Hedge Funds and Fraud: The Future of Due Diligence

Garrity, Graham, Murphy, Garofalo & Flinn and PRMIA (Professional Risk Managers International Association) sponsored a webinar that focused on the signs of fraud and what you can do detect fraud in the context of hedge funds.

The agenda and my notes:

  • The profile of a fraudster (James Tunkey, I-OnAsia)
  • The psychology of the gullible investor (Stephen Greenspan Ph.D., Clinical Professor of Psychiatry, University of Colorado)
  • Current legal and regulatory requirements for hedge funds (Philip Thomas, Esq., Garrity Graham)
  • A hedge fund insider’s view (Samuel Won and Greg Ivancich, Global Risk Management Advisors, Inc.)
  • The regulatory future for hedge funds (Philippa Girling, Esq., FRM, Garrity Graham)

James Tunkey of I-OnAsia, started off with The Profile of a Fraudster. He is a certified fraud examiner. His focus was on the incentives, structures and control systems in an organization.

James put forth the proposition that Fear, Greed, and Honor are the three drivers of fraud. In the context of private investment funds, they are driven by the fear and honor of not making investment targets. There is greed trying to make more money for themselves.

Stephen Greenspan focused on the psychology of the gullible investor. (He has a new book out Annals of Gullibility and an article in the Wall Street Journal: Why We Keep Falling For Financial Scams.) Everybody is capable of being scammed (and probably have been). Stephen has also been scammed. He was a Madoff investor. He breaks a foolish action into three different groups: (1) practically foolish act, (2) non-induced socially foolish action, and (3) induced socially foolish action. It is this induced socially foolish that is gullibility.

Stephen pointed out that investor mania is like a Ponzi scheme. The early investors tell others about how wonderful their investments performed. There is a social feedback loop that drives the mania. The scam artists are skilled manipulators at using these factors.

Phillip Thomas looked at some regulations in place and steps you can take as part of the diligence. He pointed out that in today’ s environment, it is not a good time to be cutting back on compliance.  He led a discussion through some recent court cases to highlight some of the issues.

Disclosure, potentially manipulative practices, and valuation are three hot regulatory topics. There are several rules in place limiting the sale and reconciliation of securities. As for valuation, you should have a segregation of responsibilities and oversight.

Some tools that don’t work very well.

  • The due diligence questionnaire. These are probably canned responsibilities and are unlikely to uncover problems
  • Form ADV. Also have canned answers
  • Interview of Managers. He thinks this is a good a tactic, at least as a smell test.
  • References. The problem is that they will only give you good references.

He thinks out that you should run a background investigation of the principals.

He moves on to some best practices for due diligence:

  • Don’t take anything from the fund manager at face value
  • Be suspicious of a manager limiting access to information
  • Consult specialist professionals who will be able to spot irregularities
  • Pay attention to what industry leaders are saying and doing about best practices.

Samuel Won and Greg Ivancich presented the view from inside a hedge fund. They believe people were too busy chasing returns during the extended bull market to spend time and energy on due diligence. Too many people just did check the box diligence and did not take a close look.  Investors did not look at the underlying processes and operations at their investment funds.

They also see a regulatory sea change coming, likely to be draconian and over-reaching. They expect to see changes in requirements from institutional investors. Firms may also use the existence of their risk management and compliance as competitive differentiators. There will also be some new best practices emerging.

They see a need for independence. it is important not just to have an independent audit of financial statements, but also of infrastructure, processes, controls, investment style, valuation, and risk management.

Philippa Girling looked at the global political reaction to the current crisis and how it will affect hedge fund regulation.  Germany and France are pushing for deeper regulation that the U.S. IMF is also pushing. (Any country using the term “shadow financing” wants more regulation.) The European Union as a whole is looking to regulate hedge funds.

There are several proposed laws at the federal level: The Hedge Fund Adviser Registration Act, Supplemental Anti-Fraud Enforcement Act Markets Act, and the Hedge Fund Transparency Act. There are also some proposed hedge fund laws in Connecticut.

What can we do?

  • Anticipate regulatory developments
  • Anticipate increased due diligence
  • Establish appropriate protections to meet anticipated regulations and investor demands. (We have already seen the Obama administration putting a short time line on enacting regulatory problems.)
  • Evaluate risk
  • Manage compliance
  • Ensure Anti-Money laundering procedures are in place
  • Conduct fraud assessments
  • Review current documents for improvement to current best practices
  • Be ready for enhanced due diligence visits from potential investors

Some of the more interesting questions from the Q&A sessions:

What are the most important red flags?

  • A manager not delivering information, instead standing alone on their reputation
  • Lack of third party administrator/custodian

Will regulation just lead to more avoidance?

  • SEC registration does not mean there has been an effective review
  • The UK centralized model takes away the US regulatory arbitrage (different agencies reviewing different types of investment companies)
  • Companies may flee to less-regulated places

, , , , , , ,

Comments are closed.