Down and Out in Beverly Hills : Mr. Ruderman’s Ponzi Ways

Bradley Ruderman, a hedge fund manager from Beverly Hills, California has pled guilty to running a Ponzi scheme. Mr. Ruderman is facing up to 51 years in prison. He will learn his fate on December 7, 2009.

Appearing before U.S. District Judge John F. Walter heard Mr. Ruderman’s admission that he took approximately $44 million from approximately 22 investors while claiming returns of approximately 60% annually. Specifically, he pled guilty to two counts each of wire fraud and investment fraud. Here is the SEC press release announcing their formal complaint in which they froze Ruderman's assets.

Mr. Ruderman orchestrated his scheme via his firm, Ruderman Capital Partners. He surrendered to federal agents in May. In April Mr. Ruderman sent a letter to investors claiming that the firm’s funds were almost entirely gone. Mr. Ruderman had spent $8.7 million on a myriad of personal expenses. The list includes two Porches. He also had over $5 million in Poker losses.

Adding to the laundry list of problems, Bloomberg is reporting that Mr. Ruderman lied about the identity of his investors claiming that Lowell Milken (chairman of the Milken Family Foundation) and Larry Ellison (Chief Executive Officer of Oracle Corp.).

While a famous investor may not always take a call if a hedge fund manager is touting their relationship with a particularly dazzling or well respected investor it would behoove any investor to pick up the phone or send an email to at least attempt to confirm the relationship If the prestigious investor picks up the phone you may be able to garner more color on the details of their relationship with a particular manager. Should you not be able to confirm the relationship, at the very least as an investor you will sleep better at night knowing that you tried. Further, the hedge fund manager should be able to explain why their highly respected investors won’t return your call – and it should be a good indicator or a yellow flag at the least which would add another data point to your operational due diligence process.

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Insider trading and Bear's Collateral Condo Pledge: A long list of red flags

Ralph Cioffi, a former Bear Stearns hedge fund manager, has been indicted for an alleged fraud which contributed to firm's downfall. Mr. Cioffi and another former Bear Stearns hedge fund manager, Matthew Tannin, were indicted last year. The duo allegedly mislead investors about the status of the firm's two hedge funds whose failure costs investors approximately $1.6 billion in July 2007. Bloomberg is reporting that according to the government, Mr. Cioffi also "rarely" listened to the firm's compliance trading measures and had a combatitive relationship with Bear Stearns compliance and legal department.


Mr. Cioffi has also been charged with insider trading for redeeming $2 million from the Bear Stearns Enhanced Fund. This represented approximately 1/3 of his investment in the fund. Specifically, the government is claiming that Mr. Cioffi used material non-public information to time his withdrawal before the fund's collapse. Adding insult to injury news is also coming out that Mr. Cioffi attempted to pledge his investment in the fund as collateral for a building loan for a luxury condo complex his brother was building in Sarasota, Florida. Bear Stearns apparently didn't grant approval for this. Apparently, "Cioffi became extremely upset and accused the general counsel of BSAM of being behind the decision," the U.S. said in court papers.

Outside business activities fund relatives building developments, in-fighting among internal units, a hedge fund manager fighting with the firm's compliance department and a hedge fund manager reducing his stake in the firm. This long list of red flags seems to keep getting longer...

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Butler and Tzolov face the music - for now....

Eric Butler, a former Credit Suisse Group AG broker, was convicted today of three counts fraud. Specifically, Mr. Butler pled guilty to conspiracy to commit securities fraud, securities fraud and conspiracy to commit wire fraud.


Mr. Butler's conviction relates to fraudulently selling millions in subprime securities and reaping huge commissions in the process. Mr. Butler's co-defendant Julian Tzolov also plead guilty to conspiracy, wire fraud and securities fraud. He turned on his former colleague and became a prosecution witness against Mr. Butler. Mr. Tzolov, he was originally thought to have fled to Bulgaria but actually fled to Spain for three months to avoid persecution but returned to testify. Mr. Tzolov even went so far to hire a bodyguard and carry false documents while on the lamb. Mr. Butler faces a maximum sentence of up to 45 years.

It looks like the judge will go easy on them since he believed they operated in a so-called "culture of corruption." Adding insult to injury Bloomberg is reporting that the judge told lawyers for both the defense and the government to put Mr. Butler and Mr. Tzolov's deeds in the context of, "how pernicious and pervasive was the culture of corruption, lack of regulation” and “serious negligence in the financial services industry in supervising people like this.” I'm sure this will be a big condolence to Butler's and Tzolov's victims who include GlaxoSmithKline Plc, Roche Holding AG and Potash Corp. of Saskatchewan.

Butler and Tzolov's scheme involved selling securities which they told people were backed by federally-guaranteed student loans. They further told their clients that they were a safe alternative to bank deposits or money market funds. In fact, the subprime securities were linked to auction rate securities. It is expected that Mr. Butler will appeal.... stay tuned.

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Madoff feeder fund trouble continues - Tremont and Fairfield's Slow Death

It is being reported that William Galvin, the Massachusetts Secretary of State, has rejected a settlement offer by Fairfield Greenwich Group to repay $6 millon to Massachusetts investors who were victims of fraud in the Madoff scandal.



Galvin's civil complaint, in part, claims that Fairfield executives were coached by Madoff on how to answer federal investigators questions. The complain further alleges that Fairfield misrepresented how much they knew. With the settlement offer reject a hearing is scheduled for September 9.

Fairfield spokesman Thomas Mulligan was quoted as saying, "It would be irresponsible for Fairfield to devote any more time or resources to a case involving at most a dozen people with losses of $6 million, when Fairfield is facing litigation involving thousands of investors and hundreds of millions of dollars elsewhere."

In other Madoff feeder fund news, Tremont Group, has been forced to auction off its hedge fund assets.

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Madoff’s Film Studio and the risks of outside business activities

It has been reported by Bloomberg that Madoff’s son Andrew and Nehst Media Enterprises LLC are being sued for $5.3 million. Nehst is a Madoff-funded film studio. The suit is being brought by allegedly wronged filmmaker Dana Offenbach whose production/director credits includes such independent films as Hav Plenty, Love & Orgasms and The Mamsahib.



Ms. Offenbach is seeking at $5 million in punitive damages and $300,000 in regular old-fashioned damages. Also named in the suit are Nehst Chairman Larry Meistrich and CEO Ari Friedman. The complaint alleges that Madoff was the “principal investor” in Nehst film studio. Here is a video about Nehst which is described as one-stop shop for independent film making that interestingly doesn't mention anything about the Madoff connection:



This suit highlights another important, yet often overlooked, aspect of hedge fund operational due diligence – outside business interests. Often times during the operational due diligence process investors are so focused on reviewing the risks associated only with the hedge fund manager that they often fail to cast a wide enough net to look at exogenous risks, such as outside business activities.

Any such activities are often important for a number of reasons. By way of illustration, suppose the Chief Investment Officer or lead Portfolio Manager of a hedge fund invests in a music company run by one of his close relatives, let’s say in this case his son. Continuing our example, when asked this question the standard hedge fund reply is often, “Mr. So-and-so does not devote a material amount of time to any external endeavors.” Some hedge funds may even go further and state, “All such external outside business activities must be approved by the firm’s compliance department.”

While all that sounds great, such activities often involve more than simply writing a blank check to a relative. Often times, and with the best intentions, the check writers/Portfolio Manager will be involved if not for the sole reason that they want to offer guidance to their relative and perhaps, albeit less noble an objective, look after their investment.

There is nothing inherently wrong with such external activities or investments. That being said, during the operational due diligence process investors should take steps to learn about these outside activities and determine what risks or distractions they may pose to a hedge fund manager. Many investors will be surprised to learn what external activities a hedge fund manager may be invested in. Knowledge of such activities will allow investors to make more informed allocation decisions and provide another data point by which to manage operational risk.

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"It was all fake" - Madoff's Frank DiPascali Jr.'s Begins Talking...

Frank DiPascali Jr., Bernard Madoff’s former “chief lieutenant” and chief financial officer formally entered his guilty plea yesterday. Mr. DiPascali pled guilty to 10 felony counts of conspiracy, fraud, money laundering and perjury. DiPascali was hired by Madoff straight from Archbishop Molloy High School. He went onto work for Madoff for 33 years. Some notable quotes from Mr. DiPascali’s appearance include:


-"I ended up being loyal to a terrible, terrible fault."

-"I apologize to every victim of this catastrophe, and to my family and to the government. I'm very, very sorry."

-“It was all fake”

-“It was all fictitious. I knew no trades were happening.”

-“I knew I was participating in a fraudulent scheme, I knew everything I did was wrong, and it was criminal, and I did it knowingly and willfully. I accept complete responsibility."

Despite these statements and both the prosecution and defense arguing for bail, U.S. District Judge Richard Sullivan denied his $2.5 million bail.

In making this decision the Judge Sullivan cited a presumption that a convict should be denied bail in the absence of "clear and convincing" evidence that he isn't a flight risk.

Here is a video discussing Mr. DiPascali's appearance:


With Mr. DiPascali remaining behind bars perhaps it will continue his continued cooperation and the additional parties who participated in the Madoff fraud he is expected to name.

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Frank DiPascali Jr.'s Secret Fee Arrangments - Don't Ask Don't Tell

Frank DiPascali Jr. is scheduled to plead guilty today. Mr. DiPascali was reportedly Madoff’s top aide who sometimes referred to himself as the Chief Financial Officer of Madoff’s firm. While the specific charges to which he will be pleading guilty to are unclear (although it is likely to include multiple counts of fraud) it is suspected that his sentence will be lessened by the fact that he is reportedly cooperating with investigators. This cooperation is also supposed to assist investigators in strengthening their case against certain feeder firms. These supposed deals guaranteed certain feeder funds (and perhaps even funds of hedge funds) with higher rates of return, albeit fraudulent ones, than other Madoff clients were receiving.


I find these supposed deals quite interesting. While pre-Madoff it may have been unheard of to think that investors with the same terms might all be generally receiving the same performance returns for investment in the same hedge funds it is now becoming more apparent that all investors are not competing on a level playing field. Please note I said above, investors with the same terms. That’s just the problem, not everyone has the same terms for each hedge fund investment. While, today many hedge funds seem to be resisting the temptations they may have succumbed to a few years ago to enter into side letters with investors spelling out a myriad of different nuances such as capacity agreements, most favored nations clauses and the like, such agreements are still prevalent, if not only for legacy reasons.

Here is a video from Fox Business News about the planned guilty plea:


During the course of the operational due diligence process, it is often useful to inquire about not only the so-called standard fund terms listed in the fund’s offering documents and marketing materials but about what “special deals” other investors may have bartered. Sometimes a hedge fund may clam up and simply state they don’t disclose the details of other investors. This curt response should be viewed as a stumbling block, not a brick wall. When faced with such a dilemma, the role of the operational due diligence analyst should be to try to utilize their red flag social network, to locate other investors and gather some general market intelligence. This may not yield any results, but at least it’s worth asking. Additionally, if the same request is sent to the hedge fund for this information several times they may eventually crack. Uncovering such information is no guarantee that a hedge fund manager may give you the same preferential terms as it may have given to a day one or extremely large investor, but it will give you the peace of mind to know that you are making an informed decision.

In Mr. DiPascali’s case, any unwillingness to talk, even generally, about such deals should have certainly been a red flag. Bloomberg even reported that Madoff didn’t want any notes taken during meetings, no less discussing such sensitive issues about fee arrangements. Now it looks like those investors which were swindled by Madoff will have to learn about them via court documents rather than during the due diligence process.

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Another day, another fraud - Mr. Pippin's search for Ponzi fulfillment

Stuart J. Pippin of Kerrville, Texas, USA today was to be sentenced today for defrauding 35 investors of over $2 million dollars. Mr. Pippin, who is 60 years old and in a twist of irony, is named after a famous Broadway musical in which, “The Leading Player invites the audience to join them in a story about a boy prince searching for fulfillment.” Perhaps that’s what Mr. Pippin’s investors were looking for when they wrote checks without apparently performing any due diligence whatsoever.


Mr. supposedly told investors he would be running a commodity trading pool. The problem was that no trading actually occurred. Even worse, Mr. Pippin never even had bothered to set up a trading account for his CTA, Pippin Investments. In classic Ponzi fashion, Mr. Pippin even went so far as to manufacture false account statements and pay false dividends to some investors with other people’s money.

As if it was any consolation, at least the good Mr. Pippin wasn’t discriminating in selecting his victims which including his brother Fred, his former dentist brother-in-law Randall Voigt and other friends and relatives.

The CFTC caught on and sued Mr. Pippin who in 2006 was forced to pay $1.68 million in restitution and $106,500 fine. More recently the FBI came in and pursued a criminal indictment for wire fraud which is the crime he was being sentenced for today.

While this amount of money lost in this case may seem paltry when compared to the large scale sums of hundreds of millions of dollars in play in fraud cases such as Madoff, these cases highlight an important point. Often times it is the ultra-high net worth individual rather than the large institution that needs to be overly cautious in the hedge fund due diligence process.

This is particularly true for operational due diligence when an investor may have little to no concept of the additional types of operational risk they are signing up for when investing in a hedge fund manager. Perhaps a new good rule of thumb for hedge fund investing harkens back to an old classic: if a manager cannot explain, either operationally or from an investment perspective, what they are doing and it seems too good to be true – don’t invest. There are plenty of other people who will provide transparency in an effort to secure your investment.

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Has Rigor Mortis Set In On Your Due Diligence?

Corgentum Consulting has released a new piece entitled, "Has Rigor Mortis Set In On Your Due Diligence? - The dangers of inflexible operational risk methodologies."
This paper outlines the benefits of adding an element of flexibility to operational due diligence approaches and cautions against overly rigid operational risk methodologies.
The piece can be found in the Research section of the www.corgentum.com website or via direct link here.
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Another Hedge Fund Fraud - Mark Bloom Over Concentrates

Last week, hedge fund manager and certified public accountant, Mark Bloom pleaded guilty in U.S. federal court to charges he faced in the U.S. Here is the original SEC complaint and the original CFTC complaint.


Mr. Bloom was accused of, among other things, stealing in excess of $20 million from clients and selling illegal tax shelters while working at BDO Seidman LLP.

Mr. Bloom was the manager of the North Hills Fund and admitted to committing securities and mail fraud. Bloomberg reported that the North Hills fund investment strategy was purportedly to be diversified among several hedge fund strategies however, Mr. Bloom apparently concentrated over 50% of his fund into something called the Philadelphia Alternative Asset Fund (a former commodity trading pool which appears to be in receivership). More interestingly, it has also been reported that Mr. Bloom waited more than a year to tell investors of this concentration in the Philadelphia fund.

What seems interesting to me is that this notion of investors waiting to be told certain pieces of information by a hedge fund. Due diligence in hedge funds, both investment and operational, is a two-way street. Long gone are the days of investors being able to sign away large sums of money and wait to hear how the manager allocates them. Any basic investment due diligence review of any organization which allocates capital (i.e. - the North Hills fund in this case) should include specifics of how this capital is being allocated. While investors may be subject to fraud, if a manager claims to have allocated capital to a certain entity investors should not be afraid to confirm this. While a full detailed confirmation may be overbearing, a spot check, particularly for large relationship is certainly not unheard of.

This concept is extended throughout the field of hedge fund operational due diligence as well. Investors should not take on face value that a hedge fund may or may not have a certain relationship with a particular underlying organization to which capital has been allocated or a particular service provider. Confirming such relationships often takes little more than a quick phone call or email and investors who have done so will sleep much better at night. Of course, more detailed due diligence reviews can and should be performed to determine the way in which certain service providers work with hedge funds, but at least confirming the relationship is a good starting point.

In the case of Mr. Bloom and North Hills it seems that if investors, or their advisers, may have done a little due diligence, a possible fraud may have been detected before they lost their money.

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A Service Provider Switch - Raise the Yellow Flag

Forbes reported that the NIR group, which has recently faced accusations of faulty returns, has just switched firms to provide valuation services. It is reported that NIR previously worked with a third-party firm for valuation services called WTAS. Interestingly, the WTAS home page describes it services as, "We specialize in full service individual and business entity tax compliance and consulting. Our goal is to provide you with opportunities and solutions to help you attain your vision." No mention of valuation services here.


The interesting part of this story is that just a few days ago NIR's Corey Ribotsky told Forbes in a statement: "It is also notable that Mr. Mizel's complaint insinuates a claim that AJW's assets have been improperly valued, yet AJW utilized a third-party valuation service (WTAS)." Even more interesting, NIR is not naming who this new mystery third party valuation agent is.

A service provider switch, regardless of which function the service provider is performing for a hedge fund should always raise a yellow flag at a minimum, if not a full blown red flag. Obviously, certain service provider functions (i.e. - auditor, administrator etc.) are more sensitive than others (i.e. - information technology provider). When evaluating a service provider switch there are three critical points to consider:

• Motivation for making a switch


• Timing of the switch


• How long the switch takes

Motivation for making a switch

Some hedge funds are proactive, others are reactive. Switching a service provider in response to litigation or a specific large investor concern may not be in the best interest of the entire organization. Other reasons a hedge fund may switch a service provider may include fees, perceptions of a particular service provider etc.

Timing of the switch

Investors should consider whether a hedge fund is selecting the appropriate time to make a service provider switch. Monitoring not only the reasons but the timing of a hedge fund's decision to terminate one service provider in place of another is also important. As an extreme example, a hedge fund switching auditors before an audit would not be the best timing.


How long the switch takes

Certain service providers take longer to complete a switch than others. Legacy hedge fund administrators for example often require a number of months at a minimum to properly complete a switch. Often times, it takes a few months of running in parallel with two administrators to complete a switch. A hedge fund may announce a switch, but it may not be completed in actuality for quite a long time. Hedge funds can take several steps to facilitate this process before a switch is complete and investors should inquire as to whether a hedge fund has taken such steps.

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Cartoon Gallery: Madoff, Hedge Funds and Ponzi Schemes

There have been a number of cartoons put out involving Bernard Madoff, Ponzi schemes and hedge funds lately. We have put them all together in a new cartoon archive. Here are some of the notable ones:

For a more complete list of Madoff and Ponzi cartoons please visit our cartoon gallery.

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The importance of independent valuation for private investments

Forbes is reporting today that the NIR Group (whose website states Experience, Integrity, Performance) is being accused of running an investment scam. The details emerged in a lawsuit filed by investor Steven Mizel against NIR which is run by Corey Ribotsky out of Roslyn, NY. This is the second major alleged hedge fund fraud to come out of Long Island. The previous one was Nicholas Cosmo's Agape World from Hauppauge, NY.


A lawsuit filed against Mr. Ribotsky (a graduate of Brooklyn Law School) and NIR AJW Qualified Partners claims that they, "appear to have provided investors with valuations of the Fund's securities which are wholly fanciful." In March this year it was reported that NIR settled a lawsuit from Gerald and Michael Tucci and Plum Beach Partners related to a delayed payout of a redemption).

NIR’s primary investment strategy was to participate in PIPEs (private investments in public equity). Forbes also reported that in those deals Ribotsky invested cash in thinly traded public companies, in return for securities convertible into discounted common shares of the company. The result of a Ribotsky investment has often been that the company's stock plummets in value, but Ribotsky has continued to post excellent returns. In a note to investors last year, Ribotsky said one of his main funds was up 8.27% in the first nine months of 2008 and that NIR Group funds had experienced "little volatility and have had positive returns in 114 out of 117 months."

Here is a link to an interview Mr. Ribotsky conducted with Bloomberg (with an odd disclaimer):

Aside from the numerous redemption and gate issues surrounding this case, NIR’s situation highlights the importance of both on-going due diligence and independent valuation. Continuous positive performance in light of a market which would generally cause a decline in a particular hedge fund strategy is certainly a red flag. Risk management and analysis not only of performance data but portfolio holdings to monitor such things as style drift can often detect when a hedge fund manager is straying from their original investment profile or perhaps even inflating (or dampening) performance.



Such situations often revolve around valuation issues. When there is a lack of independent oversight in the valuation process the hedge fund manager often has too much control on striking portfolio marks. Exacerbating the situation, is that investors often do not have the level of transparency necessary to gauge whether such valuations are inflated. An independent administrator can help to mitigate such risks, but only if they are valuing the entire portfolio and not performing a NAV light rubber stamp review.

Ultimately, the investor has responsibility for gauging the independence and accuracy of valuations of private investments for which the hedge fund manager may determine the mark. Detailed initial and on-going operational due diligence can facilitate this process. Often red flags travel in packs and investors performing frequent operational due diligence reviews increase the odds of spotting yellow flags before they turn red. This allows investors to redeem before a gate is invoked or they end up in court trying to get their money back.

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Ten Questions Every Investor Should Ask Their Hedge Fund Manager: Operational Risk

In the post-Madoff environment many hedge fund investors, both institutional and ultra-high net worth, are taking an increased responsibility for overseeing their own due diligence. Hedge funds should be addressing operational risk across a multitude of different operational risk factors.
Corgentum Consulting has released a paper which outlines ten questions every hedge fund should be able to not only answer, but explain why they made certain operational choices which led to these answers. The full paper entitled, Ten Questions Every Investor Should Ask Their Hedge Fund Manager: Operational Risk, can be read on the Research section of www.corgentum.com or via direct link here.

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Fund of hedge funds operational risk framework study

In a recent post HedgeCo.net's discussed Corgentum Consulting's survey of fund of hedge funds operational risk frameworks.



The post entitled, "Fund of Hedge Fund Operational Due Diligence - Study" , provides an overview of the key points of Corgentum's study which is titled, "Analyzing Operational Due Diligence Frameworks In Fund Of Hedge Funds." .

The study can be found in the Research section of the www.corgentum.com website here. The full HedgeCo.net post can be read here and on the Hedge Fund News Blog .

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Preparing for the operational due diligence visit: A hedge fund's guide

As a result of the current economic environment and frauds such as the Madoff scandal, hedge fund investors have placed an increased importance on performing detailed operational due diligence reviews.

Corgentum has recently released a paper which outlines a few key steps a hedge fund can take to ensure that they are adequately prepared for an operational due diligence review. The paper can found in the Research section of the www.corgentum.com website, or via direct link here.

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Thinking outside the box - Seven innovative due diligence techniques

The nature of due diligence is changing. In this new environment, investors need to be innovative in their approach to due diligence.


Corgentum has released a paper which outlines several innovate hedge fund due diligence techniques. The paper can found in the Research section of the http://www.corgentum.com/index.html website, or via direct link here.

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Family Offices and public pensions stress the need for operational due diligence

The recent sentiments from two investment conferences from two very different and influential groups of investors are clear: due diligence and in particular operational due diligence, will be a key factor in designing and maintaining any hedge fund (or fund of hedge funds) investment program.

At the recent the Public Fund East Summit (which was primarily attended by public pension funds) and the Family Office & Private Wealth Management Forum in Newport, Rhode Island both groups shared similar concerns and opinions about due diligence.

From early on in the conference one message was: a lack of comprehensive due diligence was previously not being performed and that in the post- Madoff environment both family offices and public pension funds are particularly focused on operational risk in alternatives in general and hedge funds in particular.



Some key points being stressed by both groups on the operational due diligence front include:

• Using a hedge fund managers time in a productive way

*Importance of on-site visits (walking the floor and kicking the tires)

*Reference checks & background checks

*Need for independent operational oversight

*One can get to a point of diminishing returns but there are a lot of boxes that need to be checked

*Stress on trade flow, counterparty management

*The importance of document collection and review

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The Importance of Cash Controls: Chief Operating Officer Charged With Fraud

In what is an interesting twist on the continued stream of frauds and Ponzi schemes, it seems that rather than an alleged fraud being perpetrated by an investment professional an alleged fraud was undertaken by a hedge fund's chief operating officer.



It is being reported that Manhattan District Attorney Robert Morgenthau's office has charged the chief operating officer of 3V Capital Management LLC, a Mark A. Focht of Suffern, NY, with stealing $250,000. Allegedly, Mr. Focht utilized a forged authorization form in April 2007 to transfer money from a bank account belonging to Pierce Diversified Strategy Master Fund. It has also been reported that Mr. Focht then utilized the money for personal investment. The specific charges include, Grand Larceny in the Second Degree, Forgery in the Second Degree, Falsifying Business Records in the First Degree.

This case highlights the importance of cash control and transfer procedures within hedge funds, particularly in an operational risk context. Fraudulent cash movements can be extremely dangerous to the health and well being of hedge funds and their investors.

Here are some operational best practices which would likely have prevented such a scenario from occurring:

• Multiple signatories required to transfer cash - this takes the power away from one single person being able to potentially steal cash

• There should be limits on the amount of cash that can be transferred at any one time

• Cash should only be able to transferred to certain parties (i.e. - approved vendors etc.)

• Certain types of cash transfers should not be allowed to be originated by the fund (like personal payments to the COO)

But its not surprising that such an alleged event occurred if the Chief Operating Officer, the person who is generally responsible for enforcing such cash transfer policies, was the one allegedly orchestrating the fraud.

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Investing in hedge funds just got harder: Corgentum

Corgentum Managing Partner, Jason Scharfman recently authoried a guest article for Pensions and Investments where he discusses the many challenges facing pensions seeking to perform operational due diligence on hedge funds.

The article, which is featured in the publication's Regulation & Legislation section, is entitled, "Investing in hedge funds just got harder" . In the piece, Mr. Scharfman writes, "In the post-Madoff environment, sponsors of pension and other funds face a number of complex challenges with respect to performing due diligence on hedge funds..with all of these potential pitfalls, what are pension funds to do? There are a number of basic steps that can be taken to ensure a pension fund is adequately insulated from bearing unnecessary operational risks when investing in hedge funds through separately managed accounts structures."

Mr. Scharfman goes onto highlight the benefits and pitfalls of separately managed accounts including, the fact that such structures do not completely remove operational risk. The full article can be read on the Pension & Investments website .

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The effects of Obama administration plan on rating agencies

Corgentum Managing Partner, Jason Scharfman, was featured on Forbes.com discussing the potential effects of the Obama administration proposed financial regulatory plan on rating agencies. In the article entitled, "Obama Calls For More Change: The determined president shifts his attention and energy to the troubled credit rating industry," . Mr. Scharfman states, "Rating agencies are going to be looked at more closely, and will be placed under much more accountability and liability."

Highlighting the increased importance of due diligence, Mr. Scharfman additionally was quoted as stating, "Rating agencies will be viewed more as a guide, rather than the be-all-end-all, and you'll see more due-diligence, whether for banks or their clients." Mr. Scharfman also discussed the importance of sufficient capital adequacy requirements in the wake of the events of Barings Bank and Long-Term Capital Management. The full article can be read on Forbes.com.

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Impact of European hedge fund regulation in the US

In the article entitled, "Europe's Hedge Fund Regulation Efforts Have US Implications", Jason Scharfman, Corgentum Managing Partner, discusses the potential consequences of European hedge fund regulation in the US with the Wall Street Journal. Mr. Scharfman outlines that new regulations are actually "going to hurt a lot of pension funds and other large hedge fund investors because it will be giving them a false sense of security."


He further goes on to clarify that "hedge funds aren't trying to avoid tough regulation so they can commit fraud. Rather, they are trying to avoid the bureaucratic red tape that can cost managers lots of time and money, and ultimately dent investors' returns." The full article can be read on the Wall Street Journal website (subscription required).

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Third party administration: a hedge fund necessity?

Corgentum, a provider of comprehensive operational risk consulting services to the alternative investment industry, was feature in a recent Opalesque article entitled, "Has third party administration become a necessity?"

Jason Scharfman, Managing Partner of Corgentum, comments on the often complicated relationship between hedge funds and administrators saying, "98% of all hedge funds view administrators as a waste of money and a necessary evil that they are forced to use because of their investors."

The full article can be read on Opalesque.com (subscription required).

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Obama and Geithner's New Hedge Fund Regulation Fosters Environment for Next Madoff

It has been reported that on June 17 the Obama administration is reported to release its new plans for broad financial regulation. This will reportedly be followed by the June 18th testimony of Timothy Geithner before the House Financial Services Committee.

Reuters reports that it is likely that the administration plan will effectively carve up the existing regulatory framework into four agencies. These will be:
1)the FED
2)the FDIC
3) a new entity which will be the merger of: Office of Thrift Supervision and the Office of the Comptroller of the Currency
4) another new entity which will be the merger of the: SEC and CFTC

Here's an outline of how it is supposedly all supposed to break down:

THE FED
The new plan will support putting the Federal Reserve in charge of broadly overseeing systemic market risk.

While the Fed may lose some of its oversight powers over consumer protection (such as credit cards and insurance issues) it will likely gain several new regulatory powers including supervisory powers over: broker dealers, private equity, derivatives and hedge funds.

The FED's Advisory Committee
The FED would be backed up by a so-called, "advisory committee" (similar to the President Working Group on Financial markets) to assist in monitoring system risk.

THE FDIC
The proposal will give new power to the Federal Deposit Insurance Corp. (FDIC) to oversee the unwinding of troubled financial institutions.

OFFICE OF THRIFT SUPERVISION AND THE OFFICE OF THE COMPTROLLER OF THE CURRENCY
It has also been speculated that the Obama administration will propose merging the Office of Thrift Supervision and the Office of the Comptroller of the Currency. So effectively instead of the current four bank regulatory agencies, we would be left with three larger ones.

THE SEC + CFTC
It has also been reported that a likely merger of the SEC and CFTC is likely - this new entity would oversee: investor protection and market integrity. Although other reports have come out, including this one by Bloomberg, suggesting that Geithner may not support such a merger. Such public dissent by Geithner is nothing new as continued turmoil seems to persist between Geithner and President Obama's chief economic advisor, Larry Summers.

Where is the Unsystemic Risk (Aka: Operational Risk) Regulatory Oversight?

While it has also been reported by CNBC that republicans are preparing their own version of financial system regulatory overhaul, on the surface it seems that these plans have essentially completely ignored, or severely minimized, the risks association with the operational risks in hedge funds.

Operational risks (i.e. - legal and compliance risks, valuation and accounting risks, reputational risks, asset verification, third part independence etc.) are exactly the types of risks that led to the Madoff scandal and the recent deluge of hedge fund frauds and Ponzi schemes. Ignoring such risk fosters a lax regulatory environment that could foster the next Madoff.

It seems as if the voices of the hedge fund industry lobby groups such as AIMA and the MFA, at least in the US, were loud enough to steer the discussion away from operational risk.

Where are the investor advocate groups touting the importance of enhanced operational risk disclosures for hedge funds and private equity?

With regards to alternative investments these proposed plans are essentially the polar opposite of the gist of the European Union's directive which - while still not focusing on operational risk - places a great deal more emphasis on overall transparency, risk reporting and monitoring.

How many more Madoff's will it take before the US, and the rest of the world, begins to dedicate the appropriate focus towards truly monitoring operational risk?

Many compliance and legal professionals in the US feel that a good first step would be with the SEC enhancing form ADV disclosures, but it seems as if this is a low priority on Mary Schapiro's to do list.

A Mini Regulator Not A Super Regulator
The planned merging of the SEC and CFTC, with the combined oversight of the Fed, effectively creates a super regulatory agency for the hedge fund industry.

With respect to operational risk in the alternatives space, this is the wrong approach.

Operational risk data collection and on-going monitoring from hedge funds and private equity will best be served by an experienced regulator focused on the nuances and specifics of the hedge fund industry. Lumping hedge funds together with all other financial institutions (such as banks, mutual funds, thrifts, insurance companies etc.) is simply the wrong approach. Too many small operational issues will slip through this broad regulatory net. These smaller issues may not be deadly in isolation but in aggregation they can snowball into a Madoff like blizzard for the financial markets.

A better approach would be a smaller regulatory agency (or dedicated division of a larger regulator) with the nimbleness and detailed knowledge and experience necessary to properly oversee and monitor operational risk in

[caption id="" align="alignleft" width="192" caption="Harry Markopolos"][/caption]

hedge funds. To quote Harry Markopolos (the man who knew Madoff was a fraud) - they should have enough experience to "have gray hair or no hair."

Unfortunately for US investors, and perhaps fortunately for the hedge fund industry lobbies, who generally it seems oppose such increased transparency and disclosure requirements are not in the plan for the short term regulatory framework.

A Continued Hedge Fund Exodus from Europe?
This proposed lax operational risk disclosure environment, the failing of increased hedge fund regulation on the state level (i.e. - recent news of Connecticut's recent decision to let proposed hedge fund legislation, which would in part

[caption id="" align="alignright" width="92" caption="Crispin Odey"][/caption]

enhance disclosure requirements, die for the time being) combined with the hedge fund industry's disdain over the EU directive, may add more fuel to the talks of a European hedge fund exodus, from hedge fund manager's such as Crispin Odey, from UK to the US. Hopefully, the US is appropriately planning for the impending deluge.

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Hedge Fund Manhunt! - With Love from Bulgaria...

Lest we think we were entering the hedge fund fraud doldrums of the summer, when news was released ofthe manhunt for Bulgarian national Julian Tzolov.
[caption id="" align="alignleft" width="214" caption="Mr. Tzolov in cuffs"][/caption]
Mr. Tzolov, an ex-credut suisse trader who was charged with fraud along with another Eric Butler in September 2008, was declared a fugitive last Friday by the U.S. government. By complete coincidence, this was exactly three weeks before Mr. Tzolov's trial for fraud was to begin.
He was under house arrest while pending trial for fraud related to subprime mortgages. He left his houseon May 9 and never returned.
Guess Mr. Tzolov didn't hear about the new extradition treaty between the US and Bulgaria.
The hedge fund industry loves a good manhunt - the most memorable being Sam Israel's dramatic stint on the lamb.
[caption id="" align="alignright" width="166" caption="Bayou's Sam Israel Captured"][/caption]
Let the hunt begin!
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The Depth Of The Dive: Gauging The Scope And Scale Of Due Diligence

Corgentum Managing Partner, Jason Scharfman, has written an article as a guest contributor for FINalternatives. The article, The Depth Of The Dive: Gauging The Scope And Scale Of Due Diligence .
The piece states in part, "in the post-Madoff environment it is no longer acceptable for a fund of hedge funds or any institution, which allocates to hedge funds, to simply claim that they have comprehensive investment and operational due diligence practices. These firms must be able to consistently demonstrate the depth and breadth of their due diligence." The full article can be read on the FINalternatives website here.
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The Lawyer, the Professor and the hedge fund fraud

Another day, another scandal. The SEC yesterday froze the assets of a Texas based PrivateFX Global One Ltd. after charging the firm with fraud. Specifically, the charges state that Robert D. Watson and Daniel J. Petroski, allegedly forged bank statements to inflate returns. The strategy managed by the firm was ironically called “Alpha One” and claimed to generate profits through their proprietary foreign-currency trading software program that they called “Alpha One.” The CFTC has filed similar charges.

Mr. Watson resigned last month from Texas A&M, where he had been an Executive Professor of Finance at the Mays Business School. Looks like he submitted his resignation a bit too soon. Mr. Petroski is both a lawyer and a certified public accountant. It is reported that the firm had raised approximately $19 million from investors.

Echoing signs of Madoff the firm allegedly told investors that it never had a losing month and returned an annual 23%. Interestingly Watson and Petroski are also accused of creating phony account statements and records for SEC investigators. Obviously, they were not phony enough to fool the SEC.

This is a classic case where basic due diligence, asset verification and independent custody would have been key elements in preventing a fraud. There is nothing inherently wrong with black box FX trading models run by professors with snazzy names but investors need to look past the smoke and mirrors. Here’s a simple rule that has gained acceptance in recent months - if a hedge fund manager cannot break down their strategy in plan simple terms to explain how they are making money don’t invest – period.

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AIMA to EU Commission: Thanks, but no thanks on proposed directive

AIMA today announced its intention to fight the European Commission’s draft directive for Alternative Investment Fund Managers tooth and nail.

AIMA’s CEO (Andrew Baker) stated, “There are provisions in this directive with potentially serious consequences for managers, investors, service providers and advisers internationally. As the global trade body for the industry it is right therefore that AIMA takes the lead in mobilising resources in order to secure the best possible outcome for the industry on the directive.”
There has been much furor over this directive – but what exactly is all the fuss about?
On April 30, 2009 the European Commission issued this directive with the goal of creating a comprehensive framework for hedge funds and private equity managers in the European Union. The directive also has implication for certain alternative investment service providers including administrators. This directive is essence seeks to fill a regulatory gap in the European Union by applying to hedge fund and private equity manager and administrators who are established in the EU yet are not regulated under directive 85/611/EEC undertakings for collective investment in transferable securities (UCITS) or so called AIF Managers.

Part of the criticism of this directive is its vagueness, and rightly so. As an example many critics have pointed to the “established in” language questioning what this truly means. For example, would a hedge fund manager originally founded in the US but with a satellite office in the EU be established?

The directive further establishes a number of hoops managers must go through including:
· obtaining authorization from the competent authority of their home Member Sate
· Suitability requirements
· Disclosures with regards to internal arrangements with respect to risk management, valuation, asset safekeeping and regulatory reporting

Hedge funds clearly do not like this proposed piece of legislation one bit. It is very interesting to see different reactions to hedge fund regulation in the US and abroad. In the US, hedge fund groups such as AIMA openly stated they embraced notions of additional regulation and increased transparency. Yet it seems that when regulators take them seriously and make an effort to make disclosure requirements meaningful, the hedge fund industry quickly changes its tune. To me this demonstrates the hedge fund industry’s implicit acceptance of the notion that information disclosure requirements being proposed in the US are far below meaningful levels to place a meaningful disclosure burden on hedge funds.

As an example, Florence Lombard, Executive Director of AIMA stated, “We are very concerned about the manner in which the European Commission’s directive on the industry has been drafted. It does not appear that the drafting of the Alternative Investment Fund Managers Directive has been coordinated with the relevant international institutions. The G20 mandated the Financial Stability Board and IOSCO (International Organization of Securities Commissions) to look at these issues, and it is not clear how this directive will fit in with the new international architecture established by the G20.”

Hedge funds should not necessarily bear this burden and are right to fight it, but taking such a hostile stance as the [Photo]industry has taken against the EU directive does little to foster a collaborative environment where hedge fund investors, regulators and hedge funds themselves share the burden for industry regulation and setting appropriate and meaningful minimum disclosure requirements. Furthermore, global coordination (among groups like the G20, IOSCO, the SEC, the FSA and hedge fund industry groups) should be fostered as opposed to individual jurisdictions and industry lobbies each proposing their own versions of a regulatory framework.
This carving up of the regulatory globe will certainly foster an environment where different practices and disclosure requirements exist in different jurisdictions. This is not necessarily bad in and of itself, but in major hedge funds jurisdictions (UK, Hong Kong, US) a certain level of regulatory uniformity and uniform minimum disclosure requirements will likely only help the hedge fund industry and further protect its investors.

Analyzing Operational Due Diligence Frameworks In Fund of Hedge Funds

Corgentum consulting released a study today entitled Analyzing Operational Due Diligence Frameworks In Fund of Hedge Funds.

This study seeks to develop a transparent benchmark against which operational due diligence frameworks may be compared. Key study findings include:
• Only 27% of fund of hedge funds have a full time person on staff or team dedicated to fraud detection

• There are less resources are dedicated to operational due diligence in the US as compared to the rest of the world(Asia and Europe)

• There is lack of consistency in fund of hedge funds operational due diligence approaches

• Smaller fund of hedge funds (under USD $1 billion) use a wide variety of operational due diligence frameworks with less dedicated resources

The full study can be read on here.

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Are Hedge Funds Becoming Regulated Banks?

It seems like the Treasury’s Tim Geitner is getting behind the Federal Reserve to promote uniformity in derivatives. Specifically, in February several banking industry major players (Goldman Sachs Group Inc., JPMorgan Chase & Co., Credit Suisse Group AG and Barclays Plc) voiced their opinion to the Treasury arguing that the banking industry should require that traditional bank regulatory practices with regards to derivatives. It seems Geitner is trying to get his ducks in a row after some initial stumbling regarding the specifics of his plans to deal with toxis assets.

Banks want to level the playing field by requiring regular corporations, energy companies and hedge funds to face the same capital adequacy requirements and margin levels that bank do with regards to OTC derivatives.

Putting banks and hedge funds on the same playing field makes sense to promote transparency in derivatives. While there is some good in this, this type of move by the Fed is fraught with peril for hedge funds. This can represents a dangerous precedent and a slippery slope of hedge funds to be regulated alongside of banks in regards to other issues such as leverage requirements, position disclosures, overall risk budgeting and operational information disclosure.

These regulations focus on establishing the Fed as a systemic risk regulator. Systemic risk is extremely important but it is not the entire regulatory equation. This focus on systemic risk is important but once again it is of growing concern that the government is being steered by powerful lobby groups to ignore the continued threat of operational risk (aka: unsystemic risk) including fraud. Perhaps the hedge fund industry should take a page from the bank’s playbook and be more vocal in Washington with actionable recommendations, instead of the general pat on the back fodder that has been stated by most hedge fund lobby groups, to further craft future regulation before the hedge industry becomes regulated away.

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Hedge Fund Red Flag Warning System

The UK’s Serious Fraud Office announced that it is working on creating a hedge fund red –flag warning system. This is a follow up to the two arrests that were made in earlier this week in relation to the Weavering Capital fraud.

The Weaving arrests made via raids at houses in Kent and Surrey marks the first arrest in a hedge fund case in the UK.

It will be interesting to see if regulators in other jurisdictions create similar red-flag systems warning systems. Furthermore, I would like to see how such systems integrate any operational risk concerns instead of focusing purely on investment related concerns and the use of leverage as most of such previous proposal have in the past.

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Corgentum's Scharfman Supports the Proposed Uptick Rules on CNBC's Closing Bell

Jason Scharfman, Managing Partner of Corgentum Consulting, was featured on CNBC's closing bell with Bob Pisani discussing the proposed uptick rules to combat short selling abuses in a segment called, "Curbing the Shorts." Mr. Scharfman highlights the need for the reinstatement of the uptick rule. The discussion includes a review of the recent SEC roundtable on the subject including an overview of academic research in this area and a discussion of the circuit breaker and bid test proposals.

The clip is available here:


This segment was part of a larger segment of the uptick rule which can be viewed in full on CNBC's website here.

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Corgentum, Hedge Fund, Operational Risk, Due Diligence, Madoff

APRIL 15, 2009

FAS 157 (aka: the fair-value measurement standard) is an accounting standard which first took effect in November 2007. According to the Financial Accounting Standards Board (FASB), FAS 157 "...defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements."

FAS 157 has a number of ramification outside the hedge fund industry. As an example, here is a recent video examining the effects on banks of relaxing mark-to-market accounting rules.


FAS 157 was a big deal when it was first put into effect. For hedge fund's (and their auditors) FAS 157 presented a number of unique due diligence challenges. Specifically, the original incarnation of FAS 157 requires hedge funds, in their audited financial statements, to classify assets into one of three levels. The levels are supposed to show indicate to investors the amount of certainty with which they can value an asset.

Level 1 - Assets with readily observable market prices. Inputs for the assets in this level are quoted prices (unadjusted) in active markets.

Level 2 - Assets with no readily observable prices but they have inputs that are based on them. An example of this would be an interest-rate swap whose components are observable points - such as a Treasury bond.

Level 3 - Assets where one or more of those inputs does not have readily observable prices. Level 3 is the most controversial Level.

There is a general perception that investors place a premium on liquidity and that for the vast majority of hedge fund situations the more liquid (i.e. - Level 1) the better. As such, the natural progression of FAS 157 led to a struggle between hedge funds and auditors in the way their assets would be presented to investors.

When FAS 157 first was announced many hedge funds (and their auditors) were unsure which FAS 157 Level certain assets should be classified. It seemed some hedge funds/auditors were set to error on the side of caution. Others seemed more open to assuaging their hedge fund client's vocal objections to the classification of certain assets.

Some people in the private equity world have classified FAS 157 as "stupid." The SEC's former Chief Accountant Lynn Turner, has given FASB a failing 'F' grade.

(Others have raised questions about which FAS 157 assets should be classified in when they have no value (such as toxic assets). In light of the recent economic environment it seems that change is in the air to reform FAS 157. In recent Congressional testimony a number of big names (Ben Bernanke, Sheila Bair, Tim Geitner, Mary Schapiro) have suggested reforming FAS 157 (aka: Mark-to-Market) and Fair Value accounting.

Even FASB has acknowledged that FAS 157 needs some work and since issued three final Staff Positions (FSPs) intended to provide additional application guidance and enhance disclosures regarding fair value measurements and impairments of securities - which is accounting speak for clarify what we should have made clear the first time. Maybe FASB should read some this book before making anymore recommendations.

Specifically, the three groups of FSPs are:

1) FSP FAS 157-4 (the exciting sequel to FAS 157-3)- Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly

2) FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments

3) FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments

“The issuance of these final FSPs follows a period of intensive and extensive efforts by the FASB to gather input on our proposed guidance,” states FASB Chairman Robert H. Herz.

Thanks for all your hard work.

So let me get this straight - FASB puts out a rule which confuses everyone and provides little guidance on how to use it. Then works really hard to clarify it while hedge fund's, investors and auditors twist in the wind in the interim. Why wasn't all of this work put into gathering input gathered done beforehand? The FSPs are expected to be voted on later this week.

Some have blamed mark-to-market accounting as fueling some of the problems with the economy. Others have claimed there is nothing wrong with the rules but rather other issues such as over leverage should be blamed. FAS 157 is nothing more than a classification system. On face value it will do nothing to effect the actual underlying assets held by a hedge fund manager. It raises a number of issues related to judgment of hedge fund managers and their auditors. It is unclear if different auditors would classify certain assets into levels uniformly.

Hopefully, the new guidance from FASB will remove some of the judgment and discretion for the FAS 157 classification process. At the end of the day I question whether mark-to-market accounting really deserves all the criticism it has received. While there are good arguments on both sides, certainly a sound risk management policy should compliment any accounting methodology in place and not, as it seems had been the case with many hedge funds, be driven by it.

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