Friday, April 22, 2005
Hedge Funds as B-Ds/Compliance Issues
A Broker-Dealer Morality Tale
John Hintze
April 25, 2005
Citadel Investment Group and Ramius Capital may be using broker-dealer affiliates to build new businesses as part of their natural growth as financial institutions. But broker-dealer affiliates can also be used to obscure business practices, including fraudulent ones, by minimizing the traditional market scrutiny of hedge funds.
To the dismay of investors and Wall Street participants, that is apparently what happened when KL Financial, a Palm Beach-based hedge fund, collapsed in early March, leaving investors with more than $100 million in losses.
KL Financial acquired a broker-dealer in 2001 that reportedly had a pre-existing correspondent clearing relationship with Spear, Leeds & Kellogg Specialists LLC, which was bought by Goldman Sachs and is now part of its execution and clearing operation.
Gary Klein, a former Securities and Exchange Commission enforcement official who is currently representing investors suing KL Financial, says the relationship with Goldman gave the broker-dealer, Shoreland Trading, "immediate credibility" on the Street. As a result, it was probably able to get financing and pursue trades that a prime broker would have frowned at.
Shoreland Trading left Goldman last summer and moved to Penson Financial Services, a clearing firm headquartered in Dallas. Sources familiar with Shoreland's relationship to Penson said the clearing firm provided leverage to Shoreland, as clearing firms typically do, although it was unclear by press time whether Penson suffered losses as a result.
Indeed, it was unclear which firm Shoreland was using to clear through shortly before its collapse. Dan Son, the president of Penson Worldwide, said Shoreland cleared through Penson through late December or very early January. Shoreland then reportedly moved to West Coast clearing firm Wedbush Morgan, although officials there declined to comment.
Sources said Goldman and Penson each viewed Shoreland as a proprietary trading broker-dealer. Both firms also provide prime brokerage services directly to hedge fund managers, and prime brokers typically employ sophisticated risk management models to monitor their customers' trading for undue risk. As a broker-dealer, however, KL Financial's Shoreland Trading used those firms' correspondent clearing functions, and correspondent clearers have long argued that they are simply trade processors and are not responsible for their correspondents' actions.
That argument especially applies to proprietary trading correspondents, which stand to lose only their principals' own capital. For correspondent clearers, proprietary traders are a source of high trading volumes and hence fees, without the requirements to service broker-dealers catering to investors.
Shoreland, however, was not truly a proprietary trader, since it had investors through its hedge fund affiliate that apparently funded its trading. In a fully disclosed clearing relationship, the clearing firm also sends statements to the broker-dealer's customers. In the case of KL Financial, its investors received statements purporting fantastic gains. But those statements came from the hedge fund and clearly had little to do with the financial results provided by the clearing firms. In fact, each clearing firm reportedly ended its relationship with Shoreland based on concerns about Shoreland's financial health and risk.
Even the Pacific Exchange, which Shoreland joined in May 2003, failed to detect the trading activity that ended up costing the hedge fund's investors more than $100 million.
"Any time you have a registered broker-dealer, you think you have additional layers of compliance. You're supposed to be sitting with a [Series 24-licensed principal who is] supervising all this, and the exchange is coming in to look at [the broker-dealer's activities]," said Klein.
Klein noted that exchanges examine registrants at least once a year-which is one reason hedge funds so adamantly opposed registration under the Investment Advisors Act of 1940. Hedge funds will have to register under that statute next February, and while the requirements are far less demanding than registering as a broker-dealer, even hedge funds without broker-dealer affiliates will face annual examinations.
Copyright 2005 Thomson Media Inc. All Rights Reserved.
http://www.thomsonmedia.com http://www.iddmagazine.com
John Hintze
April 25, 2005
Citadel Investment Group and Ramius Capital may be using broker-dealer affiliates to build new businesses as part of their natural growth as financial institutions. But broker-dealer affiliates can also be used to obscure business practices, including fraudulent ones, by minimizing the traditional market scrutiny of hedge funds.
To the dismay of investors and Wall Street participants, that is apparently what happened when KL Financial, a Palm Beach-based hedge fund, collapsed in early March, leaving investors with more than $100 million in losses.
KL Financial acquired a broker-dealer in 2001 that reportedly had a pre-existing correspondent clearing relationship with Spear, Leeds & Kellogg Specialists LLC, which was bought by Goldman Sachs and is now part of its execution and clearing operation.
Gary Klein, a former Securities and Exchange Commission enforcement official who is currently representing investors suing KL Financial, says the relationship with Goldman gave the broker-dealer, Shoreland Trading, "immediate credibility" on the Street. As a result, it was probably able to get financing and pursue trades that a prime broker would have frowned at.
Shoreland Trading left Goldman last summer and moved to Penson Financial Services, a clearing firm headquartered in Dallas. Sources familiar with Shoreland's relationship to Penson said the clearing firm provided leverage to Shoreland, as clearing firms typically do, although it was unclear by press time whether Penson suffered losses as a result.
Indeed, it was unclear which firm Shoreland was using to clear through shortly before its collapse. Dan Son, the president of Penson Worldwide, said Shoreland cleared through Penson through late December or very early January. Shoreland then reportedly moved to West Coast clearing firm Wedbush Morgan, although officials there declined to comment.
Sources said Goldman and Penson each viewed Shoreland as a proprietary trading broker-dealer. Both firms also provide prime brokerage services directly to hedge fund managers, and prime brokers typically employ sophisticated risk management models to monitor their customers' trading for undue risk. As a broker-dealer, however, KL Financial's Shoreland Trading used those firms' correspondent clearing functions, and correspondent clearers have long argued that they are simply trade processors and are not responsible for their correspondents' actions.
That argument especially applies to proprietary trading correspondents, which stand to lose only their principals' own capital. For correspondent clearers, proprietary traders are a source of high trading volumes and hence fees, without the requirements to service broker-dealers catering to investors.
Shoreland, however, was not truly a proprietary trader, since it had investors through its hedge fund affiliate that apparently funded its trading. In a fully disclosed clearing relationship, the clearing firm also sends statements to the broker-dealer's customers. In the case of KL Financial, its investors received statements purporting fantastic gains. But those statements came from the hedge fund and clearly had little to do with the financial results provided by the clearing firms. In fact, each clearing firm reportedly ended its relationship with Shoreland based on concerns about Shoreland's financial health and risk.
Even the Pacific Exchange, which Shoreland joined in May 2003, failed to detect the trading activity that ended up costing the hedge fund's investors more than $100 million.
"Any time you have a registered broker-dealer, you think you have additional layers of compliance. You're supposed to be sitting with a [Series 24-licensed principal who is] supervising all this, and the exchange is coming in to look at [the broker-dealer's activities]," said Klein.
Klein noted that exchanges examine registrants at least once a year-which is one reason hedge funds so adamantly opposed registration under the Investment Advisors Act of 1940. Hedge funds will have to register under that statute next February, and while the requirements are far less demanding than registering as a broker-dealer, even hedge funds without broker-dealer affiliates will face annual examinations.
Copyright 2005 Thomson Media Inc. All Rights Reserved.
http://www.thomsonmedia.com http://www.iddmagazine.com
# posted by Tom @ 4:20 PM 
