Another day, another scandal. The SEC yesterday froze the assets of a Texas based PrivateFX Global One Ltd. after charging the firm with fraud. Specifically, the charges state that Robert D. Watson and Daniel J. Petroski, a
Mr. Watson resigned last month from Texas A&M, where he had been an Executive Professor of Finance at the Mays Business School. Looks like he submitted his resignation a bit too soon. Mr. Petroski is both a lawyer and a certified public accountant. It is reported that the firm had raised approximately $19 million from investors.
Echoing signs of Madoff the firm allegedly told investors that it never had a losing month and returned an annual 23%. Interestingly Watson and Petroski are also accused of creating phony account statements and records for SEC investigators. Obviously, they were not phony enough to fool the SEC.
This is a classic case where basic due diligence, asset verification and independent custody would have been key elements in preventing a fraud. There is nothing inherently wrong with black box FX trading models run by professors with snazzy names but investors need to look past the smoke and mirrors. Here’s a simple rule that has gained acceptance in recent months - if a hedge fund manager cannot break down their strategy in plan simple terms to explain how they are making money don’t invest – period.
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FAS 157 has a number of ramification outside the hedge fund industry. As an example, here is a recent video examining the effects on banks of relaxing mark-to-market accounting rules.
FAS 157 was a big deal when it was first put into effect. For hedge fund's (and their auditors) FAS 157 presented a number of unique due diligence challenges. Specifically, the original incarnation of FAS 157 requires hedge funds, in their audited financial statements, to classify assets into one of three levels. The levels are supposed to show indicate to investors the amount of certainty with which they can value an asset.
Level 1 - Assets with readily observable market prices. Inputs for the assets in this level are quoted prices (unadjusted) in active markets.
Level 2 - Assets with no readily observable prices but they have inputs that are based on them. An example of this would be an interest-rate swap whose components are observable points - such as a Treasury bond.
Level 3 - Assets where one or more of those inputs does not have readily observable prices. Level 3 is the most controversial Level.
There is a general perception that investors place a premium on liquidity and that for the vast majority of hedge fund situations the more liquid (i.e. - Level 1) the better. As such, the natural progression of FAS 157 led to a struggle between hedge funds and auditors in the way their assets would be presented to investors.
When FAS 157 first was announced many hedge funds (and their auditors) were unsure which FAS 157 Level certain assets should be classified. It seemed some hedge funds/auditors were set to error on the side of caution. Others seemed more open to assuaging their hedge fund client's vocal objections to the classification of certain assets.
Some people in the private equity world have classified FAS 157 as "stupid." The SEC's former Chief Accountant Lynn Turner, has given FASB a failing 'F' grade. 
(Others have raised questions about which FAS 157 assets should be classified in when they have no value (such as toxic assets). In light of the recent economic environment it seems that change is in the air to reform FAS 157. In recent Congressional testimony a number of big names (Ben Bernanke, Sheila Bair, Tim Geitner, Mary Schapiro) have suggested reforming FAS 157 (aka: Mark-to-Market) and Fair Value accounting.
Even FASB has acknowledged that FAS 157 needs some work and since issued three final Staff Positions (FSPs) 
Specifically, the three groups of FSPs are:
1) FSP FAS 157-4 (the exciting sequel to FAS 157-3)- Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly
2) FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments
3) FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments
“The issuance of these final FSPs follows a period of intensive and extensive efforts by the FASB to gather input on our proposed guidance,” states FASB Chairman Robert H. Herz.
Thanks for all your hard work.
So let me get this straight - FASB puts out a rule which confuses everyone and provides little guidance on how to use it. Then works really hard to clarify it while hedge fund's, investors and auditors twist in the wind in the interim. Why wasn't all of this work put into gathering input gathered done beforehand? The FSPs are expected to be voted on later this week.
Some have blamed mark-to-market accounting as fueling some of the problems with the economy. Others have claimed there is nothing wrong with the rules but rather other issues such as over leverage should be blamed. FAS 157 is nothing more than a classification system. On face value it will do nothing to effect the actual underlying assets held by a hedge fund manager. It raises a number of issues related to judgment of hedge fund managers and their auditors. It is unclear if different auditors would classify certain assets into levels uniformly.
Hopefully, the new guidance from FASB will remove some of the judgment and discretion for the FAS 157 classification process. At the end of the day I question whether mark-to-market accounting really deserves all the criticism it has received. While there are good arguments on both sides, certainly a sound risk management policy should compliment any accounting methodology in place and not, as it seems had been the case with many hedge funds, be driven by it.
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The article reads in part, "While automation and outsourcing were mandated to eliminate mutual fund operational risk, the risk of outright fraud in the hedge fund industry is now fueling service provider growth. Scharfman theorized the average hedge fund [investor] might not be able to undertake due diligence on its own, turning businesses like Corgentum a necessity rather than a luxury." 
