By Stephen Taub
George Canellos is no stranger to the Securities and Exchange Commission. The 45-year-old, who in July took over as a regional director of the regulator, most recently spent six and a half years as a defense attorney specializing in securities cases. During that time he often found himself on the opposite side of the SEC as a partner in the litigation group of the New York office of Milbank, Tweed, Hadley, & McCloy.
Prior to that, Canellos spent nine years as a federal prosecutor in the U.S. Attorney’s Office for the Southern District of New York, serving as chief of the major crimes unit. For the bulk of that time he worked alongside the SEC enforcing securities laws, focused on larger-scale white-collar crimes. He also spent time as a deputy chief appellate attorney, supervising appeals to the Second Circuit.
The last case Canellos tried led to the conviction of Alan Bond, the former president and chief executive of investment advisory firm Albriond Capital Management. In 2002, Bond was sentenced to more than 12 years in prison for a kickback and bribery scheme and a trade allocation scheme lasting from 1993 through 1998. “George combined first-rate litigation skills with a real interest, aptitude and level of knowledge of the types of complex trading products and practices the SEC should be focusing on,” says Scott Edelman, vice chairman at Milbank Tweed. “There are not many who can do both.”
For part of his tenure at the U.S. Attorney’s Office, Canellos’s boss was Robert Khuzami, who earlier this year was named as the SEC’s director of enforcement. They overlapped for about eight years and served together on the securities and commodities fraud task force of the U.S. Attorney’s Office. “In some respects my interest in government was inspired by him,” Canellos asserts. So when he learned that the SEC’s new chairman, Mary Schapiro, and Khuzami were recruiting someone to head the New York office, Canellos threw his hat into the ring.
The New York office—with about 390 professional staff, including 210 inspectors—is the largest of the SEC’s regional offices. It is responsible for two important missions: enforcement of securities laws and conducting inspection programs of registered broker/dealers, investment advisers, mutual funds and other regulated entities. It is also responsible for investigating the activities of hedge funds, even though many of them are not registered. About 60% of all U.S. hedge fund assets are managed in New York.
Altogether, there are 6,000 registered broker/dealers in the U.S., and the SEC’s New York office is responsible for inspecting about 1,546 of them, among other entities. One thing the New York office does not do is make the rules. That takes place in Washington.
In his first press interview since taking the job, Canellos spent about two hours chatting with contributor Stephen Taub in the SEC’s lower Manhattan office about the challenges facing him and the regulatory challenges facing the hedge fund industry.
What most prepared you for the job?
I bring the perspective of someone who has represented clients and witnesses in SEC matters from the other side. It is an important perspective to have in this job. It is important to know the consequences of your own actions for adversaries and members of the securities industry who are the subjects of investigations. It is also important to know their pressure points—what motivates them. In addition, I think my experience as a federal criminal prosecutor grounded me in the discipline of analyzing every case as if it were going to trial—with a view to the law, the application of the law to the facts, and whether the facts can be established by admissible and credible evidence.
What is your mandate regarding hedge funds?
It is not fair to say I have a particular mandate. No one said I have to do X, Y or Z. But it is fair to say everyone has recognized that a massive realignment of the securities industry has occurred during the past 20 years, and among the changes in the industry were the explosive growth of hedge funds as well as private equity firms. They are a crucial part of the securities industry now and operate in manners that have some of the characteristics of a broker/dealer, essentially as intermediaries in the market. Meanwhile, the number of registered broker/dealers is declining.
What’s the big concern here?
The fact that hedge funds are presently unregulated presents challenges. We have seen some migration of the market from regulated entities—broker/dealers—to unregulated ones.
How do hedge funds behave like broker/dealers?
If you are a hedge fund posting bid and ask prices for a wide range of securities, the hedge fund can act in a way that closely resembles a market maker. Hedge funds are now major sources of liquidity in the market, and many regularly post bids and asks in a manner akin to broker/dealers. Moreover, electronic communication networks allow market participants to cut broker/dealers out of the trade and directly access the bids and asks of other participants, many of which are hedge funds. So hedge funds are major players and intermediaries in the market.
What concerns you most about the many hedge funds that are not registered?
When you are registered, you are subject to random inspection by the SEC and, if you are a broker-dealer, by self-regulatory organizations. You are required to maintain critical books and records, such as three years’ of correspondence, e-mails, trade blotters and customer-related records. And a host of laws and regulations are designed to address conflicts of interest, preservation and segregation of assets. If you are not registered, many of those substantive rules don’t apply to you.
Which ones?
Most significantly, record-keeping requirements and rules subjecting the firm to inspection by the SEC. The absence of such requirements and rules presents a potentially significant regulatory gap that may be addressed by legislation in the future. In the meantime, there is a significant difference between the regulations governing hedge funds and those governing registered entities. However, some tools developed by the SEC in the past few months could be critically important in the regulation and investigation of hedge funds.
Like what?
One example is the Enforcement Division’s power to enter formal orders of investigation. If you are not a registered entity and the SEC knocks at your door and says it wants to see your books and records, you are free to decline the SEC’s request and refuse to cooperate. However, this does not mean the SEC can never get information from you. The SEC can subpoena you. Historically, subpoena power was used only when a formal order of investigation was entered by the five commissioners after an extensive internal process.
Even if the commissioners were prepared to liberally use subpoena power, an extensive and sometimes lengthy process was required to obtain their approval. That process was a practical impediment to the use of subpoenas and meant the power to subpoena was used sparingly. However, in the past few months, the commissioners delegated to the Division of Enforcement the authority to enter formal orders, and it has in turn delegated authority to all senior officers of the enforcement division, including three or four people here in the New York office. This means my colleagues and I can enter the order if we need to get records from a hedge fund.
What does this mean in practical terms?
Even though hedge funds are not subject to inspection, we’re not going to have as many obstacles in obtaining information from them. Unregistered participants in the securities market now know if the SEC needs and requests records, and they decline to provide them, there is a substantial probability that a subpoena will be coming their way. We still need to have a legitimate investigative basis for utilizing subpoenas. But hedge funds won’t be able to take advantage of what we all once knew were significant procedural barriers to obtaining them.
Is this a big deal?
Yes. As a former federal criminal prosecutor, I felt this change was long needed. Twenty-five-year-old criminal prosecutors could issue grand jury subpoenas on their own authority, while much more experienced SEC attorneys, including senior supervisors, could not. In my experience at the Justice Department, we always had the possibility of a grand jury subpoena in our back pocket. Anyone who refused to cooperate in our investigations knew he would likely face an appointment with the grand jury.
The power to subpoena information whenever you need it is one of the most basic and important tools of an investigator. I believe the mere knowledge that SEC staffers can secure the authority to issue subpoenas more easily and quickly will be enough to secure the full and prompt cooperation of many parties who otherwise might drag their feet, dodge questions or refuse any form of assistance to the SEC staff.
Do you think the hedge fund community realizes this is a big change?
I think the message is going out. I’m not sure it is fully appreciated.
Of course, this could have occurred in practice in the past.
Yes, but there has been a shift in policy and attitude, at least within the New York office. Historically, there was reluctance on the part of the inspection staff of the SEC to seek information from nonregistered parties for good reasons—chiefly because the SEC has no statutory right to inspect nonregistered parties and because Congress did not expect such parties to bear regulatory burdens comparable to those of registered parties.
Now the SEC has the authority to use subpoenas when conducting official investigations of potential violations of the securities laws. We are now much more ready to use both of those means of obtaining information from nonregistered entities. And we intend to coordinate closely our inspection and enforcement programs so our inspectors have the teeth and claws they need to obtain any information necessary for a thorough examination, including—when appropriate—information from unregistered parties.
What changed?
The Madoff fraud and the lost opportunities that existed to identify the fraud based on information available through third parties—including unregistered third parties, such as feeder funds—underscore the importance of seeking information from third parties.
What activities of hedge funds concern you the most?
Algorithmic trading, dark pools and other trading practices that rely on highly sophisticated technology and lack transparency. The SEC needs to understand these practices better, and they deserve more attention and resources. In my view, such practices present risks to individual securities, including potential market manipulation, as well as some systemic risks for the market as a whole.
Does this mean you are going to take a closer look at all of those successful algorithmic traders? Many have great long-term records.
I can’t comment on any specific investigations or inspections. I will say algorithmic trading is an important area for the SEC to understand better. It is also a very important area for in-house lawyers and compliance staff to understand better. Many senior lawyers and compliance personnel at investment managers and broker/dealers that engage in algorithmic trading don’t have a great understanding of what’s behind the curtain, what’s inside the black box that generates huge profits for their firms. Understanding such trading methods and programs is a serious challenge for lawyers, compliance officers and others who are not trained in mathematics and computer programming.
What is the remedy?
The SEC is and has been using quantitative methods of its own to help evaluate market risks and identify participants in the market who are worthy of heightened scrutiny—for example, based on the nature of their performance compared with the performance of traders pursuing comparable strategies. In addition, we have been making clear through our inspections that we expect firms to develop rigorous compliance procedures and controls around their use of quantitative trading techniques.
Are you going to send inspectors to firms with outsize returns?
Not necessarily. Outsize returns, however, can be a red flag if the basis for those returns is not clearly explained by conditions in the market, the nature of the investment strategies and the amount of leverage employed. You can have Madoff–style aberrational performance that is not that high but is steady. Moreover, even seemingly aberrational returns may be completely explicable based on the trading strategy pursued and the relevant market conditions.
When the Madoff scandal broke, some commentators said his returns should have been a red flag. But others have done much better. Should those with much higher steady returns also have red flags?
Not necessarily. I think the extent to which Madoff’s returns by themselves were a red flag has been oversimplified. It is only when you analyze Madoff’s performance against his stated investment strategy, with reference to the particular securities in which he claimed to invest, and assess the likelihood that such a strategy could generate such consistent returns given the market conditions that existed during the relevant period, that glaring red flags begin to become evident.
The important point is that many parties, including regulators, lacked the sophistication in markets and the statistics to appreciate the extent to which Madoff’s returns were aberrational. When you hear someone is up 12% and the market is up 25% this year, that doesn’t seem so high. But maybe so, if you are up every month and your returns don’t correlate with the market you purport to be investing in. The SEC is taking very analytical approaches to evaluating performance and other characteristics of market participants, including hedge funds.
What else concerns you about hedge funds?
Some managers have multiple funds. Some are 2 and 20, some 1 and 20. Some don’t have performance fees. Some of their funds have losing positions and no incentive fee. Some of these funds are invested in similar products. The investment adviser is making decisions all at once on behalf of all entities, which have separate beneficial owners. Sometimes there are cross-trades between funds or accounts under the management of the same adviser or principal trades with affiliates of the adviser. I am concerned about the allocation of trades between and among funds and beneficial owners, that managers are skewing investment decisions in order to maximize their own fees, including favoring some funds or accounts over others.
What is the regulatory issue?
The manner in which investment managers address such conflicts of interest present potential issues of fraud and breach of fiduciary duty. Let’s say you buy a hard-to-price structured asset you think could become a big winner. Does the manager put it in the fund with the performance fee or the one underwater? What if he moves the security from one fund into another fund? It’s called an agency cross-trade. What steps are being taken to assure the prices are correct? Why is he doing it? Why is he making the change? Because he has a redemption request and is eager to get the security out and it is easier to put it in one of his other funds when there is no liquidity in the market? Why is he doing it if there is no liquidity? A whole host of issues have come up, especially in the past year. This is an area of practice that is ripe for fiduciary abuses.
What are your particular concerns?
I have particular concern about traders, structurers and bankers who have recently begun to manage outside money and lack experience as investment advisers. I am particularly concerned when such inexperienced advisers start up their own firms, rather than joining organizations with established compliance departments and long experience with the 1940 Act. These are people who are not always well schooled in how to manage the conflicts and exercise the fiduciary responsibilities of an asset manager. And if they are startups or small operations, they often don’t get the outside help they need to make sure they are acting in compliance with the law.
Is registration of all hedge funds inevitable?
I am not in the best position to provide a prediction. There is a lot of momentum, especially in the aftermath of Madoff, to devise an appropriate form of regulation. Momentum in the past did not translate into legislation.
What about transparency of positions, trades and short sales on a more regular basis? Would you urge disclosing more?
That is an issue more in the purview of other divisions. I would note that there has been a migration of trading away from exchanges, broker/dealers and more highly regulated markets toward less transparent markets, such as ECNs and OTC trading.
Are offshore funds a source of concern?
Improving our ability to investigate and obtain information concerning offshore funds is a priority for the SEC and the New York office. We already enjoy some excellent collaboration with foreign regulators, but improving MOUs [memoranda of understanding] and our collaboration with foreign regulators is a high priority. If we have a strong collaborative relationship, we can request certain information, and they hand it to us.
What do you want to know?
There is a ton of information regarding offshore entities that is more difficult for regulators and investors to obtain by virtue of being offshore. For example: asset valuation. Want to make sure the offshore fund you are invested in isn’t a Ponzi scheme? If its assets are held in the custody of a large domestic financial institution, both you and the SEC are more capable of inspecting it. One of the lessons of Madoff and other recent Ponzi scheme cases is that investors themselves need to be quite vigilant regarding risk management before making an investment. If you are investing in a hedge fund, you must be sure that the fund has an independent custodian [and a] major independent accounting firm. As an investor, I would want to know if the fund purports to have custody abroad. And if so, where? Know where the administrators are. When the answer to any of these questions is offshore, it may impair your practical ability to police them.
Do you have any other big concerns regarding hedge funds?
Insider trading is a big concern. Whenever you have a big group of highly sophisticated investors looking to trade on a short-term basis and exploit short-term price movements through options and other derivatives, you have a danger. Also, when you have participants deeply connected in the investment community—banks, issuers—and they have heavy incentives to obtain information to trade and are capable of using leverage and information to exploit small price differences.
I’m not saying hedge funds are bad for markets. Having more market participants generally enhances liquidity and creates markets for capital-raising and corporate finance. Having skilled investors is a great thing. It assures capital is deployed to the highest and best use. The challenge is to put appropriate safeguards in place to ensure that hedge funds operate in compliance with the law.
Photographs by Mike McGregor
