HEDGE FUNDS;  THEIR ROLE AND INFLUENCE IN TODAY'S FINANCIAL MARKETPLACE                                  

      "Hedge Fund" is an often used expression, but surpris­ingly, one  without even a ge­neric mean­ing.  It is a term that has been used to describe an under­capitalized individ­ual trader actively buying and selling new issues for his own account as well as a multi­billion dol­lar lim­ited part­nership whose general partner has carte blanche to transact deals for the group, with the intent that he maximize the partnership's profits.  Hedge Fund transactions may in­clude the pur­chase and sale of any form of security or commodity, long or short[1], equity or debt, pas­sively or with the view of taking  control.  All of the foregoing can be executed in al­most any combina­tion.  This memorandum primarily addresses the most common se­curity oriented, capital pools which are also those re­ceiving  the most notoriety.

     Hedge Funds come in all sizes and shapes, from the now fledg­ling Dome Capi­tal Man­agement, currently raising money to do "Day Trad­ing,"[2] to the $20 Billion  off-shore Quantum Fund, run by George  Soros,  which does not accept American In­ves­tors.   There are Hedge Funds that specialize in such esoteric fields as Junk Bonds, Derivatives, Currency Trad­ing, Geo­graphic Areas, and even Hedge Funds whose raison d' etre  is the investment of partner's funds in other Hedge Funds.[3]  A January 21, 1992 article in Financial World­­­ points out that the pension funds of Harvard, Stan­ford, Duke and the United Mine Workers are either invested in Hedge Funds or at least are considering them as AN alternative finan­cial tool. 

     Contrary to popular regulatory misconceptions, a Hedge Fund does not necessarily have to be a limited partnership to be recognized as one by "The Street".  This inadequate defini­tion is the consequence of insufficient knowledge regarding the scope of activi­ties en­gaged in by sole pro­prietors performing similar functions.

     The larger Hedge Funds aggressively compete for  new dollars, trumpet­ing their heroics to a cult of sophisticated gamblers look­ing for the hottest hand in town.  The smaller sole proprie­torships use their own funds and prefer to blend into the background. Only the bro­kers re­ceiving their busi­ness know who they are and the scope of their operations.

     Whether they work alone or in concert, Hedge Funds  exert enormous influence over all phases of the fi­nancial marketplace, at times creating turmoil unparal­leled in the financial world.   The earlier a potentially profit making opportunity can be uncovered, the greater the probability of beating the competition to the quarry.[4]   The com­bined as­sets of these funds most certainly number in the hundreds of billions of dol­lars, and be­cause of their un­regulated na­ture,  they are able at times to hold large invest­ment bank­ing firms in virtual servitude for past or future favors.       Before proceeding further let us define this amor­phous creature that we refer to in this article as a "Hedge Fund",  understanding that the term is applied by "The Street" to any en­tity that acts in mysterious ways.  My definition of  the term would be: a pool of ag­gres­sively managed funds whose scope of investment in fi­nancial instruments is lim­ited only by the terms and conditions of its char­ter (most of the time) and the ego of its man­age­ment.      Most of the major Hedge Funds will generally not pursue a prospective investor unable to risk seven figures.  This is not true of Multimanager funds, which invest their lim­ited part­ner's assets in a multi­tude of funds, hoping to both spread the risk and give the "small investor", a chance to play in the big leagues.  Because Multimanager Hedge Funds charge very high man­agement fees and levy substantial assessments, they must demonstrate extraordinary perform­ance.[5]   Added to these fees are those charged by the Hedge Fund itself, creating enormous bag­gage for the investor.     Further complicating the investment decision,  unregis­tered Hedge Funds with less than one hundred investors are exempt from a public reporting requirement.  When superior results are attained,  the fund management will arrange press conferences to bombard the public with their results.  Under-performance is accompanied by evasion and silence.   This lack  of regula­tion and selective reporting  fosters fraud.  One man­ager broadcast substantial trading profits during a period when he had actually wiped out the majority of the Fund's investors.  The "Alice and Wonder­land" per­form­ance, though unverifiable, continued to attract gullible partici­pants.[6] 

1.  THE PURCHASE OF NEW ISSUES

     The 80's were Wall Street's decade of easy money, large cars, yuppies, and LBOs.  The 90's appear to be shaping up as the decade of deprivitizing the LBOs created in the pre­vious decade.  Lower interest rates have allowed the refi­nancing of much junk bond debt at more fa­vorable rates.  Superior management along with the elimi­nation of fat has substantially turned many of these companies around.  New issues of these only recently private companies are prolif­erating, fueled by the best new issue envi­ronment in market history.    New issues are the financial lifeblood of Ameri­can Industry.   However,  their under­writ­ings inherently spark extraordinary conflicts of interest.  When the syndicate de­partment of a brokerage house prices a new issue,  it is representing both its clients and the issuer. 

     In this,  the most ephemeral of all financial deci­sions,  there is no perfect  way to strike a balance between supply and demand.  If the price is  perceived  to be "too up­scale," the issue does not sell.  If it  is considered underval­ued, the secu­ri­ties com­mand a premium,  and the is­suer concludes that it has given up too much equity for what was received in return.  On Wall Street, you are never any better than your last offer­ing.  If the Initial Public Of­fering ("IPO") trades flat or at a discount, the in­vest­ment banker becomes known as a pur­veyor of dogs; if the issue appreciates,  he acquires a reputa­tion for underpric­ing and investors will flock to his next offering. 

     As principal transactions currently represent the most profitable area of  Wall Street's business, an unsold or badly  placed underwriting  can literally ruin a small in­vest­ment banking firm's reputation, since it ef­fects both the brokerage firm's clien­tele and the issuer adversely. 

     Hedge Funds receive preferential treatment in under­writings be­cause they are generally willing to step up to the plate, win or lose.  Of­ficially Wall Street is on record as abhorring almost everything the "hedgie" stands for, and ordinary brokers[7]  are advised to avoid them. This is par­ticu­larly true in the new issue market, where they are his­tori­cally  perceived not as investors, but as "fast buck artists," whose allocated shares must be repur­chased by the investment banker's cli­ents at higher prices.  In actual­ity, the syndicate manager maintains Hedge Fund accounts on his own personal books, thereby covertly controlling the ebb and flow of the IPO.  In return for favorable treatment on hot IPOs, Hedge Funds can be counted on to take down chunks of poorly priced, ill-conceived and under subscribed new is­sues, thus pre­venting  the deal from aborting.

     Not all issues trade at premiums, so it must be assumed that either the major­ity work out favorably, or that there are other incentives persuasive enough to cause these funds to run the transac­tional risks.  During hot new is­sue mar­kets, the process functions smoothly, with the premium de­rived from numerous profitable IPOs far outweighing an occa­sional loss.  These Funds function full time only when the new issue market is hot or other considerations can be ar­ranged. 

     The IPO climate that has existed since 1989 offers an example of such a feeding frenzy. [8]  In breaking down recent record  "street" profits  the financial press identify IPOs as their most substantive source.  Incen­tives may be of­fered in  return for pur­chas­ing se­curities that al­most assuredly will decline in price.  An incisive overview on incestuous rela­tionship that often exists between brokerage firms and their more flexible clients. The details of this type of transaction will receive major press momentar­ily as the Alan E. Rosenthal trial unfolds.  The Govern­ment's con­tention is that Rosenthal exerted con­trol over funds under his manage­ment to purchase Drexel Burnham Lam­bert's (Michael Milken) underwritings that were not being well received by the "Street".  In exchange for Rosenthal's generosity, Drexel, it is alleged, arranged $1.6 million in phony losses for him, thus reducing his income taxes.  Although not a Hedge Fund, ($2 billion pension and bene­fits fund) the Rosenthal Case will be one of the first substantive public examples of this type of activity.[9]  This form of bar­ter  has in­finite possibilities, some  of which withstand scru­tiny, while others might  ex­ceed ac­cepted  le­gal and ethical  bounda­ries.[10]

     If a firm errs in pricing, it is almost universally to the disadvan­tage of the is­suer.  Fur­ther, the process gener­ally results in undue concen­trations of original issue shares owned by profes­sionals rather than the public.  Hedge funds are often granted ge­neric "puts" against their trans­actions, and run little or no risk, while the public re­ceives only the scraps in  premium issues and is bulldozed by frenetic stockbrokers into pur­chasing IPOs that insti­tutional investors who have done their homework, perceive as going no­where at best.                   

     Professionals can invariably gauge the demand for a particular new issue in ad­vance.[11]  Wall Street Syndicate Departments  readily supply this information to valued cli­ents who  can then deter­mine the IPO's probable premium or discount, and adjust their activities accordingly.  Some Hedge Funds have research staffs that do superb analytical work and are therefore much better equipped to do business in this arena than the public.[12] 

     For a sure thing, you can't beat selling naked into a secondary[13] that is known to be coming at a discount from its current trading levels.  This presents a no-lose situ­ation for the un­derwriter and the Hedge Fund.  The issuer and its shareholders will receive either less money for its securities or will have to issue more stock to receive the same amount, thus creating unnec­essary dilution.  The Hedge Fund for its part is aware that it can cover its short at a discount from its cost price, without commission, by repur­chasing the shares in the secondary.  The Investment Banker is assured that if the issue is placed with funds having short positions, those securities cannot come back into the market.  This is especially important because there will be no residual effect upon the offering allowing the issue to bounce back once the syndicate is closed, thus making the in­vestment banker a hero in his clients eyes.  It also places the brokerage firm in a position to make a larger commitment to the issuer. Whatever stock that has been sold short will be repurchased in addition to whatever buying interest the investment banker may garner through normal supply and demand channels. 

     Usually this type of agreement is reached substantially before the offering and although a fairly common "Street" occur­rence,  its ille­gality does not seem to preclude its use. Some firms avoid this costly step by selling stock in their own deals short and covering in the offering thus eliminating the mid­dleman.[14]

2.  "DEAL" STOCKS

     Many of the largest Hedge Funds trade only in ac­quisi­tion-oriented tender of­fers.  In this, Wall Street's ulti­mate arena, the participants only operate with an open throttle at appropriate times. 

     Tight money for acquisition purposes has caused a se­vere retrenchment in this group.  Such funds assemble blue ribbon staffs, or hire con­sultants, to perform the highly complex evaluation of every possible contingency. The staff may include lawyers, who advise on Justice Department impli­ca­tions,  actu­aries, who analyze the demogra­phy of the tar­get's stock­holders to predict the outcome of the vote on any given pro­posal, in­dustry  research specialists whose sole func­tion is to determine whether the target is,  indeed, "in play",[15] and whether a competi­tor may offer an increased price.  Bidders use the rating services to relate the in­vest­ment grade of the debt issued as part of the bidder's package to its worth in the mar­ketplace.  Most impor­tantly, the acquiring Company tends to tacitly co-opera­te with Hedge Funds, in resolving questions such as whether the bid may be changed or raised and under what circum­stances the paramour may lose all interest in its quarry.   The Hedge Fund's attorneys evaluate "poison pills", pro­tective state legisla­tion, and the suitor's chances of prevailing over these and other poten­tially insur­mountable road­blocks. "Golden para­chutes" are examined for le­gality, cost and potential rene­gotia­tion.

     When all of this esoteric data has been compiled, a mathematical model can be created that quantifies the  risks.  The model also predicts, within certain parameters,  what profit  the transaction will produce if it proceeds as anticipated as well as the potential down­side, should un­foreseen events occur.  On the basis of this risk/reward calculation, the bid­der can determine whether to buy, sell,    

short or conclude that the investment is not worth the gam­ble. [16]

     The incestuous relationship between Hedge Funds and the potential acquirers works well for both.  Stock ownership quickly flows from investors to speculators.  Equity hold­ings  in the target shift from loyal, long-term investors to speculators with an eye on short-term profits meas­ured in days or even hours.       

     The Hedge Fund model of the stock price of a target company is primarily based on three variables:  the likeli­hood that this or another similar transac­tion will take place, the time in which it will  probably occur, and the price at which the transac­tion could even­tually culminate.  When the Hedge Fund model coincides with the projected stock price, profits can be predicted with a fair degree of cer­tainty.  In view of the nominal holding period, very high annual­ized re­turns are the rule.

     In this forum, brokerage commissions are the price of admission.  Fees are one of the ubiquitous wild cards that make this activity a province that should be solely composed of pro­fessionals.   Transactions are exe­cuted for a commis­sion of pennies per share regard­less of the securities price.  It is this differ­ence alone that may  create the margin  be­tween profit and loss, logically barring all but the most misguided of amateur investors from this domain. 

     The public is generally unable to prevent  a calamity by hedging a deal using a combi­nation of  options, convert­ible securities, warrants, rights, or futures available to the Hedge Funds.  Esoteric securities products such as "down and out op­tions" [17]or "synthetics"[18] are also unknown and generally unavailable to the public, but a valuable tools used by pro­fessional trad­ers.  

     Having extensive holdings may require the borrowing of substantial quantities of the un­derlying or similar security to create the off­setting positions.  These instru­ments  may be in short supply and, usually under these circumstances, are loaned only to fa­vored cli­ents.  If secu­rities are en­tirely unavailable, hedges have often been created by na­ked[19]short or long sales through American Broker-dealers or foreign interme­diaries, without any consideration of de­livery.    

     Unlike Hedge Funds, the public also foregoes tax breaks by being unable to arbitrage.  Funds may obtain virtually risk-free tax re­lief by re­moving the unprofit­able leg of the  transaction  at year end and tem­porarily replacing it with the stock's synthetic.

     Rumors abound in this market place periodically, taking one of two forms.  "The deal will tank", or  "another higher bid is going to be made shortly."  These fables may circu­late figuratively at the twelfth hour and are usually incor­rect, often providing the un­scru­pulous with an escape valve from the potential failure of a trans­action.

3.  SELLING SHORT    

     Hedge funds whose primary purpose is selling short demonstrated ex­po­nen­tial growth during the eighties.  Prof­its are derived by identifying and short selling, ideally, a combination of thinly capitalized, theoretically overpriced securities, whose accountants may use questionable ac­count­ing practices. If there is something unsavory hiding in one or more of the corporate officers' background so much the better.  Add to the foregoing an undercapitalized invest­ment banker with a negative regulatory history along with a stock with a limited number of retail market makers,[20] leav­ing only one ingredient left to be mixed into the brew; an SEC investigation followed by a negative public relations cam­paign.  Under this scenario no matter how sig­nificant the company's product or how capable the manage­ment, the company would have little chance of  raising addi­tional public fund­ing in the foreseeable future. 

     Investors threw cash at these Hedge Funds, resulting in too much money chasing a lim­ited number of quality deals.  The ensuing decline in the caliber of investment, coupled with a series of critical miscalculations concerning market movements, resulted in substantial nega­tive growth.  This trend was not alleviated by a gradual leveling of the regu­latory playing field spurred on by Congressional Hearings, which investigated a host of charges brought by compa­nies that had become victims.  The Hedge Funds' high profiles also created abundant negative publicity, much of which concern­ing the manner in which these Funds conducted busi­ness, and contributed, albeit to a lesser degree, to a near flood of redemption's. 

     Al­though there are undoubtedly many exemplary inhabi­tants of the fi­nancial limbo of short sales,  the sobriquets "Mortician" or  "Undertaker"  are aptly ap­plied to some of the players. (In most cases, those names were chosen by the Hedge Fund itself, solely to add an un­nerving element to their victim's perception of their pow­ers.)  Once the target is identified, rumors and in­nuendo abound, at times prevent­ing tar­get companies from completing an exist­ing financ­ing or re-entering the capital markets.  The re­sult is often the destruction of what, under other cir­cum­stances, would have been a perfectly viable business.

     To prevent a recurrence of the market collapse of 1929 and to fore­close the possibility of "bear raids", it was determined that, on listed exchanges, se­curi­ties could not be sold short unless the last previous different way trade was lower than the short sale.  These regula­tions encom­passed the perceived loopholes within the then existing market environment.   The modifications did not include non-exchange traded securi­ties. At the time, unlisted securi­ties could not generally be sold short, as timely delivery was not possible.  Fully paid for shares, which were the non hy­pothicatable[21] property of their owner and could not be used for the set­tlement of a transaction.  With the advent of margin eligible OTC securi­ties, decades later, al­most all securities became lendable and could be shorted with reason­able impunity.  A regula­tory door had uninten­tionally been left ajar in an environment that could not have perceived the dramatic changes that would occur decades later in over-the-counter marketplace.   

     The Eleventh Report by the Committee on Government Operations states: "The com­mittee has found, however, that many of the reports of rumor-spreading abuse are entirely cred­ible and are strongly suggestive of abuse.  Moreover, the widespread nature of these reports and the high degree of similarity among them constitute a highly con­sistent pattern.  The committee finds, therefore, that a pattern of abusive and destruc­tive rumor mongering, targeted specifi­cally at companies in the equity se­curities of which some short-selling investors have established major short posi­tions, appears to be occurring."  The report continues: "This study has not been completed, but the evi­dence exam­ined so far suggests that naked short selling or its func­tional equivalent does occur in large volume in some equity issues."

     The Committee on Government Operations of the Securi­ties and Exchange Commission concluded: "The SEC has never, as far as the committee is aware, brought an enforcement case, or even sought seriously to investigate a case in which, the cen­tral allegation of abuse was the malicious dissemination of false or unverifiable nega­tive re­ports about a public company, its offi­cers, its products, or other matters that, if true or believed by investors, would be likely to influ­ence negatively the trading price of the company's stock."

     "For this reason, the committee finds substantial basis for concern that the SEC's policing of the fairness of the markets in this respect may not be adequate."

     The committee's concern regarding this aspect of the SEC's enforcement pro­gram is fur­ther heightened by the pre­pared testimony of Mr. Sturc for the SEC's Division of En­forcement.  In explaining why the SEC has not found it prac­tical to bring enforce­ment cases against short sellers in most instances, he stated: "Finally, many of the complaints we receive about alleged illegal short selling come from companies and cor­porate officers who are themselves under in­vestigation by the Commission or oth­ers for possible vio­lations of the securities and other laws.  When there is an obvious economic justification for short sales, it is ex­tremely difficult to prove:...(ii) the ma­terial false state­ment/omission and fraudulent intent requirements of Rule 10b-5.  This is particu­larly true in those situations where, for example, our investigation tends to show that at the time when short sellers were allegedly disseminating false rumors, in fact, the issuer was disseminating materi­ally false financial statements."

     The committee concluded that: "This statement by Mr. Sturc has the appearance of a de facto "no-action" assurance to short sellers concerning any actions they may take to disseminate false rumors about companies that are the object of SEC fraud in­vesti­gations."  Further the committee stated: "Finally, the committee finds that there has been an uncom­fortably close di­rect working relationship between certain un­known short sellers and the SEC enforcement staff."  The committee concludes that: "Regardless of the appropriate­ness, from an enforcement per­spective the investiga­tions opened regard­ing possible fraud by short-seller target com­panies,  the de facto working relationship between short sellers and the SEC enforcement staff has the ef­fect of providing bounties to the short sellers for their enforce­ment tips when the en­forcement investigations be­come known in the market."

     A strategic alli­ance between the Securities and Ex­change Commis­sion, vari­ous influen­tial financial publi­ca­tions, and Hedge Funds, has taken its toll on many emerging com­panies.  (The SEC has stated accurately that Hedge Funds provide valu­able research to the government in their effort to uncover violations.)  The Securities Acts of 1933 and 1934 omitted regulations that would have offered the same pro­tec­tion to over-the-counter securities that these regula­tions provide to historically higher priced and more ade­quately capi­tal­ized listed companies. Pecu­liarly, those entities that did not require increased regulation for their survival were granted it, while those that required protec­tion were ignored.  The regula­tors had unknowingly compro­mised an entire segment of the se­curities industry, thus making it susceptible to the same bear raids the Securities Acts had been formulated to eliminate.  This historic over­sight has been exacerbated by  the NASD's sluggish response in addressing these inequities.  The consequence of this regulatory foot drag­ging, has been the perpetuation of the ob­scene profits made by both the Hedge Funds engaged in these activities, as well as the broker-dealers that are the beneficiaries of the considerable commission in­come that is generated.

     Over-the-counter market makers have been indulged ex­cessively by regula­tors, concerning the delivery of securi­ties that they have sold short for their proprietary trading accounts.[22]  Within the over-the-counter market's "Alice In Wonderland" world of non-regulation, short sales are allowed on down ticks, marketmakers are not obligated to effectuate timely delivery, and reporting rules, in place for dec­ades on the exchanges are not considered necessary.  Even legal challenges have been  hampered  by anomalies in the securi­ties laws governing unlisted trading.  Self regulatory agen­cies, particularly the National Association of Securities Dealers, have been apathetic when it came to enacting the modifica­tions essential for the protection not only of pub­lic investors, but of the companies listed within the mar­ketplace.  These regulatory flaws have continued to en­able Hedge Funds to act with impu­nity.

     The Securities and Exchange Commission expresses some frus­tra­tion with re­spect to short selling when it states, "Restrictions on short sales (e.g., selling an in­dex future without owning the underlying com­ponent stocks) have never been imposed on options and futures prod­ucts.  Moreover, the difficul­ties of extending such restric­tions to options and futures prod­ucts would be substantial.  The Commission's short sale rule, Rule 10a-1 un­der the Exchange  Act prohib­its persons from selling stocks short at a price below the last sale price (minus tick) or when the last trade in­volv­ing a change in price was a minus tick.  

     A futures or options trader who sells short on a minus tick is simply re­spond­ing to price declines in the cash in­dex.  A short sale re­striction that takes into ac­count move­ments in the un­derlying cash index would be ex­tremely com­plicated and would impose substantial compliance burdens and risks on traders.  Nevertheless, the absence of short sale restrictions, coupled with the greater leverage of futures argu­ably presents the potential for greater speculative selling than could occur in the stock market." (Nowhere does the SEC address the fact that one does not need to be hedg­ing to sell indexes short.  This represents a clear viola­tion of the intent that regulators have  ap­plied to the listed exchanges.)

     A unique technique for permitting the public uncon­strained  access into the short selling arena without con­cern for normal regulations, was recently the subject of a Wall Street Journal Article: "At a time when many investors are wondering if stock prices are too high, Fidelity In­vestments is reviving a program that allows in­vestors to bet on the share price declines in 10 stock market sectors.

     The giant Boston mutual fund company is letting its discount-brokerage cus­tomers short-sell a fistful of Fidel­ity's 35 Select mutual funds, each of which invest in a single industry group.  Just as in shorting a regular stock, investors can sell bor­rowed shares of the 10 earmarked funds, hoping to profit by later repurchasing the fund shares at a lower price.

     The most popular funds for shorting at this moment are Fidelity's three health care specialty funds: Select Biotechnology, Select Health Care and Select Medical Deliv­ery.  These three ac­count for more than 90% of the $6.5 million in mutual-fund short posi­tions held by Fidelity Bro­kerage Services customers.

     Along with Fidelity, mutual fund short-selling is also offered by Jack White & Co., the San Diego discount broker­age firm.  Jack White offers approximately 100 funds for short selling, includ­ing funds from Janus Group, T. Rowe Price Associates and Twentieth Century Investors."

     As a consequence of recent hearings held by the House Commerce, Consumer and Monetary Affairs Sub Committee, mo­mentum toward the creation of a more level regula­tory play­ing field seems to be developing. 

4.  ACQUISITION OF COMPANIES     Many Hedge Funds have chosen the purchase of "deal stocks"[23] as their milieu. Will the deal print?  What is the probability of a higher of­fer?  Acquisition-oriented Hedge Funds have benefited from their own sub­stan­tive internal research, industry forecasts, and in-house capability to evaluate the spectrum of ele­ments comprising these remark­ably complex transactions.  The clout provided by the gen­eration of enormous commissions, provides access to "the Street's" highly techni­cal institu­tional re­search and so­phisticated cor­porate fi­nance generated analy­sis.  The Hedge Funds' pro­pinquity to fi­nancing and their capability of pay­ing  the massive success fees investment bankers require for the provision of capital, gives them ac­cess to any American publicly traded Company.  Many of today's corporate Chief Executive Offi­cers started out as Hedge Fund manag­ers, domi­nating  as­sets that later allowed an or­derly evolution into corporate raiding.  As a result these CEO's now control many highly lev­er­aged public and  pri­vate companies.  Some of the largest, most rapidly accumulated fortunes in America have been assembled by (and for) Hedge Fund managers.

    On occasion, an acquisition may be the consequence of a miscalculation.  A number of proxy battles have arisen  from  "greenmail", Wall Street's generic term for blackmail.  By as­sembling large quantities of the securities in an ostensi­ble target and simultaneously transmitting ominous sig­nals, the Company's management will often pay a bounty to convince its unwelcome suitor to back off.  Occasionally the bluff is called and the pseudo acquirer is obliged to proceed or suffer a substantial financial setback and, potentially more damaging, the loss of face.  In these skirmishes the target is frequently critically injured even though the aggressor has been vanquished.  The converse is also true; the Hedge Fund may have won a Pyrrhic victory.  An in­escapable conse­quence of this form of financial combat is a crippled target and a lower stock price.  The Company may be left noncom­petitive, saddled with debt and generally far less valuable.  No matter what the eventual outcome,  the reality is that the attorneys invariably profit while the stock­holders as­suredly will lose.[24] 

     When the ranch has been wagered on the outcome of a deal that later aborts, passive Hedge Funds are often mys­ti­cally transformed into "Deal Hedge Funds". Either the loss may be unacceptably large, or the elimination of the main pursuer may cause a substantial contraction in the securi­ties price, impinging upon the Fund's performance, thus, the investor, out of necessity, may well turn out to be the eventual acquirer.

     Hedge Funds have been embroiled in a substantial number of the recent, large, unfriendly corporate public acquisi­tions.  Their inti­mate knowledge of "The Street" and

its nuances provide them ready access to financing, often initiated by hungry investment bankers.  The latter may well have identified the target, pro­posed  the deal, fabricated the blueprint, and then provided the funds to pro­ceed.   

     The demise of junk bonds and the overall dismal plight of American Banking has virtually brought this activity to a standstill.  In spite of Wall Street's current record prof­itability, there are currently more out of work investment bankers than at any time in financial history.

5.  HEDGING (ARBITRAGE)

     Since we have had financial markets, anomalies have oc­curred within two or more classes of similar securities issued by the same company.   The equivalent is also true of compa­rable companies within  indus­try groups as well as the various debt instruments issued by the same or equivalent issuers.  By establishing a long position in one instrument and the simultaneous shorting of its equivalent, within a limited time, these  anoma­lies customarily disap­pear, and the se­curities once more re­sume trading within their his­toric re­lationships.  The SEC Staff Report the October 1987 Market Break stated that, "Under normal market conditions, any sig­nificant deviation from theo­retical value for more than a few minutes results in arbi­trage programs that act to reduce the premium or discount".  Gains tend to be small, but frequent, and inas­much as the transactions are so highly leveraged, minute aberrations usually result in substantial profits relative to the ac­tual equity invested. 

     Arbitrage requires liquidity and functions most effec­tively in markets having a substantial degree of public participation.  For the most part it is a general lack of sophistication within this group that gives birth to the distortions essential for pure arbitrage to recur often enough to pro­vide a comfortable living for the many people engaged in this activity.

     With the advent of publicly traded options, additional opportuni­ties emerged, bringing with them infinite permu­tations and combinations.  Puts, calls, convertible securi­ties, along with rights, warrants, synthetics and deriva­tive index products provided previously unimag­ined vari­ations for the participants. For a time, the complexity of these com­bi­nations played havoc with margin re­quire­ments. For example, Hedge Funds, acting as Arbitra­geurs, might purchase an "in the money"[25] call at a negli­gible premium, and simul­tane­ously sell the se­curity.  The arbi­tra­geur  avoids losses by re­ceiving the stock loan rebate,  and if the stock value de­clines,  he stands to make sub­stantial prof­its.

     There currently exists some type of financial instru­ment designed to prevent just about any conceiv­able market loss.  Some derivative products have been designed to create portfolio insurance.[26]  The SEC when reporting on the ef­fect of derivatives as they interrelated to the Oc­tober, l987 market decline stated, "In reviewing the events of October 1987, it is important to emphasize that the in­creased con­centration of trading in the derivative index products is not at­tributable only to portfolio insurers.  While more dif­ficult to quantify, we believe that low execu­tion cost and margin requirements for de­rivative index prod­ucts have encouraged a wider group of institutions to depend on the liquidity of the index futures markets to liquidate substan­tial por­tions of their equity portfolio more quickly than they would be able to through the stock market.  As dem­onstrated on October 19, however, the assumed liquidity levels of the futures market be­came dramatically lower dur­ing a market plunge resulting in large futures price dis­counts and spillover stock selling."

     The latest entrant in an already crowded field is a creation of the Chicago Board of Trade labeled a "Cap".  Caps guard against a drop of 30 points in the Standard and Poor's 100 stock index over a three month period.  New to the fixed income arena is the  Chicago Board of Op­tions Exchange's Long-Term Interest Rate Option or LTX which of­fers impunity against certain interest rate changes. These, and other types of hedging, were described in the Forbes issue of October 23, 1989 about S. Donald Sussman, General Partner of Poloma  Partners, which at the time was a $400 million Hedge Fund:  "Since June ('89) for instance, he has been buy­ing  Del Webb Corpora­tion's con­vertible debentures and shorting the company's com­mon stock.  If  Del Web­b's stock falls, Sussman will make heaps of money on the short  sale, but won't lose too much on the convertible debenture, be­cause the bond's price [sic] supported by its 10 3/8% cou­pon.  But if the stock takes off, the convertible is likely to get as big a kick as the stock because of the bond's conversion privilege."

     "Not only do Sussman's clients stand to win whatever the stock price, they also pick up the coupons on the bond and make money from the short rebate."  Sussman indicated that he has achieved returns of over 20% a year at the level of risk associ­ated with T Bills."[27]

     This is a precise example of what is referred to in "Street" parlance as a bonafide arbi­trage.  Margin require­ments only require the deposit of nominal amounts of cash or securities when it appears that both sides of a transaction are equivalent, and that, to a substantial degree, what occurs to one segment will also occur to the other.  The appreciation that Mr. Sussman al­ludes to usually necessi­tates substantial lever­age.  An example used by the SEC provides in­sight into this.  "The impact of current margin lev­els is that an institution could use the SPZ fu­tures contract to es­tablish a speculative long position in order to increase quickly its stock portfo­lio po­sition, or a speculator could buy or sell the SPZ futures contract, and with a margin deposit of $1 million, could control a stock-equivalent position of over $8 million.  Similarly, a port­folio in­surer or other institution wishing to adjust its portfolio quickly through the sale of fu­tures could create a hedged short futures position with a market value exceeding $12 million, with the same $1 million deposit.  This is sig­nificantly higher leverage than can be achieved under stock margin requirements.  Moreover, the increasing popularity of index substitution, index arbitrage, and portfo­lio insur­ance, has resulted in an increas­ingly greater percentage of futures positions being taken precisely for the purpose of replicating cash market stock positions.[28]

     In contrast to the securities markets, fu­tures markets are not subject to federal margin levels.  The CFTC[29] has authority to pre­scribe margin levels for futures only in emergency situ­ations.  Otherwise margin levels are set by the commodities exchanges."

     Stock loan rebates substantially increase transactional profitability with the po­tential re­sultant income factored into the financial model.  Depending on the ratio of finan­cial instruments that are long and short, it is conceivable that even a failed deal may be profitable for the investor.  Stock loan rebates are virtually un­known and, for the most part, un­avail­able to the public.  

     Stock loan income may provide a fail-safe to arbitrage transactions.  Hardly under­stood, even on Wall Street, stock loan activity enjoys a sinister reputation.  Only re­cently has it been fully in­tegrated into the general back office function of most brokerage firms.  Other broker­age firms still prefer to deal through intermediaries rather than in­sti­tute their own de­partments, further narrowing the member­ship of a  misunderstood, exclusive club.

     By operating stock loan as stand-alone or brokered fa­cilities, and failing to inte­grate ar­bitrage and stock loan into a common function, canny traders were able to take advantage of their less knowl­edgeable associates.   Stock loan de­partments make mas­sive profits, often to the disad­vantage of competing in-house di­visions, and still represent a virtual wilderness of regula­tion.  The undis­closed fringe benefits avail­able to entrepreneurs that wheel and deal in the lend­ing of securities make them among Wall Street's highest paid "professionals", both on and off the books.

6.  EXEMPT SECURITIES

     The more aggressive Hedge Funds are willing to specu­late on almost any  securities transaction.  Although they may not be ordinarily consid­ered a component of the Hedge Fund ar­se­nal,  Government Securities and commodities present unique opportunities and contrasted to other investment vehicles.  Control can be gained over prodigious quan­tities of  se­curities by  using insignificant expendi­tures of capi­tal.  Normal margin re­quirements do not apply to unregulated securities, (Government Issues) and the amount of money or collat­eral that is re­quired will vary from brokerage house to bro­kerage house and from client to client.  Margin re­quirements are a matter of negotia­tion and clout, varying dramatically.  Obviously Hedge Funds fall into a most fa­vored status in margin negotia­tions. Commodity margins, although more formal, are elastic, and relatively insignifi­cant equity is re­quired to enter into a futures transaction.

     Until May 1991, the Government granted primary dealers

impunity in connection with various types of trading irregu­larities.[30]  The perception by the Government was that this trade off would continue to aid in the maintenance of an extremely liquid mar­ketplace for its securities. This was believed necessary for the continued issuance of substantial quantities of Federal debt.  Primary dealers have an af­firmative obligation to consistently maintain substantive two way markets to preserve their primary dealer status.  A number of firms have dropped out recently due to mergers.  Trading losses caused by obligations to trade even under undesirable conditions have created an even greater toll.  Although a still much desired status, primary dealership is no longer a license to print money, especially if one is not a member of the ruling, inner circle.[31]      

     Three Hedge Funds, Quantum Fund, Tiger Fund and Stein­hardt Partners, along with Salomon, bought $10.6 billion of the $11.3 billion, May 1991, two-year, Treasury note issue.  This action effectively cornered[32] the market, creating substantial trading loses among competing dealers.  Simulta­neously, it increased the cost to the Government and tax payers in floating this issue.  Considering that the Hedge Funds which were embroiled in the re­cent Solomon  scandal are neither the most ag­gressive nor  the most ac­complished in Gov­ernment Securi­ties trading,  it is unlikely that this inci­dent oc­curred in a vacuum.  Professor John R. Coffee,[33] stated: "Financing ar­rangements such as the kind the Stein­hardt Partners is said to have requested from Salomon could serve as a vehicle for tacit collusion."[34]  This incident changed the manner in which the Government and the public perceived primary dealers.  Whether regulators were com­pelled to take action due to the accusations lodged by dis­gruntled competition, or the feeling that the American pub­lic would no longer countenance the ongoing  blatant disre­gard for regulation exhibited by dealers conducting business within the Treasury Markets, the incidents surrounding the May 1991 "Bill Auction",  will cause the primary dealer community to straighten up their act, and play by the rules, at least for a time.      

     These Hedge Fund Managers did not wake up one morning and say to each other, "let's corner the Gov­ern­ment Se­curi­ties Markets".  It is certain that if the transaction could have been cornered in house without having to share the spoils with outsiders,  Salomon would have done so.  Al­though it may seem hard to believe, the issue was not the $11 billion, which could have been handled internally.  Outside clients were necessary to complete the sham and make it appear legitimate. 

     A November 1,1991 memorandum to Hays Gorey Jr., from The Department of Justice stated: "It was recently reported that prior to the April note auction a dozen Wall Street professionals met and discussed, among other things, the up­coming two year Treasury auction.  The group in­cluded repre­sen­tatives of Steinhardt Partners (Michael Steinhardt), the Caxton firm (Bruce Kovner and Scott Luttrell) and others who purchased substantial amounts of April and May two year notes." According to another article, bidding information was routinely shared among primary dealers.

     Assuming, arguendo, that no collusion occurred, there is still no apparent mo­tive for mar­ket-cornering unless more than just transac­tional benefits were ex­changed.  Obviously, the many variables within a transaction, such as commission, can be adjusted to recapture a portion of the spoils, or conceiv­ably an outstanding chit had been called. (The Treas­ury limits any purchaser to 35% of the auction's total.  To the extent that a dealer is acting as an agent for others, such pur­chases are not in­cluded in the total).      

     Professor John R. Coffee also reports the following:  "Perhaps the oddest cir­cum­stance surrounding the standard operating behavior of Salomon  (and probably other firms) is that it often did not charge any retail spread to its larg­est customers because it wanted their business in order to learn the volume and price level of their bids.  In ef­fect, Salomon was paying (by forego­ing the customary spread) to learn the terms of competing bids from its own customers.  This fact underscores the anomaly (and fun­damental conflict of interest) in securities firms being both agents for cus­tomers and bidders for their own accounts at the same time.  In truth, the position of the largest primary dealers resem­bles that of the specialist on a stock exchange; the spe­cialist knows from its book of limit orders what the likely future direction of trading will be.  As a result, the secu­rities laws subject the specialist to a negative ob­ligation not to trade, except to the extent necessary to maintain a "fair and orderly" market.  In con­trast, primary dealers are subject to no similar limitation and in fact constantly trade for their own accounts."

     At least one source has laid the blame for the recent Government trading scan­dal upon Lib­erty Brokers, "A bond bro­kerage firm owned by Salomon and several other large primary deal­ers.  It shows (the memorandum) how Liberty's favorit­ism, towards its joint venture parents, dis­torts the market to the detriment of the other partici­pants therein.  It demonstrates how the transmission of certain information can be used to increase the interest rate the Government pays, to provide profit making op­portunities for large deal­ers who receive such information at the expense of other dealers and investors in the market, and otherwise to create anti-com­petitive distor­tions. It con­cludes that the current struc­ture of the market, with Liberty being owned by the major primary dealers, encourages collusion and competitive dis­tortions, and urges that the present investigation be fo­cused on the conduct which the structure suggests is indica­tive of violations of the antitrust laws and portends future structural changes which will render the anti-competitive consequences even more dire."  This memorandum of November 1,1991 to the Justice Department, suggests that Liberty engaged in improper transmission of infor­mation which gave an unfair ad­vantage to its owners.

     The peculiar element in the May 1991 transaction was only that, when the  Govern­ment raided the chicken coop they accidentally caught a couple of turkeys that had made a wrong turn.  The "Treasury" had  suddenly changed the rules of the game at the most inoppor­tune of moments.  One would al­most believe that Salomon dealer had somehow stepped on the wrong toes, once to often and "The Street" fed the firm to the wolves at the most em­barrassing time pos­sible.  Pure chance could not have produced these strange bedfel­lows. It is doubtful that the Hedge Funds in­volved in the deal either originated or orches­trated it.   

     All unregulated commodities  create the same market-cornering opportunities  that oc­curred in the Solomon mat­ter.  Hedge Funds will again strike in unfamiliar ven­ues   potentially reaping havoc as the Hunts did in the silver market.  You can wa­ger, however, that the plan for the trans­ac­tion  will have been  created  else­where.  These people did not be­come extremely af­fluent by playing all their games on the road.

7.  PRECIPITATING DECLINES IN FALLING MARKETS

     During the October 1987 market crash, Hedge Funds may, as some have al­leged, have added fuel to the fire by selling into a decimated market.  The logic of this alle­gation, as it relates to listed securities, however, seems highly flawed.  It would appear much more reasonable to take advan­tage of a panic to cover short positions at un­usually favor­able prices.  Like any other in­vestor, a Hedge Fund sells its securities to avoid the conse­quences of market erosion.  I have seen no allegations that during the October 1987 crash, Hedge Funds illegally sold short selec­tively on down  ticks within a group of stocks in which they were already short.  This would have been illegal, unless the trans­action  was executed in the over the counter mar­kets. (This is not to say that this isn't the modus operandi for many Hedge Funds. Piling on, bear raids and rumors are part and parcel of their way of life.  The circumstances existing in October of 1987 hardly required any additional help from this group, having been presented a spectacular opportunity to cover their shorts, not to enlarge them.)  

     The breed of Hedge Fund that primarily deals in over the counter securities does not traf­fic in broad market issues, but concentrates within a group of stocks that it has extensively researched.

     Hedge Funds would be more likely to use the over the counter market in a panic due to its lack of regulation, and illi­quidity to le­gally cause margin calls and liquidations.   In view of this, the overall October 1987 market collapse, should, perhaps, be blamed on the use of indexing, the fail­ure of the spe­cialist system, irregularities in the OTC marketmaking system, along with a generally dismal business outlook, rather than Hedge Fund activity.                                              

8.  CONFLICTS BETWEEN PROFITS AND REGULATION IN OFF      SHORE FUNDS       

     Hedge Funds' extraordinary growth in the eighties was, in large measure, due to the enormous profits that they generated for their principals. Global Asset Management has over $4 billion under allocated management and is the larg­est of Multi-man­aged funds, using over 60 different manag­ers.  Many ceased accepting investors' funds, concerned that managing too much money could cause them to become unwieldy and unable to  maintain the historically high re­turns that their investors had come to expect.   

     Hypothetically, the limited partner would re­ceive a preferred re­turn off the top.  (i.e 8 1/2%) and a 50/50 split of the profits, or 20% of the profits and various assorted fixed management fees. Annual growth rates of the more successful  types of these funds during the 80's were no less than 20% per year.  Assuming a $100,000,000 fund earning $20,000,000, in the first instance it would throw off  over 14% to the limiteds and al­most $6.000,000 per year to the general partner.  In the second more common ex­ample, the manager would receive $4,000,000 and the limited a 16% return. There are nuances in each example, attributable to variations in fees and the non-participation of managers in losses.       

     Should the size and/or activity of  Hedge Funds be regulated?  As­suming that these pa­rameters can be defined, how are Hedge Funds to be pre­vented from moving offshore, in search of more lenient securities regulations?  Some of the household names in fund man­age­ment such  as Fidelity, Scud­der, Alliance Capital Management, Putnam and Merrill Lynch are advising and/or managing Off Shore Funds.  Optima Fund Management successfully took their Fund of Funds con­cept overseas through a Bermuda-based vehicle.  Its twelve manag­ers comprise the Who's Who of the American Hedge Fund Indus­try, including noted short seller James Chanos.  His Op­tima Futures Fund, Ltd., another offshore vehicle, was set up solely to short American se­cu­rities.

     Offshore funds are not constrained relative to the aggregate number of investors they can rep­resent, nor are they constrained by capital gains taxes.  Additionally,  the European Eco­nomic Community's relaxed regu­lations on cross-border sales, under which a registration in one country is accepted in all, result in ease of entry and provide the capability of establishing busi­nesses within time frames inaccessible to institutions subject to U.S. se­curities regulations.  Sur­prisingly, the liberal EEC regulations will soon apply to American funds, that do business in Europe as well. 

     The cliché that "the world has become much smaller" is more meaningful within the fi­nancial arena than in any other.  Global mar­kets coupled, with round the clock trad­ing, create an environment in which  U. S. regulators may  soon have insignificant impact even with respect to the functioning of our securities markets. Whenever there are rules, there invariably are techniques to circumvent them, especially when the potential return is such a tantalizing prize.  Securities laws, un­less internationally adminis­tered, will at best have trivial significance.   World mar­kets are far more sophisticated than those of two decades ago when IOS was allowed to run amuck, but this time, the shoe may be on the other foot.  Archaic American securities laws may be our undo­ing in the global marketplace.   These regulations were cre­ated in an environment of isola­tionism and pro­tectionism and have not changed to keep pace with the cur­rent dynamics of the global economic environment. Regulators are on the horns of a dilemma; by moderating  regulations to remain competitive with international securi­ties markets we will be compromising many of the laws that were enacted as a result of 1929 crash and ensuing global depression.

A shift towards the liberalization[35] of our securities markets could imperil the investing public and eliminate the more level playing field enacted in the 30's.  By not con­forming to the world's more gener­ally relaxed  regulatory environment we are running the risk of perceptibly eroding this country's great­est resource, the American Securities Markets.  The market's historic liquidity, coupled with the flexible approach essential to promptly respond to the in­vestment community's ever-changing appetite for the indis­pensable financial products are essential in under­writing the continued growth of this country.   The capitalism that separated us from the remain­der of the world is no longer solely our province.  In less then one decade we have wit­nessed a dramatic change within the global capital raising process.  Stock markets, almost unheard of  scant years ago, are now active throughout the Pacific Rim, Eastern Europe, and South Amer­ica. They potentially offer to their own in­vestment communities the economic muscle  once pe­culiar to this nation, which facilitated the financial growth that made our country the economic power it has become.    The correct answer may only exist retrospectively and already we no longer may be the masters of our destiny. 

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