Does regulation prevent fraud?  Who knows?  But according to this colorful and detailed account of one famous case, the SEC should think again if it expects to stamp out fraud using new regulatory powers.  The case is Manhattan Capital and the chronicler is Chidem Kurdas, one of the world’s most experienced and articulate hedge fund journalists.  Kurdas’ account of the Manhattan case in the Winter 2009 edition of The Independent Review is well worth the read – particularly as we move into an era of greater hedge fund oversight.

Kurdas points out that “regulatory frenzy occurs every time another fiasco occurs.” And when it does, it’s often ineffective unless an interested party complains after the fact – that is, when the damage is done.”

Kurdas says that “at least one aspect of the Manhattan Fund vividly demonstrates regulations failure to deter fraud.” But it’s clear that this case study (written before the Madoff Affair) may provide some important lessons.  In a nutshell, here’s what happened…

Michael Berger, described by Kurdas in this blog post as a “restless” 22 year old Austrian immigrant, launched Manhattan in 1996 with a decidedly bearish view of equities.  According to Kurdas’ account, he raised $600 million over 4 years from investors who, like him, wanted to take out a sort of “insurance” against a market downturn.  The problem, of course, was that this market downturn didn’t come soon enough for Berger and his investors.

Although Manhattan was later described as a Ponzi scheme, Kurda’s explains that it was actually a “real investment operation”. But as losses mounted, Berger began to cook the books by submitting fake holdings data to his administrator.  That administrator trusted Berger’s data since it purportedly came directly from the fund’s introducing broker – a small Ohio firm that in turn used Bear Stearns as its prime broker.

The problem was, Manhattan accounted for a significant portion of the introducing broker’s revenue – leading some to believe that it was too quick to acquiesce to Berger’s demands.  One of the those demands was More…