white-collar crime area, in my view.
Chairman Specter. Well, my red light is on so I would yield
now to Senator Hatch.
Senator Hatch. Well, thank you, Mr. Chairman.
Mr. Friedrich, as you know, the Sarbanes-Oxley Act defined
a new Federal crime--securities fraud. It was designed to get
past a patchwork set of laws under which securities fraud has
previously been prosecuted. Now, that section codified at 18
U.S.C. Section 1348 gave the Department of Justice a strong and
important tool for combating illegal securities fraud,
something that they did not have before.
Now, what steps has the Department of Justice taken to
ensure that hedge funds and corrupt securities analysts do not
commit securities fraud in violation of Section 1348?
Mr. Friedrich. I would say generally, Senator, obviously
this is an area that we are aware of. There have been
prosecutions, as I mentioned before, against principals of
hedge funds. As to the use of that new statute, that is a
statute that we train on in our securities fraud training at
the National Advocacy Center. It is a tool that has been used,
and I think it is a tool--as I mentioned, there have been 53
indictments under that statute to date. I think it is a tool
that will be used with increasing frequency in the area of
hedge fund fraud or other types of securities fraud.
Senator Hatch. Thank you.
Mr. Blumenthal, in your testimony, you recommend
specifically new regulation of hedge funds, and I agree with my
colleague from New York, Senator Schumer, that such civil
regulations would be the exclusive jurisdiction of the Banking
Committee.
Now, I did watch you on ``60 Minutes'' on that program a
few weeks ago where you were addressing the relationship
between independent analysts and various hedge funds. As I
recall, you indicated that criminal investigation and
prosecution of these is very, very difficult. Now, in your
testimony, you just suggested that we need new tools for
criminal enforcement, and that is within the jurisdiction of
this Committee.
So I have basically two questions for you, Mr. Blumenthal,
and basically, that is, what new tools would you like us to
come up with for criminal enforcement? And what tools would you
like to see us investigate and come to a conclusion on with
regard to all of these matters?
Mr. Blumenthal. I think the new tools, Senator--and I am
happy to respond, although obviously Federal jurisdiction is
not within my purview. New tools should include stronger
penalties, but also stronger protections for whistleblowers,
stronger penalties against retaliation for individuals who are
doing their job honestly and forthrightly and who may be
victims of retaliation, either as whistleblowers or as public
officials, as staff members of any of the agencies involved,
whether criminal or civil, and perhaps some consideration of
criminal penalties for that kind of retaliation. Obviously,
obstruction of justice is one possibility, but there should be
consideration of protection for whistleblowers and deterrence
against retaliation.
But, also, as you are obviously very well aware, Senator,
resources are key in this area. And when I mentioned before
that these cases are very complex and challenging, they are
also very resource intensive. And my hope is that the resources
for the criminal justice prosecutions will be provided by
Congress so that both the Department of Justice and the SEC can
exercise their criminal jurisdiction to investigate and
prosecute.
Senator Hatch. You mentioned in your testimony that the
number and financial power of hedge funds, now reportedly more
than 13,000 hedge funds--I had 11,500; it goes up all the
time--with assets exceeding $24 trillion, I believe you said,
provide fertile opportunity for potential fraud based on false
or deliberately misleading stock analysts' reports. And I have
to say that this is a matter of great concern to me, and you
mentioned at least a couple of cases in here where there have
been real allegations of collusion between hedge funds and
analysts that may be corrupt or may be cooperating or may be
conspiring to do wrong here.
My time is up, but I just want to thank both of you for the
work that you do do, and we are concerned about this. I believe
that the vast majority of hedge funds are honest people and
doing a good job, but there are literally, literally thousands
of them, and I am really concerned about if there is widespread
collusion and conspiracies to knock down the price of shares in
various corporations, that could really discombobulate our
whole market.
I think my time is up, Mr. Chairman.
Chairman Specter. Thank you very much, Senator Hatch.
Mr. Friedrich, to what extent does the Department of
Justice monitor the civil suits which have been brought? For
example, Biovail, a pharmaceutical company, has alleged in a
suit brought in New Jersey State courts, alleging that several
hedge funds, an independent stock research firm, and a research
analyst had participated in market manipulation to harm
Biovail's stock. The lawsuit further contained allegations that
similar executions were orchestrated on other companies,
Calgene and Biowaste Technology, Incorporated.
Are such lawsuits of assistance to the Department of
Justice to followup to make a determination as to whether those
allegations are true or whether they would support a criminal
prosecution?
Mr. Friedrich. I think the best way to answer that
question, Senator, good criminal chiefs in every district make
a practice of reading the newspapers and looking for lawsuits
of the type that you describe. I think the best way to put it
would be that is an indication that further questions may need
to be asked. That is something that can tip us off that there
may be some irregularity.
Chairman Specter. Well, are you following up on Biovail's
contentions?
Mr. Friedrich. Unfortunately, Senator, I cannot comment as
to any pending matter that the Justice Department might have. I
can comment as to closed matters, and if I may just add to what
Senator Hatch asked a moment ago, as to Section 1341, I can
tell you that there was a Section 1341 complaint that was filed
recently in the Northern District of Georgia as against the
operators of a hedge fund.
Chairman Specter. And what is the status of that matter?
Mr. Friedrich. There has been a public complaint filed, and
there has not been any other public actions so far as that case
itself.
Chairman Specter. Attorney General Blumenthal, have you
initiated any criminal prosecutions in the State of Connecticut
against hedge funds?
Mr. Blumenthal. We have not, Senator, and they have been,
as Mr. Friedrich has indicated, rare at the Federal level as
well. But I think it is an emerging area of interest, and I
know that State criminal as well as civil authorities are
monitoring and following closely those actions involving
Biovail and Overstock.com because they reflect on the need for
greater disclosure. If there were disclosure, for example, of
the relationships between the hedge funds and supposedly
independent analysts, it would have a very positive effect in
preventing perhaps the kind of collusion or manipulation that
is alleged. Again, these claims are only allegations at this
point. So we are following them to determine whether there is
evidence and whether, in fact, they will ever go to trial.
Chairman Specter. Attorney General Blumenthal, do you know
if there are any actions brought by other State Attorneys
General? The New York Attorney General, Mr. Spitzer, has been
very active in the market area. Do you know if his office or
any other Attorneys General have initiated either criminal or
civil lawsuits in this area?
Mr. Blumenthal. There have been none, Senator, so far as I
am aware. But I know that there are very strong interests on
the part of States like Connecticut, New York, and others in
this potential area of manipulation or fraud, and certainly
there is no reluctance to use existing State criminal
authority, as we have done before.
Chairman Specter. I was interested in a speech which Fed
Chairman Ben Bernanke made recently where he says, ``The
primary mechanism for regulating excessive leverage and other
aspects of risk-taking in a market economy, referring to hedge
funds as the discipline provided by creditors, counterparties,
and investors. And Chairman Bernanke is against regulation but
looks for the market to handle it itself.
Now you have the circuit court decision limiting what the
SEC can do, and in an area where there is so much opportunity
for manipulation and such enormous profits reported that two
individuals last year made in a hedge fund market $1 billion,
listen, free economy, earn what you can. But where there is
such enormous public impact, we ought to be looking at tough
enforcement matters, especially with the void which we have at
the moment with the most recently court ruling until the
Banking Committee has an opportunity to provide the answers and
the Federal legislation comes up and whatever is done with the
SEC, which needs to be done.
So I would urge you, Mr. Friedrich, to take a close look at
this area and tell us if the existing laws are adequate or if
you need tougher sanctions, if you agree with Mr. Blumenthal
that there ought to be some civil treble damage penalties. My
inclination would be against it. I would not want to give you
that option. I would rather have you use the criminal statutes
if you have crimes, if you have allegations of crimes, and
especially serious ones.
Senator Hatch, before we move on to panel two, would you
care to ask anything further?
Senator Hatch. Well, if I could. I did not particularly
want to make this hearing one about naked shorting, but I might
have a question for both of you on that.
Let me just ask you this: How does your group work? How
many meetings do you have with your particular regulatory
group, the CFTF? Who do you invite as U.S. Attorneys? Are they
all from the financial districts of the country, or are they
from across the country? And where do you go with that? How
often do you meet?
Mr. Friedrich. It is a mix of representatives. There are
representatives--the Deputy Attorney General chairs it. There
are people from the Deputy's office who basically administer
the task force on a more hands-on basis. There are a range of
U.S. attorneys. Some are from the major districts. Some are
from smaller districts. There is representation by the FBI, the
SEC, the CFTC, and other relevant Federal agencies. Really,
there is a lot of, I would say, sort of strategic direction,
making sure people have the right resources, exchanging ideas
about best practices, and items of that nature. In terms of--
Senator Hatch. How often do you meet?
Mr. Friedrich. I believe since Deputy Attorney General
McNulty has been in, I believe there has been one meeting. I am
not sure of the frequency of the meetings before he got here.
Senator Hatch. OK.
Mr. Friedrich. And I know they are planning another.
Senator Hatch. Is this issue on your agenda? How do issues
get on the agenda?
Mr. Friedrich. I think really that is driven by what
people--sort of items of current interest, either things that
the regulators or the law enforcement folks or the Bureau want
to put on the table, new trends that they are seeing. We are
constantly looking for new trends and making sure that the
resources that we have are arrayed in a logical way with
respect to those trends. New types of corporate fraud,
exchanging best practices, exchanging ideas about new court
rulings--that type of thing.
Senator Hatch. Maybe either or both of you could answer
this question: As I understand it, with regard to naked short--
well, shorting in general, naked shorting in particular, within
3 days after the date of sale, you have to register that with
the--what is it called? The Depository Trust and Clearing
Corporation? It is the DTCC, I believe. But it is my
understanding that, at least last time I heard about it, there
were about $6 billion per day in failure to deliver stock under
the naked shorting situation.
Are you both familiar with that? That to me is startling,
and I have also heard from various sources that sometimes some
of these companies will register the stock over in, say,
Europe, like Germany, so that they do not have to meet that
requisite of reporting to the DTCC.
Mr. Blumenthal. Clearly, this is an area--this area is one
that ought to be a focus for the Securities and Exchange
Commission, and I hope it will be. It is largely beyond the
purview of State authority, but it opens new opportunities and
very fertile ground for manipulation and fraud and is tied,
again, to hedge fund activities and illustrates the need for
the deterrent effect of strong criminal penalties and stronger
enforcement. There is no question that the penalties themselves
will be dead letter unless they are enforced, like any criminal
statute.
Senator Hatch. Are both of you aware that that is going on?
Mr. Friedrich. I am aware that that is a practice which is
occurring, and I agree with you in terms of your statement of
what the legal requirements are in that area. I know that the
SEC as well as both major exchanges have taken public positions
in terms of naked shorting, what it means and what it does not
mean.
Senator Hatch. Well, how can we allow $6 billion a day not
to be reported? I mean, that is a lot of money, especially over
a year, to not be reported and accounted for. And as we all
know, naked shorting is where there is not enough stock to
cover the short.
Mr. Blumenthal. And it poses a danger to the markets, the
health of the markets and their integrity.
Senator Hatch. That is my point. It could really kill the
marketplace if this is widespread. Now, I do not believe it is,
but there may be some instances where it will. If it is $6
billion a day, which is what I have been told, then there have
got to be a lot of instances where this is being violated, and
it ought to be stopped. Do you both agree with that?
Mr. Friedrich. Respectfully, that is an area where I would
really have to defer to the SEC in terms of answering a
question like that.
Senator Hatch. Do you agree?
Mr. Blumenthal. I agree, but I would probably also have to
defer to the SEC.
Senator Hatch. You would defer also. I will defer it to the
SEC, too, and I am suggesting that they better get on the ball
and start checking on this type of stuff.
Thank you both. I really appreciate it.
Chairman Specter. Thank you very much, Senator Hatch, and
thank you, Mr. Friedrich and Attorney General Blumenthal. We
very much appreciate your coming in.
We will now turn to our second panel: Mr. Aguirre, Mr.
Kasowitz, Mr. McLaughlin, Mr. Blickenstaff, Mr. Lamont, Mr.
Anifantis, Mr. Schilit, and Mr. Boersma.
Our first witness is Mr. Gary Aguirre, formerly senior
counsel with the Division of Enforcement at the Securities and
Exchange Commission; nearly 40 years of litigation experience,
including the areas of construction disputes, environmental
regulations, securities litigation, and criminal defense; has
published a number of scholarly legal articles, including one
on the litigation arising out of the Enron debacle and the
application of Section 10(b) of the Securities Act related to
fraud; bachelor's degree in politics and a law degree from the
University of California, Master of Fine Arts from UCLA.
Mr. Aguirre, we very much appreciate your joining us here
today. We have a copy of a lengthy letter which you have sent
to the Chairman and Ranking Member of the Banking Subcommittee
on Securities and Investment, which will be made a part of the
record, and we look forward to your testimony.
STATEMENT OF GARY J. AGUIRRE, FORMER INVESTIGATOR, SECURITIES
AND EXCHANGE COMMISSION, WASHINGTON, D.C.
Mr. Aguirre. Thank you, Mr. Chairman. I deeply appreciate
the opportunity to offer some views on this critical issue.
I would like to say preliminarily that I have forwarded
your letter inviting me to testify today to the Securities and
Exchange Commission, and yesterday I was informed by the
Securities and Exchange Commission in a letter that it is their
view that existing regulations prohibiting the disclosure of
nonpublic information applies to my testimony today. So since
there are various penalties that are applicable to disclosure
of nonpublic information, I redrafted my testimony yesterday
and submitted it so that it was intended to only disclose
matters that have already been made public. Among those
sanctions are criminal sanctions.
I would like to offer this perspective: I believe that--
Chairman Specter. Well, Mr. Aguirre, just a comment. I take
issue with what the SEC has said to you. This is an oversight
hearing on Federal criminal statutes, and there is a
constitutional responsibility in this Committee, and we need to
know the facts. And it may be that we will take some of your
testimony in closed session, but I would have thought that had
the SEC had some concern about the invitation, they would have
communicated it to this Committee, to the Chairman. And this is
the first that I have heard about it. I have just been handed a
letter on the subject.
Mr. Aguirre. I had actually suggested--my counsel suggested
to them that if they did have some objections to my testimony,
that they pass it along to this Committee. It is also my view
that my testimony before this Committee is protected by the
Lloyd-LaFollette Act. But given the contention of the SEC, I
had prepared written testimony that I submitted that merely
included what was public. I will do the best I can to answer
your questions. I will do the best I can.
Chairman Specter. Well, that is all you can do, but I think
it is particularly problemsome when the information which you
have heretofore disclosed and has been in the public domain
raises questions about the propriety of what the SEC has done.
This is not a matter of some comment about some third party.
This is a matter about the propriety of what the SEC is doing.
Mr. Aguirre. I agree with you 100 percent, Senator.
Chairman Specter. We will start your time at 5 minutes so we
can give you the substantive on substance without talking about
these collateral matters, not to take it out of your time.
Thank you, Chairman.
I think that it helps to begin any analysis of the hedge
fund potential for abuse on the financial markets by discussing
three classes of those types of abuses:
First is the long-term capital risk, and I am really not
going to discuss that. It is more the subject, I think, of
someone familiar with several different agencies.
The second class of hedge fund abuse is hedge fund fraud on
their own investors, and that class of fraud has been the
subject of most of the cases that have been brought by the SEC
and the Department of Justice. It has been the subject of cases
for approximately 10 years. It is probably the SEC's strongest
suit. And I am not sure to what extent it is going to require
any form of regulation.
The third area is the type of fraud that injures ever other
market participant. The type of fraud we are talking about
today or the potential type of fraud we are talking about today
is one class of that. But there are multiple sub-classes of
this type of fraud, for example, insider trading, different
forms of market manipulation, the recent use of market timing
and late trading by hedge funds to effectively siphon funds
from the accounts of small investors. These are all classes of
this type of fraud.
Now, this fraud derives from the amount of trading that
hedge funds do. We know that at this point that trading amounts
to something in the area of 30 percent or more of the New York
Stock Exchange and a larger percentage of the trading in other
forms of securities. That can only be expected to significantly
increase as we move from $1.3 trillion in hedge funds to $6
trillion in hedge funds over the next 9 years.
I believe the impact and the cause of that is the
significant funds that are generated in fees and commissions to
the various brokerage firms and investment banks that deal with
hedge funds.
If we look at the extent of scrutiny of hedge funds in this
area, this third class of fraud, over the last 25 years, we
will find that there was effectively no scrutiny until 2004.
And I am not quoting my own research. I am quoting comments in
recent SEC publications.
In 2004, the SEC did not discover any of this class of
fraud; rather, it was discovered by a State Attorney General--
Mr. Spitzer. That class of fraud, hedge fund abuse of mutual
funds, was costing small investors somewhere in the vicinity of
several billion a year over several years.
Now, there has been over the last year a second class of
fraud discovered, this second class impacting the market
participants in general, and that is the PIPE cases. I discuss
those to some extent in my written testimony.
Now, aside from those two classes of fraud, you will have
to search long and hard to find any enforcement by the
Securities and Exchange Commission of any other class of hedge
fund abuse against other market participants. I am talking
about insider trading. I am talking about market manipulation.
I am talking about the class of fraud that we are talking about
today. The case that I handled, which I believe was perhaps one
of the largest, if not the largest, or the broadest
investigation of a hedge fund involved both market manipulation
and insider trading. What I found there is that most of these
referrals from the New York Stock Exchange and SROs had been
coming into the SEC for years and had not been acted upon.
It appears that my time has run out, Senator.
[The prepared statement of Mr. Aguirre appears as a
submission for the record.]
Chairman Specter. Thank you very much, Mr. Aguirre. We will
come back to you and give you an opportunity to amplify your
statement during the question-and-answer session.
Mr. Aguirre. Thank you.
Chairman Specter. Our next witness is Mr. Marc Kasowitz,
senior partner of Kasowitz, Benson, Torres & Friedman,
representing large multinational corporations. ``American
Lawyer'' has included Mr. Kasowitz on its list of the top 45
lawyers under 45. That is kind of precarious category to be in,
Mr. Kasowitz, subject to leaving it involuntarily.
Mr. Kasowitz. That was 9 years ago when I was 45.
[Laughter.]
Chairman Specter. You are not one of the top 54 under 55,
are you?
Mr. Kasowitz. Well, but today is my birthday, Mr. Chairman.
Chairman Specter. Well, happy birthday. Cum laude from
Yale, law degree from Cornell, editor of the Cornell Law
Review. He is testifying today on behalf of the Alliance for
Investment Transparency.
Thank you very much for coming in today, Mr. Kasowitz, and
we look forward to your testimony.
STATEMENT OF MARC E. KASOWITZ, SENIOR PARTNER, KASOWITZ,
BENSON, TORRES & FRIEDMAN LLP, ON BEHALF OF THE ALLIANCE FOR
INVESTMENT TRANSPARENCY, NEW YORK, NEW YORK
Mr. Kasowitz. Thank you for inviting me, Mr. Chairman.
Our firm has developed a considerable expertise and
experience in the subject that the Committee is addressing
today. We represent a number of clients who have been severely
harmed by the market manipulation activities of certain
extremely powerful hedge funds and certain supposedly
independent securities analysts. Those clients have joined
together to form the Alliance for Investment Transparency, on
whose behalf I appear today.
Our law firm has filed a lawsuit on behalf of one of our
clients against some of those hedge funds and analysts, and we
are currently investigating and analyzing claims on behalf of
other clients. But I want to make clear at the outset that this
is in no way a vendetta against hedge funds in any way. In
fact, our firm represents many hedge funds in a variety of
matters. The concerns I am addressing today have nothing to do
with all those hedge funds which engage in perfectly legal and
legitimate investment activities, and they have nothing to do
with truly independent securities analysts.
However, what our clients and other companies have
experienced is truly shocking. These companies have been
targets of a pattern of egregious collusion between certain
influential hedge funds and certain supposedly independent
analysts, including analysts at major Wall Street firms whose
research, in effect, was bought and paid for by the hedge funds
as part of illegal market manipulation schemes, typically
involving short-selling.
We are not talking about short-sellers who are making an
honest bet that a company's stock is about to fall. We are
talking about short-sellers who manipulate the market to cause
a drop in a company's stock price by engaging in schemes to
disseminate false and distorted research and other
disinformation.
The schemes those hedge funds engage in are strikingly
simple but frighteningly destructive. They often target high-
tech, biotech, and pharmaceutical companies. Here is one of the
ways in which those schemes work.
The short-selling hedge fund selects a target company. The
hedge fund then colludes with a so-called independent stock
analyst to prepare a false and negative research report on the
target. The analyst firm agrees not to release the research
report to the public until the hedge fund accumulates a
substantial short position in the target company's stock. Once
the hedge fund has accumulated that substantial short position,
the report is disseminated widely, causing the intended decline
in the target stock price.
The report that is disseminated--and this is also very
important--contains no disclosure that the analyst was paid to
prepare the report, no disclosure that the hedge fund
participate in the preparation of the report, and no disclosure
that the hedge fund had a substantial short position in the
target stock. Once the false and negative research report has
had its intended effect, the hedge fund then closes its
position and makes an enormous profit, and it makes that profit
at the expense of the proper functioning of the markets, at the
expense of innocent investors, and at the expense of the target
company and its employees.
There are a number of other ways that hedge funds and
analysts illegally manipulate the market as well. They engage
in organized campaigns to drive down stock prices by spreading
rumors and falsehoods in the financial press, on Internet chat
boards, in investor conference calls, at analyst presentations,
and at industry conferences. There are orchestrated campaigns
to communicate egregiously false information directly to a
target company's board of directors, larger shareholders,
principal banks, and outside auditors.
We are aware of instances in which the perpetrators of such
campaigns have sought to instigate regulatory investigations
based on disinformation in order to cause more adverse
publicity about the targeted companies. The effects of these
campaigns have been devastating to the companies, their
employees, and everyday investors.
You heard Mr. Aguirre talk about Pequot, at least in his
correspondence to this Committee. Those allegations, if proven,
are outrageous and illegal. The same is true here. The conduct
that I have described today is egregious and illegal.
Underlying both of these situations is the fact that this
industry has grown so large, so powerful, and with so little
transparency that the potential for gross fraud and abuse is
stunning. In fact, based on the testimony of witnesses before
this very Committee today, no one even knows within $1 trillion
how large the hedge fund industry actually is. One witness
estimates $2.4 trillion; another estimates $1.5 trillion;
another says it is $1.2 trillion. The fact that we do not even
know how big the industry is within a trillion dollars--which
is real money, even in Washington, D.C.--proves the incredible
lack of transparency.
There is a pervasive pattern of illegal conduct. Civil
remedies exist to address it on an individual basis. But it is
critical that law enforcement utilize all of the tools at its
disposal to assure that that conduct is uncovered, punished,
and deterred.
Thank you.
[The prepared statement of Mr. Kasowitz appears as a
submission for the record.]
Chairman Specter. Thank you very much, Mr. Kasowitz. We now
turn to Mr. Joseph McLaughlin, a partner at Sidley Austin, a
practice focusing on securities regulation and enforcement; had
been a member of the New York Stock Exchange Legal Advisory
Committee to the Board of Governors; currently a member of the
Subcommittee on Market Structure; a law degree from Columbia
and a bachelor's degree also from Columbia. He is testifying
today on behalf of the Managed Funds Association.
Thank you for coming in, Mr. McLaughlin, and the floor is
yours.
STATEMENT OF JOSEPH MCLAUGHLIN, PARTNER, SIDLEY AUSTIN LLP, ON
BEHALF OF THE MANAGED FUNDS ASSOCIATION, NEW YORK, NEW YORK
Mr. McLaughlin. Thank you, Mr. Chairman. Good morning. The
Managed Funds Association is a global membership organization
based in the United States. It serves the needs of the
professionals who specialize in the alternative investment
industry. It has over 1,000 members who include professionals
in hedge funds, funds of hedge funds, and managed futures
funds. Its members manage a substantial portion of the
estimated $1.2 trillion or more invested in these vehicles.
On behalf of its members, MFA has worked with committees of
the House and the Senate on hedge fund matters and with the
President's Working Group on Financial Markets and that group's
constituent departments and agencies.
As members of this Committee are aware, hedge funds are
more easily defined in relation to what they are not. They are
essentially investment companies that are not publicly offered.
The hedge fund universe is characterized by a wide variety of
strategies with different risk characteristics and different
return expectations.
To the extent that hedge funds engage in short-selling as
part of their investment strategy, they tend to dampen what may
be irrationally positive market perceptions. They contribute to
liquidity and price formation. To the extent that they target
companies whose financial positions or whose accounting may be
suspect, short-sellers try to identify the bad actors in our
marketplace.
As for short-selling, as I am sure you are aware, Mr.
Chairman, the SEC was given by Congress plenary authority to
regulate short-selling. It has done so. It recently adopted
Regulation SHO to deal with the market operational problems
that short-selling can create and to deal with the potential
manipulative effects of short-selling.
Mr. Chairman, whether investment managers are investing on
the short side or the long side, they have a fiduciary duty to
their investors to consider all reasonably available
information that might bear upon the advisability of their
decisions. And where available information leads some investors
to take significant short positions in a public company's
common stock, it sometimes occurs that the public company will
allege that the short seller has been assisted by third parties
and is seeking to profit from the short position.
For example, companies frequently allege that investors
established a short position in a company stock while feeding
reports to the financial press, analysts, or other third
parties that criticize the company's accounting or financial
conduct. These allegations are not new. In my experience, they
have been around since the 1960's when I started practicing
law. They may well go back much more into the distant past.
This does not involve just hedge funds, but other investors as
well. The fact is these allegations on the part of public
companies have seldom been substantiated.
As discussed previously, short-sellers often turn out to be
right in their conclusions about public companies. MFA believes
it would be a serious policy mistake to inhibit short-sellers
from continuing to perform the essential contrarian function I
have described and that would raise serious constitutional
issues to attempt to chill short-sellers' communications with
third parties.
Mr. Chairman, if an investor knows its allegations about a
company are untrue, then existing law and SEC rules provide
ample means for dealing with this conduct. As we have seen from
the pump-and-dump schemes, which essentially involve the
reverse situation from what we have here, the SEC has ample and
enforcement authority under Rule 10(b)(5) and other provisions
of the securities laws.
Of course, unlike the pump-and-dump schemes, it is
sometimes difficult to identify the source of negative
information, except by requiring the recipient of the
information to reveal his or her sources, a step that
enforcement authorities are often understandably reluctant to
take.
At the same time, Mr. Chairman, persons who receive adverse
information have their own responsibility to treat it with a
degree of healthy skepticism. We believe the financial press
has been increasingly diligent over the past few years in
identifying possible sources of bias of persons whom they quote
as having positive or negative views on a stock.
In this connection, independent analysts are not subject to
rules of the New York Stock Exchange or the NASD aimed at
revealing conflicts of interest and otherwise enhancing the
integrity of an analyst's research. The views expressed or
reported by independent analysts are still part of the relevant
mosaic, however, and users of independent research must make
allowances for the fact that independent research is not
subject to the same internal and external scrutiny and
standards as research produced by securities firms.
Mr. Chairman and Senator Hatch, MFA unequivocally condemns
the intentional spreading of false or misleading information.
At the same time, there will be many cases where the facts in
the law are not clear, and MFA believes that the remedy in such
cases should be not to chill speech but, rather, to encourage
more speech. And we urge that the Congress and the regulators
follow this principle in their further deliberations.
Thank you.
[The prepared statement of Mr. McLaughlin appears as a
submission for the record.]
Chairman Specter. Thank you, Mr. McLaughlin.
Our next witness is Mr. Kim Blickenstaff, co-founder,
Chairman, and Chief Executive Officer of Biosite, Incorporated;
25 years' experience in health care financing, market
management, sales and strategic planning; previously held
various financial operations and marketing positions with
Baxter Health Care, National Health Laboratories, and High-Tech
Incorporated; a master's degree in business administration from
University of Chicago, and a bachelor's degree from Loyola, a
certified public accountant.
We welcome you here, Mr. Blickenstaff, and look forward to
your testimony.
STATEMENT OF KIM BLICKENSTAFF, FOUNDER, CHAIRMAN, AND CHIEF
EXECUTIVE OFFICER, BIOSITE, INCORPORATED, SAN DIEGO, CALIFORNIA
Mr. Blickenstaff. Thank you, Chairman Specter and Senator
Hatch. I really appreciate you inviting me to this Committee.
Obviously, my name is Kim Blickenstaff. I am a founder and
Chairman and CEO of Biosite, Incorporated, and I think the only
CEO on the panel today, so I think some of my perspective may
be interesting.
Just briefly, Biosite is a San Diego-based medical
diagnostics company. We do utilize biotechnology techniques
within our company to develop rapid diagnostic tests to improve
the diagnosis of time-critical diseases. I should note that the
company actually went public on the Nasdaq back in 1997.
My testimony today is going to relate to a period in 2002
in which Biosite experienced a rise in its stock price
accompanied by highly negative independent research coverage
that contained inaccuracies and speculation, so I will show you
a lot of details in my comments. Also, I should note that
during this same period the company's short position increased
six-fold. In many cases, the distributions of these independent
reports seemed to be timed to offset positive business
developments that the company was reporting on a number of
fronts. Due in large part to our experience during this period,
we believe that the unregulated activities of independent
research firms and their possible links to hedge funds merits
further investigation by your Committee.
Just to provide context, I will share some specific
situations that influenced my perspective.
In the spring of 2002, Biosite's business had upward
momentum following reports of several financial and scientific
developments. The stock had increased from $13 a share in
January of that year to approximately $19 in February, and by
May it had reached $36 a share on the Nasdaq. Much of the
enthusiasm was fueled by the investment community and their
believe that the market for a new test that we had introduced,
our Triage BNP Test, which was the first test for congestive
heart failure in the marketplace, could be a very substantial
market opportunity. And I believe the rapid rise of our share
price over that period of time and the opportunity to
speculate--or negative speculation about the entry of potential
competitors into the rapidly growing marketplace set the stage
for what we experienced next with the independent research
community.
Just to give you background, in the 10 months from February
to December 2002, the number of shares controlled by short-
sellers increased from 690,000 shares to 7.1 million shares,
which represented nearly 50 percent of our outstanding stock,
and we have the unfortunate distinction of being the most
highly shorted stock on any of the exchanges here in the United
States.
During this same period, Sterling Financial Investment
Group, which is a Florida-based research firm, issued at least
seven negative research reports on Biosite, each carrying a
``sell'' or ``sell short'' recommendation and an $11 target
price in contrast to our $36 market price. Contrary to standard
industry practices, no author was listed on the reports, and we
believe these reports contain numerous inaccurate or false and
misleading statements, which ultimately lent volatility to the
stock's performance, thereby harming many of our long-term,
fundamentally based investors.
Just to give you an example, in a number of reports issued
in the summer and fall of 2002, Sterling predicted the failure
of our BNP test due to the expected entry of a competitive test
into the marketplace. In several of these reports, Sterling
included outright inaccuracies regarding the competitive
advantages that supposedly favored the competitive test. The
reports also included inaccuracies and misstatements about our
own test performance, which were also construed to be an
advantage for our competitors.
On September 11, 2002, the same day that Biosite announced
positive news, a column was written by Sally Yanchus which
appeared on a website called RealMoneyPro.com. The column,
which was critical of Biosite, was posted to Yahoo's Biosite
message board, so it got onto the Internet.
Ms. Yanchus previously participated on our quarterly
conference calls under the affiliation Nightingale and Farber,
and we were subsequently able to link Ms. Yanchus to Sterling
Research through an NASD Disciplinary Panel Decision, dated
April 15, 2005, which refers to her admission of knowingly
including inaccuracies in reports on another health care
company while working on behalf of Sterling Financial. And I
should note that this all happened during the same timeframe
that she was involved in these postings on Biosite.
So, on November 18, 2002, members of my management team,
including myself, met with the analyst from Sterling Research
at the American Heart Association meeting. During our
discussion the Sterling analyst told us her research at the
conference--she was doing specific research on our products--
had elicited positive feedback on our BNP test. She also
acknowledged that certain reports that they had previous
released did contain inaccuracies, but indicated that what her
research director wanted written was not necessarily in line
with her own views from her own research. She further
maintained that she felt our company would continue to do very
well in the marketplace and expressed surprise as to why her
managers felt the stock continued to be a good short target.
When we asked her why she was writing negative material about
the company, she said that her role was research and that the
reports were, in fact, written by someone else who was at
liberty to revise her research. She also said she was
considering leaving Sterling because of the way they were
operating and her discomfort about these operational processes
on the research writing.
So during this entire period, I should note our BNP test
was, in fact, gaining market momentum. Sales grew from $3.4
million in 2001 to $38 million in 2002, despite the
competition. Despite all the progress being made by Biosite,
our investors continued to see their investments compromised by
the volatility in our stock that was created by the
dissemination of these reports through various methodologies.
Finally, I should note that in the fall of 2002, we
attempted to independently investigate the activities of the
short-sellers and their links to Sterling. Unfortunately, the
lack of visibility into these trades made it impossible for our
investigators to definitively produce a link between Sterling's
activities--
Chairman Specter. Mr. Blickenstaff, how much longer would
you need?
Mr. Blickenstaff. Just 2 seconds. It failed to produce a
link between Sterling's activities and the resulting increase
in our short position. Nevertheless, we believe the parallels
between the magnitude and the timing of Sterling's research
activity and Biosite's short position increase was more than a
mere coincidence.
I will conclude and go to questions when you have them at
the end of the presentations.
[The prepared statement of Mr. Blickenstaff appears as a
submission for the record.]
Chairman Specter. Thank you very much, Mr. Blickenstaff.
Our next witness is Professor Owen Lamont, Professor of
Finance and Senior Associate Dean for Faculty Affairs at the
Yale School of Management; previously had been an associate
economist and research associate to the Boston company Economic
Advisers; also served as assistant professor of economics at
Princeton University and assistant professor of Finance at the
University of Chicago Graduate School of Business; a bachelor's
degree with honors from Oberlin and a Ph.D. in Economics from
MIT.
We welcome you here, Professor Lamont, and the floor is
yours.
STATEMENT OF OWEN A. LAMONT, PROFESSOR OF FINANCE, YALE SCHOOL
OF MANAGEMENT, NEW HAVEN, CONNECTICUT
Mr. Lamont. Thank you very much, Mr. Chairman. I am honored
to have this opportunity to testify today.
As an economist, I am concerned with prices, the need to
get the prices right. When the prices are wrong, investors are
hurt and resources are wasted. In order to get prices right, we
need to have all information, both the positive information and
the negative information, get into the market. Just like in the
world of politics, free speech is essential in the world of
finance.
Unfortunately, U.S. financial markets have a substantial
optimistic bias built in. The good news is accepted, but the
dissemination and discovery of bad news is suppressed. This
bias happened for two reasons. One is it can be difficult
technically to short-sell, and short-selling is today primarily
done by hedge funds and is an important channel for negative
information to get into the market. A second component of this
bias is retaliation through legal means and other means against
any public criticism of the company, whether it be from
journalists or short-sellers or analysts.
What happens when negative information is suppressed?
Stocks can become overpriced, and we have already mentioned an
example of that today, which is Enron. To prevent future Enrons
from occurring, we need to make sure that pessimistic voices
are heard in the market.
Our current financial system is not set up to encourage
short-selling. We have many institutions set up to encourage
people to go long, but few institutions set up to encourage
people to go short. And there are technical issues with short-
selling relating to our system of lending equities. Our system
is just not designed to facilitate short-selling of equities,
and for some stocks it can be just difficult or impossible to
short them.
In the case of analysts, part of the optimistic bias of our
system comes from sell-side analysts--not independent analysts,
but sell-side analysts from investment banks. These analysts
have an incentive to curry favor with the issuing firms in
hopes of gaining future underwriting business, and there is
substantial evidence that these analysts have in the past been
corrupt and intentionally issued overoptimistic forecasts.
The antidote to this problem is independent analysts
unaffiliated with any investment bank, and that antidote was
mandated in the 2003 settlement between investment banks and
securities firms and the Government.
In the case of Enron, for example, independent analysts
were substantially less optimistic than the analysts from
investment banks. So independent analysts can help detect
problems. Unfortunately, independent analysts also have an
incentive to be overoptimistic because if they issue negative
reports, they may be sued or otherwise harassed by the
companies that they cover. And these lawsuits are a particular
threat to independent analysts because they are typically small
companies that lack the resources to withstand lawsuits.
So I think there is a variety of evidence from academic
studies that when you cannot short-sell, stocks can get
overpriced. One example I have studied is battles between
short-sellers and firms. These are cases in which firms sue
short-sellers or otherwise take actions to prevent short-
sellers from shorting their stock. And consistent with the idea
that when it is hard to short a stock it gets overpriced, firms
that are fighting with short-sellers tend to have their stock
price decline a great deal in subsequent years, suggesting that
it was overpriced to begin with, either because of excessively
optimistic investor expectations, because of a problem at the
company, or just plain fraud on the part of management.
A notable feature of the data that I studied is that many
of the firms that fight with short-sellers are subsequently
revealed to be fraudulent, and a variety of other evidence
suggests that short-sellers are good at detecting and
publicizing fraud, not just overpricing but fraud on the part
of firms. I think the SEC and the other regulators cannot be
our only line of defense against corporate fraud. We also need
a vibrant short-selling community.
In the case of Enron, I think that illustrated many of the
benefits of short-selling. Executives from Enron in their
recent trial in Houston claimed short-sellers had caused the
demise of the company, Enron. I think that claim is nonsense.
The jury did not buy that story, and neither should you.
So my opinion is that we need to make the system less
lopsided and more hospitable to short selling. We might also
want to consider ways of protecting independent analysts from
lawsuits from companies. We do not want these analysts to be
cheerleaders. We want them to be able to express their honest
opinions.
Congress and the SEC are going to continue to hear
complaints from companies about short-sellers. An example that
I think is useful about who tends to be right in these
situations comes from hearings in 1989 when the House Committee
on Government Operations had hearings about the alleged evils
of short-selling, featuring testimony from supposedly
victimized firms. Officials from three firms testified at these
hearings. Subsequent to this testimony, the presidents of two
out of these three firms were charged with fraud by the SEC. So
when you hear companies complain, keep in mind that short-
sellers are often the good guys.
Thanks very much for this opportunity to testify. I would
be happy to answer your questions.
[The prepared statement of Mr. Lamont appears as a
submission for the record.]
Chairman Specter. Thank you, Professor Lamont.
Our next witness is Mr. Demetrios Anifantis, manager of
Small Business Relationships at J.P. Morgan Chase, formerly
client relation manager with Camelback Research Alliance;
previously held positions with Thompson Financial, Chase
Manhattan, and Skyy Spirits; bachelor's degree in economics
from the University of San Francisco and a master's in
economics from Fordham.
We welcome you, Mr. Anifantis, and the floor is yours.
STATEMENT OF DEMETRIOS ANIFANTIS, FORMER CLIENT RELATIONSHIP
MANAGER, CAMELBACK RESEARCH ALLIANCE, INC., SCOTTSDALE, ARIZONA
Mr. Anifantis. Thank you so much, Mr. Chairman, Senator
Hatch. I am pleased to be called to testify before this
Committee this morning.
As you mentioned, I did work for Camelback as a client
relationship manager performing services for Camelback
subscribers for approximately 1 year. I was in the trenches, so
I am basically speaking from experience today on exactly what
took place at one of these independent research firms. I do
work for J.P. Morgan Chase right now as a small business
banker.
During my tenure at Camelback, I became well acquainted
with Camelback's business model and its management team and
staff. It was a relatively small operation while I was there.
Camelback touted itself as supplying ``independent
research'' for a fee to subscribers. It was in the business of
publishing reports on public companies, and it also sold some
software to subscribers that would rank public companies
according to their financial performance and prospects.
Basically this was a firm that touted itself on forensic
accounting analysis, taking tax returns and financial
statements and analyzing those tax returns and financial
statements.
I worked most closely with Donn Vickrey, who was one of
Camelback's two principals. Vickrey and the other principal,
James Carr Bettis, were the individuals who founded Camelback
and had control of Camelback's operations.
Vickrey was directly in charge of this independent analyst
group, and Carr was more of a head figure of the company.
Vickrey's key function was to oversee the research and writing
that went into the reports covering publicly traded companies.
Another manager, Jeff Mindlin, had the primary
responsibility of engineering as well as managing the financial
models that ranked each company.
There were approximately 18 to 20 analysts during my tenure
at Camelback; at any given time, approximately 10. These
analysts had responsibility to research and write reports on
publicly traded companies. The analysts were all recent
graduates of universities with 4-year degrees in business-
related disciplines, yet management instructed employees to
share with clients that the analyst team was comprised of CFAs
and/or CPAs with advanced degrees, even though it appeared to
me that none but Camelback's top management had such
designations. All these individuals who were analysts at
Camelback were graduates, recent graduates, recent undergrad
graduates, with no certifications at all.
Camelback advertised analytical reporting services on
companies whose securities were publicly traded on various
exchanges, the three major exchanges here in the United States.
At the time I worked for Camelback, Camelback's client base
consisted almost exclusively of large hedge funds and a couple
mutual funds. My responsibilities included working with the
clients to see that their requests were being met with a view
toward keeping them satisfied so they would retain their
subscription to Camelback's publications.
The price for Camelback's subscription varied, but commonly
there was an annual base subscription of approximately $25,000
to $30,000 per year. For this fee, the client would receive
access to all of Camelback's published reports and access to
all historic reports on publicly traded companies. So all the
reports that were written during Camelback's tenure were
available to any client, even new customers or new clients.
Camelback published these reports on several websites that
clients did have access to.
Camelback's promotional material and its actual sales
practices included selling a yearly ``Base Subscription''
service to its research reports. Included in this package that
I just referred to, between $25,00 and $30,000 a year, also
came two custom reports, and these were reports that any of the
customers could come and request from Camelback on a specific
company.
Typically, Camelback's subscribers would call Camelback and
request these reports. That was usually who they called. They
usually called me, either through myself or Vickrey. All report
requests would be drafted by an analyst and turned over to
Vickrey for final approval.
These reports were represented to be qualitative analysis
and were essentially more subjective in their coverage than
quantitative, which was the models I was referring to earlier.
In Camelback's qualitative reports, the company covered would
receive an alpha score from ``A'' to ``F,'' ``A'' being a
strong company, ``F'' being a very weak firm.
Frequently, the subscribing client of Camelback requesting
the custom report would actually supply Camelback with
information on the companies that were the subject of the
requested report, with instructions to consider and include
such information in the report. Usually, the client would
instruct Vickrey and other Camelback personnel involved in the
intake of the request and the research and writing of the
report to generate either a positive or negative report on the
company that was the subject of the request.
When a request came in to me, one of the three questions--
or two of the three questions that I would always ask of each
client that was requesting a report was: Do you currently hold
a position in the stock? And if you do hold a position, is it
long or short? And this as information that Donn Vickrey wanted
prior to beginning the research of any one of these companies.
Just to wrap up here, since I am running out of time, I
really truly believe that Camelback is built on deception,
corruption, and a complete non-independent model. Independence
to me means that all opinions and interpretations are not
influenced by any third party or outside source. Camelback also
held reports for specific clients, as mentioned by Mr.
Kasowitz, where a customer would request that a report not be
disseminated to the general paying subscriber base due to the
fact that that requesting client, the client who requested the
report, could gain some form of position in that stock. As the
panel knows, it is oftentimes difficult to build a sizable
short position--
Chairman Specter. Mr. Anifantis, how much longer will you
require?
Mr. Anifantis. Just a minute, Mr. Specter.
The other thing in regard to the deception, Camelback
mentioned to all of its employees and professed that it did not
run money or did not operate any hedge funds or did not co-
manage any funds, which they did.
They would offer joint attacks with media personnel. Within
days, even hours of releasing a report, a journalist individual
would publish a report that was negative on the same firm.
To wrap up, I believe that this type of thing I saw at
Camelback is more common in the industry than regulators
believe. The independent analysts feel it is virtually
unregulated and lacks meaningful disclosure. I hope my
testimony here today results in change in this area, both in
enforcement and regulation, that will benefit America's public
companies and their shareholders.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Anifantis appears as a
submission for the record.]
Chairman Specter. Thank you, Mr. Anifantis. Has Camelback
changed its name?
Mr. Anifantis. Yes, it has. It is now Gradient Analytics.
Chairman Specter. Thank you.
We now turn to Mr. Howard Schilit, founder and Chairman of
Center for Financial Research and Analysis; previously an
accounting professor at American University; author of the book
``Financial Shenanigans: How to Detect Accounting Gimmicks &
Fraud in Financial Reports;'' a Ph.D. and MBA in accounting and
finance from the University of Maryland, master's in accounting
from Binghampton, and bachelor's degree from Queens.
Thank you very much for coming in today, Mr. Schilit, and
we look forward to your testimony.
STATEMENT OF HOWARD SCHILIT, CPA, FOUNDER AND NON-EXECUTIVE
CHAIR, CENTER FOR FINANCIAL RESEARCH AND ANALYSIS (CFRA, LLC),
ROCKVILLE, MARYLAND
Mr. Schilit. Thank you, Senator Specter and other esteemed
members on the Committee. I am grateful to have this
opportunity to participate in this important hearing.
The perspective that I would like to share based upon the
background first as a professor and author about topics on
ethics and a founder of an independent research firm is about
the independent research industry itself. I was one of the
pioneers in the industry back in 1994 and observing the
behavior of research firms and our clients, and I will have a
series of recommendations on how to improve the behavior and
eliminate some conflicts.
I would first like to mention briefly one or two things
about the investment management profession, and then I will
move on to the research side.
Investment managers can be segmented into two groups; those
that own stocks on the long side only, and those that can short
stocks. And it is important to recognize good or bad behavior
can and does occur in both of those groups. I think in terms of
the focus of this Committee, look more broadly, not just at a
subset of investment managers, the hedge fund community, but
more broadly at the behavior of investment managers in general.
Moving to what is referred to as the independent research
profession or organizations, perhaps as many as 500 investment
research organizations are now selling a wide variety of
products and services to investment managers. While most are
still one- or two-person ``mom-and-pop'' operations, some have
grown to generate tens of millions of dollars in revenue.
Some research firms have well-thought-out conflict-of-
interest policies while others may demonstrate little or no
scruples.
I believe the most important result of this Committee's
work would be to move the investment research profession to
establish policies and procedures to eliminate both real and
perceived conflicts of interest.
I have half a dozen specific recommendations that perhaps
you would like to consider.
For firms selling a prescription product, all subscribers
should receive the product at the same time and in the same
form. No subscribers should be given advance copies, nor should
they ever be tipped off of an upcoming report.
Second, research firms should refrain from using nonpublic
information to trade in their own accounts, particularly in
advance of disseminating a report to subscribers.
Third, research firms that make recommendations for stock
purchase or sale should not be permitted to also manage an
investment fund. While this may sound self-evident, today some
research firms are also investment firms, either long-only or
hedge funds.
Four, fees received from investment management clients
should never contain a percentage of profits earned from the
research. Becoming a partner with a client would immediately
strain the objectivity and independence of the research
analyst.
Five, research firms that also provide investment banking
services should be prohibited from ever using the label
``independent.''
Six, company-sponsored research creates a special conflict-
of-interest problem and should generally render the research
firm as ``not independent.''
And, finally, just as an oversight board exists for
auditors, the Public Company Accounting Oversight Board, and
many other professionals, such a board is needed to review
policies, procedures, and practices of independent research
firms.
While this list is far from complete, I think it may be a
good starting point.
A few words about the relationship between the independent
research firm and the investment managers.
Today, pressure can be brought to bear on research firms by
investment managers, such as hedge fund professionals, to write
or not write on certain companies, and perhaps even to provide
nonpublic information to a high-paying client. My experience in
running a large research center for over a decade is that by
establishing transparent and verifiable rules for both clients
and employees, rarely will clients push the research firm to
act unethically. It is critical that at the beginning of a
relationship with a client, he or she knows the rules of the
game and also knows that they will always be enforced. That
means occasionally firing a client who is unwilling to play by
the ethical rules established by the research firm.
A few concluding thoughts. While there may be only isolated
cases of bad behavior by investment managers or research
providers, the need exists for a careful review of the
practices of each group and how they interact. For sure, from
time to time investment managers will act badly and try to
pressure research providers to act unethically, to the
detriment of clients and investors in general. This problem is
not too different than the one we all face as parents, as our
usually wonderful children sometimes act badly and try to
pressure us to do things we later regret doing. The absence of
rules or failure to enforce them not only emboldens children to
misbehave, but also investment managers.
I hope these thoughts and recommendations were helpful. I
look forward to answering any questions.
[The prepared statement of Mr. Schilit appears as a
submission for the record.]
Chairman Specter. Thank you, Mr. Schilit.
Our final witness today is Mr. Jonathan Boersma, Director
of Standards of Practice, Centre for Financial Market
Integrity, CFA Institute; responsible for managing and
directing the development of the institute's Code of Ethics and
Standards of Professional Conduct; previously worked in the
investment management industry; bachelor's degree in economics
from the University of Wisconsin.
We appreciate your coming in, Mr. Boersma, and the floor is
yours.
STATEMENT OF JONATHAN A. BOERSMA, DIRECTOR, STANDARDS OF
PRACTICE, CFA CENTRE FOR FINANCIAL MARKET INTEGRITY,
CHARLOTTESVILLE, VIRGINIA
Mr. Boersma. Thank you, Mr. Chairman, and thank you for the
opportunity to speak with you today.
For more than 40 years, CFA Institute has administered the
Chartered Financial Analyst, or CFA, examination and awarded
the CFA charter, a designation I share with nearly 70,000
investment professionals worldwide.
The hallmark of membership in CFA Institute is adherence to
our Code of Ethics and Standards of Professional Conduct. Each
of our members, as well as more than 100,000 candidates in the
CFA program, must abide by and annually attest to their
adherence to our Code and Standards. Among other things, our
Code and Standards require our members to maintain their
independence and objectivity, prohibit them from engaging in
market manipulation, require that they perform their research
with diligence and rigor, and require that they disclose any
conflicts of interest.
The term ``independent research'' can have different
meanings. It is not simply the product of a firm lacking an
investment banking department. Research can be influenced
internally, through investment banking, or externally, by the
company the analyst is covering or by an investor. Client-
sponsored or even issuer-paid research, whereby a company with
little or no research coverage hires a firm to write a report
on their company, is certainly not independent.
The key question is whether this research is objective.
Research that is by its very nature dependent can still be
objective. Our Code and Standards mandate all research must be
conducted with integrity, thorough analysis, and care. There
must be a reasonable and adequate basis to support and
substantiate recommendations. This applies to positive and
negative ratings. Analysts must not rely on hearsay or rumors,
but must conduct careful investigations and rigorously test
their hypotheses.
Conflicts of interest are often present and must be managed
appropriately--all with the mandate that investors' interests
must come first. In order to maintain trust and confidence in
our capital markets, it is critical that such conflicts are
minimized to ensure that investors' interests are protected.
Thorough disclosure is key here. This means, for example,
letting investors know whether the research report has been
funded by a third party.
Another conflict that has been raised is whether analysts
should be allowed to own, or short, shares in the companies
that they cover. While some argue that analysts should be
prohibited from taking such positions, others maintain that
analysts should be required to because it aligns their
interests with those of their clients. Our view is that this is
indeed a conflict of interest and, like any other conflict,
needs to be managed carefully--through black-out periods, pre-
approval of trades, or other means. Further, this conflict must
be disclosed in order to help investors fully evaluate
analysts' recommendations.
Last year, CFA institute issues the Asset Manager Code of
Professional Conduct. This voluntary code is to be used by
asset managers, and hedge funds in particular, as a template
for developing procedures that protect investors and promote
ethical behavior. We believe that asset managers have a
responsibility to act with integrity and, relevant to our
discussion here today, refrain from market manipulation. Under
the code, asset managers must not knowingly spread false rumors
or attempt to influence analysts to rate or recommend a
security in a way that benefits the asset manager or their
clients.
Asset managers are not prohibited from hiring outside
research firms to supplement or validate their own research.
Such research may be positive or negative, and asset managers
should be free to take investment actions as a result of their
own negative views or as otherwise confirmed by an outside
research provider.
Finally, let me say a word about corporate issuers, because
they also have a role to play here. In December 2004, CFA
Institute and the National Investor Relations Institute issued
joint best practice guidelines dealing with the relationship
between analysts and corporate issuers. These guidelines, which
have been endorsed by the New York Stock Exchange and Nasdaq,
outline the duties and responsibilities of analysts and
corporate issuers with the goal of reducing retaliation and
improving the integrity of research.
As I stated at the beginning, all analysts have a
responsibility to act with integrity and to publish only
honest, thorough research. Market manipulation of any kind must
be dealt with appropriately. Yet analysts must be free to state
their opinions and be protected from pressures or threats from
the companies when they do so. Not every stock is a ``buy,''
and analysts must have the freedom to say so. Corporate issuers
must refrain from trying to influence analysts because that is
market manipulation as well.
In closing, I would like to thank you, Senator Specter, for
the opportunity to speak with you, and we offer our assistance
as you examine these issues further.
[The prepared statement of Mr. Boersma appears as a
submission for the record.]
Chairman Specter. Thank you very much, Mr. Boersma.
For the record, I want it noted that a number of key
prospective witnesses declined to participate or cooperate with
the Committee. We had sought representatives from SAC Capital,
from Rockner Partners, and from Camelback Alliance. And we had
sought the testimony of Mr. James Chanice. It was the thought
of the Committee that they all had important testimony to add.
We have compulsory process, as you know, if necessary, and we
may call upon those people in the absence of coming in today to
respond for the record. So let the record show that those
matters are under consideration by the Committee.
Beginning with Mr. Aguirre, to what extent did your work
with the SEC involve referrals to the Department of Justice on
any matters which might have had criminal overtones, such as
those we are discussing today with hedge funds and so-called
independent analysts?
Mr. Aguirre. No, it did not. It did not involve independent
analysts. We did--
Chairman Specter. How about hedge funds?
Mr. Aguirre. Well, yes. The case that I was investigating
when I was discharged was referred to the U.S. Attorney's
Office in New York, and I met with the U.S. Attorney and the
FBI on the case in June--
Chairman Specter. Well, that matter is under active
investigation by the U.S. Attorney and the FBI?
Mr. Aguirre. I understand that it is not. But that
information has been--I picked that up from the media, which I
understand was passed along to them by the SEC.
Chairman Specter. I did not follow that. You say it is not
under active investigation, but you had consulted with the U.S.
Attorney and the FBI?
Mr. Aguirre. I did, in June of 2005.
Chairman Specter. And what happened after that?
Mr. Aguirre. Well, in June of 2005, we basically presented
the facts of the G.E.-Heller investigation to the U.S.
Attorney.
Chairman Specter. And what were those basic facts?
Mr. Aguirre. That the CEO of Pequot had appeared to obtain
a tip from the CEO of an investment bank.
Chairman Specter. And would you define what a ``skip''
means?
Mr. Aguirre. Pardon?
Chairman Specter. Would you define what a ``skip'' means?
Mr. Aguirre. I said ``tip,'' sir.
Chairman Specter. Tip, oh. Well, I know what a tip means.
Mr. Aguirre. Yes.
Chairman Specter. Go ahead.
Mr. Aguirre. We provided that information to the U.S.
Attorney and the FBI.
Chairman Specter. I know what a tip means, but you mean a
tip which would be relevant to some inside information?
Mr. Aguirre. Yes, regarding the pending acquisition. I had
done a good deal of the background research through millions of
e-mails, searching through calendars, credit card receipts,
telephone records, and had basically come up with one
significant lead as the possible tipper. We provided that
information--after meeting with my supervisors and getting
their approval, I provided that information to the U.S.
Attorney and the FBI.
Nine days later, I believe that investigation was
essentially stopped when the investment banker--there was a
newspaper article in the Wall Street Journal on June 23, 2005.
That newspaper article announced that Morgan Stanley was
considering rehiring Mr. Mack. And until that point, June 23rd,
this investigation had the solid approval of my supervisors. I
had received accolades for it. I was told by my assistant
director that he had given me a personal award, said that he
was not sure he had ever given this award to anyone else. It
was the highest one of his personal awards. And 9 days later,
the investigation was stopped.
Chairman Specter. Do you know why the investigation was
stopped?
Mr. Aguirre. Well, I can tell you my conclusion from all of
the evidence. I received a phone call from Morgan Stanley on
June 23rd, from the head of their compliance. He had this
question: Are you going to proceed against Mr. Mack? Because if
you proceed against Mr. Mack, we are going to have problems in
having him step in as CEO. We do not want him to step in as CEO
if there is going to be a securities case brought against him
by the SEC. Until that point, this case was, as I said,
supported by everyone.
Over the next 7 days, I saw the investigation come to a
grinding halt. Essentially I was left out of meetings. High-
powered attorneys contacted my supervisors. I was present when
my assistant director spoke with the person who had called me
from Morgan Stanley.
Chairman Specter. You were present during that
conversation?
Mr. Aguirre. The assistant director, after I informed him
of the question from Morgan Stanley, called the compliance
attorney from Morgan Stanley to corroborate what he had told
me.
Chairman Specter. Well, are you talking about a
conversation which you overheard?
Mr. Aguirre. Yes, I am. He was on speakerphone.
Chairman Specter. And who were the participants in the
conversation?
Mr. Aguirre. Mark Kreitman, Assistant Director Mark
Kreitman; Eric Darnell, who was the head of compliance at
Morgan Stanley. Also in the room were Robert Hanson, my branch
chief.
Chairman Specter. Those were all the people present?
Mr. Aguirre. Yes.
Chairman Specter. And what was said?
Mr. Aguirre. Assistant Director Kreitman asked Mr. Darnell
to confirm his question that he had addressed to me, which was,
essentially, Are you guys going to go on Mr. Mack? Because we
have got a problem if you do, and we want simply want to know
if you are serious about proceeding against him.
At the end of the phone conversation, Mr. Kreitman said,
``I think we have got to let them know that we probably will.''
And then he said, ``But, first, I am going to call Associate
Director Paul Berger and let him know.''
So Mr. Kreitman called Associate Director Paul Berger, and
the conversation went something like this--
Chairman Specter. Were you a party--you overheard the
conversation?
Mr. Aguirre. It was on speakerphone.
Chairman Specter. Go ahead.
Mr. Aguirre. Mr. Kreitman said to Mr. Berger, ``Paul, this
case is coming along pretty well now. We got this phone call
from Morgan Stanley, and I think they want to know whether we
are serious about it. I think we are going to go on this, and I
think we ought to say something now.''
Mr. Kreitman was cutoff in mid-sentence by Mr. Berger, and
it was rather sharp. Mr. Berger said, ``I don't think we are,
and we shouldn't say anything.''
Now, the problem was that Mr. Berger knew very, very little
about the investigation that I had conducted.
Chairman Specter. How do you know he knew very little about
the investigation?
Mr. Aguirre. Well, the information that I passed along--
customarily, when Mr. Berger was apprised, I would be asked to
prepare something. Mr. Berger had not participated in any
meetings. Most of the conversations I had were verbal. And I
think he said something during the phone conversation that
implied that he was not that familiar with the facts of the
case. And the facts that I am talking about had been developed
in the last, oh, 3 or 4 weeks.
After the conversation with Mr. Berger, there was an abrupt
reversal by my supervisors in their support for this
investigation. I wrote two extensive e-mails to Mr. Kreitman
outlining for him the facts suggesting that Pequot had acted on
insider information and the facts at that point that suggested
that Mr. Mack was the most likely--I shouldn't say ``most
likely.'' At that point I gave several possibilities, and I put
Mr. Mack at the top of the possibilities.
Chairman Specter. Top possibility for what?
Mr. Aguirre. Being the tipper.
Now, Mr. Kreitman would not discuss the case with me. He
was angry. He refused my request that we take Mr. Mack's
testimony.
Chairman Specter. You say he was angry. That is conclusory.
What evidentiary base do you have to say that?
Mr. Aguirre. I had provided him with two e-mails and two
spread sheets. The tone of his voice. He threw one of the
spread sheets at me physically. He was unwilling to discuss the
case.
I walked out of his office. I sent him an e-mail confirming
what had just happened. Now, that was--
Chairman Specter. You sent an e-mail contemporaneously with
the event?
Mr. Aguirre. Yes.
Chairman Specter. Could you provide that to this Committee,
please?
Mr. Aguirre. I will, sir.
Chairman Specter. Thank you.
Mr. Aguirre. That e-mail essentially stated that what he
was doing in stopping the issuance of the subpoenas was
frustrating the investigation. I did not receive a response
from that for almost 4 weeks, and I did not--in fact, I
provided him with two e-mails, two spread sheets supporting
what I saw as the next logical step in the investigation.
Chairman Specter. Could you provide this Committee with
those spread sheets?
Mr. Aguirre. I will, sir.
Chairman Specter. Thank you.
Mr. Aguirre. Now, there was no response to any of these e-
mails--the nine-page e-mail, the six-page e-mail, the spread
sheets, or the e-mail confirming his refusal to allow these
subpoenas to be issued.
Now, before this, I probably issued something between 90
and 100 subpoenas in the case. On one occasion, I sent an e-
mail recommending that we take 27 different--we use 27
subpoenas for 27 different witnesses. And it was unquestioned.
Most of the discussions would be fairly brief. In this case,
there were no discussions.
On approximately June 23rd, my branch chief--now, this is
just about the same time that the newspaper article came out.
When I brought up the possibility of issuing a subpoena with
him, he told me that Mr. Mack--that this would be very
difficult, Mr. Mack had very powerful political connections. He
would not authorize it and I would have to speak with Mr.
Kreitman.
In July, I sent an e-mail to Associate Director Berger
informing him that my branch chief had told me that it would be
very difficult to take Mr. Mack's testimony because of his
political connections.
Chairman Specter. Will you supply us a copy of that e-mail
as well?
Mr. Aguirre. I will.
Chairman Specter. Thank you.
Mr. Aguirre. Mr. Berger did not respond. I had a similar
conversation with him shortly before I sent him the e-mail.
When I did not get a response from Mr. Berger, I sent an e-mail
to the Director of Enforcement, and I told her that--I reminded
her that she had been present at a going-away party for a
senior SEC official who had worked with me on the case. He was
probably the most experienced person at the SEC in conducting
investigations of insider trading. He taught insider trading to
new enforcement staff. He taught insider trading to foreign
officials.
At his going-away party, he had told Director Thomsen that
the most important case that he had worked on in his 30 years
with the SEC was the case that I was heading. He told her that
in my presence.
In the e-mail I sent to Director Thomsen on August 4th, I
informed her that--or reminded her of the statement that this
senior staff person had made, and told her that the case was
not moving in circles and could I speak with her about it. I
did receive an e-mail and she did say, ``Well, bring in the
team.''
The next day, August 5th, in an e-mail and a face-to-face
discussion, my branch chief advised me that they were going to
reconsider my request, that they would vet my facts and then
make a decision. He suggested that we would do this after we
were both back from vacation. He was going on vacation the next
day. As soon as he got back, I would be on vacation. So that
meant the facts would be vetted in September.
I notified the Director of Enforcement that it would not be
necessary to meet with her because the matter had--the facts
had changed. They were going to reconsider this issue.
I went on vacation, and on approximately August 30th I
received a phone call to call the office. I called the office
and spoke with Associate Director Mark Kreitman, Branch Chief
Hanson, and they told me that I was being discharged.
Chairman Specter. Anything to report after that? Before you
do, I have asked you specifically for a number of e-mails, but
I did not interrupt you on some of the others. But please
provide all the e-mails you have referenced, or any others
which are relevant.
Mr. Aguirre. I have provided a sworn statement--
Chairman Specter. Will you provide those e-mails?
Mr. Aguirre.--and 46 exhibits to the Finance and to the
Banking Committee and to the Office of Special Counsel. Are you
asking for those e-mails, Mr. Chairman?
Chairman Specter. With the Banking Committee of the Senate?
Mr. Aguirre. Yes.
Chairman Specter. Oh, no, that is fine. They are in the
jurisdiction of the Senate. You need not provide anything which
would be duplicate. We can access those.
Anything further to say on this subject, Mr. Aguirre?
Mr. Aguirre. Well, all of my evaluations through the moment
that I was discharged were positive. My pay raise went into
effect 11 days before I was fired. After I was fired--I think I
have said enough.
Chairman Specter. Well, I have gone considerably over the
5-minute limit here because I did not want to interrupt your
testimony on this matter. And we will work with the Banking
Committee, and all the documents which you have provided them
we will have access to. And we may discuss this with you
further.
We are running late so I will not pursue the matter now,
but we will review the documents, as I say, and doubtless have
questions for you at the staff level beyond today.
Mr. Aguirre. Sure.
Chairman Specter. Thank you.
Mr. Aguirre. Thank you.
Chairman Specter. Senator Hatch?
Senator Hatch. Well, this has been an interesting hearing,
and I think it is an important hearing because if some of the
allegations are true--and I presume you are all testifying
truthfully, and your statements are pretty dramatic--then we
have got some work to do up here on Capitol Hill.
Mr. Anifantis--am I pronouncing that right?
Mr. Anifantis. Yes.
Senator Hatch. When did Camelback change its name?
Mr. Anifantis. Camelback changed its name I believe in--it
was shortly before I was actually let go, I believe October.
Senator Hatch. Was it before or after the ``60 Minutes''--
Mr. Anifantis. Much before that.
Senator Hatch. Before that.
Mr. Anifantis. Yes, about a year and a half before that.
Senator Hatch. And they changed the name to Gradient
Analytics?
Mr. Anifantis. That is correct.
Senator Hatch. OK. Mr. Kasowitz, a few years back, we saw
successful prosecutions in what are called pump-and-dump cases,
as I understand it. In my view, what you are describing, it
seems to me, in your testimony is a slam-and dam case, if the
allegations are true. To me, talking down a good stock in order
to benefit a hedge fund's short position is just as damaging to
the markets as almost anything you could do if the talking-down
is false.
Now, if this activity is widespread, it certainly has the
potential to destroy investor confidence. I would like you to
flesh out for us what the full ramifications of these alleged
assaults on your clients really were.
Mr. Kasowitz. Well, the ramifications are that there is
damage at almost every level. There certainly is damage for the
process of orderly markets because in the circumstances that I
have described that our clients have experienced, clearly the
hedge fund that is engaged in an improper manipulation,
according to the way I have described it, is gaining a
significant benefit not only in knowing about and being able to
analyze a particular company and its operations, but, in fact,
in damaging the company, damaging the value of its stock
through the dissemination of false information, which the hedge
fund controls. It writes the false information. It controls
when that false information is disseminated. It controls the
dissemination of that false information through an analyst firm
that is supposed to be independent but, in fact, is not. And
then it reaps great benefits from it. The shareholders of the
company that is attacked in that way are damaged dramatically
because the value of their equity holdings are substantially
diminished. The employees of that company and the management of
the company are damaged dramatically because the company, being
under such attack, then faces business problems. The kinds of
problems that it faces are problems with business partners,
problems with its own banks and lending institutions who either
terminate or redo the financing vehicles and the like.
It is just problems up and down the spectrum, both on a
macro level with respect to the market and on a micro level
with respect to this particular company and its investors.
Senator Hatch. Mr. Anifantis, how did Camelback make its
money? I mean, did they have people subscribe to their
analytical monthly letters or weekly letters, whatever it is?
How did they make their money?
Mr. Anifantis. Senator Hatch, thanks for the question.
Camelback predominantly made their money through the
qualitative service, which is the research service, which is
the analyst reports. They were priced, as mentioned, between
$25,000 and $30,000. Also, there were--
Senator Hatch. They would pay $25,000 or $35,000 for the
report or for all of the reports that they did?
Mr. Anifantis. For an annual subscription to all of the
pieces that would be published by the firm during that year, by
Camelback during that calendar year, or during that contract
year.
The other way they made money, there were a couple
customers that did only have packages that were based on custom
reports. For example, a customer would sign up to the service
to receive six custom reports, and six custom reports only.
There was another set of customers that used what they
sold, which was a quantitative model. It was basically a
mathematically driven model which spat out scores based on
accounting statistics.
Senator Hatch. Was this a subscriber list or did you have
salespeople go out and get these customers or how--
Mr. Anifantis. The customers were predominantly acquired
via outgoing calls by a staff of sales folks.
Senator Hatch. OK. Mr. Blickenstaff--Mr. Chairman, I am a
little bit over. Could I have a few more questions?
Chairman Specter. Go ahead.
Senator Hatch. Mr. Blickenstaff, you described Sterling's
approach to you and how it really affected your company
detrimentally. How did they charge for their services? Do you
have any idea?
Mr. Blickenstaff. No. In fact, I was just looking at the
disclosure. There is a fine print at the bottom of this
research report. The one thing they did disclose is that they
had no shares of Biosite's stock, so nobody owned our shares.
It also said they never had a banking relationship, so we never
paid them. And then it went on to say that we were not paying
them for this research. I mean, of course we would not pay them
for this kind of negative research. So who actually paid for
the research is not disclosed in this sort of letterhead, and I
think that is one key thing. If you could tell who actually was
financing this, what firms were involved, that would be a big
step toward saying this is paid advertisement.
Senator Hatch. It would seem to me that ethically, Mr.
Boersma, that there should be a disclosure of who is financing
the research and whether or not there is a connection between
the financing and the actual outcome of the research.
Mr. Blickenstaff. I would agree. On the sell side, sell-
side analysts have to disclose whether there is a banking
relationship with the firm, and obviously, you know, all the
sell-siders that were covering us had not done underwriting, so
there was not a banking relationship.
Senator Hatch. You felt, though, even though your product
was proving to be very beneficial and that you had gone up
from, what $13 million to $38 million in just a short period of
time, that here were all these negative reports that kept
stultifying your stock.
Mr. Blickenstaff. Absolutely. In fact, to give you a good
example of the kind of research report, we actually had--in the
third quarter of 2002, we beat expectations on our guidance on
the ramp of BNP, and yet the headline is we beat expectation,
but all the BNP risk remained of competition and--so it seems
to turn good news into bad news, and all the reports then turn
bad news into even worse news. So there is--
Senator Hatch. We in the Congress fully understand that.
[Laughter.]
Mr. Blickenstaff. Believe me, I know what a negative
campaign is all about. I have lived through it.
Senator Hatch. I think we understand it maybe even better
than you do.
Mr. Blickenstaff. I think you might.
Senator Hatch. Mr. McLaughlin, you are a very important
person and I have a lot of respect for you, and I am sure you
have heard this story before. Hedge funds get access and they
get information because the number of trades they order in a
given day is so lucrative, or at least they want it to be
lucrative. What do you make of this assessment? Just how much
power do these funds have over the marketplace? If there are
11,500 of them, or more, what kind of power is that in the
marketplace? I am not finding fault with the hedge fund
business because I know there are a lot of honest, decent hedge
funds out there, but it is a tremendous amount of power, isn't
it? And I have heard that up to 30 percent of the marketplace
happens to be short-selling, which I believe is essential to
keep the marketplace honest. But what about that?
Mr. McLaughlin. Well, Senator Hatch, I cannot confirm
whether 30 percent of the volume on a given day is short or
not. I am sure there is someone who can do that.
Senator Hatch. Sure.
Mr. McLaughlin. Any large customer or group of large
customers tend to have some influence with the firms that
execute their orders. It would be suicide, however, for a
broker-dealer firm, because of the importance of the order flow
from one or a group of hedge funds, to jeopardize its standing
with its customers, clients, and with the enforcement agencies
to step over the line and provide information, for example,
where there was a duty of trust and confidence not to provide
that information.
Senator Hatch. I agree that is true with regard to broker-
dealers. What about analytical firms?
Mr. McLaughlin. Well, independent firms, as I stated
earlier, may not be subject to the same considerations, the
same controls as firms that are members of the NASD or the New
York Stock Exchange. I notice that the firm that Mr.
Blickenstaff is referring to here is a member of the NASD and,
therefore, of course, is subject to that organization's rules
about having a reasonable basis for research and disclosing
sources of bias. So when a report like this is published, it
would be subject to that full range of controls and safeguards
designed to promote the integrity of research.
At the same time, there are many other firms providing
information that would be relevant to investment decisions. And
I hasten to add, as I stated earlier, it is very hard to draw
the line here between independent analysts who are not subject
to the same safeguards, sell-side analysts who are, and then
you have the financial press, bloggers, and other people who
publish information as well. And to deal with this problem, to
the extent it is a problem, you have to consider what you might
be doing that would have the effect of chilling communication,
legitimate debate about companies and their prospects.
Senator Hatch. Well, let me ask you this: I have no doubt
that most of these funds, these hedge funds, are operating
within the law. But would you agree--at least I assume that
hedge funds are equally subject to the anti-fraud provisions of
the Federal law.
Mr. McLaughlin. Of course.
Senator Hatch. And I assume that hedge funds worry that the
accusations that we have been hearing today could spoil the
industry's reputation if they are true. So I wonder if you
could provide us with some examples of self-regulatory steps
that the hedge fund industry has taken to make sure that we do
not have fraud or insider trading through short-selling like
some have described here today.
Mr. McLaughlin. Well, each hedge fund is required by--each
investment adviser, at least registered investment adviser, is
required by law to have procedures in place to prevent
violations of law arising from that type of activity. In
addition, the MFA, on whose behalf I am appearing here today,
recently published a set of best practices in this area. To the
extent that hedge funds on the trading side and analysts on the
analyst side are members of organizations--and, of course, the
CFA Institute does in its area just what the MFA does in its,
to try to raise the standards of conducts of its members.
Neither organization has the ability to require people to
become members or to follow these best practices.
Senator Hatch. Can research that is paid for by a hedge
fund with a large short or long position in a particular stock
be later published as ``independent'' research without some
kind of disclosure?
Mr. McLaughlin. Under the 1933 Act--and this has been true
since 1933--if research is paid for by a company, it must be
disclosed. If research is paid for by a client, in my view it
ought to be disclosed, but it would depend on the reliance of a
particular analyst's customers and the marketplace's reliance
on that analyst whether there would be a fraud violation if it
were not disclosed.
Senator Hatch. What is your estimation of how well the
industry is complying across the board with reporting on
especially naked shorts to the Depository Trust and Clearance
Corporation? The DTCC, I guess it is.
Mr. McLaughlin. The hedge fund industry?
Senator Hatch. Yes, let's limit it to that.
Mr. McLaughlin. Again, I have no statistics on that
subject, but I would like to point out that the SEC did adopt
Regulation SHO just 2 years ago.
Senator Hatch. They have regulations, but they are not
enforced. Wouldn't you agree?
Mr. McLaughlin. I think the SEC understood when it adopted
SHO that it is impossible to prevent every short sale from
taking place without a borrow.
Senator Hatch. Well, it is my understanding that the SEC
responded to the problem of naked short-selling by enacting
SHO, and that was enacted in, if I recall, January 2005. And
that was to limit--SHO was enacted to limit market distortion
caused by naked short-selling. But I think you would have to
admit it falls pretty short of the goals that they set.
Mr. McLaughlin. I don't know whether I am in a position to
admit that, but I think the SEC is certainly concerned about
trying to further reduce the extent of naked short-selling.
Senator Hatch. I would think so. First, the Regulation SHO
grandfathers in all failures to deliver that occurred prior to
January 3, 2005, exempting a large portion of liabilities that
will never be delivered. And, second, while Regulation SHO
requires that the SEC publish a list of companies that have
been targets of predatory short-selling, those for which
brokerage firms have failed to deliver a large number of
stocks, this seems only to have served as an identification
list for further targeting of those firms. And, you know, I
think that Regulation SHO also has failed to require either the
disclosure or the aggregate failures to deliver in the
marketplace or a number of failures to deliver of a particular
company's stock. And, finally, despite the apparent widespread
continuation of naked short-selling in the marketplace, there
are no serious regulatory or criminal consequences for brokers
repeatedly failing to deliver. Are you aware of all that?
Mr. McLaughlin. Yes, I am, Senator Hatch. I go back on the
regulation of short-selling for a good many years. I do not
mean here to defend the practice of naked short-selling--
Senator Hatch. I have not interpreted you as defending it.
I think your testimony has been very straightforward and good.
Are you aware that some of these companies actually go and
register over in, say, Germany?
Mr. McLaughlin. I have to say, Senator Hatch, that remark
confused me when you said that earlier. I really--
Senator Hatch. That is what my understanding is. I may be
wrong on that. I would be happy to be corrected.
Mr. McLaughlin. I certainly have clients that are going to
public abroad these days instead of in the United States.
Senator Hatch. My understanding is they do that in order to
avoid having to report within the 3 days required here. Now, I
may be wrong on that, but I would sure like to--would you mind
looking at that and helping us understand--
Mr. McLaughlin. I would like to look at that. I am very
curious about it. I have not heard about that happening.
Senator Hatch. If that is so, then that is a very serious
charge that I know has been made to me personally and to others
here on the Committee.
Mr. Chairman, I have taken too much time, I understand, and
I certainly appreciate your forbearance and your kindness in
allowing me to do so.
This has been a very important hearing. We acknowledge that
the Banking Committee has the vast majority of control and
jurisdiction here, but we do have the Justice Department
jurisdiction, and that is pretty significant. And some of the
things that I have heard here today really have alarmed me,
especially from you, Mr. Aguirre. I have to say that I am very
concerned, because if we do not get to the bottom of some of
these things and make sure that things are straight, honest,
and decent, we could have some really, really serious
difficulties in our society.
So I just want to thank you all for being willing to come
in and testify and to help us to understand this better, and
hopefully we can get through it and figure out what needs to be
done. We appreciate your suggestions as well.
Chairman Specter. Well, thank you, Senator Hatch, for the
work you did while you were Chairman of the Committee and for
your suggestion on holding this hearing today. It is past noon,
and we have run way over time, but I want to ask just a few
more questions.
Mr. Kasowitz, you have outlined in some pretty strong
language factual matters suggesting criminal conduct. have you
relayed those to the Department of Justice?
Mr. Kasowitz. That was directed to me, Mr. Chairman?
Chairman Specter. Yes. Mr. Kasowitz.
Mr. Kasowitz. We have included certain of the matters that
I have discussed today within a civil lawsuit brought under a
State RICO statute in New Jersey. That complaint is a matter of
public record. Our focus has been with respect to that, and we
certainly are here in cooperation with the Committee and stand
prepared to cooperate with all regulators.
Chairman Specter. Well, the allegations in your lawsuit are
allegations of fraud?
Mr. Kasowitz. That is right.
Chairman Specter. Wouldn't they fit within the statute
which I cited earlier, knowingly executes a scheme or artifice
to defraud a person in connection with any security, et cetera?
Mr. Kasowitz. Section 1348?
Chairman Specter. Yes.
Mr. Kasowitz. I believe they would.
Chairman Specter. Well, why don't you report it to the U.S.
Department of Justice?
Mr. Kasowitz. Well, we certainly--
Chairman Specter. Let me make a suggestion to you, instead
of asking you why you have not, make a suggestion to you that
you do. They have investigative resources, but not unlimited.
You have factual materials. Tell them about that.
I would also like you to take a look at the statute and
give the Committee your judgment as to whether it ought to be
expanded, whether the penalties are sufficient, what you think
of Attorney General Blumental's testimony about civil penalties
as well.
And, Mr. Blickenstaff, you have testified about an employee
of a so-called independent analytical firm telling you that the
information published was false and erroneous, but she had no
power or recourse but to let it stand. Correct?
Mr. Blickenstaff. That is correct.
Chairman Specter. Did you consider reporting that to the
Department of Justice?
Mr. Blickenstaff. Well, given the fact that we could not
actually tie the hedge funds to these activities by the
research firms, we came to the conclusion that it was a very
small matter that, you know, probably was not reportable to a
higher level.
Chairman Specter. Well, it was a matter which seriously
prejudiced your firm. Didn't it?
Mr. Blickenstaff. Yes, it did, sure.
Chairman Specter. It sounds to me like it comes within the
context of the statute as scheme or artifice to defraud in
connection with the sale of a security.
You are a citizen. You are a businessman. You do not have
the resources to conduct a criminal investigation.
Mr. Blickenstaff. That was part of the problem. I think we
spent several hundred thousand dollars trying to investigate
this whole matter, and that was the only piece of this that
really we could point to that we felt was, you know,
borderline. But--
Chairman Specter. Well, that is why we have a Department of
Justice. I used to be a district attorney. People brought me
information of this sort. If it sounded to me like a violation
of law, we had detectives to go out and investigate.
Mr. Blickenstaff. Well, at the time there was not a lot of
focus on this whole hedge fund activity and these research
firms that we are talking about today, and, you know, we were
advised by Kroll & Associates that there just was not a
groundswell in any of the major Justice Departments or the SEC
that really would, you know, look at this matter. So we just
sort of--
Chairman Specter. Well, maybe we are creating a
groundswell.
Mr. Blickenstaff. We would be willing to cooperate.
Chairman Specter. How long ago did this conversation occur?
Mr. Blickenstaff. That conversation was in 2002. I think we
do still know where that person is located.
Chairman Specter. Well, I think you probably have a 5-year
statute of limitations here, so consider making an official
report on it and let the Committee know if you do, and we will
pursue it and followup. OK?
Mr. Blickenstaff. We will do that. Chairman Specter.
Professor Lamont, you talk about
investment bankers who like to secure favoritism with their
customers and may exaggerate their report about their
customers' stock. Does that come within the kind of language
here, knowingly executes a scheme or artifice to defraud with
the sale of a security, do you think?
Mr. Lamont. I could not--
Chairman Specter. I know you are a professor of economics.
Mr. Lamont. Yes.
Chairman Specter. How does that sound to you?
Mr. Lamont. I could not give you any legal advice. I can
tell you that in 2003 the SEC and other regulators had a
settlement with the underwriters and the securities firms, a
$1.5 billion settlement, so there must have been some legal
basis for that settlement.
Chairman Specter. Well, I am always suspect on civil
settlements which are designed to go halfway. They are usually
accompanied by a statement that there is no admission of
liability or responsibility, disclaimers of every sort, but it
has the effect of terminating a matter. And that does not
really utilize the real power of criminal prosecution on white-
collar crime, which I described earlier.
Mr. Schilit and Mr. Boersma, you have testified about and
we have heard other testimony about the lack of professionalism
among so-called independent analysts and lack of training. Mr.
Anifantis went into some detail on that. Where you have a real
estate broker, there are State laws which require the real
estate brokers to take tests and to maintain certain standards,
and a real estate broker deals with very small sums--relatively
small sums of money for limited clients. Is this a matter which
ought to be the subject of State laws? If you practice law
without a license in Pennsylvania, you are subject to a
criminal prosecution. What of that, Mr. Schilit? How about some
sanctions which would be analogous to those considerations?
Mr. Schilit. Well, the recommendation I was making is you
have an industry, the investment and research industry, which
has grown dramatically, and there are not standards. So if you
wanted to leave your position in the Senate and form a research
company, there are no prohibitions for you to do that and label
yourself as an independent research company.
Chairman Specter. Well, I could not become a real estate
broker.
Mr. Schilit. Correct. And so, you know--
Chairman Specter. Maybe it is more--
Mr. Schilit. Well, the recommendation--
Chairman Specter. Maybe I can do more harm as a real estate
broker than as a research analyst. I doubt it.
Mr. Schilit. But I think the spirit of what you are
suggesting I certainly would agree with, that there has to be
standards before you enter that field.
Chairman Specter. Mr. Boersma, what do you think about
that? I am trying to get a few more opinions here and draw this
hearing to a close?
Mr. Boersma. There is an examination for--
Chairman Specter. We are about to interfere with tomorrow's
hearing.
Mr. Schilit. There is an examination for those that work in
a broker-dealer setting, but there is not any certification
required for independent analysts, and we certainly think the
CFA program and designation is a mark of good standing for
analysts. But they are not required to do that.
Chairman Specter. Well, after listening to the testimony
today and after reviewing a lot of documents in this field, it
is my judgment that we are dealing with a matter of enormous
importance, $1.2 trillion, maybe more, as Mr. Kasowitz says,
maybe double, and it is on its way to a lot more than that. And
although it is only 5 percent of the market from the statistics
I have seen, it has 30 percent of the transactions. And you had
the case in 1998 where the company with assets of $3 to $4
billion leveraged it to $80 to $100 billion. And had they
collapsed, it would have had enormous repercussions. And you
have potential for $1 billion a year, which is fine if it is
done legally, but with only limiting it, as the Chairman of the
Fed says, to pressures within the industry, it has enormous
potential for abuse. And regulation is fine. That is up to the
SEC and up to the Congress generally and the Banking Committee.
But the Department of Justice and State prosecutors have a very
important role to play here. And prosecutions for white-collar
crime and jail sentences have a tremendous deterrent effect.
And this Committee intends to push the Department of Justice to
do that.
If you have information, Mr. Kasowitz, Mr. Blickenstaff,
others, pass it on.
Senator Hatch. Mr. Chairman, can I just ask one more
question?
Chairman Specter. Are you serious?
[Laughter.]
Senator Hatch. Yes, I am serious.
Chairman Specter. I know you are serious, but I mean about
one more question.
Senator Hatch. It might be more than one. But I will try
and keep it to one. I just want to ask Mr. Kasowitz, I
mentioned to Mr. McLaughlin--and this is something I understand
is done, but I may be wrong on it. I would just like to know.
These folks on these naked shorts are supposed to file with
the Depository Trust and Clearing Corporation within 3 days.
SHO was to try and make sure that they do that. But it is my
understanding that some of these companies, to avoid doing
that, go and register a stock in a foreign country. I will use
Germany as an illustration. And then they can avoid it for
months on end. Where there is not any stock to go get, which is
the definition of ``naked shorting.''
Are you aware of that?
Mr. Kasowitz. The case that we have filed for our client,
Biovail, does not involve that situation. I have heard reports
similar to the ones that you have read about, Senator.
Senator Hatch. Well, I would appreciate--Mr. Aguirre, have
you heard about this?
Mr. Aguirre. No, I have not.
Senator Hatch. OK. Well, I would appreciate any information
anybody on this panel, or otherwise, can give us on that,
because if that is true, that I think may be very well
constitute fraud. It may not, but it may very well constitute
fraud that we are concerned about here under this particular
statutory section, in order to evade reporting because they
know that they are naked shorting and they cannot cover the
stock.
These are matters that I think are very important. Mr.
Schilit, do you have any awareness of that?
Mr. Schilit. I do not.
Senator Hatch. Anybody else have any awareness of that?
[No response.]
Senator Hatch. OK. Well, then, I just wanted to ask that,
and I would appreciate, Mr. McLaughlin, Mr. Kasowitz, if you
can help us to understand that process. And if we are wrong, I
would like to know. I would just like to know what is right
here. I don't have any axes to grind here. I would just like to
do what is right, and I am real concerned, as you can see the
Chairman is, about some of the things we have heard here today
and that we have been studying. We do not want to hurt anybody.
We just want to make sure that our markets are not ruined
because of the fraud.
Chairman Specter. Thank you, Senator Hatch and thank you
all.
[Whereupon, at 12:15 p.m., the Committee was adjourned.]
[Questions and answers and submissions for the record
follow.]
[Additional material is being retained in the Committee
files.]
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