Will More Regulation Limit Faud on Wall Street?

Chidam Kurdam attempts to answer that question in a recent article in the Independent Review, entitled, "Does Regulation Prevent Fraud? The Case of Manhattan Hedge Fund." This excellent article examines the collapse of the Manhattan Hedge Fund. In many ways, the failure of the Manhattan Hedge Fund parallels the Bernard Madoff's fraud on the street. The clientele was limited to the influential and wealthy. Many of them were seasoned investors and its collapse was used as an argument for more regulation. Investors received bogus reports showing profits and hiding a declining net asset value. The curious, who questioned the results given the rising market and short-selling strategy of the fund, were told, “If you don’t understand, it’s your problem.” Some who were not deterred by the manager's arrogance warned the SEC. This time, unlike with the Madoff fund, the SEC took action and terminated the fraud.

The Manhattan Hedge Fund offered protection against a falling market. As Kudam states,

Investors wanted a shelter for the end of the boom, but they didn’t want the losses that were the price of that shelter. Berger gave them the comforting impression that they were buying a safeguard plus a solid return. What he appeared to offer was especially tempting because it was a deal that you really cannot get: free insurance. Other short sellers were not faking, and their performance was at best mediocre. It looked as if his clients were having their cake and eating it, too. No wonder they were happy to pour money into the fund.

The same could be said of the Madoff fund. The false earnings record and the herd effect continued to attract new money. Kurdam labels this belief perseverance and confirmation bias. "[O]nce convinced that they were getting a great deal, they did not look for evidence of failure."

The Manhattan Hedge Fund has been used as an example of what happens without regulation. However, what was done here and by Madoff is illegal. Kurdam argues that there are plenty of applicable laws on the books. More laws will not help, because most frauds are only caught after one party complains and the damage is done. Frauds like this are perpetrated because of the willingness of clients to believe and the self-interest of third-parties that profit from the fraud. More regulations can create a complacency that assists the fraud. Bernard Madoff Investment Securities was a member of FINRA and Bernard Madoff sat on the advisory committee for the SEC. CBS reports that Madoff even joked with SEC members about his extraordinary profits. In addition, Mark Madoff served on the board of the National Adjudicatory Council, the division that reviews disciplinary decisions made by FINRA.

Mental blind spots are common to all humanity, whether in the markets or in the government. The people Berger misled were experienced, highly sophisticated investors with immense resources and every ability to intervene. The fiasco happened because they misperceived the situation. If insiders are subject to knowledge gaps and cognitive biases, outsiders must also be subject to such gaps and biases. Although government agents are independent, they are outsiders with less information, no special cognitive advantage, and weaker incentives. Unlike private actors who bear the costs and benefits of their own choices, public decision makers do not face all the consequences of their choices (Whitman and Rizzo 2007, 442–43), especially when their failures are attributed to a lack of power or resources so that they escape responsibility for their mistakes.

We will probably never know why Bernard Madoff, a well-respected and wealthy individual, did what he did. Kurdam leaves us with the impression that the manager of the Manhattan Hedge Fund initially did not have a criminal intent. He believed that his short-selling strategy was right and that if he could cover up the initial losses his strategy would prove profitable for investors in the long-run. His self-assurance and ego were so strong that he refused to accept the fact that he might be wrong. As losses snowballed, he was forced to perpetuate the fraud.

It may be that investors would have suffered smaller losses had they been dealing with a true criminal. A criminal will terminate the fraud when he believes he has maximized his profits or is likely to be caught. An egoist will continue the deceit past when a self-interested criminal would have made a hasty exit. An egoist thrives on the adulation he receives from the community of investors. He is smarter and is more insightful than others. If he can just continue a little longer, had a little more money, he can prove he is right.