“I’M SO TIRED of the lies right now that I could scream. I’m not a good liar and my mom always said it made my ears turn red,” laments Charles L Harris, principal of hedge fund Tradewinds International.
When the performance of 43-year-old Harris’s hedge fund headed south he made a decision that would not only change his and his family’s lives for ever but also those of all of his investors.
When he realized that he had no other choice than to come clean, Harris made a DVD recording in July 2004 asking his investors to treat him with compassion and permit him to continue his efforts to try to recoup their lost money.
He also admitted that he had taken investor money offshore. The recording in which he confesses to being a pitiful liar shows him on a boat, presumably the $481,000 62-foot yacht listed in his assets, probably anchored somewhere in the Caribbean.
Tradewinds International LP was created by Harris in 1996 and was run from his home and an office in Winnetka, Illinois. It invested in currency, bond and equity products. In 2001, he created Tradewinds LLC, the general partner of his second investment fund which was called Tradewinds International II LP.
Harris explains: “Last year [2003] we had an error and we actually lost about 8% for the year instead of being up by 12%. I knew it existed and I tried to make up for it and I just made a big mistake… big mistake.”
Two months after Harris sent the recording to investors, on September 1 2004, in a coordinated effort the SEC and the Commodity Futures Trading Commission brought a civil lawsuit in the federal district court in Chicago, Illinois, against Harris and his hedge funds. The funds’ assets were frozen and an order to preserve all documents was obtained by the court.
Although most hedge funds and funds of funds prefer to have investors believe that hedge fund fraud is not a significant concern, it is happening too often to be ignored.
In the past three months alone the SEC has brought five cases against hedge fund advisers for allegedly defrauding investors or using their funds to defraud others.
This brings the total of such cases for the past five years to 51 and estimated investor losses to more than $1.1 billion.
Jamey Basham, branch chief at the office of investment adviser regulation in the SEC’s investment management division, says: “It’s very common to see misrepresentations by the hedge fund adviser to investors to cover up losses.”
He adds: “For the smaller frauds, it’s more common that it’s just outright diversion of assets. For the larger cases it’s more common to see failed trading strategies.”
NAV misrepresentation On September 9 the US Department of Justice, through the US District Attorney’s office for the Northern District of Illinois and federal agents, filed a criminal lawsuit against Harris, and the FBI arrested him in Miami.
The CFTC and the SEC allege that Harris had fraudulently raised at least $10 million from at least 30 investors for Tradewinds International II. They allege that he defrauded investors by misrepresenting the value of the fund and past rates of return.
They also allege that he misappropriated the funds by using them allegedly for personal and business purposes.
In particular, Harris faces allegations that he told investors in 2003 that the fund’s net asset value was between $18 million and $23 million when trading account statements show a total value of $1.1 million during that time and only around $30,000 left at the end of 2003.
In addition, the CFTC states: “Harris may have used at least $1 million in investor funds for purposes other than trading, including for Harris’s personal and business expenses” during 2003 and 2004.
The SEC’s complaint alleges that “in 2003 and 2004, at least $2.4 million of investor funds were never transferred to the trading accounts, but were used instead for Harris’s personal and business expenses and to repay investors at artificially inflated rates, while Tradewinds II secretly incurred losses”.
In the footsteps of Ponzi When a manager maintains the fiction that a fund is producing returns by using new investors’ cash to repay other earlier investors “at artificially inflated rates” rather than investing it, it’s known as a Ponzi scheme. The criminal strategy is named after Carlo Ponzi, who in 1919 was the first to utilize it.
Harris might face up to 30 years in prison if he’s found guilty of the charges brought by the DoJ. He might also face a fine of at least $1 million, depending on his ability to pay, and the court can also declare forfeit any ill-gotten gains. Both the civil and criminal lawsuits are pending and Harris is being held in custody.
His is not an isolated case.
The SEC filed its most recent action against hedge fund advisers on October 14 for alleged association with a Ponzi scheme. The SEC filed a complaint in the US District Court for the Southern District of Ohio alleging that several individuals had, among other things “defrauded dozens of investors by conducting a Ponzi Scheme through a purported hedge fund, Paramount Financial Partners, LP.”
The SEC also alleges that the one of the individuals and various fund marketers persuaded people to invest at least $15 million in the hedge fund between at least May 2000 and March 2001 and then the individual “misappropriated or diverted those funds to pay earlier investors and pay personal business expenses”.
The largest of the five actions the SEC has filed against hedge funds for fraud since the end of July involves 33-year-old Charles Angelo Haligiannis and hedge fund Sterling Watters.
On August 13, the SEC alleged that Haligiannis had “systematically been defrauding investors who purchased limited partnership interests in Sterling Watters”. It accuses the manager of raising at least $27 million since 1996 by dramatically misrepresenting the performance of the fund.
The SEC alleges that Haligiannis stated in marketing material that the fund had $180 million in assets and that it had returned more than 1,500% since inception. It also alleges that the manager had sent investors a quarterly account statement at the end of July that “showed an aggregate of tens of millions of dollars of investor equity in the fund” when brokerage records show the fund had been losing money to the point that it was “essentially worthless”.
The US Department of Justice, under the auspices of the US Attorney for the Southern District of New York, announced the unsealing of its indictment against Haligiannis on September 30.
In addition to similar accusations as the SEC, the DoJ alleges that Haligiannis used new contributions to pay existing investors or to “fund withdrawals made for Haligiannis personally”, in a manner similar to a traditional Ponzi scheme.
The indictment also alleges that in 2000, for example, the fund reported that it was up 41.45% for the year but had in fact suffered more than $17 million in trading losses.
The regulatory response While these cases and others proceed, the debate over how to prevent hedge fund fraud from getting out of control is becoming more intense.
Hedge fund assets have grown by more than 30% in the past year alone and are expected to reach $1 trillion as early as the end of the year.
Regulators are trying to extend their oversight to hedge funds. But they probably have too few capable staff to be effective. Meanwhile, some hedge funds are responding to demands to demonstrate an independent confirmation of valuations of their holdings and performance. But investors still need to be wary of how these valuations are obtained.
The potential for investors to be taken advantage of by unscrupulous hedge fund managers has become such a concern to the SEC that it made it one of its priorities when it proposed a new rule and amendments to the Investment Advisers Act of 1940. However, it is not clear that compulsory registration for managers of hedge funds with assets above a specified size, the rule the SEC came up with, is the answer.
Controversy The rule was passed on October 26, but not without controversy. Only three of the five SEC commissioners – Democratic commissioners Harvey Goldschmid and Roel Campos and chairman William Donaldson – voted in favour. Republican commissioners Cynthia Glassman and Paul Atkins opposed the rule.
The split between the commissioners reflects the split in industry opinion. Many market practitioners doubt that registration will bring any benefits. According to the SEC, 54% of the letters received during the consultation period opposed the rule, 19% supported it and the remaining 27% raised issues with the rule.
The Investment Company Institute and Investment Counsel Association of America were among those that favoured it; the Managed Funds Association joined the majority of hedge fund managers that responded in opposing the rule.
More than 40% of existing hedge funds already register with the SEC and many testify that the registration process is not burdensome.
Jonathan Bean, managing director at Mellon HBV Alternative Strategies, says: “We’ve been registered with the SEC for more than four years.” He says compliance has been relatively simple. “[For example,] we had a CFO from day one,” he says. “But most don’t,” he adds.
He points out, though, that the additional cost involved will mean “fewer participants coming to the market”. This might work in the favour of existing hedge funds as there will be fewer of them chasing market opportunities. “I suspect higher returns for those in the market now,” says Bean.
While the SEC commissioners concur that there has been an increasing amount of hedge fund fraud, opinion is divided as to whether mandatory registration of managers will prevent it.
Commissioner Glassman says of the five most recent cases brought by the SEC: “The proposed rule would have had no effect on any of them.” This is because managers of hedge funds with less than $25 million in assets under management will not be required to register. Four of the five most recent cases involve hedge funds under that size.
Ted Laurenson, partner at law firm Baker McKenzie and a member of the American Bar Association’s task force for the proposed hedge fund rules, says of the recent cases brought by the SEC against hedge funds: “My own view is that it’s quite unlikely that someone who is going to engage in this kind of activity would register with the SEC in the first place, even in the face of a requirement to do so.”
Evading the regulator Laurenson points to another widely held concern with SEC hedge fund regulation. “A concern a lot of us have, which has given rise to scepticism, is that the people who do the SEC examination are generally very junior people at the SEC,” he says. “They’re not particularly in a position to evaluate what’s going on within a hedge fund [for complex strategies].”
Commissioner Glassman takes up this point. She says: “The chairman has stated that the SEC only has 495 staff conducting examinations of around 8,000 mutual funds managed in over 900 fund complexes and over 8,000 investment advisors.” She adds: “We’re already stretched as an agency to examine the mutual fund industry with around 91 million investors.”
The implication is that those who have enough money to invest in hedge funds had better be able look out for themselves.
Richard Perry, head of the financial services group at law firm Simmons & Simmons, agrees. “[SEC hedge fund regulation] is unlikely to be effective because they have enough difficulty regulating mutual funds and now have to take on hedge funds as well,” he says. “And the priority must be mutual funds because it involves retail investors and they need the protection.” What can regulators do? Perry says: “I could imagine a scenario where a registered investment adviser is not permitted to calculate the NAV of their funds.”
Regardless, the SEC hopes that making hedge funds register will at the very least give it a definitive view of the number of hedge funds operating in the US and the size of assets invested in them.
Moreover it hopes that the requirement for hedge funds to be able to prove robust pricing procedures for valuing funds and the threat of an unannounced visit from SEC inspectors will at least help to discourage hedge funds from defrauding investors.
Investors themselves might be well advised to inquire more closely into hedge funds’ risk management infrastructure and the quality and independence of middle-office staff employed to confirm valuations. These are a bulwark for shareholder protection at the large investment banks from which many star traders have sprung into the less regulated and less controlled hedge fund world in recent years.
Bitter experience Banks have endured bitter experience of rogue trader risk that has driven them to beef up risk management and hire independent staff capable of standing up to the forceful personalities of star traders who bring in big revenues for the firms.
Many hedge funds lack such infrastructure. “One of the issues is the mispricing of securities in order to hide failures from investors,” says Robert Plaze, associate director of the investment management division at the SEC.
“Here are people under immense pressure to produce returns and so some people succumb to fudging. There are no internal checks against fudging. There’s no-one looking over their shoulder to check pricing.” He adds: “Mutual funds have a board of directors and auditors.”
It may be that the hedge fund industry would have moved towards objective pricing without regulators pressing for it. Dan Shapiro, partner at law firm Schulte, Roth & Zabel, says: “Regardless of registration [requirements], there’s a lot of pressure from investors and people who work with hedge fund managers such as prime brokers and administrators to move in the direction of more objective attempts [at pricing].”
A Capco study published in its Alternative Investments journal in August shows that valuation issues have played either a primary or contributory role in 35% of hedge fund failures. It also found that in more than half of these cases, failures due to valuation issues were caused by fraud and misrepresentation.
Shahin Shojai, director of strategic research at Capco, says: “If [a hedge fund] manipulates the numbers then everybody loses money. So you need independent people not paid by the hedge fund to evaluate what hedge funds do.”
Head of risk management at Man Global Strategies John Vlasto says that Man’s business makes use of independent valuation services and third-party risk management services.
| SEC cases filed against hedge funds Since August 1 2004 | ||
| Date of filing | Defendant | Alleged amount |
| 02-Sep | Charles L Harris | $10mn |
| 25-Aug | Haligiannis et al | $27mn |
| 24-Aug | Scott B Kaye et al | $1.9mn |
| 18-Aug | Gary M Kornman | $142,000 |
| 09-Aug | Anthony P Postiglione et al | $5mn |
He says the firm uses valuation service providers to capture the prices of instruments held in the underlying MGS managed accounts. The valuation service provider (VSP) will then calculate the month-end net asset value of these funds for Man.
Many administrators, such as Bysis, Citco, PFPC and HSBC/Bank of Bermuda, offer independent valuation services.
HSBC acquired Bank of Bermuda in February this year which included its Alternative Fund Services division (AFS). Post-acquisition, AFS has more than $170 billion in assets under administration and $140 billion of that is alternative assets, with the majority being single hedge fund and fund of fund assets.
Drew Douglas, global head of product management for HSBC’s Alternative Fund Services, says: “Single strategies and pricing are an issue in the industry and as investments become more complex it becomes more difficult.”
Equities are easy to value as they are traded on an exchange. However, the widespread use of complex products such as credit default swaps, swaptions, floors and caps have made it more difficult for hedge fund managers to price their investments, let alone for third parties to do so. “[Independent valuation is] all based on the caveat that an independent expert can value the products,” says Capco’s Shojai.
Shojai believes that “99% of people trading convertibles have no idea how they are priced. You’ve got fixed income, options and underlying equity constantly changing. If you have got a portfolio of these things it’s the most difficult thing to do.”
This makes it easier for prices to be controlled. “If [a fund is] down 10% [the manager can] easily manipulate convert pricing to show that it’s up by 10%,” he says.
Valuation service providers use brokers and counterparties to value complex trades. However, there’s the potential for collusion between the broker and the hedge fund manager as the manager is the broker’s client. “VSP providers would insist on at least two sources for such trades,” says Man’s Vlasto.
HSBC’S Douglas believes that administrators are meeting the challenge. “We price [complex instruments] by using complex pricing models.” Models are not the market but at least they can be independent.
A third party provides the software. For example, HSBC uses SunGard’s FastVal. “FastVal by SunGard Reech allows us to independently price a range of over-the-counter products,” says Douglas. “We often get prices from a market maker or broker and use pricing tools to validate it.”
Douglas acknowledges that illiquid securities are also difficult to price. “If it’s a listed instrument but it hasn’t traded for a while we often use the average of brokers’ prices,” he says.
Hedge fund managers are moving towards daily pricing, which is proving to be another challenge for administrators. HSBC’s Douglas believes that half the challenge of providing independent daily pricing is to identify good software. “[You need software for] managing market data and connectivity to the underlying environment to enable you to do it on a daily basis,” he says.
It’s not enough just to know that a hedge fund has an independent administrator. Investors need to know the role being played by the administrator as many hedge funds that employ administrators do not use them for calculating NAV.
Peter Astleford, partner and co-head of the financial services group at law firm Dechert, says: “In the US, some do [use administrators] to some extent which is the worst because [investors] think they have the comfort of independent administration [that is, independent valuation].”
Side pocket security
Another way in which hedge funds have begun to deal with securities that are difficult to value is to exclude these securities from the fund’s NAV and put them in a so-called side pocket instead.
“What that means is that the investment is held only for the benefit of the people that were investors in the fund on the day that the investment was made,” says Harry S Davis, a litigation partner at Schulte, Roth & Zabel who represents many hedge funds.
“The security in the side pocket is not marked to market or revalued when the rest of the portfolio is revalued (such as monthly for purposes of calculating the monthly NAV). Instead the security is kept at the value at which it was purchased,” he adds.
“The security isn’t valued again until the fund sells the security and then it is valued at its actual sale price. This takes the subjectivity out of the valuation process because the security is only valued twice, once when it is purchased (at its actual purchase price) and again when it is sold (at its actual sale price). And the only investors who get the profit or loss from that security are investors that are in the fund at the time that the security is purchased,” explains Davis.
The profit or loss on the sale of that security is then credited to the capital accounts of only those investors who had investments in the fund at the time the security was purchased.
But, what if an investor wants to get out before the security has been sold? “You could redeem your investment in the non-side-pocketed part and get the other [returns from the side-pocketed investment] when [the manager] gets rid of it,” says Davis. “Alternatively, the manager could give the redeeming investor its pro rata share of the security.”
European-based industry players believe the fact that there have been few cases of hedge fund fraud discovered in Europe so far – if any – shows that the wider use of independent administrators by European hedge fund managers has acted as a preventive.
There is a stark difference between the European model and the US model. Research and data firm HFR’s figures show that most offshore funds use an administrator whereas many US-based funds do not. Of the 87.8% of the funds (onshore and offshore) in the HFR database that reported to HFR that they use an administrator, only 24.4% are domiciled in the US.
Perry at Simmons & Simmons, says:
“One thing that’s clear in the European model is that it’s the norm for an administrator to independently calculate the net asset value per share of the fund.” He adds: “The norm in the States is for the investment [hedge fund] managers to calculate the net asset value per share [themselves].”
Astleford adds: “US hedge funds [typically] calculate NAVs wholly or partially themselves. So either through fraud or error there’s a lot more scope to get it wrong.”
After attending a recent conference held in the US by the Institute of Financial Engineers, Perry says: “It’s clear that no-one there, including investors, seems to be demanding independent pricing of funds. It’s just what they’re used to. People are saying ‘what’s the value add of an administrator?'”
European hedge funds might be more likely to use third-party administrators partly because of UK tax law. “My theory [as to why the European model is different] is that European hedge fund management has been centred around the UK until now,” says Perry.
“UK tax rules on offshore funds mean that [hedge fund managers] make sure the fund is clearly managed and controlled outside the UK. Therefore, it’s been convenient for everybody to appoint non-UK fund administrators to deal with the administration side including NAV calculations. It has reinforced independent administration and calculation of NAVs.”
Tax imperatives
It’s an unintended consequence that may benefit investors. Hedge fund managers need to minimize their funds’ onshore activities in the UK in order to take advantage of tax benefits offered to offshore funds. This often means that the European hedge fund managers are based onshore in the UK and as much of the rest of the business as possible is outsourced to offshore service providers.
Conversely, hedge funds in the US are onshore and there has been no tax motivation to contract administration services out to an independent service provider.
Independent valuation will not on its own prevent hedge fund advisers from engaging in fraudulent activity.
For example, infamous hedge fund Manhattan Investment Fund, whose principal Michael Berger was found liable for securities fraud in 2001, had a third-party administrator and yet was still able to dupe investors. Berger was shorting technology stocks as the sector boomed, yet was able to present a gain to investors as he had “inserted a confederate between the fund administrator and broker”, says the SEC’s Basham.
The US District Court for the Southern District of New York found that instead of reporting losses to investors, Berger had created fictitious statements in which he significantly overstated the market value of the fund’s holdings.
It’s a complex and dangerous world where sticking by simple and familiar precepts may be the best defence. Schulte’s Davis says: “Investors should say ‘show me your portfolio, show me how you’re doing that'”. He adds: “If it sounds too good to be true then it probably is.”
