New York – Daniel Loeb, who runs New York-based Third Point Management with the $5.6 billion in hedge fund assets under management, reported a significant increase in SEC activity in his second quarter letter to investors. According to Loeb, the SEC served subpoenas on over 50 hedge funds seeking information on short sales in Bear Stearns and Lehman Brothers and the dissemination of rumors about those companies in the market. Despite widespread reports of a hedge fund cabal to bring down Bear Stearns, the SEC treads a fine line as they go after rumor mongering.
The trigger for SEC activity was the demise of Bear Stearns. Former Bear officials cried foul, claiming that there was an orchestrated effort on the part of hedge funds to bring the firm down. As related in an article in Vanity Fair, the conspiracy theory hinges on a flood of ‘novation’ requests (requests made to third party banks to take over swaps and other OTC instruments for which Bear was the counterparty) four days before Bear went down. Former Bear officials analyzed the novation requests, and found that they were concentrated on three firms: Goldman Sachs, Credit Suisse, and Deutsche Bank. Deluged with requests, two of the firms, Goldman and Credit Suisse, put a temporary halt on accepting the requests, which was translated in the market as Goldman and CS questioning Bear’s credit quality. Lehman Brothers’ management added to the cabal theory by citing reports of a celebratory breakfast by hedge funds the Sunday morning following Bear’s collapse.
Conspiracy theories are titillating but the reality may be less sinister than depicted by Bear Stearns and Lehman. It was logical that the majority of the novation requests should go to GS, CS and DB, which are among the stronger investment banks. This may not be evidence of a premeditated plan, but rather a consensus view on the counterparty risk of swaps dealers.
Conspiracy or not, the SEC’s attempt to track rumors raises a few issues. Foremost would be the ability of investors to communicate among themselves. Loeb reports that Third Point was subject to an SEC audit in 2007, after the firm registered as an investment advisor (and we wonder why hedge funds are reluctant to register.) According to Loeb: “During the course of the audit, the examination staff noted that we regularly communicate with portfolio managers at other hedge funds about investment and trading ideas. The SEC later informed us that it had commenced a formal investigation of Third Point primarily relating to these types of communications.”
There are legitimate reasons for hedge funds and other investors to communicate investment and trading ideas. It is a natural part of investing. Barron’s and other financial publicaitons regularly publish trading ideas from investors. From a research perspective, it is not unusual for research firms to have investment affiliates. Does this mean that those research firms will have restrictions on their ability to disseminate investment ideas? In some cases, communication between investors is formalized in conferences, blogs or online forums. As one example, Drobny Global Advisors runs a closed online form solely for macro hedge funds to share trading ideas and strategies.
Because of their secrecy, hedge funds attract scrutiny. But the SEC’s focus on hedge fund communications opens more problems than it solves.
The full letter from Dan Loeb can be found here.