Dead Companies Walking

by Scott Fearon

  As companies bring in more and more investment capital, their performance inevitably declines. But do they stop taking on more assets? Of course not. They just start another fund and give it a catchy new name like their “Dynamic Growth Fund” or some such BS. As a smaller, leaner fund, this new entity has a chance to reap much larger returns. Fund managers often make sure this happens by transferring winning trades from larger funds to these newer, smaller ones. They then market the hell out of those newer funds by touting their astounding returns until those funds, too, get too big to keep posting great stats. Then, rinse and repeat—they start the whole cycle again.

  But what about the new funds that don’t do well? There are plenty of those. And companies have a sure-fire strategy for dealing with them: they shut them down and erase them from their books. It’s called survivorship bias, and it happens all the time. A fund goes south and starts to post poor results, so the bosses step in and—bingo, bango—it goes down the Wall Street rabbit hole, never to be heard from again. They either wipe it out entirely or they merge it into other, better-performing funds. Of course, the investors in that fund don’t get their money back or anything. Those losses aren’t imaginary for them. But if you read the mutual fund company’s marketing materials, it’s like the fund that lost them their money never existed.

  G(r)ifted

  The thing that really gets me about guys like my former friend the hedge fund manager, and way too many others in my industry, is that they present themselves as pillars of their communities while they’re secretly scamming their investors. The only reason I trusted my friend with my money in the first place was that he came off as a decent family man. I assumed that someone who seemed so wholesome would manage my money responsibly. That assumption was wrong.

  Another way sleazy money managers burnish their reputations is by spreading huge amounts of money around to charities and other worthy causes. That was one of Bernie Madoff’s main MOs, and it worked for him for decades. No one wanted to believe that such a generous philanthropist was a complete fraud.

  A few years ago, I attended a fund-raiser for a school I helped found for disabled kids. It’s a great event that we throw every year. We always start off with a silent auction and then we bring on some entertainment. That year, both Dana Carvey and Robin Williams were scheduled to perform. Before the auction could even get started, the singer Sammy Hagar, of all people, jumped on stage and declared that he and his buddy Larry Goldfarb were each going to donate $50,000 right then and there so that we could skip the auction and go right to the show. Larry was a local hedge fund manager with a reputation for partying with rock stars like Hagar and writing out big checks to charities. The audience applauded wildly, and Larry came on stage to take a bow. We were all thrilled at his classy, selfless gesture . . . until we found out the money he gave the school wasn’t exactly clean. In 2011, Larry was busted for dipping into his clients’ funds to bankroll his own pet projects and investments, including stakes in real estate ventures and a record company (remember, he liked to hang out with rock stars).* Some of Larry’s investments actually made large returns, but he neglected to share those profits with the people who had made them possible—his investors.

  Laird Cagan, the investment banker who fed my former friend those iffy green energy stocks, is a big-time donor to charity, too. Thanks to his generosity, the soccer stadium at Stanford University is named after him. But at least one of his gifts hasn’t worked out so well for the people who received it. In 2007, Laird gave $1 million in stock to his hometown of Portola Valley to help finance a new town center. What a guy, right? Wrong. It’s hard to believe, but Laird pulled the same game on his city as his pal pulled on me. The stock was restricted, and the town couldn’t legally sell it until 2012. By then, it was worth a grand total of $60,000.†

  *“SEC Charges Bay Area Hedge Fund Manager with Misappropriating ‘Side Pocketed’ Assets,” SEC press release, March 1, 2011.

  †Bonnie Eslinger, “Portola Valley Wants to Dump Donated Stock After Watching It Lose $940,000 in Value Since 2007,” San Jose Mercury News, July 19, 2012.

  Hedge fund managers do this, too. They’ll shut down money-losing funds, only to reopen them months or years later. This allows them to bypass high-water mark provisions in their investment agreements so that they can charge the standard 20 percent performance fee before they fully recoup prior-year losses. Another classic trick is to squirrel away bad investments in larger accounts so they won’t affect the returns as much as they would have in smaller vehicles. This practice was so common in my area of Marin County, people used to call it the 101 Allocation after the main freeway here. Fund managers would shove their losing investments into big institutional accounts and put their winners into smaller funds—often the ones they themselves and their friends and family had invested in. Then, as the saying went, they’d be out the door and on Highway 101 by 1:01 p.m.

  Tricks like allocation and front running have been around for a long time, and they’re still quite popular. You might think someone in the regulatory sector would, I don’t know, regulate these behaviors. But agencies like the Securities and Exchange Commission (SEC) aren’t just outmanned and outgunned by Wall Street; they’ve essentially abdicated their responsibilities for overseeing my industry. Sure, they make occasional headlines for busting a few blatantly bad actors like Larry Goldfarb and Bernie Madoff, but these cases are the proverbial exceptions that prove a rule. The vast majority of Wall Street’s scams not only go unpunished, but many of them are allowed to continue out in the open without the faintest threat of prosecution.

  About ten years ago, I got a voice mail from a woman working for a well-known and well-connected boutique brokerage in Arkansas. She said they were arranging a PIPE (private investment in public equity) for Stonepath Group Inc. (stock symbol: STG), a troubled freight forwarder. A PIPE is a last-ditch funding mechanism for failing companies in which batches of discounted shares are sold to big investors like hedge funds. They almost never save the companies from bankruptcy, but they often wind up lining the pockets of shady money managers. At the time, Stonepath’s stock was trading for $3, but the woman said that if I bought into the PIPE scheduled for a week later, I could purchase shares at a significant discount. She concluded her message with an astonishing bit of doublespeak: “By listening to this voice mail, you are now in receipt of nonpublic information and are thus prohibited in trading on the company’s stock. But if you do decide to use this information to your benefit, it is not our role nor is it in our interest to question your decision.”

  I couldn’t believe what I had just heard. Here was a complete stranger leaving me inside information on my voice mail, then all but winking and nodding at me as she invited me to use it. Why would she do such a thing? Because the entire PIPE process depends on guys in my position doing exactly what she was supposedly telling me not to do—using that inside information to make a fast profit.

  Here’s how it works. Brokerages like the woman’s employer call up hedge fund managers all over the country and invite them to participate in an upcoming PIPE. The fund managers immediately short the stock of the company involved. Then, a week or so later, when the PIPE occurs, they buy in at the discounted price and use those exact shares to cover their positions. It’s the easiest money you can possibly make. The fact that it’s completely and unquestionably against the law doesn’t matter one scintilla to anyone involved—not to the brokerages arranging them, not to the money managers profiting from them, and, unfortunately, not even to the regulators who are supposed to stop them.

  Over the years, I’ve received several invitations to profit on inside information during PIPE deals. But that voice mail from the woman in Arkansas was so egregious, I decided I had to do something about it. I got the contact info for an SEC lawyer from a friend of mine, and I called the guy from my room at the Hyatt in Monterey during the American Electronics
Association Conference. When I told him about the message I’d received and how rampant the PIPE scam had become, he wasn’t at all surprised about it.

  “We’re aware that some people have been covering short positions on PIPE offerings,” he said. I’m not sure, but it sounded like he stifled a yawn midsentence.

  “Are you planning on doing something about it?” I asked.

  The lawyer let out a sigh. “Look, I’m going to be straight-up with you. Do you know what I make every year?” Before I could hazard a guess, he gave me the answer: “A buck twenty-five.”

  “Okay, you make $125,000 a year. That’s not exactly minimum wage.”

  “No, it’s not. But the guys shorting these PIPE deals make millions.”

  “But your job is to regulate those guys and enforce the law.”

  “Sure it is. But when it comes to things like this, that’s a lot harder than it seems. The investigation would take years. They’d hire ten different lawyers and fight me every step of the way. And in the end, we’d be lucky if they wound up paying a small fine.”

  “Let me just make sure I understand what you’re telling me,” I said. “I just informed you that I have a licensed broker on tape giving me inside information and practically begging me to use it, but you don’t plan to pursue the matter?”

  “No,” he stated flatly. “I do not.”

  “So all these people breaking the law are just going to keep getting away with it?”

  He paused for a moment before answering.

  “Yes, Mr. Fearon. I’m afraid they are.”

  Notes

  *William A. Sherden, The Fortune Sellers (San Francisco: Wiley, 1999), 6.

  †Amy Feldman and Joan Caplin, “Is Jack Grubman the Worst Analyst Ever?” Money Magazine, April 5, 2002.

  ‡Charles Gasparino, “Salomon Admits That It Sent Hot IPOs WorldCom’s Way,” Wall Street Journal, August 27, 2002.

  §John Bogle, “The Mutual Fund Industry 60 Years Later: For Better or Worse?,” Financial Analyst Journal 61, no. 1 (2005): 15–24.

  ¶“Tiger Slain as Losses Plunge Hedge Fund into the Red,” CNN.com, November 2, 1998.

  **Daniel A. Strachman, A Tiger in the Land of Bulls and Bears (San Francisco: Wiley, 2004), 169.

  Conclusion

  Learning to Love Failure All Over Again

  When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it.

  —Frederic Bastiat

  Only those who dare to fail greatly can ever achieve greatly.

  —Robert F. Kennedy

  In more than two decades of running my hedge fund, 2009 was the only year we lost money. And I’m not talking about a little money, either. After producing a compound annual growth rate of 13 percent after all fees for the previous eighteen years, and outperforming the S&P 500 by an average of almost 5 percent a year during that time, we were down over 12 percent in 2009. All told, my fund lost over $36 million on short investments. For larger funds, that would be a relatively minor hit, but at the time, I was only managing $140 million, so my short losses wiped out almost a third of our assets! Luckily, our long investments offset some of that and we were “only” down a net of $17 million.

  Why did this happen? Mostly, it was my own fault. I blew it. I shorted a number of companies that I expected to fall steeply and even go to zero. Instead, almost all of them wound up rising on the year. What led me to these calamitous investments? You could say that I made some of the same mistakes that I describe in this book. It hurts to admit, but I misread the conditions of the markets as badly as Chemtrak’s CEO did when he told me his take-home cholesterol test would outsell home pregnancy detectors. And like Global Marine’s CFO and his magical rig utilization number, I clung too tightly to my formula for investing and failed to adapt to unforeseen circumstances. By the time I realized how badly I had goofed, I was caught just as flatfooted in the face of these new realities as the brass at Blockbuster when they tried to save themselves by selling candy and popcorn.

  In some ways, I got caught up in a kind of mania, too. Things looked so dire after the 2008 crash, virtually nobody in the popular press and the financial world thought the markets would recover. I willingly joined in with the bears because I believed wholeheartedly in a certain narrative: things were going to get worse. Back in the dotcom days, people like Women.com’s CEO were blinded to any chance they could fail. A decade later, in 2009, I couldn’t see a way the companies I had shorted couldn’t fail. As I have talked about repeatedly throughout this book, that sort of hubris is a dangerous thing in business and in investing.

  I was definitely my biggest enemy in 2009. But something else was happening that year, too. The markets were not behaving the way they had behaved for my entire career, and the normal functioning of the financial system had been distorted. The companies I shorted were textbook examples of terminally ill businesses, with vanishing revenues and crushing debts. I didn’t think many of them would last until Christmas. If someone had predicted that not only would all of them still be solvent by the end of the year, but that many of their stocks would have tripled and even quadrupled in value, I would have referred that person to a psychiatrist. But that’s exactly what happened.

  The reason for this was simple: our country’s political, corporate, and financial elites wanted it that way. Unlike previous recessions, which mainly hit the working and middle classes, this recession rocked America’s investing class, the very people running Wall Street and Washington—the very people who had caused the downturn in the first place. They refused to admit that they had failed as badly as all of the failed companies I have described in this book. So instead of letting the stocks and bonds of almost every major investment bank, and many other debt-laden companies, go to zero, they protected themselves from the consequences of their own ineptitude by turning our stock market into the financial equivalent of professional wrestling.

  First came the massive injections of taxpayer cash into the financial sector. A lot has been written about that boondoggle, so I won’t go into too much detail on it other than to say that it was the largest and most brazen upward redistribution of wealth in the history of capitalism—and it was only the beginning. Next, the Fed yanked interest rates down to virtually zero. They’re still there as I write this. This move hasn’t gotten the press that the Wall Street bailouts did, but it might have been even more destructive. It punished the prudent to help the profligate. People who had done the right thing and put money into their savings lost out so that poorly managed corporations could refinance what should have been fatal debt loads. Doomed businesses were able to replace high-interest, fast-maturing bond issues with longer-term paper yielding a fraction of what they would have owed otherwise. Congress even sweetened the deal by giving some companies additional five-year tax “look-backs,” which allowed them to recalculate previous returns and claim giant retroactive refunds. It all added up to one big nationwide, taxpayer-subsidized cooking of the corporate books.

  Almost to a person, the executives who ran the failed businesses I detailed in this book were decent, well-meaning individuals who acted in good faith. They sincerely believed in what they were doing, but for one reason or another, things just went wrong for them—as they often do in a healthy market economy. Like I said in the introduction, the thing that has made our country such a great incubator of innovation is the freedom we have always given our businesspeople—not just the freedom to make ridiculous amounts of money thanks to good decisions, but the freedom to go spectacularly broke because of bad ones.

  But now that crucial freedom is in peril. And I’m not just saying that because I lost a few million dollars on some short investments in 2009. I can afford to lose some mone
y. And unlike far too many of my peers on Wall Street, I don’t need to keep making more and more just to please my ego. But the way I lost that money was very disturbing to me. I understand that we went through a major crisis and that solutions enacted in the fog of such a dire emergency are not always ideal. But here’s the problem: nothing has changed in the interim.

  After Charles Ferguson received the Best Documentary Oscar in 2011 for his brilliant film Inside Job, he stepped to the podium and made a terse statement: “Three years after a horrific financial crisis caused by fraud,” he said, “not a single financial executive has gone to jail.”* The crowd in attendance cheered him. For a day or so afterward, Ferguson’s point was discussed and debated in the news media. Then, once again, the whole subject petered out.

  Thanks to Ferguson’s film and numerous other investigations, we know what caused the financial crisis. Some of the most powerful figures in the financial industry knowingly defrauded millions of people and stole billions, perhaps trillions of dollars. These weren’t honest business mistakes. This wasn’t like some misguided entrepreneur trying to market home cholesterol kits or open a Cajun restaurant in Marin County. Like Ferguson said, this was massive fraud. These were malicious, premeditated crimes. And yet the criminals who perpetrated them have never been held responsible. Incredibly, they were even rewarded for their misdeeds—not just with the massive bailouts that most people have heard about, but with the less publicized interventions that followed.

  It’s no secret why these powerful financial criminals were allowed to get away with the equivalent of an economic massacre. Again, as Ferguson and other brave journalists have documented, Wall Street has essentially captured the very systems that are supposed to monitor and police it. The SEC is a joke. Washington, DC, is essentially a one-party town now—the money party. The business media, with a few exceptions, is full of card-carrying Wall Street apologists. Even academia has been co-opted.