Portraits of five hedge fund fraud cases
| Published date | 09 May 2008 |
| Pages | 179-213 |
| Date | 09 May 2008 |
| DOI | https://doi.org/10.1108/13590790810866890 |
| Author | Majed R. Muhtaseb,Chun Chun “Sylvia” Yang |
| Subject Matter | Accounting & finance |
Portraits of five hedge fund
fraud cases
Majed R. Muhtaseb and Chun Chun “Sylvia” Yang
California State Polytechnic University, Pomona, California, USA
Abstract
Purpose – The purpose of this paper is two fold: educate investors about hedge fund managers’
activities prior to the fraud recognition by the authorities and to help investors and other stakeholders
in the hedge fund industry identify red flags before fraud is actually committed.
Design/methodology/approach – The paper investigates fraud committed by the Bayou Funds,
Beacon Hill Asset Management, Lancer Management Group (LMG), Lipper & Company and Maricopa
investment fund. The fraud activities took place during 2000 and 2005.
Findings – The five cases alone cost the hedge fund investors more than $1.5 billion. Investors may
have had a good opportunity for avoiding the irrecoverable costs of the fraud had they carefully vetted
the backgrounds of the hedge fund managers and/or continuously monitored the funds activities,
especially during turbulent market environments.
Originality/value – This is the first research paper to identify and extensively investigate fraud
committed by hedge funds. In spite of the size of the hedge fund industry and relatively substantial
level and inevitably recurring fraud, academic journals are to yet address this issue. The paper is of
great value to hedge funds and their individual and institutional investors, asset managers, financial
advisers and regulators.
Keywords Due diligence, Fraud, H edging, United States of America
Paper type Research paper
1. Introduction
Hedge fund doesnot have a universally accepteddefinition. The term is not definedin the
federal securities laws. In general,the creation of the first hedge fundis credited to Alfred
Winslow Jones in 1949. He was born in Australia and was brought to the USA when he
was four yearsold. According to Lhabitant(2002, p. 7), Jones raised a $100,000equity fund
and $40,000of the fund is his own capital.To avoid strict regulationsof the Securities and
ExchangeCommission (SEC), the fundwas structured as a general partnership.Hence, the
investment strategy could be implemented with maximum flexibility.
According to McCrary (2002, p. 7), the President’s Working Group on Financial
Markets defined hedge funds as “a pooled investment vehicle that is privately organized,
administered by a professional management firm ... and not widely available to the
public.” Since the returns of hedge funds do not highly correlate with the returns of
capital markets, they are likely to provide different returns than traditional inv estments.
The fund managers often invest a considerable amount of their own wealth in the
funds they manage and generally lock up clients’ capital for a few weeks or months
and in some cases even years. They refuse to discuss their trading strategies because
they do not want competitors to imitate their moves. Hedge funds are not allowed to
advertise and predominantly serve institutions and wealthy investors. Generally, the
fund managers charge fees of 1 to 2 percent of the total amount of assets under
management plus 10-20 percent incentive fee based on the funds’ performance
(Wyderko, 2006).
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1359-0790.htm
Portraits of five
hedge fund fraud
cases
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Journal of Financial Crime
Vol. 15 No. 2, 2008
pp. 179-213
qEmerald Group Publishing Limited
1359-0790
DOI 10.1108/13590790810866890
1.1 Comments on the importance of the hedge fund industry
In 1998, the former Federal Reserve Chairman, Alan Greenspan, stated that:
Many of the things which hedge funds do [...]tend to refine the pricing system in the United
States and elsewhere [...] there is an economic value here which we should not merely
dismiss [...] I do think it is important to remember that hedge funds [...] by what they do,
they do make a contribution to this country.
In 2004, he suggested that hedge funds play an important role in providing market
liquidity and that they contribute to the flexibility and efficiency of our financial
system. Also, the 2003 SEC staff report and the President’s Working Group report
advised that the absence of hedge funds from the capital markets could lead to fewer
risk management alternatives and a higher cost of capital (Atkins, 2004).
According to Roye (2004a) of the SEC, one report estimates that hedge funds
represent approximately 10-12 percent of the USA equity trading. The former SEC
chairman, Donaldson (2004), quoted in Business Week that a single hedge fund
adviser has been responsible for an average of 5 percent of the daily trading volume
on the New York stock exchange. The hedge fund’s activities affect the USA capital
markets either directly or indirectly. They provide not only liquidity and price
efficiency but also risk distribution. Treasury under secretary randy quarles also
suggested that the hedge funds provide more choices for investors and greater
efficiency for global market (Campos, 2006). According to a recent article in the LA
Times, currently hedge funds manage in excess of $1.8 trillion. By 2015, assets of
hedge funds are projected to increase to $6 trillion (Campos, 2005; Wyderko, 2006;
Roye, 2004b).
The demographics of the hedge fund investors have also extended from wealthy
people to smaller investors and institutional investors. Lower minimum investment
requirements of some hedge fund and the fund of hedge funds (FoHFs) make hedge
fund investments more accessible to individual investors. Roye (2004b) noted that
FoHFs represented approximately 20 percent of the capital of the hedge fund market
and are one of the fastest growing sources for the hedge fund industry. In addition,
more and more private and public pension funds are increasing the percentage of their
portfolio devoted to hedge fund investments.
1.2 Hedge funds fraud
Muhtaseb (2005) reported that, fraud is one of the business risks related with any type
of business activity. The types of fraud seen in hedge fund fraud cases are not
exclusive to hedge funds. The compensation structure of the hedge fund industry
whereby the fund manager pay is based on fund performance, coupled with the right
circumstances can encourage fraud.
From year 2000 to 2005, the SEC has brought more than 52 hedge fund fraud cases.
The hedge fund investors lost approximately $1.5 billion. Specifically, 12 cases were
brought in 2002, seven cases in 2001 and six cases in 2000 (Roye, 2004a; Donaldson,
2003). Ferris (2004) stated that “about $1 for every $250 invested in hedge funds in 2000
was lost to fraud.”
According to Capco’s paper “Understanding and Mitigating ...” operational issues
account for 50 percent of the hedge fund failures. The most common operationa l issues
include:
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.misrepresentation of fund investments (41 percent);
.misappropriation of investor funds (e.g. for personal use) (30 percent);
.unauthorized trading and style breaches (14 percent); and
.inadequate resources for fund strategies (6 percent).
The former chairman of the SEC, Donaldson (2004), listed following the types of fraud:
.gross overstatement of performance by hedge fund advisers;
.payment of unnecessary and undisclosed commissions; and
.misappropriation of client assets by using parallel unregistered advisory firms
and hedge funds.
The study by Capco (Valuation Issues, 2003) showed that improper in-house valuation
of the fund assets is a major root problem in 35 percent of hedge fund failures. The
valuation problem is caused by fraud and misrepresentation (57 percent); process,
systems or procedural problems (30 percent); and mistakes or adjustments (13 percent).
1.3 Regulation
Before, hedge funds were required to register with the SEC. They are not directly
examined and inspected by the SEC. The former chairman of the SEC, Donaldson (2004),
stated that approximately 80 percent of the hedge fund fraud cases are attributable to
fund managers who were not registered with the SEC. Since February 1, 2006 under the
Investment Advisers Act of 1940, the hedge fund advisers need to register with SEC and
make their books available for the SEC to examine. The rule applies to investment
advisers who manage more than $25 million. It also affects the advisers who permit
investors to redeem their interests in a hedge fund within two years (Zuckerman and
McDonald, 2005).
According to Roye (2004b), history has shown that the introduction of appropriate
and balanced regulation has served as a springboard of substantial industr y growth
and development. The registration requirement of the hedge fund gives the SEC the
ability to conduct examination of the hedge fund industry, discover the fund’s
operational problems in the early stages, and take action to prevent possible fraud and
sudden catastrophic loss to investors.
This requirement on hedge funds did not last long. On June 23, 2006, a federal
appeals court ruled that the SEC lacks the authority to regulate hedge funds, dealing a
possibly fatal blow to the commission’s efforts to oversee the hedge fund industry. The
three-judge panel of the USA Court of appeals for the District of Columbia Circuit ruled
unanimously that the commission exceeded its power by treating investors in a hedge
fund as “clients” of the fund manager. The commission has authority over any
manager with at least 15 clients, and it used that to require hedge fund managers to
register. The law suit was brought by Philip Goldstein.
1.4 Purpose of the study
The objective of this paper is to present a complete profile of five hedge fund fraud
cases. The background of the fund, fund management team, relationship with
constituents and investment strategy of each hedge fund was studied. How the fraud
Portraits of five
hedge fund fraud
cases
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