Investors Are Responsible for Plotting Their Own Fate

Thursday, 23 Feb 2012 12:29 PM

By Jacob Wolinsky

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How the mighty have fallen.

In 2006, John Paulson was a relatively unknown hedge fund manager. Over the next few years, Paulson rose to fame with his spectacularly successful bets against subprime mortgages. Paulson became one of the most well-known hedge fund managers in the world.

Now the tides have reversed significantly. Paulson’s main fund was down more than 30 percent last year while the broad stock market was up several percent. His fund lost more than $500 million investing in an alleged Chinese fraud called Sino-Forest. Paulson’s luck just got even worse: He is being sued by an investor for this investment.

A Florida investor accused Paulson of not conducting proper due diligence for the Sino-Forest investment. A small firm named Muddy Waters published a report comparing the company to a Ponzi scheme. After the report, shares of Sino-Forest tanked. The stock, which trades on the Toronto exchange, is now being investigated by Canadian authorities.

This story is so absurd for so many reasons. I hope it is tossed out by the judge, since it sets a very dangerous precedent, which would indicate that the SEC believes that no one be personally liable for stupid transactions.

I cannot get into all the reasons but below are several:

• To invest in hedge funds, the SEC requires investors to meet certain criteria. Only investors who meet this threshold could even invest in Paulson’s fund. Since the SEC does this to assure that only “sophisticated” investors buy into hedge funds, the SEC should also assume investors understand the risk. This case is even worse than a retail investor suing a broker for recommending a bad stock.

• Many companies trading on foreign exchanges file financial statements with local Chinese authorities and in the countries they list in. The problem is that the statements with local Chinese authorities aren't online and widely accessible. Investors must physically get hold of them. I know this from colleagues who were among the first to discover fraudulent Chinese companies trading in the United States. If anyone should be blamed, it is the auditors of Sino-Forest, Ernst & Young and other major auditors who gave them a clean stamp for the past 15 fiscal years.

• The last point is that Paulson has been managing money for decades. He doesn't trade frequently but still has bought and sold hundreds of securities during that time period. If every single trade he made can be considered negligent, almost no one would be immune. Even the best investors, including Warren Buffett, have made bad investments or bought into fraud.

I hope the judge tosses this case out and lets investors know clearly that when they invest in a fund or a stock, they are the ones who should be held liable.

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