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Hedge Funds Can Be Headache For Broker, as CIBC Case Shows

Wall Street Journal

On Wall Street, hawking hedge funds has become hugely profitable. But a recent arbitration award against Canadian Imperial Bank of Commerce shows the downside for brokerage firms that market these lightly regulated investment vehicles.

A three-person arbitration panel this month ordered the bank’s brokerage arm, CIBC World Markets, to pay almost $3.6 million to 11 wealthy investors who lost $5.5 million investing in a New York-based hedge fund marketed by the firm. One of the investors was former professional baseball player Bobby Bonilla.

The case is a cautionary tale for both brokers who are pushing hedge funds more aggressively and for investors who are putting more of their savings into them. Hedge funds are private investment partnerships that traditionally have catered to the wealthy and big institutions, but they increasingly are available to smaller investors. The funds sometimes make high-stakes bets on stocks, currencies and other investments, often using borrowed money to boost returns.

U.S. hedge funds today manage about $1 trillion in assets, up from around $400 billion just four years ago.

In the CIBC case, the aggrieved investors claim that the bank’s brokerage conducted almost no “due diligence,” or research, on the fund that it sold its client, part of a hedge-fund family known as Red Coat, and failed to disclose that some of Red Coat’s other funds were losers. Then, after they learned that the fund was tanking, they weren’t allowed to cash out — even though a CIBC employee involved in the brokerage’s marketing efforts for Red Coat was allowed to pull his money, documents in the arbitration show.

“This case sends a message that firms can be held accountable if they market a virtually unregulated product to their customers without performing proper due diligence and then fail to monitor once it has been sold,” says the investors’ lawyer.

CIBC declined to comment. During the arbitration process, it said it did extensive background research on Red Coat and argued that the investors were well aware of the risky nature of the investment, having signed agreements stating Red Coat was “designed for sophisticated persons who are able to bear the risk of substantial loss.”

Most people who put money in hedge funds have few legal options if they feel they were wronged when investments go sour, other than going through the costly process of suing. Brokerage clients, however, agree ahead of time to settle any disputes through arbitration, usually overseen by the National Association of Securities Dealers. That restricts their access to the courts, but provides a lower-cost alternative.

The CIBC case is one of the first big ones involving a hedge fund to snake its way through the arbitration process, so it could be a harbinger. Unlike judges in court cases, arbitration panels don’t formally create precedents that subsequent panels must follow because each case is decided independently on its merits. But arbitrators sometimes look to other decisions for guidance.

Because most of their investors are very wealthy and sophisticated, regulators have approached hedge funds with a laissez-faire, buyer-beware attitude. But U.S. federal regulators have moved to increase scrutiny of the vehicles as they have become more available to the middle class.

That trend has been driven in part by the desire of Wall Street firms like CIBC World Markets to get into the lucrative game, selling their own hedge funds, creating investment vehicles based on multiple hedge funds (so-called funds of funds) and marketing independently run hedge funds in exchange for a share of the fees that investors pay.

Traditionally, hedge funds have required an initial investment of at least $1 million. But some clients who invested in Red Coat through CIBC World Markets put down as little as $75,000, suggesting that some might not have been as wealthy as typical hedge-fund investors. Red Coat charged investors a 1% management fee, plus 20% of any profits the fund earned. CIBC World Markets got one-fourth of both fees for clients it steered toward Red Coat — or one-quarter of a penny for every dollar invested plus 5% of any fund profits, the brokerage firm said during the arbitration process. CIBC shared those proceeds with its brokers.

Red Coat also steered stock-trading business — and the commissions it paid for such services — to the CIBC brokerage. That provided an added incentive for CIBC brokers to steer investment clients to Red Coat. In September 2000, the executive who ran the CIBC World Markets office in Los Angeles told the CIBC executive in charge of deciding which hedge funds to market to CIBC clients that Red Coat had promised to double the amount of stock-trading commissions it would pay the brokerage to $3 million in 2002.

“This is a very sharp group of individuals that are worthy of our consideration and hopefully your department’s approval,” CIBC’s Los Angeles-based Richard Wisely said in the letter to Howard Singer, the chief of the brokerage’s Alternative Investments Group. Mr. Wisely no longer works for CIBC and didn’t respond to requests for comment.

Most of the law firm’s clients were persuaded to invest in Red Coat by CIBC in early 2001 — without being told that Red Coat’s other funds weren’t doing very well. In a letter to Red Coat investors the previous November, the former mutual-fund executive who ran the hedge fund, Ken Londoner, said 2000 performance for one of his other funds was “very disappointing.”

In September 2001, the hedge fund’s performance took a turn for the worse, and CIBC canceled its sales agreement with the hedge fund a month later. But CIBC’s clients were locked into the fund because they had signed documents agreeing to keep their money in the fund for a year unless the fund gave them permission to withdraw earlier. All 11 of the aggrieved investors tried to cut their losses by liquidating their investments, but Mr. Londoner refused to let them.

One of that fund’s investors, however, was allowed to liquidate: Mr. Wisely, the man who used to run CIBC World Markets’ Los Angeles office and who told CIBC’s alternative investment chief, Mr. Singer, that Red Coat’s managers were “worthy.” Mr. Wisely had told Red Coat’s Mr. Londoner in an August 2001 letter that he needed the money so he could help out a brother who was going through a divorce.

Later, in a letter to another CIBC executive, Mr. Singer called Mr. Wisely’s move a “preferential” liquidation that constituted “a significant ethical breach.” Mr. Singer couldn’t be reached for comment.

By the end of 2001, during the arbitration process, the fund’s assets had fallen in value by 71%, and investors learned that most of Red Coat’s assets — including some borrowed funds — were invested in the poorly performing stock of one health-care company:, which is now known as Med Diversified and has been in bankruptcy proceedings since late 2002.