Avoiding Fraud: What Investors Need to Know (HedgeWorld)
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Avoiding Fraud: What Investors Need to Know
By Susan L. Barreto, Senior Reporter
Thursday, March 14, 2002
CHICAGO (HedgeWorld.com)—A slick sales presentation and hot performance numbers do not necessarily a wise investment make. There’s just a bit more to it than that, as some investors have learned the hard way.
Sometimes something as simple as a background check can save an investor from incurring legal fees on top of management fees. Some fraud cases have gained notoriety for their tales of greed, deception and outrage and make for great cocktail conversation. However, no investor ever wants to admit to having been duped, and no one wants to discuss his investments in the open forum of a courtroom.
The combined experience of due diligence experts suggests that some of these disasters could have been averted with the use of some simple tools that investigators use to discover a manager’s background.
“Something so simple and so basic wasn’t done in so many instances,” said Daniel Kramer, a lawyer at Schulte Roth & Zabel LLP, New York.
Background Checks
He suggests checking an individual’s education to make sure the manager actually graduated from the schools he said he did. If a person is willing to lie about his education, it’s hard telling what else a manager may be withholding, according to Mr. Kramer, who is a litigator with his law firm.
In some of the most prominent hedge fund fraud cases, a simple background check would have revealed much about the trustworthiness of the manager.
For example, in the case against Michael Berger, the manager of the Manhattan Investment Fund Ltd., a background check would have revealed much. Mr. Berger, in his mid-20s, had very little experience in the securities industry. So while Mr. Berger told investors that he was making money shorting Internet stocks, it turned out his fund was losing money even though he said the fund was gaining between 12% and 27%.
“A lot of it was common sense, but people were blinded by greed,” said one observer of the Berger case.
Chris Manthey, a third-party investigator with due diligence firm BackTrack Reports, agrees that background checks can reveal much about a manager’s experience or lack thereof. Mr. Berger was a college dropout and his only experience on Wall St. was in creating a newsletter.
“People who have the pedigree don’t have the problems,” Mr. Manthey said.
It usually takes Mr. Manthey three weeks to gather info on a hedge fund manager. His research involves searching for criminal cases, civil cases, regulatory actions and a person’s education and work history.
For example, in doing basic due diligence on a manager named David Mobley Sr., head of Maricopa Investment Corp., he discovered that Mr. Mobley had been indicted and had a personal bankruptcy on his record.
Mr. Mobley’s 170 investors lost US$59 million because he diverted their money to fund failed business venture, including a mortgage company, a golf and country club development and a cigar bar.
One way investors can screen out the really bad guys is through Lexis-Nexis searches for lawsuits and news databases for any information related to the manager or his company. A helpful tool Mr. Manthey suggests is the National Futures Association website (www.nfa.futures.org), which lists any regulatory actions against a manager past or present.
“It shouldn’t be I shook his hand and he seemed okay,” Mr. Manthey said.
One of the most recent cases of alleged fraud involves the Art Institute of Chicago and officials at Integral Hedging LP, Samer El Bizri, Conrad P. Seghers and James Dickey.
Although we may never fully know the answers to the questions in this particular case, it seems after some investigation it was a situation that could have been prevented, according to due diligence experts.
A bit of research on the part of HedgeWorld along with the help of Mr. Manthey revealed some interesting information about Intregal’s officials.
Raising Some Red Flags
A number of court cases involving Messrs. Seghers and Bizri and their respective firms, might have raised suspicions regarding the credibility of the strategies and funds managed by Integral officials, even though the firm’s record with the NFA was clean, according to Mr. Manthey.
Three cases in particular point to the group’s problems regarding some investments that pre-date the Art Institute’s involvement with Integral.
The first lawsuit was filed in 1998 and Mr. Seghers was one of the plaintiffs in a class action case against FirstPlus Financial Group, which was accused of making “false and misleading statements” that artificially boosted the home equity lender’s stock.
Mr. Seghers’ first partnership with Mr. Dickey, Exponential Returns LP, lost more than $564,000 in its First Plus investments made beginning in March 1997 and liquidated in October 1998, according to court documents.
Breach of Contract Lawsuits
Then there is the SureQuest case involving a breach of contract, which was filed by Mr. Seghers in July 2000—the same year Messrs. Seghers and Dickey made an initial presentation to the Art Institute. The facts of the case begin in 1999.
In the suit against Steve Mills, head of SureQuest Systems, the case involved an oral agreement in which a stipulated sum was to be paid and money was allegedly lost in a joint stock investment. Mr. Mills did not make the payment and insisted that he had no ability to pay, according to the lawsuit filed by Mr. Seghers. In the same suit, terms for a written equity swap and financial agreement between Mr. Seghers and Mr. Mills involving shares of Healthaxis and Viking Capital Group were also not met.
The third suit involving Mr. Seghers is still playing out in the federal court in the Northern District Court of Illinois in Chicago. Mr. El Bizri, who handled trading for Integral was involved in this suit as well. FC Stone, a futures commission merchant in Chicago, is suing Bizri Capital Partners and Integral Hedging for a breach of contract.
That case stems from a fraudulent trade allocation scheme that was orchestrated by two former FC Stone employees. The resulting losses were felt in an account maintained by Bizri Capital Partners. The dispute surrounding the actual account losses and purported consequential damages of the scheme is detailed in a lawsuit filed in June 2001.
In the court documents, FC Stone claims that Bizri Capital failed to notify FC Stone of errors in its account or otherwise suspicious trading activity until almost one year after the first unauthorized trade was allocated to the account. Shortly after FC Stone notified Mr. Bizri of the scheme, the Commodities Futures Trading Commission and the NFA began to investigate Mr. Bizri and its related business activities, the lawsuit states.
The amount in dispute cannot exceed $594,021.70, according to FC Stone. Integral comes into the case since FC Stone alleges that Integral was preparing to sue FC Stone for the account losses. The case has been placed in arbitration and Integral’s lawyer Larry Friedman is now representing both Integral and Bizri in the lawsuit.
Other Discoveries
Other documents also reveal bungled investments, such as a 10K filed last year by Broadband Wireless International which details a settlement with Mr. Seghers’ Genesis Market Neutral Fund. The fund and Mr. Seghers performed consulting services for the company in 2000. In March 2000, Genesis entered into several agreements with Broadcom to purchase Broadcom stock. Genesis Market Neutral inadvertently overpaid by $175,000.
To settle the claim, an agreement was reached with Genesis and approved by the court, in which Broadcom was to issue 1,050,000 shares of company stock; 150,000 shares were issued. The remaining shares were issued at the rate of 150,000 shares a month until complete in October 2001. Mr. Seghers and Genesis have released Broadband Wireless from any further liability, according to the SEC filing.
Mr. Manthey said he couldn’t remember seeing anything like this in his 13 years of doing due diligence work. There are a very small number of investors that get involved in these types of cases, he added.
One of his clients, ALLETE Inc., Duluth, Minn., decided not to invest in Mr. Seghers’ fund after concluding they could not find out enough about the strategy to understand the investment. An outside marketing person made a presentation to ALLETE officials without providing much in the way of detail of the strategy, said Robbie Burkhart, who handles investments for the company’s $200 million cash reserves fund and $400 million pension fund that both invest in hedge fund strategies.
“He said they were pretty secretive about what they do,” Mr. Burkhart said. ALLETE never went far enough past the secrecy to even begin the due diligence process.
Not all smaller investors follow their gut reactions, while even more don’t have the chance to do background research. According to due diligence experts, bigger providers of hedge fund services such as hedge funds of funds are more apt to hire a third-party due diligence team than smaller investors. Those smaller investors and larger institutional investors, such as pension funds, normally defer to a gatekeeper to do some of this research.
So, if a fund manager is secretive about his investment process, should investors’ assume he is a con man?
Profile of a Fraudulent Manager
After analyzing a number of hedge fund fraud cases, Mr. Kramer has created three categories of managers that tend to get caught up in malfeasance.
The first category is the traditional conman. This is a person who isn’t a trader and doesn’t know anything about the markets. Mr. Mobley may fit this profile in that he was not educated (only graduating from a vocational high school in Toledo, Ohio) and never was involved with the securities industry.
Mr. Mobley also had been indicted by a grand jury for theft. The case was later dropped after he agreed to return $20,000 he had borrowed from a fellow church member.
The second profile of a fraudulent manager is the young, energetic, reasonably smart young kid who mixes up a bull market with being a savvy investor, Mr. Kramer said.
The case of Mark Yagalla may fit this profile. Mr. Yagalla, in his mid-20s, was recently sentenced to five years for defrauding 110 investors. He began investing in the mid-1990s and had some early success with investments in AOL and Dell. Once he started his own hedge fund he promised investors returns as high as 60% on short-term securities. At the same time, Mr. Yagalla’s spending habits began to blossom, eventually forcing him to use the assets of the hedge fund to support his luxurious lifestyle.
The third type of fraudulent manager is a person who can’t come to grips with a loss. The manager takes what could be considered a modest loss that could have been taken on the chin and doubles up the investment and digs a deeper hole, Mr. Kramer said.
Michael T. Higgins may have been one such hedge fund manager. He ran Ballybunion Capital Partners. He started out with $125,000 of his own money, but was down to $11,000 by yearend. Nevertheless, he was able to raise $7.6 million claiming he was gaining double-digit returns annually on hedge fund websites.
Mr. Kramer suggests that investors should be wary of managers who claim to have confidential computer formulas that predict market movements. Investors should as themselves the following questions:
Is something unusual?
*Is the fund deviating from its stated trading strategy?
*Is there difficulty communicating with the fund’s manager or in having instructions followed?
*Is there an unusually high turnover rate in personnel?
*Does reported performance deviate greatly from other funds in a similar category?
Investors who get burned in hedge fund fraud are often scared off from the alternative investment area, Mr. Kramer said. There isn’t necessarily a real pattern to the fraud, but some people keep investing. They just become more careful the next time, he added.
Ultimately not every manager fits a specific mold, so getting to know a manager can be an important part of the due diligence process. “At the end of the day, it’s a relationship of trust between investors and managers,” Mr. Kramer said.
SBarreto@HedgeWorld.com
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