The hedge fund industry currently finds itself under siege. Events including the Madoff scandal, the global financial turmoil and the publication of the proposed European Directive on Alternative Investment Fund Managers have put hedge funds in the spotlight to an unprecedented degree. These same developments have seen concerns raised over the fraud risks that may be inherent in hedge funds. Certainly, we at the Serious Fraud Office have been facing frequent questioning over our approach to the industry.

Shared interest
To answer this question,I would like to start by asking another question in return: who were the biggest victims of the Madoff fraud? True, the most direct losers were Madoff’s investors, many of whom tragically lost their life savings. These are the kinds of people the SFO was set up to help protect, and we aim to do so. But another major loser from the Madoff scandal – certainly in reputation terms – was the hedge fund industry itself, which found itself linked repeatedly with fraud in the media. In effect, a small number of isolated but breathtaking frauds have undermined public trust in an entire industry. Our role and objective are to drive down the incidence of fraud, and the best way to do this is by stopping frauds from happening in the first place. So we share a common goal with the hedge fund industry in countering fraud, to protect not just the industry’s investors but also its reputation.

A pathologist, not a regulator
This close alignment of interests shapes our approach to the industry. We are not out to ‘get’ hedge funds. On the contrary, we are committed to working closely with industry bodies such as the Alternative Investment Management Association (AIMA) and with hedge funds managers themselves to tackle fraud in the sector. Two key points underpin these efforts at engagement. One is that we are not a regulator. Our focus is purely on serious and complex fraud, and we get involved only when things go wrong. A bit like a pathologist, we examine the corpse, make a diagnosis and try to avoid the same thing happening again. Secondly, our expertise is in large and sophisticated frauds, not in the market processes that provided the vehicle or them. By combining our own deep experience in tackling fraud with hedge fund practitioners’ knowledge of market operations, we have the best possible chance of identifying and stopping fraud.

Reasons for scrutiny
That said, hedge funds do have several characteristics that cause us to pay particular attention to the sector. The first is that they tend to be less transparent than other financial products and services, reflecting their use of distinctive investment strategies and their high-net-worth client bases. Secondly, hedge funds’ speed of operation is unparalleled. Part of their strength is that they can change their investment strategies by the day, and move large amounts of money around very quickly. Thirdly, the dynamics through which hedge funds win and retain investors are often the reverse of those seen elsewhere. Traditional fund managers strive to convince potential investors of their trustworthiness. In hedge funds, the power of individual managers’ reputations means it is often investors who feel they need to stay in the fund manager’s good books. At the SFO, we appreciate there are sound commercial reasons for all three of these attributes. But their overall effect is to increase the level of fraud risk around hedge funds, meaning we must track developments in the industry especially closely.

Early warning
So, what indicators might provide early warning of fraud in hedge funds? In the wake of Madoff this question has attracted intense interest, with many studies published listing potential warning signs. These analyses have tended to focus narrowly on the needs of the investor. To fill this gap, we have applied the co-operative approach I described above. This has included the creation of a multi-stakeholder Hedge Funds Working Group made up equally of market practitioners, advisers and commentators – hedge fund managers, auditors, lawyers and journalists – on the one hand, and of the FSA, SFO and Serious Organised Crime Agency (SOCA) on the other. By bringing together our own and SOCA’s expertise in tackling sophisticated fraud with the market practitioners’ insights into how hedge funds operate, the working group has built a computerised process model of a hedge fund. This model has provided the basis for a new analysis of how money can be taken out of the hedge funds illegally. As a result, we have been able to create an industry’s-eye view of the red flags indicating fraud. We will publish this analysis before the end of the year to provide practitioners, regulators and enforcement agencies with a robust listing of the warning-signs, enabling us to continue co-operating to bear down on fraud.

Lessons to date
As we compile this list, recent experience has already provided a number of valuable pointers. While hedge funds are renowned for their complexity, they appear to be vulnerable to two fairly basic frauds: either the fund accepts investment, but does not acquire the assets it claims to be buying on the investor’s behalf (often on such as scale that it becomes a genuine Ponzi scheme in which new investments are recycled to keep existing investors content without any underlying assets at all); or the fund accepts the investment, but misrepresents the value of the assets it acquires. In combination with these types of misrepresentation, there are four forms of criminality that have been commonly related to hedge fund frauds. These are:

• Money laundering: Investors using hedge funds as a means of laundering the proceeds of crime, exploiting their lack of transparency and offshore domicility.

• Tax evasion: Offshore domicility used to facilitate tax avoidance by investors.

• False accounting: To extend the lifespan of the fraud, perpetrators present false documentation to investors.

• Theft: Fund managers appropriating investors’ capital for their own purposes.

Such activities commonly raise a number of warning-signs. Returns that are inconsistent with indices and peers, persistent market rumours, and unusual transfers or activity near a quarter-end or year-end all present cause for concern. The quality of the independent auditor is a further factor; the issue is not whether the auditor is big or small, but whether it has sufficient understanding and experience of the alternative investment market to provide real rigour.Any lack of effective internal challenge is a further worry, focusing on whether the fund has robust corporate governance structures, strong external directors, and evidence of proper due diligence. Warning-bells also ring in a situation where a fund has a single dominant investor, raising the risk of undue influence and smaller investors being disadvantaged. And although most funds will make use of offshore jurisdictions, the use of multiple jurisdictions, with assets flowing between several centres, may be an additional indicator.

Moving forward through engagement
As I mentioned, we will soon be publishing a more comprehensive list jointly with SOCA and the industry. In the meantime, it seems clear that the media and regulatory focus on hedge funds will continue. For our part, we are currently investigating four or five suspected frauds in hedge funds, including the UK end of Madoff. It’s in everyone’s interests that we all co-operate to minimise the risk of another Madoff or any other serious fraud. To achieve this, we will continue to engage with the industry, and to encourage early and full reporting of risks and well-founded suspicions. We want to prevent fraud, as does the industry – and the SFO will keep working with the hedge fund sector to do this.

ABOUT THE AUTHOR

Richard Alderman became Director of the Serious Fraud Office in April 2008. As Director of the Inland Revenue’s Special Compliance Office from 2003 to 2005, he was responsible for all criminal investigations.