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Tale of college ties and a $62,000 Porsche

Date: Wednesday, October 31, 2007
Author: James MacKintosh, FT.com

Take two college friends, a hedge fund and a $62,000 Porsche, stir in allegations of fraud and the potent legal brew will next week lead to a $537m (260m) court case against the former brokerage of Man Group, the London hedge fund, and an arm of UBS, the Swiss bank.

Man Financial, renamed MF Global and listed in New York this summer, and the Cayman Islands operation of UBS are accused by the receiver of the failed Philadelphia Alternative Asset Management (Paam) of negligently allowing the hedge fund's manager to allegedly hide $179m racked up in loss-making futures trades.

Man rejects all the claims, saying it had no idea a fraud was under way, and has counter-sued UBS Cayman, arguing it should have spotted the problems. It has also counter-sued John Wallace, vice-chairman of the Philadelphia stock exchange and chairman of Paam; Ed Gobora, a Paam employee; and the Cayman-based directors of the offshore fund. UBS and all the other parties also deny responsibility.

On Tuesday, in its second-quarter results statement, which highlighted $69m in costs related to the case, MF Global said: "A definitive settlement agreement is anticipated within the coming weeks." MF Global also said settlement and litigation costs were "fully insured'' and that the company would obtain "full release and dismissal of the proceedings against it while admitting to no wrongdoing".

The legal issues have simmered for two years, while furious British, European and US investors in Paam's offshore hedge fund hoped to go after the "deep pockets" of Man.

It is finally due to come to court next Monday, where the receiver had been hoping to secure triple damages under American anti-racketeering legislation. Ten days after the main trial starts, courts are also due to hear a complaint brought by the receiver for contempt of court against Paul Eustace, the Canada-based manager of the failed fund. It accuses him of cashing in his second Porsche and hiding money in his wife's name even though he agreed to an asset freeze.

"As financial frauds go, this one was uncomplicated," the receiver alleges in court documents.

"As ... trades went sour and losses began to accumulate, the Defendants [Man Financial and employees] not only hid the massive losses, but also engaged in conduct as reprehensible as it is actionable, including violating federal and state laws, regulations and rules, along with ignoring Man Financial's internal governing policies and procedures, among other things," the documents further allege.

"Hidden, the offshore fund's losses snowballed into the hundreds of millions of dollars."

The first of accusations against Man is that the group failed entirely to oversee Thomas Gilmartin, a college friend of Mr Eustace whom the receiver argues was key to the alleged scam - as well as profiting from it through his undisclosed holding in the Paam management group.

The second is that the behaviour of Mr Gilmartin and the Man back office broke money laundering rules, financial regulations and exchange rules and so breached the contract the fund had with Man, making it liable.

The central allegation is that Mr Eustace and Mr Gilmartin worked together to hide losses by shifting them into a secret account at Man to which UBS and Paam employees had no access, in the process making more than $100,000 of commissions for the broker. The receiver also alleges Man failed to follow the law and its own rules on opening accounts, right from the start of Paam.

Man and Mr Gilmartin deny the claims.

Man says the supposedly secret account was never hidden and it simply followed instructions from Mr Eustace - who had authority from the offshore hedge fund - in opening and closing access to its electronic systems. UBS, it argues, should not have relied on information from Mr Eustace to calculate net asset value and it was this information that it says was manipulated without Man's knowledge.

It also points out it posted full statements for all accounts to directors of the offshore fund - and that Man had no idea these were being forwarded, unopened, to Mr Eustace.

Furthermore, it says claims by the receiver that the Man back office was being "blackmailed" into carrying out illegal backdating of trades by Mr Gilmartin were nonsense, as it did not backdate trades. Rather, it says the trades were normal transfers between accounts.

The receiver "chose the wrong target" by going after Man, it says, as "any duty to uncover Eustace's fraud belonged to the offshore fund's service providers, not Man". Man has also pointed out that after a conflict of interest the receiver was replaced this summer, accusations against five Man employees dropped and UBS added as a defendant.

Hedge fund investors will be watching closely for lessons they can learn about avoiding fraud in the secretive industry.