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Wednesday, June 28, 2006

Hedge Manager Teaches SEC a Lesson

Phil Goldstein, hedge-fund champion, is the unhedge-fund manager.

The head of Bulldog Investors, Mr. Goldstein single-handedly challenged the Securities and Exchange Commission's attempt to require hedge funds to register with the agency. Last week, a federal appeals court delivered him victory, overturning the SEC's attempt to impose a modicum of regulation on the exploding industry.

He stands out among hedgies not because he was raised in blue-collar Brooklyn; those bootstrap stories are fairly common in the industry. It may be that he was a New York City civil engineer for 25 years. Now 61 years old, he made the move from managing building projects to running money in 1992. These days, a city worker has less of a chance of managing others' wealth than Jeff Skilling has of ringing the opening bell of the New York Stock Exchange.

The clincher of his maverick status in the world of hedge-fund managers is that Mr. Goldstein will admit, on occasion, that there are things he doesn't do well.

"I was never a very good engineer. It wasn't until my mid-to-late forties that I decided what I wanted to do when I grew up," he explains. Even today, he says, "I'm not a valuation expert. I'm a good value investor, but not that good." He credits his partner with his small-time ($225 million) operation's best investing instincts. He calls his main investment technique -- buying closed-end funds trading at a discount to their asset value -- "investment for dummies."

But Mr. Goldstein is good at stirring up trouble. Although more than 1,200 hedge funds registered under the new rule, he detested it. So he decided to fight. No other hedge fund joined his suit. Few gave him much of a shot to prevail. The fight cost him and his partners $300,000 out of his own pocket -- not, he emphasizes, his investors' pockets.

Now the requirement is likely to fizzle away. The SEC could appeal, but it probably won't. Lawmakers might try to jump in to change the SEC's mandate. The congressional clamor begins today, with a scaremongering hearing before the Senate Judiciary Committee on hedge funds' alleged collusion with independent stock-research shops.

But my guess is that after a lot of noise, Congress won't push for registration. So, in the end, many hedge funds will deregister, though some may not -- a sort of Good Housekeeping seal of approval.You might think the ruling from the court had something about whether the hedge-fund registration was a good thing or not, but you would be wrong. It centered on a definitional conundrum: whether the investors in an adviser's hedge fund are "clients." Under securities law, any adviser with more than 15 clients has to register. Hedgies tend to run firms that manage fewer than 15 hedge funds. Agreeing with Mr. Goldstein, the court ruled that the funds are the clients, not the underlying investors.

The ruling may well be correct as a matter of law. It is obvious to anyone who isn't a lawyer that the investors actually are the clients. Even Mr. Goldstein occasionally slips and calls his investors "clients," just like every hedge-fund manager.

It is always gratifying to see a David go up against a faceless governmental bureaucracy and win. But I just can't come around to the view that hedge-fund registration is so terrible. Nor can Mr. Goldstein, as it turns out.

"If the SEC had asked just for name, rank, serial number, audit and other basic information, I probably wouldn't have filed the lawsuit," he says. But because the SEC registration form asks for everything from "your last small-pox vaccination to every dirty joke you got on email," he says, it is onerous and intrusive. The registration forms run at least 35 pages long, asking for information about things such as compliance procedures, business relationships with investment banks and stock-research companies and regulatory records.

Antiregulation forces argue the costs outweigh the benefits. It is emblematic of a greater regulatory backlash these days, most forcefully expressed in the movement against Sarbanes-Oxley.

Hedge funds get a management fee of at least 1% and 20% of the investment gains -- often more. They are richly rewarded to control other people's money. Increasingly that money comes from the pension funds of regular folk. Given the huge fees and the enormous responsibility, the price of registration and keeping some lawyers on staff simply isn't that high. Nearly half of all investment advisers registered with the SEC have five or fewer employees. If they can handle the costs and hassles, hedge funds can, too.

Opponents maintain that registration won't prevent frauds. After all, as Mr. Goldstein points out, Atlanta hedge-fund firm International Management Associates LLC had registered with the SEC before its manager allegedly ripped off a bunch of investors.

Well, of course. Nothing will prevent all fraud. It turns out the SEC detects plenty of skullduggery through routine examinations. According to Lori Richards, the SEC's examinations director, 11% of SEC enforcement actions brought last year were the result of fraud detected during such inspections.

"Fundamentally," she says, "what we're looking for in these exams are indications of fraud. We look at the account statements the adviser sends to its clients and compare them with the custodian's records to see whether they match, we look at the adviser's disclosures to its clients, and we look at the adviser's process for pricing securities."

Here is the key: "Like any cop on the beat," she adds, "the prospect of being examined by the SEC itself has a deterrent effect."

Another benefit is that a hedge-fund census would give the SEC improved perspective. Hedge funds are diverse entities, engaged in sophisticated strategies. It is clearly to the rest of the market's benefit if the chief market regulator knows generally who and what is out there to better anticipate potential problem areas and crises.

What hedge funds should realize is that registration is good for them. The industry is attacked for being secretive, under-regulated and engaged in risky behavior. The reality is much more benign, especially since most hedge funds take fewer risks than typical, long-only mutual funds. Their name derives from the fact that they hedge their bets -- often by betting on declines in stocks and indexes by selling them short -- to avoid volatility. Registration would make hedge funds loom less ominously in the public consciousness.

The SEC should have offered some carrot with its stick of registration. It still can. Let hedge funds advertise. Let them tout performance, as mutual funds do. Let them open themselves up to a wider variety of investors.

Then Congress should make them register.

Notablecalls: You are probably not going to find this article from

Saturday, June 24, 2006

Is Your CEO Lying? - Barron's cover

In their eternal quest to get an investment edge, hedge funds have long hired forensic accounting firms and even private detective agencies to ferret out dirt on short-sale targets. But now that pursuit has moved to another level.
Barron's recently stumbled across several hedge funds that have hired a five-year-old Boston company called Business Intelligence Advisors, which employs a number of former CIA and other national-security operatives to do behavioral analyses of corporate executives. The intent: to detect when managers are being less than candid or lying in their communications with shareholders, during interviews and quarterly earnings conference calls or even in press releases or management discussions in 10-Ks.

"The richer the medium, the better for detection," says the company co-founder and chairman, Liam Donohue, who also is a venture capitalist. "But our people can glean plenty of insight from heavily lawyered news releases as opposed to our being present during interviews or analyzing video or audio tapes."

The company also offers training seminars to teach security analysts, portfolio managers and, lately, corporate auditors detection techniques and how to ask questions that better elicit information.

But uncovering deceptive behavior -- regardless of whether it's executives are being evasive or telling baldfaced lies to cover up a scandal -- remains the ne plus ultra of BIA's mission for the hedge-fund crowd. "This is information that's incredibly useful to anyone making high-stakes financial bets," boasts BIA's other founder, former corporate lawyer Cheryl Cook.

One hedge-fund analyst regularly uses BIA operatives (information "elicitors," in company jargon) to analyze the conference-call transcripts and press releases of companies that his hedge fund is shorting. He even had a Business Intelligence Advisors expert, posing as an assistant, accompany him to an interview with two executives from a financial-services concern in which his fund had a large short position. While he took notes on the interview, the BIA employee concentrated on just one thing -- the managers' verbal and nonverbal behavior. The BIA agent, unaware of whether the hedge fund was betting on, or against, the company, found both executives acting highly deceptively when discussing a number of key financial issues, such as possible shenanigans with their reserves.

The stock of the company in question -- the hedge-fund manager would speak with Barron's only if we wouldn't identify him, his firm or the stock -- has since fallen more than 25% and the analyst thinks it has a long way to go on the downside, despite a once avid bullish following on Wall Street, he contends.

"The value of BIA experts is both in their ability to confirm what one suspects and also indicate where in the financials one should drill down into," he explains. "Of course, all they can uncover is concern or deception. They can't tell you the degree of magnitude of any problem areas they detect."

Such services don't come cheap, but getting an exact figure is difficult, in part because they vary from job to job.
Most important to Business Intelligence Advisors -- which doesn't appear to have any rivals that do precisely what it does -- are language cues, mainly because printed or transcribed corporate communications are at times the only material its experts have to work with.

First, its specialists try to gauge whether managers definitively and directly answer questions and forthrightly address issues, rather than tap dance around the subjects. Among the verbal dodges they look for are managers' use of "protest" statements when confronting areas that make them uncomfortable instead of, say, firm denials of questionable behavior. Here, the term "protest" is used in the older sense of the word -- as an assertion or affirmation, rather than an objection.

The litany of common protestations is numbingly familiar to anyone who has a passing familiarity with corporate spin.
"Our accounting is in strict accordance with Generally Accepted Accounting Principles" has been asseverated by executives charged in every financial fraud during the Enron era. Likewise, fraudsters never tire of asserting that their companies' financials have passed muster by their accountants, rating agencies and regulators such as the Securities and Exchange Commission. Other bromides often evoked as protest statements are: "We have an experienced management team in place." Or perhaps, "Our business is extremely complex." And, finally: "We have a great business plan that will really start to deliver soon."

Protest statements, according to BIA operatives, fulfill a number of purposes beyond permitting executives to avoid giving factual answers. By invoking a higher authority such as GAAP, the managers hope to divert attention from problems and convey the sense that all is well with the company. At a minimum, protest statements imply a lack of comfort on given issues. At a maximum, they signal outright deception.

Other cues that BIA experts place a lot of stock in are management replies larded with irrelevant specifics, meant to obscure some troubling issue. Often the details are accurate as presented.
Qualifying words can be important also. When executives resort to such locutions as "candidly," "honestly" or "to tell the truth," watch out. They might be trying to manage perceptions rather than convey fact.

Ad hominem attacks on accusers are another staple of managements seeking to cover up problems and blunt charges. Typically, whistle-blowers and other critics are dismissed as "disgruntled former employees" or "cranks." The aim is both to impugn an accuser's credibility and to avoid having to directly deny the charges.

Nonverbal cues can also be important, though they are often subtle. For example, BIA officials assert that, in judging credibility, most people are overly biased by such nonrevelatory externals as lack of eye contact, apparent nervousness and posture. Instead, BIA looks for such indicators as what it calls "shifts in anchor points." Executive zingers are often proceeded by a sudden shift forward in body weight, for example. The onset of fidgeting -- such as playing with a water bottle or cup of coffee -- can likewise betoken acute discomfort in an executive. This is particularly telling if it contrasts with previous mannerisms and tics.

Examples of Business Intelligence Advisors' methodology are found in the company's main training video -- an April 2001 CNBC interview of Sanjay Kumar, then the CEO of Computer Associates, which is now called CA Inc. (ticker: CA).

At the time, the Business Intelligence Advisors staff had no way of knowing that, five years later, Kumar would plead guilty to securities fraud and obstruction of justice, stemming from the company's use of back-dated contracts to pump up quarterly sales and earnings over several years. The SEC and Justice Department didn't launch their investigations of Computer Associates until almost a year after BIA had begun using the video in the spring of 2001. What BIA operatives had seized on were Kumar's on-camera responses to questions that had been raised in a New York Times article. To the observers, they reeked of deception.

Recently, in a Business Intelligence Advisors conference room in Herndon, Va., one of the company's experts ran through the video for Barron's, pointing out various cues or "tells" that, she asserted, had pointed toward deception.
The expert -- we agreed to call her by the pseudonym Grace -- a trim woman who, following graduation from Duke (with a double major in history and psychology), worked 20 years as a CIA interrogator. "No rubber hoses or other coercive techniques," she offers with a dismissive chuckle. "Duress just raises people's defenses. You catch a lot more flies with honey, rather than vinegar."

Early on in the interview, Kumar sedulously fires off protest statement after protest statement, rather than strongly denying the charges of dodgy accounting. To wit, he declares, Computer Associates accounting methodology met the strict GAAP standards "that we all live by" and, he adds, were blessed by two accounting firms.

Then CNBC interviewer Bill Griffeth gives Kumar a temporary out by talking about the revenue-growth problems that technology companies in general were having in the then-tough economic environment. Kumar seizes the opportunity to go off on a long riff about general industry difficulties. "He's trying to divert attention away from Computer Associates and run the clock out on Griffeth," Grace comments.

A trained "elicitor" pays close attention to the unwitting cues in the interview. At one point, Kumar grandly declares that there's "nothing wrong fundamentally" with the company's business practices. "Oh, really?" Grace interjects after freeze-framing the interview DVD. "That qualifier 'fundamentally' shows a real lack of conviction on his part. It implies that problems exist in at least some areas of the culture."

IN DUE COURSE, Kumar resorted to the tried and true tactic of smearing the accuser, the New York Times, to shake viewer confidence in the veracity of the article. After saying that there's no point in playing "tit for tat" with a company that buys paper by the ton and ink by the barrel, he proceeds to do precisely that. He complains that the article had no named sources, save a couple of small commercial customers. "Incredibly," Kumar adds, the reporters hadn't contacted any Wall Street securities analysts, who, of course, "know the company well." Moreover, the Times article is completely "devoid of factual reporting."

Grace moves on to another training DVD -- Bill Clinton's famous 1992 60 Minutes interview, just before the New Hampshire primary and right after widespread publicity about Gennifer Flowers' adultery charges against him had imperiled his chances for the Democratic presidential nomination.

The moment of truth comes when Clinton is asked whether he denied having had a liaison with Flowers. His reply: Both he and she previously had denied such an involvement. In Grace's view, it was a classic "non-denial denial." Clinton was to make use of the strategy again, especially when the Monica Lewinsky story broke with such ferocity.
Grace, however, points out other interesting aspects of the 60 Minutes segment, including some involving Clinton's now-famous wife. "Watch the behavior of Hillary closely, when the key question comes up," she says.

Mrs. Clinton, sitting next to her husband, had been nodding in an exaggerated metronomic fashion during the interview, in apparent approbation and support of her spouse. But Bill Clinton's answer about Flowers seems to momentarily knock her off stride. She shifts position and glances quickly at him before resuming her nods. "Something clearly upset her," Grace maintains. "Maybe he didn't give the answer she expected or deviated from the script."

Next on the hit parade is a Scott Peterson interview with ABC Television's Diane Sawyer, done in January 2003, about a month after his wife Laci was reported missing.
According to Grace, Peterson's dissimulation is obvious throughout the interview. For example, he involuntarily smirks for a brief moment after he denies to Sawyer that he murdered his wife. At another point, he closes his eyes ("Just like Jeff Skilling did when testifying before Congress on the collapse of Enron") immediately before telling what later turned out to be a lie.

Peterson answers promptly with a convincing "no" when asked if he'd had extramarital affairs, other than one he admitted to with Amber Frey. But he stumbles badly when asked if he'd ever beaten Laci. "Violence towards women is unapproachable," he replies, somewhat incoherently, evading the question.

Later, Peterson doesn't mention Laci when apologizing to both his and Frey's family for his affair with Frey. "Don't forget that, at that time, Laci was only missing, so the omission indicates that he knew she was dead," Grace asserts.
Of course, behavior analysis is easier after the fact; we all know that Scott Peterson was found guilty. But Business Intelligence Advisors has had some great calls beyond Sanjay Kumar.
Another hedge-fund manager furnished Barron's with the company's analysis of bond insurer
MBIA's press release responding to an April 2005 Barron's article accusing the company of accounting manipulation and inadequate loss-reserving, among other issues.

The report proved to be prescient. For example, it predicted that three reinsurance contracts that the company had used in 1998 to cover up a nasty $170 million claims loss would cause MBIA additional problems, even though the insurer already had voided $70 million of the $170 million in contracts and taken an appropriate earnings hit. Indeed, by the end of 2005, the remaining contracts also were voided, further hurting earnings.

The Business Intelligence Advisors analysts found indications of the additional problems in the release's wording. In one section, MBIA claimed that the investigation of the three deals was "substantially complete." To the analysts, "substantially" set off alarms.

The MBIA release also went into numbing detail as to the scope of the investigation, describing who had been interviewed and listing the documents that had been reviewed. These, according to BIA, were mere "specifics" designed to impress Wall Street while artfully sidestepping the central issues.

The release was also larded with qualifiers that, the analysts suspected, implied a lack of conviction on MBIA's part. For example, MBIA stated that it "believed" that its claims reserves were adequate. That's a weasel word. In fact, the reserves, unallocated to specific losses, have been dropping precipitously ever since, leading some critics of the company to predict that it might be facing a big reserve charge.

Business Intelligence Advisors also noted that while MBIA asserted that Barron's had created "many misimpressions," the company's response noticeably failed to rebut the article's main allegation that MBIA had manipulated earnings. Stay tuned on that score.

The stock (ticker: MBI), though currently trading in the 50s, around the same level as when the Barron's story appeared, remains under a cloud. MBIA is being investigated by the SEC, the Justice Department and the New York Attorney General's Office.

Other reports obtained from third parties show interesting assessments of different managements' credibility. For example,
JPMorgan Chase (JPM) CEO Jamie Dimon scores fairly well on the candor front in a recent earnings conference call by forthrightly dealing with his concerns over the bank's credit-card growth and the likely rise in nonperforming commercial loans.

The same can't be said for the management of
Kodak (EK). BIA analysts contend that Kodak executives, in their latest earnings conference call, were less than open about the company's back-to-school sales prospects, in-store kiosk results and campaign to boost operating margins. And, as if General Motors (GM) didn't have enough problems, the analysts give its management low marks for openness and credibility.

To be sure, there's an element of hocus-pocus in BIA's techniques. The company is secretive about many aspects of its methodology. And there's often a big difference between evasiveness and lying. But BIA doesn't overpromise. "We're more compasses for clients than human lie detectors," Grace comments.

Even so, BIA should have a bright future. After all, gilding the lily and spinning perceptions will never go out of style, especially on Wall Street.

Notablecalls: Amazing stuff.

Wednesday, June 21, 2006

At the Internet Cafe, Day Traders in India Live Mumbai Dreams

MUMBAI, India -- On the second floor of the Reliance Web World Internet cafe, behind a tangle of teenagers trying to kill each other in the network game Counter Strike, is another group of customers. They are older, noisier and glued to their rented screens.

"Hindustan Petroleum, sexy!" yelled Vinod Mishra, 38 years old, as he pumped his fist in the air, grinning at the flickering stock price of India's second-largest refining company. "My screen is like my wife. When it tells me to sell, I sell; when it tells me to buy, I buy."

While the former sailor sounds like day traders the world over, Mr. Mishra is a distinctively Indian type of investor. His office is this cramped Internet cafe, strewn with discarded paper teacups. At home, he doesn't have his own computer, Internet connection or even reliable electricity. His portfolio is tiny. His profit target is $10 a day.

"I'm not greedy," he says. "I just need enough to look after my family."
India's hot stock market has inspired many to ditch their day jobs and look for shortcuts to a better future. Online trading has more than doubled in the past 18 months to make up more than 15% of all trades on some days, according to the National Stock Exchange. Some 1.5 million Indians buy and sell stocks online, each trading an average of less than $150 a day.

But piggybacking on the stock market's historic run higher is no longer the no-brainer it has been for the past several years. The stock market has plunged 22% since touching a record high last month, wiping out $200 billion of market capitalization. That has squeezed a similar percentage of these tiny traders out of the market.
Gauri Vaswani, a real-estate broker turned day trader, says she has lost close to a third of her stock-market investment -- and a few good friends -- since the market started falling. She blames Federal Reserve Board Chairman Ben Bernanke for touching off a global selloff with talk of raising interest rates to combat inflation.
"I was stupid. I should have sold," says Ms. Vaswani, who moved to a new apartment two months ago so she could be closer to the Internet cafe where she spends her days. "Now I'm waiting for Bernanke to shut his mouth."

What Ms. Vaswani and many of her fellow traders haven't lost, is the bug. Many still hope to eke out enough profit from intraday movements up or down to change their lives in small but appreciable ways.
Other regulars at Web World left their low-paying jobs trading textiles and selling ayurvedic herbs to cash in on the unprecedented run on Indian stocks. Some have doubled their incomes.

Even with the market falling, Mr. Mishra says he makes more money buying on the dips than he could in his previous job selling engine parts for ships. There, the $6 a day he earned wasn't enough to support his wife, two children and mother, who live in a small apartment in the noisy suburbs of this city formerly known as Bombay.

He says he earns an average $15 a day from day trading. Mr. Mishra says he can now afford a private grade school for his son and daughter, a cellphone to call his brokers, a monthly movie date with his wife (a Julia Roberts film if one is showing) and still set aside some rupees for retirement.

So far he has been lucky in the market. When he loses money, it puts him in a bad mood for days but not out on the street. He refuses to even imagine what would happen if he started losing regularly. "I can't be pessimistic if I want to grow," he says.

Most Indians still earn less than $2 a day. Even someone with experience like Mr. Mishra, who fixed Navy ship engines for 15 years, usually makes less than $150 a month. He is like many Indians who want to get ahead but don't have the skills to grab one of the few good jobs as a computer engineer or the English to be a call-center employee.

Mr. Mishra grew up farming wheat, corn, sugar cane and potatoes in the fertile fields of Uttar Pradesh in northern India. He attended grade school under a tree without paper or pencils. Later, he graduated to a shed that students shared with cows.

Two years ago, he took $1,000 in navy pension money and began trading at Web World. Since then, he has doubled his take-home pay. Every morning he takes a crowded 90-minute train ride to downtown Mumbai and shows up for "work" at the back corner of the cafe before the opening bell at 9:55.

Web World charges around 25 cents an hour, hoping to earn still more from its coffee. It has squeezed more than 50 terminals into the ground floor of an old building at the center of the oldest neighborhood in Mumbai. With flat-screen panels and air conditioning, it's a noisy haven that boils over when nearby schools let out and the gamers arrive.

At 12:30 in the afternoon, Mr. Mishra empties his briefcase of its only contents: plastic containers of spicy vegetables and Indian bread prepared by his wife for lunch. The television set Web World installed for its most loyal customers -- the day traders -- is tuned to CNBC India all day.

The "trading floor" is filled with a constant banter, as each trader yells tips and taunts to the others about the money they made or lost and hot stocks they have found. One trader trades in his bare feet, while listening to tunes from the latest Bollywood movies. Another carries his trading tools -- a grimy calculator and dog-eared investment magazine -- in a plastic bag from a clothing store called Turning Point.

Each trader has his own tricks. Sumit Mehta, 27, who used to sell herbal extracts, looks for large trades by foreign brokerages and rides the slipstream. Neeraj Lohia, 29, waits until he sees the benchmark index bottom out, and then buys blue-chip growth companies. Mr. Mishra trades Indian sugar shares when there is overnight news about sugar production in Brazil.

Chairs and computer screens broken from overuse have been pushed to the corner. By the end of the five-and-a-half-hour trading day, most traders are usually a few dollars richer. Those who haven't figured out how to ride the market's current volatility were weeded out weeks ago.

Mr. Mishra says he continues to make money: about $17, he bragged at the end of a recent trading day. He says he has saved around $3,000 over the past two years. Once he has $10,000 in the bank, he says, he plans to start making larger and riskier bets on the market.

He has already used some of his earnings to rebuild his family home in the village he grew up in. He doesn't plan to go back there, though.

"It is giving me food, it is my provider," he says as he touches his fingers to his monitor, keyboard and then forehead in a Hindu sign of respect for his computer. "This is a 90% improvement to the life I lived in the village."