Hedge funds are sweeping homes and offices for bugs

security sweeps

…not the biological kind that infest beds, but listening devices.

According to the Financial Times, security firms in the New York City area are experiencing a surge in requests by hedge funds to have their offices and, in some cases, the homes of key firm members, swept for hidden surveillance devices.  This is apparently the hedge fund response to the continuing stream of arrests of industry employees on charges of insider trading.  In many cases, the SEC and FBI have cited, as justifications for the arrests, recordings of telephone calls they have made, in which the arrested parties either receive or solicit inside information that they subsequently trade on.

not so smart

This security sweep activity is more than a little crazy.  But it does illustrate two things, I think:

–the fact that the SEC/FBI tactic of making fresh arrests every few days instead of doing everything at once is having its desired effect of instilling fear into the hedge fund community, and

–it gives us some insight into the character of the management of at least some hedge funds–not that we necessarily needed this confirmation.

Why is it crazy?

First of all, the cases I’ve read about have involved a cooperating individual telephoning into hedge fund offices from, say, his home or the local FBI office and trying to get the recipient of the call to make incriminating statements.  In all these cases, the recording is done at the caller’s location.  A sweep for hidden spying devices, like in movies about the Cold War, would find nothing.

Second, legal wiretapping would be done from the telephone company premises, not from the hedge fund offices.  Same result–a sweep finds nothing.

Finally, the people who run security agencies are mostly former police officers, or FBI or Secret Service agents.  Part of their stock in trade is the cordial relations they maintain with their former colleagues.  It would be hard to believe that the FBI doesn’t have a complete list of the hedge funds who have called to have their offices swept (talk about dumb).

says something about the industry, though

At least part of this panicked reaction is hedge fund managers seeing what happens to assets under management when someone in a firm is accused of insider trading–the assets are immediately yanked by clients.  But it also shows the lack of organization, or the immaturity, of the firms in question.

what to do?

What should hedge funds be doing?  I have two observations–really three:

top management sets the tone

In any firm, all employees look to the top management for cues on what acceptable performance is.  If the boss signals that it’s ok to lie, cheat and steal to get performance, regular employees will likely respond by doing so.  Academic research suggests that a significant proportion of hedge funds do this–that they’re are willing to exaggerate their education, experience and performance to try to attract clients (look under my “hedge fund” tag for evidence).  In my mind, such firms are lost causes.

compliance training is key

In the SEC-regulated world, all investment professionals are required to have periodic training in compliance, that is, on the ins and outs of securities laws and the standards of conduct they require.  The fact of this training, and the care management takes in organizing and conducting it, goes a long way to set the ethical tone of a firm.  In fact, to my mind this is the fastest way for a top management to set standards for behavior.

bug sweeps send a bad message

What message does sweeping the office for bugs send to employees?  I don’t know exactly, but it certainly isn’t that the firm is highly ethical and has nothing to hide.

bankruptcy of Borders Group: implications for Barnes & Noble (BKS)

Borders’ bankruptcy

Last week BGP filed for a reorganization under Chapter 11 of the Bankruptcy Code and announced it had subsequently received new financing from GE Capital.

This wasn’t a big surprise, given that BGP had been reported for some time to be withholding payments to book publishers and to its landlords in order to conserve cash.  What would it be “conserving” this cash for?   –to pay salaries and keep the lights on in the bookstores and warehouses, for one thing  It’s also possible that some of its suppliers had noted Borders’ deteriorating financial condition and were asking for cash payment before shipping new merchandise.

Chapter 7 vs. Chapter 11

Bankruptcy in the US generally comes in two flavors:

–Chapter 7, or liquidation, where the debtor is considered defunct.  In this case, the bankruptcy action consists in selling the assets and distributing proceeds to creditors.

–Chapter 11, or reorganization with the debtor remaining in control. The main thrust is to put the enterprise into position to have a second chance at success.  The firm continues to operate while it restructures.  It may terminate or renegotiate contracts, including leases, under the supervision/assistance of the bankruptcy judge.  Typically, common shareholders and trade creditors are wiped out completely.   Debtholders exchange their obligations for stock in the revamped company that emerges from from the bankruptcy proceeding.

To some extent, bankruptcy can become a self-fulfilling prophecy.  Suppliers typically study the finances of their customers carefully.  They may reduce–or even stop completely–shipments at the first whiff of trouble.  Or they may ask for cash upfront instead of extending credit.  And why not, since their receivables are most likely a total loss once a customer files for bankruptcy.  The result, however, is that the store in question may no longer have the best merchandise, or the former large variety, in stock  …which means more customers stop coming.

reports of the Borders plan

Reports in the blogosphere and in newspapers suggest that book publishers want Borders to shrink its floorspace by about a third in its reorganization.

positive news for BKS?

The stock did go up about 10% last week, as the rumors of an imminent Chapter 11 filing by Borders swirled. So someone must think this is a big plus for BKS..

My guess, however, is that the demise of the current Borders will do little good for BKS.  Three reasons:

1.  Borders will continue to operate, although in about a one-third smaller form.

2.  In a case that I think is very similar to Borders/Barnes&Noble today, in 2009 consumer electronics retailer Circuit City went into liquidation.  How fast are the revenues of rival Best Buy growing today, without competition from Circuit City?  In the US, they’re not growing much  at all.  In fact, on a comparable store basis, they’re actually declining.

How so?  Circuit City’s customers didn’t all flock to Best Buy.  As I see it, the chain’s demise accelerated the trend of consumer electronics sales to a newer technology, the internet, and to the big discounters like Wal-Mart.

In the bookstore instance, the biggest effect of Borders’ shrinkage in size may well be a speeding up in the adoption rate for e-readers.   My feeling is that most of the new business will go to Amazon, not Barnes and Noble, although thee may be some shifting of Barnes and Noble’s bricks-and-mortar customers to the Nook.

3.  Another, somewhat older–but still pertinent, I think–pattern of industry development comes from toy retailing.  As I interpret the data, every year in the first half of the Nineties big discounters like WMT and TGT took market share from Toys R Us.  But every year, Toys R Us took market share away from small independent toy retailers, so it was relatively unaffected by the loss of customers was experiencing.  But then, sometime in the mid-Nineties, there were no more small independents left for Toys R Us to take market share from.  Toys had killed all the ones who were going to die.  The competitive situation had therefore been reduced to Toys R Us vs. the big discounters.  From that point on, TRU was in trouble.

I think that we may be seeing the same mid-Nineties situation emerging in the book industry, with BKS playing the role of Toys R Us, Borders and small independent bookstores the part of the small toy retailers, and Amazon and WMT being the equivalent of WMT/TGT.  If Borders and the small booksellers (who appear to be enjoying a resurgence, by the way) have no more market share to give up, then the new competitive dynamic is between BKS and AMZN.  Of course, AAPL may take some market share as well.

Given that different e-reader systems are mutually incompatible, would you feel more comfortable buying one from a company with a market cap of $84 billion (AMZN) or $1 billion (BKS); with $8 billion in net cash (i.e., after repaying all debt) on the balance sheet (AMZN) or a comparable number we won’t know for sure until reporting time, but which is probably going to be only mildly positive (BKS).  In this case, I think size will count for a lot.

I’ve posted my second update to Current Market Tactics

I’ve written the second part of my update to Current Market Tactics.   If you’re on the blog, you can also reach the post by clicking the tab at the top of the page.

I’ve just updated Current Market Tactics

This is the first of two updates of Current Market Tactics (the second will come on Sunday).  If you’re on the blog, you can also click the tab at the top of the page.

Bernie Madoff and the New York Times

a Times article

Yesterday, the New York Times published a front page article based on correspondence with, and an in-prison interview of, Ponzi-schemer Bernie Madoff.  The reporter is turning her investigation into a book.

what Madoff said

Madoff had a number of comments:

1.  Discovery of his crime has had a much more severe negative impact on his family than he expected.

2.  He has given important information to Irving Picard, the trustee appointed by the court to recover investors’ assets (despite the fact he refused to help prosecutors after he was arrested).

3.  Internal bank and investment firm correspondence he has seen while in jail convince Madoff that these partners of his deliberately failed to do due diligence before recommending him to clients.  Why?   They knew they would find fraud–and thereby kill the goose that laid the golden eggs for them.

4.  In contrast to the banks, the Wilpon-Katz family, New York real estate developers and owners of the Mets baseball team, were clueless.  Despite having a cadre of highly educated financial and legal experts, and being sophisticated investors themselves, they “knew nothing.”

5.  There is no need to pursue Madoff clients who received the assets that belong to defrauded customers.  Why?  If other lawsuits seeking punitive damages from institutions that Picard maintains were “complicit” in the fraud are successful, there will be more than enough money to pay off investors who lost part or all of their principal.

is there any reason to think Madoff is being honest?

What are we to make of this?  Is any part of it true?

We do have one indication:  …Madoff’s gloating soon after arriving in prison about how he sized up business partners and clients–and refused to have anything to do with anyone he thought might be capable of uncovering the fraud.  He wouldn’t talk to them, wouldn’t take their money.  In other words, Madoff will only speak to people he’s confident he can successfully lie to. (I realize there’s a whiff of the famous liar paradox about Madoff’s statement, but I choose to think he’s being honest here.)

If so, what does this say about the reporter, to whom Madoff seems to have given a significant amount of time?

a human tendency

More generally, it seems to me that there’s a human tendency to think of oneself as somehow special…to say, in effect, “Yes, I know he’s defrauding others, but I’m part of the “in” group.  He won’t do that to me.”  Con men cultivate this feeling and take advantage of it.

In the Madoff case, early investors seem to have believed that the superior returns he advertised came from his illegal “front running” of clients in his brokerage business (that is, buying for himself before executing orders from brokerage clients, using the client volume to push prices up).  Yet, they were happy–no, eager–to give him their money, in the belief that 1) he wouldn’t cheat them, and 2) that he was willing to gift them with some of the money he stole from others.  Sounds crazy, doesn’t it?  But that’s what a lot of people did.

my take,

for what it’s worth:

1.  Madoff gave no thought to the effect that discovery of his fraud would have on his family, so of course he’s surprised.

2.  Some of the information cited in the Picard lawsuit against the Wilpon-Katz family sounds as if it came from Madoff, or perhaps Madoff confirmed surmises Picard’s forensic accountants made, but I doubt he provided other information.  He would certainly not be a credible witness in court, even were he to choose to testify.

3.  Madoff was very clever in arranging his fee structure.  The vast majority of the hedge fund-like fees charged to customers were kept by the selling agent.  So I can imagine there was immense pressure by top managements of his business partners to look the other way.

Consider the case of GE, a blue chip company made up of decent, hard-working people.  Less than a decade ago, even parts of that corporate icon wilted under pressure from a former chairman and falsified their financial accounts, so they could be seen to be achieving earnings goals.  I’m not condoning this activity, just saying that it happens and that potential whistleblowers would likely have gotten a very frosty reception.

4.  Long-suffering Mets fans realize that the Wilpons don’t have what it takes to run a sports franchise.  We also know that Madoff spent lots of time with the Wilpons and took huge amounts of their money.  So, no matter what Madoff says, his actions tell us what he thought of them.

Nevertheless, the Wilpon family would doubtless be classified as sophisticated professional investors–and subject to the much higher standards of conduct that this entails–based on the size and breadth of their operations, their education, training and experience, and the high quality of the financial and legal staffs they employed.  Separately, the Wilpons are also apparently being sued for failure to supervise their employees’ 401k plan, virtually all of which was directed to  Madoff.

These will be interesting cases to watch.

5.  I don’t understand the logic of Madoff’s wish that customers who received money stolen from others should be allowed to keep it.  I have no idea what the law is on the matter, though.

investment implications

Two that I can see:

I think we’re all susceptible (I know I am) to the idea that our own intrinsic worth shines through so clearly in all we do that complete strangers will offer us “special” investment opportunities as soon as they meet us.  Caveat emptor is a better rule to use in investment.

I started out as an oil analyst.  One of my earliest industry contacts told me that in his experience “good” oil wells always produced continual positive surprises.  “Bad” oil wells, on the other hand, continually disappoint.  I think that’s generally true of stocks, too.  In the case of unethical conduct, a given instance may be the first you have heard of.  But it’s a very bad assumption to think that this is the first instance that has occurred, or that the negative news is limited only to the area you have identified.  In all likelihood, the opposite is true.  The instance is almost certainly not the first, and chances are it’s indicative of a corporate culture that pervades the entire enterprise.

Life is too short and there are too many good investment opportunities for us to need to bet where the odds are stacked against us like this.