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Saturday 28 May 2011

The Media's "Straw-Man Fallacies" about Madoff and Rajaratnam

The Straw Man Fallacies  is a list of falsehoods in logic and rhetoric.

It’s not a coincidence that during financial crises there is often continuous and focused attention in the popular and specialist financial media about white-collar corporate crimes. Press articles about the leaks, allegations, investigation, charges, court proceedings and even about lengthy jury deliberations. Such articles' overall purpose is to seed the suggestion that retribution against corporate misdoings is in process. The publications’ other subtext purpose might seemingly be that “crime does not pay!” etcetera. We are reminded that institutional media can often be less about informative, didiactic or anecdotal stories / news, and more about hidden agenda-driven entreaties. 

During the last downturn, dubbed “TMT-bubble” between 2000-2003, we heard much about Enron, Paarmalat and other frauds; yet the lessons were evidently not learnt.  In 2007-2009 the global capital markets nearly collapsed with imminent global systemic financial failure. An all important, global commercial paper market for short-term funding, used widely in the economy by corporations and financial services, literally ground to a sytemic halt. The real assets were different from the dotcom era bubble, this time it was housing and the financial sector bubbles. The similarity was the prevalence of the notorious structured products from securitization tied to housing and off-balance sheet liabilities. 

The media attention on one or handful of cases and /or figures being made a scapegoat serves only to propagate a distorted, exaggerated or misrepresented premise. Hitler’s contrivance was that, “All effective propaganda has to limit itself only to a very few points and to use them like slogans.” Relating my article’s headline point to one of the many Straw-man fallacies, the best fit was with the fallacy of “Biased Sample”. Also Known as, Loaded Sample, Biased Statistics, Prejudiced Statistics, Loaded Statistics, Biased Generalization, Biased Induction.

Clearly, the mass air-time and clolumn-space focusing on the long-running insider trading court case against Raj Rajaratnam, of Galleon hedge fund, and the notorious Bernard Madoff, using the Ponzi scheme fraud, is intended to convey justice prevailing. However it detracts attention from the persistent and on-going white collar mischief in financial markets (or for that matter any professions, for example, UK parliament member’s expense scandal unfolding in 2010). Also, such decoy-news takes focus away from regulatory battles taking place between hardliners and laissez-faire believers.   
Also, diverting attention “to a very few points” of reference like Madoff and Rajaratnam helps deflect stark negligence or sheer incompetence of those charged with looking after the fort i.e. executive management, quasi regulators and other authoritative oversight entities. Not quite the holistic picture is presented.

So why does the Financial Times newspaper visit Madoff in prison? Not that Gillian Tett the FT's well regarded journalist is undiscerning, but more that she is compartmentalised in her thinking and publications by an age-old institutional media machinery, designed to serve the community which it represents – in this case the financial services versus all others. Media savvy, in using investor relations, public relations, lobbyists etcetera, are the key function in diseminating straw man fallacies about a position. 

To give statistical evidence to my point  about “iceberg theory of financial crimes” and media’s role, I cite these: Since the beginning of 2007 there have been 70 fraudulent cases in hedge funds alone, including Madoff, as shown in HedgeTracker Hall of Fraud listing). That’s almost 20 cases of fraud a year in hedge funds (HedgeTracker data ends with last fraud listed in June 2010, with Luis Felipe Perez’s Lucky Star Diamonds, operating yet another Ponzi scheme).

Also, FT’s Alphaville column reported in “Insider trading investigations, continued” :

            “…We’re now approaching 40 people charged with insider trading in the sweep of Galleon, PGR and other employees, and it’s worth pausing to reflect that these have come about via an incredibly narrow field of investigation: mostly via one expert network’s activity across one sector (tech) with relatively paltry amounts of alleged illicit profits. It’s moving from the periphery to the core, but the scope remains small.”

Just to clarify, the Galleon case has swept-up 40 people related to one “expert network”, namely Primary Global Research LLC, an independent research firm that links experts with investors seeking information in primarily technology and health-care.
Any effort to identify in list-form the number of pending Securities and Exchange Commission investigations of insider trading focused on other hedge funds and other sectors... well its an impossible task! - as SEC cannot publish these investigation due to wrongly inflicting irreparable reputational damage on parties concerned, before the verdicts. However, OnWallStreet.Com they have given some indications in "FINRA Clamps Down On Insider Trading, Expands Communication". FINRA is the acronym for Financial Industry Regulatory Authority, and their work has “resulted in more than 250 referrals for possible insider trading cases sent to the SEC ” in 2010 alone.

The reader of this article is advised to make the clear distinction between the Madoff and the Rajaratnam cases. One is outright fraud and other challenges the market-integrity under securities trading rules. Two very different segments of corporate crimes. Both offences being in financial services should not subconsciously be interpreted as all wrong-doings are caught. 

Stop press, what’s this? Hot-off the press on 25th May 2011 from SEC website: 

These SEC rules regarding whistle blowers was marginally voted in by 3-2. The new regulations required under the Dodd-Frank Act are supposed to give bounties / incentives for employees to come forward with information that helps towards cutting out securities problems. At the same time, the rules are intended to enforce internal compliance efforts to be bolstered. So it seems the authoritative oversight entities are fighting back! However, the cynicism of this author doesn’t allow too much glee, as he knows “the devil is in the detail”. 

So for who does this blog article mean “economic work creation”? – obviously for the legal profession and compliance departments, but by implication also for hedge fund due diligence staff.
The due diligence work of multi-manager / fund of hedge funds operations becomes critically crucial in determining the “moral compass” of fund management operations. Those managers who operate in unspectacular but morally modest ways are beneficiaries of intended clean-up in securities operations. Some critics of hedge funds may suggest that the “edge” in hedge funds come from unfair means. Implying that increased regulation of formerly unregulated asset managers (“shadow banking!”) might take the wind out of hedge funds, and for that matter private equity sails. The author of this insight hesitates in his assertion, since industry regulation amendments tend to come and go. Once upon a time, the first Glass-Steagall Act of 1932 came on the back of the Great Depression, and moving fast-forward in time to the start of this Millennium we saw Sarbanes-Oxley, and now the Dodd-Frank Act. 

In light of the media's iceberg-theory  presentation of frauds, insider trading and regulatory changes, those making institutionalised direct allocation to hedge funds without sufficient infrastructure, or in-depth industry relationships or longevity of game better watch out. Investors with institutional due diligence on boutique asset management operations shouldn’t just conduct tick-box exercises, but relevantly, understand what I call “process-principles” i.e. understanding the micro an macro aspects of an operation’s processes and principles, so as to be able to identify inconsistencies and irregularities in systems. Indeed the institutionalisation of hedge funds has provided many positives, among them  is the greater transparency of managers, but this may equally let in complacency .i.e. tick-box due diligence.

In conclusion, “creative-destruction in economic cycles” moves in alternating waves and trends, Madoff and Rajaratnam are just two names, like a festive sacrifice to the powers. I believe in an impending tsunami of alternative investment personalities and entities in difficulties. Notice the current trend of numerous offshoots of proprietary desks, whether originated from global investment bank desks, like Goldman Sachs luminaries, or from Julian Robertson’s “Tiger Cubs”. 
The continuum of evolution and adaption by the alpha-seekers, fairly or dubiously, makes it implicit that principled understanding of micro cycles in the big picture enables them to stay ahead of the game, whether by deploying media fallacies or despite them.

27th May 2011
By K K Siva