Despite the poor job market, gutsy risk-takers can still find lucrative work pretending to be hedge fund managers. One particularly daring breed of pretend hedge fund manager is the so-called “free rider.” These Wall Street daredevils trade stocks using funds that they borrowed, without permission, from reputable stockbrokerage firms.
Though lucrative and exhilarating, free riding in the stock market carries a few notable risks, including possible New York state criminal indictment, federal criminal charges, and SEC fraud charges, as Scott Kupersmith recently learned, a successful pretend hedge fund manager from Florida. Let’s take a closer look at Kupersmith’s free riding . . .
The basic concept can be summarized by casino analogy. Posing as hedge fund managers (business cards, nice suits, blackberries, dismissive arrogance), they rent the High-Roller Suite at the Bellagio on their Amex, obtain stacks of chips on casino credit, and then go for broke at the tables. If they have a winning night, they pay for the borrowed chips, and the suite, and trouser the profits. A good investment. If they have a losing night — and this is the brilliant part — they split. A good hedging of risks.
But why, you ask, in the analogy, would the Bellagio extend gambling credit to a guest who was pretending to be a hedge fund manager? Okay, maybe the Bellagio wouldn’t do that. But many reputable stockbrokerage firms would. Here’s how Kupersmith stuck several well-known broker-dealers with his trading debts.
Kupersmith’s strategy is called “free riding.” Broadly speaking, a free rider is anyone who takes the benefit of an activity without bearing the costs of the activity. Your friend who guzzles free beer at your moving party even though he arrived just as the rest of you were moving the last piece of furniture off of the 30-foot truck is free riding. Friends who disappear when the campsite is being setup, or broken down, are free riding. Your little sister who demanded a puppy which you ended up feeding and walking is free riding. People who make risky investments with their brother’s money and keep the obscene profits for themselves are free riders. It’s definitely a profitable way to operate.
Kupersmith’s free riding involved, in essence, buying and selling stocks using a brokerage firm’s credit and then later paying only for the trades that turned out to be profitable, and sticking the brokerage with the losing trades. An SEC official aptly called this strategy: “heads I win, tails you lose.” In a nutshell, here’s how it worked.
Kupersmith’s Shell Companies
According to the criminal charges and the SEC complaint (these are only allegations), Kupersmith used “borrowed or assumed identities” to create five shell companies; that is, companies with no significant assets or operations, just names on a corporate formation document and on business cards. Incidentally, like many who later find themselves being vigorously financially regulated, Kupersmith gave his shells hedge-fundy sounding names that suggested large established operations, and not the one-man show that they were (remember the other one-man show, Fiero Brothers, Inc.?).
My three favorites names among Kupersmith’s shells are Oxford Smith Advisors LLC, Fullerton Capital Group Inc., and Atlantic Southern Capital Group Inc. We have here Advisors and Groups (shall we reserve the large conference room?), and we have Oxfords and Fullertons (fox hunt after tea?), and a regional player as well, the Atlantic Southern region in fact. Venerable entities, all.
Kupersmith used the esteemed shells to open accounts at off-shore banks that cleared through recognized and respected financial institutions in the U.S. He then opened trading accounts at over 36 brokerage firms in the names of the shell companies. The accounts were “Delivery-vs.-Payment” (DVP) trading accounts. A DVP account is a trading account that allows the customer to hold cash and securities at a third-party (a custodian bank) rather than with the brokerage firm.
Thus, for example, if Kupersmith instructed a broker to buy 100 shares of Company X, the funds for the purchase would come from one of the custodian banks. Further, if Kupersmith sold 100 shares of Company X, the custodian bank would need to deliver the shares to the brokerage to complete the sale. Important to such a setup, of course, is that the custodian banks actually possess the funds and securities needed to cover the trades.
Under standard rules, buy and sells settle three days after the trade date. Thus, Kupersmith had three days to deliver to the broker-dealer the cash for buys or the securities for sales. The broker-dealers believed that Kupersmith could deliver cash and securities to cover his trading activities because he persuaded them that he was a hedge fund manager overseeing a large amount of assets. This was key. The brokerages would not have allowed Kupersmith to trade in DVP accounts unless they believed he controlled substantial assets at the custodial banks sufficient to meet his trading obligations.
So how did he convince the broker-dealers? Well, in addition, no doubt, to superb business cards, expensive suits, and a disposition of dismissive arrogance, the regulators claim that he used mail drops and “virtual offices” in New York City to create the illusion that his shells had legitimate physical offices. He also falsely represented to the broker-dealers that the shells were well-financed and held assets at reputable U.S. financial institutions. He claimed a personal net worth of $5 million and claimed to manage over $20 million. Apparently this sufficed.
Kupersmith’s Free Ride
The essence of Kupersmith’s free riding trading strategy was best summarized in a press release from the New York County DA’s office:
From July 2009 through September 2010, Kupersmith used these accounts [at 36 different broker-dealers] to purchase approximately $64 million worth of publicly-traded securities with the knowledge that he did not have sufficient funds to pay for them. His objective was that over the course of those three days, the stock price would rise and he would sell the stock through a different broker-dealer, paying for his initial purchase with the proceeds of that sale, and making an illicit profit. In fact, Kupersmith made more than $1.2 million through this illegal trading
On several occasions, Kupersmith, through his shell companies, refused to take delivery of a security for which he had placed an order when the value of that security had dropped or the trade turned out to be unprofitable. As a result, the executing broker, who had purchased the security on the market at Kupersmith’s direction, was left holding the security and the loss associated with the unprofitable trade. On other occasions, Kupersmith, through his shell companies, failed to provide delivery of securities for which he had placed an order to sell. As a result, the executing broker was left having to provide the security at a loss to cover the sale. As a result of Kupersmith actions, the broker-dealers lost more than $830,000.
This is serious stuff. On the federal criminal complaint alone, Kupersmith faces a maximum of 20 years on each of the two counts (securities fraud and wire fraud). The strategy here was bold, and obviously it was critical that the broker-dealers believe that Kupersmith held sufficient assets to cover his trades. That’s both the key to his scheme, and the hard part to understand. Why is it so easy to pretend to be a hedge fund manager?
Why is it So Easy to Pretend to be a Hedge Fund Manager?
It is puzzling how Kupersmith could have duped so many broker-dealers. Many of the broker-dealers are well-known and experienced firms, including Morgan Keegan & Co., Inc., William Blair & Co. Inc., JP Morgan Securities LLC, Barclays Capital Inc., Janney Montgomery Scott LLC, Lazard Capital Markets LLC, and Cantor Fitzgerald & Co. And these firms are well aware of the catastrophe that ensued after the last major pretend hedge fund manager imploded, Bernard Madoff.
Yet Kupersmith was permitted to trade in large dollar amounts without, it seems, anyone verifying his assets, business relations, or track record. Perhaps it can be chalked-up to the fact that Kupersmith is allegedly a talented fraud artist. For example, he apparently obtained substantial funds through good-old fashioned false promises to investors. The DOJ’s press release notes:
To induce investors to invest in a hedge fund he claimed to control, Kupersmith falsely represented to investors that they would receive extraordinary returns – representing to at least one prospective investor that he would receive a return on his investment of approximately 43% every three months – and told prospective investors that their principal investment was “guaranteed.” Based on these, and other, misrepresentations, Kupersmith raised approximately $500,000 from investors in New Jersey and elsewhere.
Not surprisingly, he did not use the funds to place trade for his investors. Instead, he used a small amount to fund his free riding and then
spent the bulk of the funds either on personal expenditures – such as private limousine services, luxury hotel rooms, and adult entertainment clubs – or to make principal and interest payments to existing investors in Ponzi-scheme fashion.
Well, at least he didn’t buy $5,000 cowboy boots.
Nevertheless, Kupersmith’s fraud abilities, superb as they may be, seem insufficient to explain the situation here. Is there not a simple way to verify claims of asset holdings made by investors interested in DVP accounts?
Part of the answer probably lies in the sheer proliferation of hedge funds. By 2005, the number of hedge funds had soared, leading to the amusing problem that all of the good hedge fund names were gone. Taken were all of the Greek Gods, and most of the animals, mountain ranges, rivers, constellations, flora and fauna, as well as cycling and mountaineering terms and anything that “conveys something soaring, mighty, fast or majestic.” The number of hedge fund managers looking for brokerage services soared as well. And while these managers were probably not tripping over each other at the doors of the brokerage houses, given their numbers, one could imagine a culture of business-as-usual developing at the brokerages.
Perhaps through further news stories, or comments to this article, we can develop a better understanding. For now, however, many broker-dealers are likely reviewing their policies and procedures concerning DVP accounts. It simply should not be so easy to pretend to be a hedge fund manager.
Published by Jeremy L. Bartell
Financially Regulated is published by Jeremy L. Bartell, a long-time admirer of Wall Street and its interesting cast of regulators. Jeremy is an attorney with Bartell Law in Washington D.C. He represents financial professionals nationwide in Finra inquiries and investigations, Finra arbitration, securities employment disputes and registration and disclosure matters.