What can regulators do to prevent future financial scams? Little
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Another one bites the dust! You may be forgiven if this was your initial reaction when you heard about yet another financial scandal involving a hedge fund.  

On Monday, federal prosecutors charged Mark Nordlicht, the founder and Chief Investment Officer of Platinum Partners, and several of his associates with multiple criminal counts in association with a $1 billion fraud case. These scandals appear with the regularity of a metronome.  

Bayou in 2005, Madoff in 2008, Peregrine in 2012 and now Platinum, to name only some of the high-profile cases. These scandals have wreaked havoc on the financial well-being of thousands of investors.

What can we learn from this case to prevent its recurrence?  This may be a relevant question in the context of possible financial deregulation proposed by President-elect Trump during his campaign. Regardless, there's probably not much that can be done on the regulatory side, unfortunately. 

The basic mechanisms of these scandals are well-understood and have appeared in previous high profile cases. As a consequence, the legal framework has been regularly updated. Criminal penalties for financial fraud are now severe. 

For example, the former Peregrine CEO was eventually sentenced to 50 years in federal prison for fraud, embezzlement and lying to regulators. Accounting for illiquid assets has been tightened after Enron.

Auditor oversight has been strengthened after Madoff. These reforms were not without merit, but did not prevent the occurrence of subsequent cases. Further changes are likely to have diminishing marginal returns.  

Additional resources for enforcement agencies are always possible but, aside from the cost, regulators face a basic trade-off between fairness and efficiency.  Over-burdening the financial system is likely to be counterproductive.  

For example, my own research shows that the regulatory pressure put on analysts after the bursting of the dot-com bubble to provide unbiased estimates probably helped retail investors to better understand these forecasts, but reduced the overall efficiency of financial markets. 

What exactly went on at Platinum is still being litigated and details are likely to remain murky for a while.  However, if you believe the prosecution, the hedge fund, started in 2003 using seed money from individuals with checkered pasts, claimed high and steady returns for 13 years.  

The financial crisis barely made a dent in the fund's performance. If you think that this sounds a lot like the Madoff case, you are right. Perhaps unsurprisingly, this impressive accomplishment proved to be a mirage.  

Platinum was investing in complex and illiquid assets that were not properly understood by its executives. They ranged from oil exploration in the Gulf of Mexico to mini-mart chains in rural China and penny stocks in Singapore.  

These projects did poorly, but their reported performance and liquidity were buttressed by ad hoc valuation models and aggressive accounting choices. If you think this part is more like Enron, you are also right.  

The more sophisticated investors started asking questions and, perhaps unsatisfied with the answers, followed up by cashing out. To keep its operations running, Platinum allegedly played its own version of three-card Monte and transferred funds from one vehicle under its control to another.  

When this became insufficient, Platinum issued securities to outside investors and misappropriated the proceeds. Finally, the company apparently resorted to bribes to obtain more funds, this part sounding more like what happened at Parmalat in 2003 when the Italian company triggered the largest European criminal bankruptcy.

The discovery of Platinum's shenanigans was apparently serendipitous. In June 2016, a federal probe into the possible corruption of union officials in New York City led to the arrest of a Platinum executive.  

This was the beginning of a full-blown investigation into the hedge fund. Several key players contemplated fleeing to Israel before their arrest.  

The part that is less understood with these scandals is the effect of community networks on their success. Con artists face a basic challenge — they have to convince prospective victims of the need to suspend disbelief when confronted with implausibly high returns.  

Their sleight of hand is a good story, but they still need investors’ trust. Close-knit communities are typically suspicious of outsiders, but trustful of insiders.  

Once the confidence of a few influential individuals has been secured, it becomes easier to convince more people in the group to invest. Criminals enjoy economies of scale, if you will. In a more socially diffused population, it is more difficult to follow this path and economies of scale disappear.  

Unfortunately, we tend to interact more and more with like-minded individuals. Society appears to have become more fragmented.  

Combined with the power of social media, this facilitates the development of more affinity frauds —  scams that prey upon members of specific groups. In the Platinum case, the alleged wrongdoers appeared to prey on Orthodox Jews.

The collaboration of a Rabbi and generous philanthropic donations were used to secure the trust of this community. There is little that can be done to regulate trust. However, this does not mean that it should be ignored by governmental agencies.  

For example, Utah is among the states that are the most affected by affinity scams. In response, it has resorted to advertising campaigns to raise public awareness.  

The Church of the Latter Day Saints is using the pulpit to spread the word. In addition, the U.S. Attorney's Office, FBI, SEC, Utah Attorney General's Office and Utah Division of Securities are known to meet regularly.  This experience may serve as a starting point for future programs.

There is no doubt that scandals involving hedge funds will make headlines again, but hopefully we will learn how to mitigate their impact. After all, Platinum Partners, a mere $1.7 billion problem, sounds like chump change after Madoff.  Maybe there is hope after all!


Gilles Hilary is the Houston Term Professor at Georgetown University’s McDonough School of Business. He regularly teaches courses on corporate governance, risk management, financial analysis, decision making processes, and behavioral finance. His research has been published in leading academic journals such as The Journal of Finance and Management Science. He regularly presents his research at places such as Harvard University, Yale University, Beijing University, and the Massachusetts Institute of Technology. He is also the Senior Fellow of Asian Bureau of Finance and Economic Research. 


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