Staying in Front of Fraud

Vetting hedge fund managers is part of due diligence

KENNETH SPRINGER

A hedge fund manager volunteered to his investors that he had filed for bankruptcy protection. He told them the filing was a result of a disagreement with a health insurance company that refused to pay the exorbitant medical bills associated with a car accident in which his wife was seriously injured. He told the investors up front and they appreciated the disclosure.

Unfortunately, this was not the real story.

The hedge fund manager did file for bankruptcy protection. And, his wife was in a serious car accident. However the bankruptcy happened two years before the accident. The two events were mutually exclusive.

This is one example of the issues we uncover when vetting hedge fund managers. In this case, the discrepancy we uncovered in the hedge fund manager’s story was too much of an ethical risk for our client (the investors) to proceed with their investment. They figured if the hedge fund manager had knowingly lied about a bankruptcy (and deceitfully tried to blame his wife’s suffering), what else would he lie about?

Since 1991, we have conducted background checks, business intelligence and corporate investigations globally to investors of all types. In each investigation, we seek to identify issues that may impact investors’ decisions. When conducting background checks on hedge funds and managers, we have found some common themes.

One of the things we see quite often is resumé fraud or exaggeration of credentials. We have found hedge fund managers who have lied about the schools they attended (it is not statistically possible for every hedge fund manager to have gone to an Ivy League school) or the professional designations awarded (not everyone has a CFA). When we conduct background checks we confirm the degrees, licences and designations the hedge fund manager has claimed have been received.

Often a manager will downplay (or deny) involvement in regulatory actions. One investor spent six months working through due diligence with a hedge fund manager. The day before the allocation was scheduled, the manager told the investor he “might be getting a slap on the wrist” from regulators; that the situation was “not a big deal” and he was “just a scapegoat.” The investor called us, asking if it was possible that the manager had indeed been blindsided by regulators. We found that the manager had known for quite some time that disbarment and fines were coming. We know from experience that when an individual is being investigated by financial regulatory agencies, the investor knows about the inquiry. Depending on the circumstances, the individual being investigated may receive a “Wells” Notice, retain counsel and/or will be called to appear before an arbitration panel. This manager had deliberately not told the investor what was going on.

Also, when we conducted a de facto background check on the manager we found that the manager had been sued by a former co-founder of the hedge fund. The lawsuit in the court docket system showed the cause of action in this lawsuit to be “breach of contract” yet when we went further and reviewed the actual documents filed in the case, we found the co-founder of the fund alleged the manager had been inappropriately using investor funds for private use. This gets to another issue we often confront in background checks: reviewing documents filed in lawsuits identified in order to learn more. Just because a lawsuit has been closed and/or lists the cause of action as something that appears to be in the normal course of business, does not mean that is actually the case. Lawsuits should always be reviewed, documents retrieved and additional information gathered in order to get the best understanding of what transpired in each case. Robert Allen Stanford is a high profile example. Though sued for breach of contract, several complaints in these lawsuits also allege varying degrees of fraud.

When we find discrepancies between what the manager has represented and what actually happened (either in a resumé, a lawsuit or a regulatory action), we bring these matters to the investor’s attention. Often investors rely on us to approach the issue directly with the manager. As an independent third party, we often interview the managers to clarify information identified during our research and document the manger’s explanations. In these interviews we have sometimes found that there are legitimate reasons for the exaggeration, other times the manager sticks to the lie and in other situations, the manager comes clean. However it plays out, investors benefit from having these issues documented and verified in order to avoid any questions or problems in the future.

When vetting hedge fund managers for investors we routinely identify other partners or owners of the fund with whom the investors are not familiar. Whether through corporate record filings or through the Form ADVs on file with the SEC, we identify these other owners or directors of the fund. Investors need to know who has, or will have, control of the hedge fund. These other players in the fund are just as important as the manager because clearly they have an impact on the investment decisions. We always recommend conducting additional research on these owners of the fund as well as contacting the fund’s prime broker, administrator, accountant and attorney to confirm the fund’s relationship with these service providers and to learn more about the fund and its management team. As we learned from Stanford, Bernie Madoff, Ken Starr and other recent fraud schemes, the fund’s relationship with accountants is critical (as is the relationship with other providers). A lot can be learned from reaching out to these firms.

Over the past two years, investors have reassessed their due diligence procedures and sought to demonstrate that they have the proper controls in place to prevent fraud. After all, what do Stanford, Madoff and Pang have in common? None of them had criminal records…until now. Investors should know that background checks can no longer be a simple “check the box” step. It is crucial to conduct rigorous research and analysis before making an investment. Background checks are a critical component to the due diligence process and rigorous research and analysis must be completed before investors make allocations.

Lastly, hedge fund monitoring has become another critical component of investors’ due diligence process. Investors hire us to update the background checks to determine if there are any new lawsuits involving the manager; if he/she has formed any new entities that may pose a conflict of interest; to identify involvement in criminal actions or regulatory sanctions that have been filed since the original background checks were conducted; and, to locate any news articles or blogs that are derogatory about the manager.

Also in this vein of staying in front of fraud before it occurs, we offer our Ethics Hotline to hedge funds as a self-compliance tool. The hotline is a vehicle for employees, service providers and others to anonymously report fraud or unethical behavior. The complaint comes directly through us and, since we are retained through outside counsel, the complaints/allegations are addressed jointly by counsel and us and then any necessary precautionary moves are decided under the discretion of counsel and the fund. This process allows investors the comfort of knowing that a process of full transparency is in place to guard against fraud.

Ken Springer, a former FBI Agent and Certified Fraud Examiner, founded Corporate Resolutions Inc. in 1991. The company is based in New York and has offices in London, Hong Kong, Boston and Miami.