Implications for hedge funds in 2009

Originally published in the February 2009 issue

Most hedge fund investors and managers will be happy to see the back of 2008. During a year in which performance in the industry was extremely disappointing, the criminal investigation of Bernard L. Madoff Investment Securities has been exceptionally bruising. Reportedly, over 8,000 claim forms have now been distributed by Madoff’s bankruptcy trustee, and the estimated $50 billion loss is the largest suspected financial fraud in history. Investors should be reminded, however, that Madoff was not structured as, and is not representative of, a typical hedge fund.

Firstly, investors who invested directly with Madoff did not buy shares in an offshore company or partnership interests in an onshore limited partnership. They opened a trading account. The assets of the account were then managed, executed and held in custody by Madoff. Typically, hedge funds will:

• utilise independent brokers to execute trades,
• engage a fund administrator to independently calculate the NAV of the fund, and
• retain independent custodian(s)/prime broker(s) to custody the fund’s positions.

The segregation of these functions is typical of the hedge fund industry and, amongst other things, plays an important role in reducing the risk of fraud. While most feeder funds into Bernard L. Madoff Investment Securities utilised independent fund administrators and auditors, in this instance, these service providers had no other choice but to verify the existence and accuracy of the trading information back to Madoff, rather than to an independent broker.

Secondly, it was extremely unusual for a firm of Madoff’s size and supposed reputation to utilise an audit firm which was quite clearly not one of the “top four” firms nor a specialist in auditing broker-dealers or financial institutions. The vast majority of hedge funds engage one of the top four audit firms or regional firms which have an established alternative investment audit practice.

Thirdly, in this electronic era, it is unusual for a broker to refuse to send trade tickets to clients, other than in hard copy form via the postal system. All established and reputable brokers have the technology to provide their customers with timely, electronic access to their accounts. This, combined with the lack of segregation of key functions noted above, appears to have facilitated Madoff’s alleged Ponzi scheme.

Finally, Bernard L. Madoff Investment Securities was infamous for not letting investors visit its offices to perform any on-site due diligence. Investors who were provided access and “capacity” to Madoff considered it a privilege. There are less than a handful of sizeable hedge fund firms in the industry that will not permit investors to perform due diligence on their organisation. In this day and age, professional asset managers who have built significant businesses understand the need to (i) demonstrate to investors that they are following operational sound practices and (ii) provide operational transparency.

Many who invested with Madoff recognised the risks involved. A logical counter argument to all of the above “red flags” was that there would have to be substantial collusion within Madoff for such a fraud to go undetected for any lengthy period. Furthermore, Madoff was regulated by both the SEC and FINRA.

Bernie Madoff was a substantial figurehead in the US securities industry, having been chairman of the NASDAQ, a member of the board of governors of the NASD (now FINRA) and a current board member of the DTCC and the Securities Industry Association.

Madoff’s requirement for investors to custody their positions with his firm also seemed reasonable at the time, given the nature of the purported investment strategy and core business activities. However, hindsight has shown that Madoff’s reputation and stature overshadowed basic good governance principles.

Investors who were fortunate enough to redeem their money prior to the Madoff scandal have another worry: fraudulent conveyance. Court precedents related to Samuel Israel III’s Bayou Group Ponzi scheme required investors who withdrew money prior to the discovery of fraud, to return their invested principal if there was evidence that the withdrawal was prompted by suspicion or warning of fraud. Additionally, bankruptcy-receivership practices require the return of profits made within the last six years, as withdrawals paid from other investors’ contributions make the payments “fraudulent transfers”.

Investors should also be aware that those who seek recovery from third party service providers, such as auditors and fund administrators, will have an uphill battle. The Lancer Offshore, Inc case in October 2008 illustrates that, absent direct involvement in the fraud by service providers, their insulation from liability is significant.

We hope 2009 will bring better fortune to the hedge fund industry and that, once the dust settles, those investors and managers that have survived last year’s “perfect storm” will be better placed to seek out investment opportunities, having learnt significant lessons on investment and operational risk management. We anticipate that when investors allocate to the sector this year, they will do so with greater scrutiny of internal controls and operational risk management. Accordingly, hedge funds will need to be “whiter than white” and provide their investors with greater operational transparency.

Madoff is a reminder to all of us that the reputation and track record of a firm, no matter how lengthy or impressive, cannot be solely relied upon as justification of a manager’s worthiness for investment. Additionally, while most fund of funds and investment advisors will claim to have a very thorough operational due diligence process, Madoff has shown that this is not always the case. In an environment where hedge fund advisors find it increasingly difficult to generate performance for their investors, there is generally a higher risk of “cutting corners” in the due diligence process and/or ignoring warning signs which have been highlighted by analysts. Therefore, when vetting an advisor’s due diligence process, investors should ensure that their advisor is not only saying what they do, but also doing what they say.

Reiko Nahum founded Amber Partners in July 2004 and launched Amber Partners’ Operational Certification in November 2005. Prior to founding Amber, Nahum was President and Director of UBP Asset Management (Bermuda) Limited and a Member of Senior Management of Union Bancaire Privée.

Amber Partners, with offices in London, New York and Bermuda, is a leading independent operational risk certification firm to the hedge fund industry. Amber conducts comprehensive due diligence, providing certification to funds that meet a benchmark of operational quality.