Journal of Financial Crime

The billion-dollar hedge fund fraud

Greg N. Gregoriou William Kelting

Article information:
To cite this document:
Greg N. Gregoriou William Kelting, (2005),"The billion-dollar hedge fund fraud", Journal of Financial Crime, Vol. 12 Iss 2 pp. 172 177
Permanent link to this document:
http://dx.doi.org/10.1108/13590790510624909
Downloaded on: 30 September 2015, At: 01:07 (PT)
References: this document contains references to 0 other documents.
To copy this document: permissions@emeraldinsight.com
The fulltext of this document has been downloaded 340 times since 2006*

Users who downloaded this article also downloaded:

Journal of Financial Crime 2005.12:172-177.

Majed R. Muhtaseb, Chun Chun Sylvia Yang, (2008),"Portraits of five hedge fund fraud cases", Journal of Financial Crime, Vol. 15
Iss 2 pp. 179-213 http://dx.doi.org/10.1108/13590790810866890

Access to this document was granted through an Emerald subscription provided by emerald-srm:604507 []

For Authors
If you would like to write for this, or any other Emerald publication, then please use our Emerald for Authors service
information about how to choose which publication to write for and submission guidelines are available for all. Please visit
www.emeraldinsight.com/authors for more information.

About Emerald www.emeraldinsight.com

Emerald is a global publisher linking research and practice to the benefit of society. The company manages a portfolio of more
than 290 journals and over 2,350 books and book series volumes, as well as providing an extensive range of online products and
additional customer resources and services.
Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee on Publication Ethics
(COPE) and also works with Portico and the LOCKSS initiative for digital archive preservation.
*Related content and download information correct at time of download.

Journal of Financial Crime Vol. 12 No. 2

The Billion-Dollar Hedge Fund Fraud

Greg N. Gregoriou and William Kelting

Journal of Financial Crime 2005.12:172-177.

INTRODUCTION

Journal of Financial Crime

Vol. 12, No. 2, 2004, pp. 172177
# Henry Stewart Publications
ISSN 1359-0790

Page 172

With the increasing volatility in stock and bond

markets during the last two years investors are
parking pension fund money and endowment fund
money in onshore and oshore hedge funds. During
the last decade the number of hedge funds has
increased exponentially with assets ballooning to
almost $650bn.1 Because hedge funds are loosely regulated by the Securities and Exchange Commission
(SEC) and are not usually subject to the various `security' Acts that the SEC administers they have managed
to keep their aairs and trading private. The recognition of hedge funds came in mid-September 1992,
when George Soros and his group at Quantum
nearly broke the Bank of England, by shorting
British sterling to the tune of $10bn. This resulted in
a quick prot of about $1bn that week. Since then,
hedge funds have been viewed with awe and as villains, by some, for destabilising market economies.2
Today, nearly 48 per cent of hedge fund managers
are domiciled in the USA and most are not required
to register with the SEC. However, the number of oshore hedge funds is growing faster in anticipation of
tighter and stricter future SEC restrictions. The SEC
might propose that hedge fund managers register
with the SEC. Doing so would allow the SEC to
control an industry of well over $600bn. Will this
eliminate hedge fund fraud? Obviously not, especially
if the barriers to entry are low and if investors are
looking to hedge funds for added returns.
Several hedge fund fraud cases during the last few
years have captured the attention of the SEC.
Because of the number of investors such as pension
funds and endowments which pour billions into this
industry, it has warranted a second and closer look
by the SEC. A current push is under way by the
SEC to force hedge funds to provide greater transparency and make sure that their internal control structure performs soundly. This is to ensure that funds
are providers of good business and ethical practices,
but may unfortunately serve as an incentive to locate
oshore in an attempt to hide unwanted news or
even conceal the hedge fund manager's background.
This is easily done by simply shifting the fund's
assets and registering the fund in an oshore jurisdiction, free of the SEC and its regulation. Forcing

hedge funds to become more transparent could

result in a tremendous outow of capital from the
USA. Although many hedge fund managers are advocating registration with the SEC, the world's largest
hedge funds (ie Soros Group of Quantum Funds,
Zweig-DiMenna and Moore Global among others)
are located in oshore jurisdictions.
The brightest brains on Wall Street and many
talented money managers tend to migrate to the
hedge fund industry. There are a few notable managers: Je Vinik, for example, who after managing
the $50bn Fidelity Magellan Fund formed his own
hedge fund and produced spectacular returns for his
clients. However, having an unregulated environment invites hedge fund managers, of whom many
are unwilling to play by the rules, to enter the industry
as well. Additionally, many well-known money managers have also crossed over to the hedge fund industry, some of whom were under the close scrutiny of
the SEC, and decided to open hedge funds to escape
the regulated environment. Information concerning
references, qualications, investment process, performance of the fund, ethics, and ability to have a
nancial solid and solvent position can be fabricated.
Therefore, data made available by the fund itself or
by database vendors in the hedge fund industry can
often be misleading. Hedge fund database vendors,
such as Hedge Fund Research and TASS, simply
receive returns net of all fees from hedge funds. In
some cases, stellar performance may be a sign of
impending doom or may warrant another look at
the hedge fund manager's practices. Furthermore,
seeing a ve-year track record without a single negative month may be a sign that the manager may be
`cooking the books'.

THE MEMORANDUM, LACK OF

TRANSPARENCY AND INFLATED
RETURNS

An assessment of the oering memorandum of hedge

funds may be an unsatisfactory document, especially if
memorandums are not drafted by attorneys specialising in the investment areas. Furthermore, one must
make sure the investment objectives of hedge funds
are properly dened and that the document does not

Journal of Financial Crime 2005.12:172-177.

The Billion-Dollar Hedge Fund Fraud

consist of vague paragraphs. In many instances, investors blindly hand over money to hedge fund managers
without any obvious understanding of how funds are
invested, the amount of leverage used and the turnover of the funds.
Forcing hedge funds to become more transparent
may identify more fraudulent hedge funds. However,
the solution also lies at making sure proper administrators, auditors and prime brokers reduce the risk to
investors of being scammed and victimised. Creation
of a non-prot hedge fund organisation, as a police
watchdog to monitor hedge funds carefully, may
lessen the blow and detect fraudulent hedge funds
before losses occur.
Since most hedge funds are unregulated, they
operate in secrecy, as the proprietary investment strategies of the manager cannot be revealed because of the
added value they bring to the fund. This is often a
good starting point for scams to occur. Why continue
hustling for commissions, selling penny stocks, when
for the price of having a lawyer draft a believable
private placement memorandum, someone can call
themselves a hedge fund manager? Leave behind any
disciplinary problems there may have been as a
broker regulated by the National Association of
Securities Dealers and, as a money manager unregulated by the SEC, charge clients a hefty `performance
fee' far greater than anything a conventional money
manager would earn.

BACKGROUND MANAGER SEARCHES

Many private investigators on Wall Street oer specialised services to investigate and make background
checks on hedge fund start-ups and their managers.
Recently, Picerno3 reported that over 150 fund of
hedge fund managers have hired private investigators
to examine the hedge funds they are interested in
investing in. Many investors today fail to examine
criminal records or prior fraudulent activities in
related nancial industries, or determine if any disciplinary action has been taken against managers
within the securities industry.
Not only does the hedge fund manager's background need to be examined but also that of their
support sta. A check of a manager's impressive
Wall Street client references revealed that the individuals named at each rm were brokers who had
simply executed trades on behalf of the fund. Wall
Street rms had never actually invested in the hedge
fund.4

Investors are also advised to verify if the hedge fund

is registered as an adviser. If not, then the assets of the
hedge fund may not even be held at a nancial institution. Simply receiving unaudited monthly statements
with over-hyped returns is not enough; statements
must be further examined to see if indeed some
accounting rm is auditing the fund. In many cases,
if investors cannot obtain supporting documents,
such as its detailed strategy and monthly returns, it is
best to avoid the fund. Furthermore, not obtaining
net returns on time or even months later could in
fact result from `cooking the books'.
Investors regularly make the error of assuming that
the retaining of a large accounting or law rm by a
hedge fund in some way guarantees that everything
is legitimate. Usually investors also assume that
accounting or law rms are discriminatory in representing their clients. Unfortunately, if clients pay
them exaggerated fees, law and accounting rms
will appreciatively take on the obligation. Indeed,
the most thriving scammers frequently outwit the
outside experts and may use the abilities and status of
these experts to legitimise the fraud. The existence of
a well-known and respected accounting or law rm
is a factor that should be considered, but unwarranted dependence should not be placed upon their
participation.
Many of the fraudulent hedge funds simply took
investors' money and used the funds' assets for personal and business expenses, such as purchasing mansions, expensive sports cars, sailboats, and even
memberships in exclusive country clubs.
Many of these hedge funds constantly lied to investors, by falsifying reports and putting these reports on
the company letterhead of respected accounting rms.
Many have used the technique of inating returns as
well as overstating the manager's management
experience and performance fees and even in some
cases manipulating the price of warrants on certain
stocks.

WHERE WERE THE AUDITORS?

The answer to that question is, `it depends'. Since most

hedge funds are not required to register under any of
the SEC Acts (namely, the Securities Act of 1933,
the Securities Exchange Act of 1934, the Investment
Company Act of 1940 and the Investment Advisers
Act of 1940), there is no federally imposed audit
requirement. In contrast, registered investment companies are prohibited from oering or selling their

Page 173

Gregoriou and Kelting

Journal of Financial Crime 2005.12:172-177.

securities to the public without ling independently

audited nancial statements with the SEC.
However, it seems that most hedge funds do engage
independent audit rms.5 Investors, of course,
should be highly sceptical of a fund that does not
engage an independent auditor. There are potential
problems even in those cases where nancial information is audited. These problems have to do with the
auditor selection process, the qualications of the
selected auditor and the nature of the audit procedures
that the external auditor may choose to apply.
The auditors of registered investment companies
must comply with the requirements of the Investment
Company Act of 1940 and also, in the case of investment companies whose securities are listed for
trading on a US exchange, the Sarbanes-Oxley Act
of 2002. The Investment Company Act requires that
the auditor be selected by a `majority of directors
who are not interested persons' (s. 80-a-31). The Act
also requires shareholder ratication of the selected
auditor, unless approved by an Audit Committee of
the Board (Investment Company Act Rule 32a-4).
The Audit Committee must consist solely of independent directors. The Sarbanes-Oxley Act requires
auditors of listed investment companies to meet
more stringent independence tests, including restricting the provision of non-audit services to the
company by the auditor and mandating auditor
rotation (ss. 201203). The Mutual Funds Integrity
and Fee Transparency Act of 2003 which has been
passed by the House of Representatives and is presently before the Senate would extend the auditor
requirements of the Sarbanes-Oxley Act to all registered investment companies (s. 104). Since most
hedge funds are not registered, and in many, if not
most, cases are organised as limited partnerships,
there is no similar requirement for auditor selection.
Potential investors should be aware of the auditor
selection process used by the hedge fund. In many
cases, this may simply be a decision made by the
investment adviser.
Auditors of registered hedge funds must adhere to
stricter requirements than those of unregistered
funds. Auditors of registered funds must follow the
rules and guidelines established by the SEC. Auditors
of registered funds must also follow some of the rules
set forth in the recent Sarbanes-Oxley Act. Auditors of
unregistered funds are not required to register with
the Public Company Accounting Oversight Board
(PCAOB) unless the audit rm happens to audit a
public company. The PCAOB has the authority to

Page 174

scrutinise the work done by the audit rm; in some

cases, hedge fund auditors would not be subject to
the same scrutiny.
There may also be signicant dierences in the
scope of work done by auditors of unregistered
funds. Auditors of both registered and unregistered
funds should follow the guidelines established by the
accounting profession such as those established by
the American Institute of Certied Public Accountants.6 However, auditors of registered funds are
required to do more extensive procedures in some
important areas. The SEC requires auditors of registered funds to report on the company's internal
control. Auditors of unregistered funds do not have
the same responsibility. They will consider internal
control in the course of conducting the audit but to a
lesser extent. Since internal controls are of the
utmost importance in minimising opportunities for
fraudulent behaviour, investors need to be wary.
Two important areas where the amount of work
done by the auditor diers have to do with custody
of securities and valuation of securities. Auditors of
registered funds must verify custody of all securities.
In the case of unregistered funds, the amount of verication is a function of the auditor's discretion. The
same dierence applies to checking the valuation of
the portfolio. Auditors of registered funds must
verify all portfolio valuations as of the date of the
nancial statements. Auditors of unregistered funds
will determine the extent of valuation testing judgmentally. This is a very sensitive area as many hedge
fund frauds have involved fraudulent valuation of
investments. In fact, in many cases, hedge fund valuations are provided by the investment adviser. Because
of the typical fee structure for hedge fund advisers, this
provides a tremendous incentive for fraudulent
activity.

NATURE OF THE BILLION DOLLAR

FRAUDS

The frauds below are fairly typical as to the approach

used by the fraudsters to perpetrate the fraud and in the
attempted cover-ups. Although not all the fraudulent
hedge funds are discussed, it is estimated that the
amount of fraud totals slightly more than $1bn.
Consistent with the ndings of the SEC, these frauds
consisted primarily of schemes designed to misappropriate assets, or funds provided by investors.7
Investors were persuaded to invest based on promises
of extremely high returns. Funds provided by inves-

Journal of Financial Crime 2005.12:172-177.

The Billion-Dollar Hedge Fund Fraud

tors were then diverted, in most cases, to nance the

lavish lifestyles of the perpetrators in massive Ponzi
schemes. When returns did not materialise, Michael
Berger provided the investors with false statements
showing both overstated positions as well as overvalued securities and overstated rates of return of the
Manhattan Fund.8 In the case of the Manhattan Fund
fraud, auditors were also supplied with bogus statements. On 13th November, 2001, the US District
Court, in a case between the SEC and Michael
Berger, found that Berger was liable for securities
fraud, ordering him to pay $20m.
Perpetrators of the fraud involving the Pinn Fund
supplied altered nancial statements as well as forged
audit reports. Subsequently the SEC led suit and
won in March 2001 against Pinn Fund and charged
Mike Fanghella with stealing $100m from its investors. The SEC won a $109m judgment against Mr
Fanghella.9
Friedlander's Jupiter, Iris and Friedlander International funds provided investors with nancial
statements accompanied by a compilation report prepared on KPMG's letterhead. A compilation does not
provide the user with any explicit assurance; however,
association with a prestigious rm such as KPMG does
provide some level of comfort. Unfortunately, the
report was fraudulently placed on KPMG's letterhead.
In May 2001 the SEC led a civil suit against Mr
Friedlander alleging a `massive fraud' and the US
Commodity Futures Trading Commission (CFTC)
charged him and his companies with deceiving
investors in a misleading scheme.10
In the case of the Maricopa Investment Fund fraud,
David Mobley (a hedge fund manager) refused to
provide investors or potential investors with audited
nancial reports. He stated that `audits would risk
divulging his secret and highly protable trading strategies'.11 The SEC froze his assets and a federal grand
jury indicted Mobley in a federal district court in Fort
Myers, Florida for defrauding investors of $120m. He
was then freed on a $75,000 unsecured bond and since
then he has not yet been charged.12
Fraud literature suggests that a fraud has three elements: incentive, opportunity and rationalisation.13
In the hedge fund fraud cases cited, it appears that
the incentive in each case was greed and the desire to
nance exorbitant lifestyles. It is dicult to assess
opportunity but it is evident that necessary internal
controls were not in place to prevent or detect the
fraudulent activity. The strong concentration of
power in the hands of the adviser and the lack of a

formal governance structure, particularly in the case

of partnerships, provided ample opportunity for
these white-collar criminals to carry out their activities. Rationalisation often depends upon the ethics
of the parties involved. In some cases, the fraudsters
may have rationalised that `everything would work
out in the long run'.

DUE DILIGENCE QUESTIONNAIRE

Fund of hedge fund managers, as well as institutional

investors, must exercise proper care, making sure a
manager adheres to the legal requirement to manage
the funds entrusted to it prudently, as enshrined in
the Uniform Prudent Investor Act of 1994. The principle of prudence stated in that Act has been incorporated into the law of the majority of the US states.
Putnam14 denes this rule as, `Those with responsibility to invest money for others should act with prudence, discretion, intelligence, and regard for the
safety of capital as well as income.' In essence, what
the prudent investor rule says is that those investing
the money of others will, as duciaries, be required
to exercise reasonable care, skill and caution in selecting investments. Therefore, the manager is, under a
legal aspect to investing a client's money, to ensure
that the investments selected are consistent with the
risk and return objectives of the client when that
investment is assessed in terms of its impact on the
client's portfolio.
Many institutional investors apply the mutual fund
manager selection process to hedge funds, believing
that talent is available in both areas.15 Once the
money manager or institutional investor has completed their due diligence process, the duciary has
an ongoing liability in performing its due diligence
as well as carefully monitoring the hedge fund managers in the Fund of Funds (FOF). Due diligence is
considered as a very important part of the selection
process;16 a suggested questionnaire is displayed
below in Table 1. Using such a checklist will enable
investors to be more informed and educated about
selecting hedge fund and FOF managers.

CONCLUSION

Investors like hedge funds because of their low correlations to stock and bond markets, but they are often
mesmerised by their above-average returns, even in
down markets. When examining hedge fund activity
many magazines and commentators have projected

Page 175

Gregoriou and Kelting

Table 1 Checklist for hedge fund investors

Journal of Financial Crime 2005.12:172-177.

(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
(13)
(14)
(15)
(16)
(17)
(18)
(19)
(20)
(21)
(22)
(23)
(24)
(25)
(26)
(27)

Was the hedge fund manager's background veried?

Has the hedge fund manager committed had prior disciplinary action against him?
Has a criminal and bankruptcy verication been conducted?
How long has the hedge fund manager been in business?
Has the manager previously managed a poorly performing fund which was eventually shut down?
Are the fund returns provided by the manager accurate?
Is the manager listed in any hedge fund databases?
Does the manager have well-known clients?
Are the manager's clients satised?
Do the hedge fund managers return phone calls and answer all questions?
How frequently are client reports issued?
How transparent is the fund?
How much leverage does the fund employ?
Does the manager provide a detailed risk management philosophy?
Does the fund maintain proper legal counsel and administrators as well as accountants?
Does the FOF manager geographically diversify his hedge fund managers?
How does the FOF manager control risk?
Does the FOF manager report correctly address and meet all requirements to educate investors on a monthly basis?
Do the hedge funds comply with the Sarbanes-Oxley Act?
Are the hedge funds registered with the Commodity Futures Trading Commission (CFTC)?
Are the hedge funds registered with the SEC?
If unregistered, are the nancing statements avoided?
If audited, who are the auditors?
Is the audit rm required to register with the PCAOB?
If audited, what type of opinion was rendered?
Do the promised returns make sense?
Do the monthly statements reect a reasonable rate of return?

that nearly 20 per cent of all hedge fund managers

participate in deceptive activities.
To minimise the risk of becoming a victim of fraud,
the following suggestions are oered: put hedge fund
managers under close scrutiny; perform due diligence
fraud tests; examine the manager's track record;
perform background checks; meet with current
clients of the fund; nd out whether other criminal
proceedings or prior convictions exist; and make
sure nancial statements are properly audited.
REFERENCES
(1)

(2)
(3)
(4)

Page 176

Schneeweis, T., Kazemi, H. and Martin, G. (2001) `Understanding Hedge Fund Performance: Research Results and
Rules of Thumb of the Institutional Investors', working
paper, University of Massachusetts, Isenberg School of
Management, CISDM.
`Mahathir, Soros and the Currency Markets', The Economist,
27th September, 1997, p. 87.
Picerno, J. (2001) `The Happy World of Hedge Funds',
Bloomberg Wealth Manager, November, pp. 6472.
Ibid.

(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
(13)

(14)
(15)

Securities and Exchange Commission (SEC) (2003) `Implications of the Growth of Hedge Funds', Sta Report to the
Securities and Exchange Commission, Washington, DC.
American Institute of Certied Public Accountants (AICPA)
(2003) `Audits of Investment Companies', AICPA Audit and
Accounting Guide, New York, NY.
See ref. 5 above.
Securities and Exchange Commission (SEC) (2001) SEC
Digest Issue, Nos. 218 and 221, 16th November.
Hewitt Investment Group (2002) `Shadow of Enron', Liquid
Alternative Market Perspective, Vol. 2, No. 1, pp. 16.
Commodity Futures Trading Commission (2003) Press
Release No. 4859-03, Washington, DC, 24th October.
Securities and Exchange Commission (SEC) (2000) Litigation Release No. 16446, Washington, DC, 22nd February.
Brannigan, M. (2000) `Fraud Charges Set for Manager of
Hedge Fund', Wall Street Journal (Eastern edn), 20th
October, p. 1.
Albrecht, W. S. (2003) Fraud Examination, Thomson Southwestern Publishing, Mason, OH; Wells, J. T. (1997) Occupational Fraud and Abuse, Obsidian Publishing Company,
Austin, TX.
Putnam, S. (1830) The Prudent Man Rule, Putnam Investment
Company Report, Boston, MA.
Hambrecht, G. A., Spitz, W. T. and Scherago, N. F. (2002)
Selecting a Hedge Fund Manager, AIMR Publications, Charlottesville, VA.

The Billion-Dollar Hedge Fund Fraud

(16)

Anson, M. (2002) The Handbook of Alternative Assets, John

Wiley & Sons, Inc., New York, NY.

The authors thank Dr Paul U. Ali (University of

Melbourne, Faculty of Law) and Dr Robert
Christopherson of the School of Business and
Economics at the State University of New York
(Plattsburgh) for helpful comments and
suggestions.

Journal of Financial Crime 2005.12:172-177.

Greg N. Gregoriou, Assistant Professor of

Finance and Research Coordinator in the
School of Business and Economics at the State
University of New York (Plattsburgh) and hedge
fund editor for the Derivatives Use, Trading
and Regulation (Henry Stewart Publications);
e-mail: gregorg@plattsburgh.edu. Tel: (518)
564 4202; Fax: (518) 564 4215. Address: 101
Broad Street, Plattsburgh, New York, 12901.

William Kelting, Associate Professor of

Accounting at the State University of New York
(Plattsburgh); e-mail:
william.kelting@plattsburgh.edu.

Page 177