Client Alert from the Investment Management Practice

June 20, 2008

Types : Alerts

As you have undoubtedly seen in the papers, the two Portfolio Managers (“PMs”) who ran the Bear Stearns’ hedge funds that invested in subprime and other mortgage-backed securities were arrested and indicted in New York yesterday.  

In addition, the SEC released its Complaint in a civil action against the two PMs.  (SEC v. Ralph R. Cioffi and Matthew M. Tannin, Civil Action No. 08 2457 (FB) (E.D.N.Y. June 19, 1008).

Although our clients are certainly not intent on committing fraud, the apparent failure of such a large institution to provide management supervision of the PMs, compliance oversight and risk management contains lessons for everyone.  Keep in mind that (i) this discussion is based on facts alleged by the SEC, and (ii) no actions have been filed (at least not yet) against Bear Stearns or its personnel with supervisory authority over these PMs.

 

Key Claims of SEC against the Bear Stearns PMs

• Misrepresented the Funds’ exposure to subprime by lumping CDO and CDO-squared holdings in with “ABS” on performance/holdings reports to investors and failing to provide the overall exposure to subprime even though investors were asking.
• Stating that subprime exposure was limited to AAA/AA but without disclosing that CDO-squared vehicles entailed much more risk due to subordination.
• Repeatedly and substantially understated to investors and counterparties the amount of pending redemption requests.
• Provided estimated performance that they already knew was unreasonably optimistic and without appropriate caveats and which was not approved by the pricing committee under the firm’s valuation procedures.
• Withheld information from and provided patently false performance information to the bank providing leverage.
• Continuously sold funds touting own personal investments in Funds, and while telling investors and counterparties that they were adding to their own personal stakes in the Funds, they were actually reducing or not adding.
• Failed to follow Fund policies/timelines for partial redemption of personal stake when other investors held to standard Fund notice periods.
• Assured investors their hedges were working when they had not actually put hedges on a substantial number/amount of positions and any hedges in place were losing money.
• Assured investors that a new CDO-squared offering by Bear would allow redeeming investors to get out, when they knew the offering would be too late and inadequate (PMs already knew that no one wanted to buy them).
• Hid personal pessimistic views from investors and counterparties.
• Aggressively attempted to dissuade investors from redeeming, to the point of trying to humiliate investors.
• “Tablet PC” of one PM was off the Bear network and never synched to any other computer.
• Other PM kept hard copy notebooks and along with Tablet PC of other PM, went missing and was never produced to SEC.

Lessons for Everyone

• Don’t go on automatic pilot with your monthly/quarterly reports to investors; make sure they are reviewed in detail every month/quarter by the appropriate personnel.
• Present your exposures fairly and accurately; don’t play around with cute or overly technical characterizations.
• Structured products ratings should not stand alone; supplement with disclosure regarding liquidity/priority differences vis-à-vis others with the same rating.
• Avoid unvarnished venting or questioning via e-mail. Instead of creating a record of misgivings, discuss concerns in person or by phone with superiors so that your questions can actually be addressed and resolved.
• Some matters, however, must or should be documented – be sure you know which ones those are by talking to your compliance or legal person. When documenting any issue or concern, be sure you or someone else in the firm documents how it is being addressed and resolved.
• Don’t sign off on any document you believe to be incorrect or misleading; seek senior management review and the advice of compliance or legal professionals.
• Be careful with estimated NAVs. Every time you plan to release one, put the proposed e-mail or notice containing the estimate through your regular compliance process so that appropriate disclosure is included. Rapidly changing, highly uncertain or other unique market conditions mean additional caveats should be included.
• Follow your own procedures. Moreover, where a pricing committee experiences repeated and unsupported push-back from a PM, the committee should consider involving supervisory personnel.
• When faced with a redemption request from a Fund affiliate, treat it exactly the way you are treating non-affiliated investors. If you let one person out early, let everyone who requested redemption that month (or quarter, if you have quarterly dealing days) out at the same time.
• Large affiliated redemptions should be approved by the CCO (and/or CLO) and the CEO under all circumstances, even if timely notice was provided by the affiliate.
• Allow only company-issued cell phones, blackberries and PCs to be used for business purposes and have system in place to capture IM’s, prevent access to non-approved e-mail and to monitor outflow to flash or other removable drives.
• No procedures are perfect. Make sure people are engaged and paying attention to their staff members; someone should have caught on to these PMs well before their Funds failed.
• You are a fiduciary first and foremost. Your clients’ interests are paramount. Repeat it to yourself again. When the markets get ugly, repeat it some more.