Investors, Do Your Homework, Ex-FBI Agent Says |
Date: Tuesday, December 19, 2006
Author: Emma Trincal, Senior Financial Correspondent, Hedgeworld.com
NEW YORK (HedgeWorld.com)—The guilty pleas last week of James Marquez, co-founder of Bayou Management, who admitted that he conspired to defraud investors in the now-defunct fund, is a reminder that investors also have a role to play in protecting themselves, not just from fraud but also from potential blowups or investment problems.
Ken Springer, a former FBI agent and now president of Corporate Resolutions, a New York-based background check and investigation firm, said many red flags should have caused investor concern in the case of Bayou but also in the case of Amaranth Advisors, the hedge fund that collapsed in September due to bad trading bets. Another example is Pirate Capital, an activist hedge fund recently hit by heavy turnover. Investors need to do their homework, not just to uncover possible frauds but any other problematic situations that may affect their investments.
"Amaranth and Pirate are not frauds. But those are situations where you should ask a lot of questions," Mr. Springer said in an interview. "You should identify patterns of management turnover, patterns of lawsuits, discrepancies or controversies," he said.
Take the case of Amaranth. Mr. Springer said there were two red flags that should have raised eyebrows. The first one was the departure in the spring of Harry Arora, the energy team leader at the now collapsed firm. "Whenever a key person leaves, it always begs the question of why did he leave," Mr. Springer said. After his departure, Mr. Arora said he had concerns over the risk employed at Amaranth, according to press reports, and this should have been a clue, Mr. Springer said.
Another interesting lead investors should have looked at, he said, was the lawsuit Brian Hunter filed against Deutsche Bank, his former employer, for compensation reasons. Mr. Hunter was Amaranth's energy trader whose bad natural gas trade bets led to the blowup. "A lot of time, suing for compensation is not a red flag. A lot of people do that. But you always need to check that, as it can be indicative of problematic behavior," Mr. Springer said. He added that there were at least 10 to 15 people from Deutsche Bank mentioned in the text of the lawsuit that investors could have easily called. "He threw eggs in their faces. Turning the next stone over may be important. I don't know if people investing in Amaranth did any of that work," he said, referring to the work that consists of calling Mr. Hunter's former colleagues or supervisors at Deutsche Bank.
In the case of Bayou, he said, clues abounded. There was first, an employment verification discrepancy. Samuel Israel, Bayou's cofounder, claimed to have worked at Omega Advisors as a trader. According to Leon Cooperman, Omega's founder, Mr. Israel had a short tenure with Omega and did not have any trading discretion. Mr. Springer, citing a press report, said that Mr. Cooperman received only one call from an investor checking on Israel's employment history. A more interesting clue, which has not yet surfaced in the press, Mr. Springer said, was that Dan Marino, another Bayou cofounder, filed a lawsuit against an Isle of Man fund for fraud. The lawsuit reveals that Mr. Marino gave the Isle of Man fund $2 million in three installments.
"Investors should have asked: we're giving you money to invest in Bayou. How can you invest into another fund?" Mr. Springer said, adding that investors should have wondered whether this investment was coming from Mr. Marino's own pocket or from the fund. Another red flag was an apparent conflict of interest relating to Mr. Marino. Mr. Marino was listed as the registered agent of Bayou's outside accounting firm. "Everything was a set up," said Mr. Springer.
In addition, a review of public records determined that Bayou's director of investments, hired in March 2005, had filed for bankruptcy. "Had a fund of funds conducted a check on a new director of investments, this would have raised a major red flag," said Mr. Springer. And the signs continue to be plentiful: In 2003, two former employees sued Bayou. In 2005, suits were filed by two investors although they never pursued the action further.
"There were many red or yellow flags that should have been indicators for investors to call the fund and get some questions answered. If they had done that, they could have redeemed sooner. In our business, we call these clues," Mr. Springer said.
So here is the question: Why do investors fail to do their homework? "It takes a lot of time. It's detective work," said Mr. Springer. "And 45% of our investigations lead to some gray area where you need to dig deeper." He added that "A lot of funds of funds are doing their homework, but they also try to cut down costs, and so you get what you pay for." Sometimes the problem is that background check is only done online, which can be limiting. In the case of Bayou, for instance, finding the very common name of Dan Marino in the Connecticut courthouses was challenging. "You had about 60 different lawsuits with that name. We had to look at each of one to see which one related to the hedge fund."
Another case not related to fraud but raising some red flags of its own is Pirate Capital, an activist hedge fund that saw half of its investment team leave this fall. In September, Zachary George, David Lorber, David Muccia and Matthew Goldfarb, key analysts, left the firm. Carl Klein, a bond portfolio manager, left at around the same time. In addition, a couple of senior sales executives hit the exit door as well. "You can be great but if you can't keep your good employees, what does it mean? As an investor, you need to ask why all those good people are leaving," said Mr. Springer.
Mr. Springer said that in general, a lot of research involves international work. His firm has offices in New York, Boston and London, but also relies on a network of investigators checking on 150 countries.
Mr. Springer, whose clients are hedge funds, funds of funds, family offices and private equity firms, offers them as a service an ethics hotline allowing employees to report fraudulent or unethical behavior. He pointed to the fact that the Bayou fraud came to light after a whistleblower reported it. "Public companies do it now; it's part of Sarbanes-Oxley," said Mr. Springer. "I think this could be something that could help smaller funds attract investors."
Another murky area into which Corporate Resolutions seeks to expand is the possible misuse of side pockets by some managers. Side pockets are segregated parts of a fund in which illiquid investments are set aside because their valuation differs from the rest of the portfolio. "The risk is that you can have a bad trade and take it out of the fund and dump it in the side pocket," he said. Mr. Springer's idea is to convince his hedge fund clients to have independent auditors run an on-site check of the daily trade blotter in order to make sure that what's being allocated to the side pocket is there for liquidity reasons, not because the investment is bad.
It may be hard to imagine managers willing to go that far. But for the smaller players, being more transparent may end up being good business. "Hedge funds need to be transparent if they want investors' money," Mr. Springer said.
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