Dead Companies Walking

by Scott Fearon

  When I was at GT Capital, I told my bosses I didn’t want to make this mistake. I warned them that if they kept bringing in new investors, my returns would drop. But they refused to listen. I knew my situation was hopeless when I found out they had hired a legendary boiler room brokerage in Denver to market my funds. The place’s name was Blinder, Robinson but everybody called them “Blind ’em and Rob ’em.” They were a western version of old-school penny promoters like First Jersey Securities or the now-famous Wolf of Wall Street’s Stratton Oakmont, and they made their money the same way—by hawking dubious stocks to gullible investors. As soon as I learned that the higher-ups at GT had contracted with such a sleazy outfit, I immediately started looking for another job. It was abundantly clear to me that GT, like every other Wall Street firm, was only interested in vacuuming up as many assets as they could, even if it meant hurting their own customers.

  The things I’ve been talking about in this chapter are not foreign to most people in my industry. Far from it. They’re the worst-kept secrets in the financial world. Deep down, everybody knows that, just like corporations, more investments fail than succeed. Deep down, everybody knows that Wall Street brokerages routinely push bad investments to maximize their profits. And, deep down, everybody knows that overgrowing assets is bad for performance.

  To borrow a phrase, these are inconvenient truths for my business. We all know them, yet most of us desperately try to pretend that we don’t. But that doesn’t mean they’re not real or that they don’t have very real consequences—and not just for individual investors or people in the investment business. These inconvenient truths are bad for our whole society.

  Think about how bigger assets hurt performance. It’s no wonder nobody in the financial world wants to admit this. Doing so would not only cost them money, it would force them to admit an even larger, more inconvenient truth: unlike the best companies in the private sector, Wall Street often produces products that cannot scale. Let me explain what I mean. Microsoft’s Windows operating system or Amazon’s online bookselling platform are massively scalable inventions. The more customers they reach, the more profits they bring in, without sacrificing any of the quality they give to the consumers who use them. Conversely, the more customers Wall Street firms bring in to their investment vehicles, the poorer those products perform. Imagine if that happened with a new smartphone. As more people bought the phone, the quality of its service declined. How long do you think the company producing that phone would survive? And yet, year after year, Big Finance continues to reap massive profits—not for its clients, of course, but for itself.

  The asset-size paradox isn’t the only thing that separates Wall Street from the rest of the private sector. Can you think of another business in the world that would continue to exist as a going concern even after it had been proven definitively—as John Bogle of Vanguard proved about the financial industry—that most of its products are vastly inferior to other, cheaper alternatives like index funds? I can’t. How about a business whose most prestigious firms have been caught defrauding their own customers not once, but over and over again? In the normal corporate world, would such a business not only continue to operate, but actually make more and more money every year? Of course not. It would be long dead by now. And yet deceiving its clients and foisting inferior and even fraudulent products on them is exactly how Wall Street stays in business!

  Hedged

  After all my talk of Wall Street types making poor investors, you might think I would keep my money strictly in index funds. But that’s not case. I’m proud to say that, unlike some of my peers in the business, I keep almost all of my money in my own hedge fund. I’ve also made a practice of putting a little bit into other hedge funds, as well, usually ones that are just starting out. I know what it’s like trying to get a new venture off the ground, so I like to help people out. Some of these newcomers wind up earning great returns for me. Others, not so much.

  In 2005, I invested $100,000 with someone who lived near me and went to the same church I (occasionally) attend. He seemed like a smart, straight-shooting guy. He was affable and confident in his abilities, so I figured, Why not give him a chance and see what he could do?

  It turned out what he could do was separate me from my money.

  I’d always heard about the sleazy tricks fund managers use to fleece their investors. But I’d never been on the business end of any of them personally until I signed over that money to my former friend.

  The first thing that worried me was that he bought a lot of dodgy green energy companies brought public by an investment bank run by a Silicon Valley promoter named Laird Cagan. We’re talking about pure “story” stocks, companies whose only assets were a couple of engineering PhDs and—maybe—a patent or two. To be honest, I was ready to write my investment off when I saw those stocks in the audited financials. But to my pleasant surprise, my friend’s picks actually did pretty well. By early 2008, only a couple years after I’d signed over my 100K to him, my stake had more than tripled, at least on paper.

  I met up with my friend that summer, and I told him that while I was thrilled with his performance so far, I didn’t feel good about the direction of the markets. This was a few months after Bear Stearns had crashed and burned. Things were getting dire, and I urged him to start shorting stocks, something he had always been reluctant to do.

  “You’re running a hedge fund,” I said. “Now’s the time to start hedging.”

  He gave me a bashful smile and shook his head. “You’re right—the markets are looking iffy, Scott,” he said. “But, trust me, we’ve done our homework. The companies we own are going to keep going up even if everything else crashes.”

  You can probably guess how I reacted to his optimistic prediction. The next day, I wrote him an email requesting a $150,000 redemption. With the way things were looking in those days, what I really wanted to do was take everything out of his fund and put it under the nearest mattress. But I figured withdrawing that much would at least allow me to get my money back, plus a nice 50 percent return. As for the rest, I was ready to sacrifice it on the altar of my friend’s naiveté. That is, until he had the nerve to refuse my redemption request.

  After not hearing from him for an entire week following my first email, I wrote him by snail mail with my banking details and instructions for wiring the money. Two days later, a letter arrived in the mail—and what a letter it was. My friend’s fund was quite small as far as hedge funds go. He only had about $7 million under management. But what he lacked in size, he made up for in chutzpah.

  “As you know,” he wrote, “the timing of making a distribution to you is a function of complying with the appropriate ratio of retirement funds to non-retirement funds in the fund—no more than twenty-five percent of the fund can be invested in retirement accounts. Since we are very close to this ratio, I will have to attract new investors that are non-retirement accounts in order to maintain the proper ratio before I can make a distribution to you.”

  Spiked

  In 2010, the owner of the Cleveland Browns tried to take his money out of a hedge fund, only to be told that a provision in his investment contract prevented redemptions that amounted to more than 20 percent of the fund’s assets. That was a serious problem because, as it turned out, he was the only investor in the fund! So, according to that provision, because the managers of the fund had done such a poor job of attracting other investors, the Browns owner was obligated to keep his money in their hands . . . forever!

  No, Franz Kafka did not come back from the dead and go into the investment business. This was a fund managed by a perfectly respectable husband-and-wife team with Ivy League degrees and extensive experience in the financial world.* Unfortunately, those kinds of credentials do not guarantee success or integrity. The Browns owner sued the couple, and a judge ordered the return of his investment.

  *Peg Brickley, “
Cleveland Browns Owner on Offense Against Hedge Fund,” Wall Street Journal, March 8, 2011.

  If you’ve never invested in a hedge fund, or at least tried to pull your money out of one, this passage probably sounds like a bunch of nonsense. That’s because it is. Like a lot of hedge fund managers, my friend had placed an absurdly long ninety-day waiting period on redemptions. But even that was not enough for him. Even with three months’ notice, he still couldn’t or simply didn’t want to come up with my money, so he concocted this bunkum about maintaining a percentage of retirement accounts under management. Unfortunately, this has become standard practice in my industry. It’s shocking how many hedge funds “gate” their investors by inventing all kinds of legalese excuses to refuse redemptions.

  In his letter to me, my former friend not only politely refused to give me back my own money, he also served notice that, if and when he did get around to giving it back to me, he was planning to do so, at least in part, in the form of securities. Now, that might have been acceptable if he were talking about shares of easily tradable companies like AT&T or Intel. But as I’ve already said, my friend owned some pretty sketchy stocks—and a lot of them were about as liquid as Death Valley in the middle of July. I sent him a very blunt email informing him that I was not going to be pleased if he gave me stocks instead of cash. So, what did he do? He stuck me with a bunch of illiquid positions—specifically, over ten thousand “legend” shares of a company known at the time as AE Biofuels (stock symbol: AEBF).

  If you don’t know what legend shares are, they are stocks given or sold to insiders, and they almost always come with restrictions on when or how they can be sold. The AE Biofuels shares my friend gave me weren’t allowed to be traded until late December of that year. So not only did I have to wait three months to get my money out of his fund, I then had to wait another three months to turn the shares he gave me into cash. I was so angry about getting a bunch of unsellable stock, I immediately demanded another $100,000 from him. This time, he responded with ten thousand in cash and another 19,400 legend shares of, you guessed it, AE Biofuels. That meant I now owned a total of 30,114 shares of more or less worthless pieces of paper.

  Here’s the thing about legend shares: companies are required to notify the public when a bunch of them are about to come onto the market, and the minute they do so, the stock price almost always crashes. When I received my first batch of AE Biofuels shares in September, they were trading for around $7. By early December, after I’d gotten the next slug of them, the price was down to $3.35. Then, on December 10, the company noted in an SEC filing that “a significant number” of legend shares were about to become eligible for sale. Not surprisingly, investors sold off AEBF in droves. By the time I was legally permitted to try to offload my holdings, the price was down to, get this, 42 cents!

  Performance Enhancement

  It hurts to lose tens of thousands of dollars. It hurts a lot, especially when my friend’s own legally audited reports said I had actually made hundreds of thousands. But there are always risks when you make a new investment. And it’s not like I can’t afford to lose some money. I can. What galls me is how easy it was for him to screw me over and how routine this behavior is in the financial world.

  There are countless tricks that brokers and money managers have mastered to pad their stats and separate their clients from their money. New ones get invented all the time. Back in the dotcom days, fund managers would stash hot IPO shares they’d get from brokerage houses into separate, personal accounts. More recently, managers have been paying top dollar for “research” from so-called expert networks of current and former employees at public companies—research that almost always includes blatant inside information on things like pending earnings reports. This is what got hedge fund manager Steven Cohen in trouble in 2013. It also brought down the multibillion-dollar Galleon Group fund in 2009.

  The only limits on these kinds of shenanigans are the depths of shady managers’ imaginations and the shallowness of their morals. In other words, there are no limits. We’re talking about people who possess a very dangerous combination of character traits: they’re intelligent, unscrupulous, and greedy. Not all of their schemes involve out-and-out theft or clearly illegal behavior. But they’re still a long way from kosher.

  One of the things that still gets me riled up about my experience with my former friend is that, to receive all those worthless AE Biofuels shares, I had to open up my own personal brokerage account. I still haven’t sold them, and to this day they are the only stocks in that account. It just about makes me sick when I get my statements every month. You may be wondering why opening an account would be so upsetting for me, and why I haven’t put any other stocks in there to offset those terrible AEBF shares. The answer is, it’s a matter of principle. As I said, besides my occasional investment in other hedge funds, I keep almost all of my money in my own fund. I’m very proud of this fact, not only because it means I’m willing to risk my own wealth on the trades I make for my investors but because it shows that I’m not engaging in probably the oldest and most popular bit of legerdemain in my business: front running.

  Imagine you’re a money manager with a couple hundred million dollars of other people’s capital at your disposal. Now imagine that you’re planning to buy a large stake in Acme Incorporated, which is running $10 a share. You think it’s going higher, so you decide you’re going to put $5 million of your clients’ money into it. But before you do that, you call up your own personal broker and you say, “I would like ten thousand shares of Acme Inc.,” and then you wait until your own trade is done before you pull the trigger on behalf of your mutual fund or your hedge fund.

  Now, a $5 million buy is inevitably going to bid up Acme Inc., at least in the short term. Maybe it’ll only go up a couple cents if Acme happens to be a larger, more liquid concern. But if it’s a less-frequently traded stock, that investment could lift the price as much as a few dollars. Whatever it is, you watch the tape until you figure that the bump from your fund’s investment has maxed out, then you quietly call your personal broker again and tell him to unload your stake. Let’s say in Acme’s case, the stock rises one whole point before you cash out. Congratulations—you just made $10,000 in a matter of hours. And all you had to do for it was make a few phone calls.

  Front running has been out of control for a long, long time—and nothing’s changed. There are guys in my industry, guys I know personally, guys who are some of the most prominent citizens in the Bay Area, who have been front running for decades. The father-in-law of a prominent Northern California politician was an infamous front runner. It was probably the worst-kept secret in Marin County. Everybody knew he was pocketing hundreds of thousands, maybe even millions, by using his clients’ funds to juice up his own trades. But nobody gave a damn.

  Front running might seem like a victimless crime, but it’s far from it. How can anyone be sure front runners are making the best trades for their investors? Who’s to say they aren’t buying stocks based on how susceptible they are to rising on a big buy order? They might actually be buying into terrible companies that have no chance of succeeding in the long run. If the stocks sink, why should a front runner care? They’ve already made their cut. And what about all the honest investors out there who are scouting stocks based on old-fashioned things like earnings and growth? If you’ve got fund managers out there jacking up share prices with millions of dollars in other peoples’ capital purely for their own benefit, those metrics mean less and less. Pretty soon, the whole financial system gets warped. Money management isn’t about finding quality investments anymore, it’s all about short-term gains. And it’s not about assessing and managing risk because there is no risk for a front runner! They’re virtually guaranteed a profit. That’s called a rigged game, and it’s the exact opposite of what a fair and free market is supposed to be.

  There is a more fundamental reason why I care about shady practices li
ke front running in my industry. It has to do with simple fairness and professionalism. As money managers, our customers trust us with their livelihoods, the wealth they have built to sustain themselves and their families. We charge them enormous amounts of money in fees in exchange for the promise that we will do everything we can to safeguard that wealth and grow it as much as possible. But that’s not what happens. It seems like more and more people in my business see their clients’ money as a convenient pool of assets they can exploit to grow their own wealth. Even more shockingly, this attitude is not limited to individual fund managers. Like a bad video on the internet, it’s gone viral and infected the entire system—even the biggest, most prestigious firms.

  Have you ever wondered why so many mutual funds—and a good deal of hedge funds now, too—have a so-called family of funds? Seriously, take a look at the marketing materials for your average mutual fund company. It’s probably got a catalog of funds longer than the wine list at the French Laundry (which, if you haven’t had a chance to eat there, runs over a hundred pages). There’s a good reason for this, and it stems from that old inconvenient truth about the financial industry: asset size is the enemy of return.