what’s legal is the real crime

In case you missed it, something unusual happened last week: a dishonest money manager went to prison.

Former hedge fund manager Larry Goldfarb was sentenced to 14 months in prison for pocketing $6 million from side pocket investments and diverting money for his personal use. I write about Goldfarb in my book (available for preorder here!). He was a prominent figure in the Bay Area investment world.  To his credit, he gave a lot of money to charity and worthy causes. Unfortunately, a lot of it wasn’t necessarily his to give. He was busted a couple of years ago and promised to repay his investors the money he took from his fund. But Larry couldn’t stop being Larry and now he’s going to federal prison because of it.

According to the federal prosecutor in charge of the case, “instead of paying the agreed upon restitution and disgorgement, Mr. Goldfarb spent hundreds of thousands of dollars on various personal indulgences, including Golden State Warriors season tickets, private air travel, and vacations.”

Mr. Goldfarb is a poster child for many people on Wall Street and in investment management:  smart, personable, and shamelessly unethical.  He is another example of why Wall Street, far more than corporate America, needs tighter regulation. But the truly disturbing part of Goldfarb’s career might not be the illegal stuff he was prosecuted for–it’s the legal activity one of his former employers practiced right out in the open.

Goldfarb’s LinkedIn page says he was an an executive vice president at a place in Sausalito, California that helped troubled companies find funding through so-called “PIPE” offerings. PIPE stands for private investment in public equities.  They usually entail selling stock at deep discounts.  PIPEs are perfectly legal transactions, but only under one condition: buyers are prohibited from shorting the same stock they’ve purchased in a PIPE. There is a simple reason for this injunction. Shorting the stock would be a guaranteed arbitrage. You could use the shares you purchased at the discounted PIPE price to cover the position you shorted at the current market price–which, as I write about in Dead Companies Walking, is exactly what a lot of fund managers did.

A knowledgeable friend once told me that probably half of all money raised via PIPEs in the previous two decades was sold to funds that turned around and shorted the PIPE-selling company’s stock.

I have no information that Mr. Goldfarb’s former employer or his subsequent firm, LRG Investments, ever bought PIPE offerings while shorting the stock of the same companies.  But the whole PIPE process was ripe for exploitation. The companies involved were almost always money losing messes (if they weren’t, they wouldn’t need to be hawking their stock at deep discounts). Many were clearly headed toward bankruptcy. Their stocks were touted by bottom-feeding newsletters and fourth-tier broker dealers.  Making matters worse, PIPE shares were frequently restricted, meaning they couldn’t be sold for weeks or even months. Add all of this together and it’s hard to believe that any fund manager would seriously consider a PIPE offering as a viable investment. And yet, PIPEs were hugely popular among many hedge funds for years. Gee, I wonder why …

The SEC busted a handful of money managers for illegally shorting the same stocks they’d purchased in PIPEs. But the vast majority of funds got away with the scheme. Not surprisingly, PIPEs aren’t as prevalent since regulators cracked down on them. But you can be sure, smart and unethical people in my industry have already come up with the next scam–and it’s probably going on right now in plain sight.

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