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Outsource the SEC, for Hedge Fund Exams and Systemic Risk


Date: Thursday, April 23, 2009
Author: RiskCenter

Hennessee Group LLC, consultant and adviser to direct investors in hedge funds, re-released a summary of recommendations to reduce fraud and systemic risk in the hedge fund industry. Charles Gradante, co–founder of Hennessee Group, recommends that Congress, the Securities and Exchange Commission, and the Federal Reserve Bank consider the following summary of recommendations that Mr. Gradante has made over the years since 1998 to the House of Representatives, the Senate Banking Committee, the Securities and Exchange Commission, and the Commodities Futures Trading Commission.

Fraud Risk

“For obvious reasons, outsource hedge fund fraud audits to third parties, such as Kroll,” states Mr. Gradante. “They have the forensic skills and ‘street smarts’. Have Limited Partners select the company to perform the fraud audit and have that company issue a ‘Fraud Audit Report Card’ to limited partners and the SEC.”

Systemic Risk

Gradante strongly agrees with President Obama that “regulation can reduce systemic risk”. Gradante adds “I believe the President wants regulation that is proactive not reactive.”

“Assign the equivalent of a CUSIP Number to each hedge fund (especially the top 100 in assets which constitute the vast majority of systemic risk potential). Monitor leverage extended by commercial banks and prime brokers using the CUSIP Number concept,” states Mr. Gradante.

As an ex-CEO of a U.S. National Bank, Mr. Gradante commented that “the ‘Know Your Customer Rule’ is fundamental to lending. This rule has been distorted by many banks and prime brokers, with respect to hedge funds, resulting in a greater potential for systemic risk (i.e., Long-Term Capital Management).” Gradante concluded, “No balance sheet… no extension of credit.”

(See Mr. Gradante’s October 1998 Testimony on Long-Term Capital Management below).

Gatekeepers

The “Gradante Gatekeeper Concept” simply states that all gatekeepers should have a vested interest in ensuring the integrity of the hedge fund industry for investors. It should be mandated that gatekeepers are accountable and responsible as follows:

  • Lawyers: perform “A to Z” background checks on the hedge fund manager’s resume placed in the offering memorandum produced by lawyers for investors. (Resume Fraud)
  • Prime Brokers: receive annual financial audits and compare for performance accuracy to the prime broker Realized and Unrealized Gain/Loss Report. (Performance Fraud)1
  • Accountants: Limited Partners must receive their annual financial audits directly from the Accountant and not from the manager. (Document Fraud)
  • Accountants/Administrators: No “Trader Marks”… only screen marks or third party marks. Exceptions must be noted on annual financial audits to Limited Partners. (Valuation Fraud)

Policy Changes

The following policy changes should be mandated” stated Mr. Gradante.

  • Reconsider regulation of hedge funds in conjunction with Gradante’s: a) Gatekeeper Concept; b) third party fraud audit concept; and c) CUSIP number concept.
  • Mandate monthly NAV for onshore funds: Administrators are third party accountants that currently perform monthly NAV calculations for offshore funds. The incidents of fraud for offshore funds are far less than onshore funds because of this monthly NAV calculation. (Performance/Valuation Fraud)
  • As with public companies, Accountants should be voted by the Limited Partners.
  • Limit the issuance of Credit Default Swaps (CDS) on bonds to equal the outstanding supply of bonds on a specific issuance (systemic risk).

- Banks and Insurance companies should not be allowed to “over insure” a bond issuance. For example, sell $10 billion of CDS insurance paper on a $2 billion bond issuance. This practice has (in part) intensified the “crisis of confidence” in the financial services industry. No one knows who is holding “the old maid”.

- Credit Default Swaps are insurance contracts, and should not be treated as put options. Credit Default Swaps should be regulated as insurance contracts.

- Establish a clearing house for CDS market and monitor counterparty risks.

Sources:

1 Multiple Prime Brokers will require a more complicated technique.

Testimonies

(October 1998) Mr. Gradante's Testimony on Long-Term Capital Management to The Committee on Banking and Financial Services: House of Representatives, (See page 5-7)

http://hennesseegroup.com/information/info/TESTIMONY%20OF%20CHARLES%20GRADANTE%20OCTOBER%201998.pdf

(May 14 – 15, 2003) Mr. Gradante's Testimony to Securities and Exchange Commission Roundtable on

Hedge Funds, (See page 15-16)

http://hennesseegroup.com/information/info/Hennessee%20Group%20SEC%20Submission%20White%20Paper.pdf

(July 15, 2004) Mr. Gradante's Testimony to Committee on Banking, Housing, and Urban Affairs:

United States Senate on Regulation of Hedge Fund Industry, (See page 7-9, 14)

http://hennesseegroup.com/information/info/HENNESSEE%20SUBMISSION%20TO%20BANKING%20COMMITTEE%20with%20CG%20verbal%20testimony-7-15-04.pdf

(April 6, 2005) Mr. Gradante's Testimony to U.S. Commodities Futures Trading Commission: CPO and

Commodity Pool Roundtable, (See page 12-13)

http://hennesseegroup.com/information/info/HENNESSEE%20SUBMISSION%20TO%20CFTC%204-6-05.pdf

TV Interviews

November 2, 2006 Street Signs with Erin Burnett “CDS: The Undiscovered Elephant in the Room”

- Link: http://www.youtube.com/watch?v=jHLDvYZM1i8

- “No one knows who is long or short CDS, who is hedged or making directional bets.”

- “On a scale of 1-10, this is an 8 – 9 problem.”

- “There may be a problem with banks that have taken a concentrated bet against credit spreads

widening by selling credit default swaps. Counterparty risk exists.”

November 15, 2006 Bloomberg with Monica Bertran “Sellers of CDS Will Take Losses Mark-to-Market”

- Link: http://www.youtube.com/watch?v=2UkfFbndiL0

- “There are problems in the Credit Default Swap market. Spreads will widen, causing sellers of

CDS to take a hit in Mark-to-Market. A rapid widening of spreads would cause shock to market.”

- “Gatekeeper Concept: Accountants should divulge counterparty risk in audits; lawyers should do

background checks; banks and prime brokers should report leverage to Fed/SEC; and monthly

NAV calculations by administrators to reduce fraud.”

Page 4 of 5

Sources (continued):

TV Interviews (continued)

December 12, 2006 Bloomberg with Monica Bertran “Need to Do More than Raise Hedge Fund Limits”

- Link: http://www.youtube.com/watch?v=2w21p9bRItA

- “SEC/Fed should be working with Prime Brokers on monitoring leverage.”

- “SEC/Fed should increase margin requirements on futures contracts.”

- “SEC needs to raise “Net Worth” requirements for hedge fund investors.”

- “SEC/Fed needs to work with Prime Brokers on systemic risk.”

March 13, 2007 Bloomberg with Monica Bertran “Subprime Concerns”

- Link: http://www.youtube.com/watch?v=djJ4ErLhDK0

- “Subprime CDO are potential Achilles heel of market.”

August 14, 2007 Bloomberg with Brian Sullivan “Hedge Fund Redemptions”

- Link: http://www.youtube.com/watch?v=93N8kGD6Yz8

- “Hedge funds are long credit default swaps.”

- “Deleveraging problem is not going away. It will continue for years.”

January 18, 2008 Bloomberg with Brian Sullivan “Technical Analysis of Stock Market and CDS Trouble

for Banks”

- Link: http://www.youtube.com/watch?v=kl_6lpDttLw

- “Next big shoe to drop is CDS.”

- “Banks in trouble with CDS issuance.”

December 15, 2008 Bloomberg with Matt Miller “Bernie Madoff Scandal”

- Link: http://www.youtube.com/watch?v=i97_LTemvUU

- “Three things the industry needs to do:”

�� “Mandate fraud audits by third party such as Kroll.”

�� “Monthly NAV for onshore funds.”

�� “Accountants to be voted by Limited Partners not manager.”

Legal Cases

Securities and Exchange Commission vs. House Asset Management

- Manager made false statements about his background in offering memorandum.

Securities and Exchange Commission vs. Manhattan Capital

- Manager created false account statements which were mailed to investors by manager.

Securities and Exchange Commission vs. Edward Stafaci (Lipper Convertibles, L.P.)

- The Auditors acceptance of “trader marks” for several years led to sizable losses.