Bayou Fraud Exposes Tale of Lies, Drugs, Violence (Update1)
Oct. 27 (Bloomberg) -- On the afternoon of Aug. 16, police sergeant Gary Perna responded to a code 642 -- possible suicide - - at the offices of Bayou Management LLC, in Stamford, Connecticut.
Nowhere in the deserted, shorefront cottage was Bayou founder Samuel Israel III, the trading whiz behind the market- beating investment returns that the hedge fund had reported since 1997. Also missing was Daniel Marino, the man accounting for the $450 million that investors had entrusted to the firm.
As Perna arrived on the scene he expected to find Marino dead -- perhaps bobbing in the nearby Long Island Sound, he says. Perna had reason to fear the worst: A Bayou client had called 911 after arriving that Tuesday to find Bayou's offices empty, an ominous, six-page letter atop Marino's desk.
``My name is Dan Marino and this is a combined confession and suicide letter,'' the typed note begins. ``For the past seven years, I have committed a fraud of a great magnitude.''
The letter goes on to explain how Israel, scion of a prominent New Orleans family, and Marino, an accountant from Staten Island, New York, had pulled off one of the biggest scams ever perpetrated in the $1 trillion hedge fund industry.
At the heart of the story is the stormy relationship between the two men, an odd pair of misfits who met by chance 15 years ago and, at Bayou, never made any money at all. Authorities have only just begun to unravel the web of failed investments that Israel and Marino spun.
Sudden Collapse
Bayou seemed to disappear almost overnight. Just weeks before the police arrived, Israel had abruptly told clients he was closing his fund and returning their money. Then -- nothing. No checks. No explanations. No one at Bayou answered the phones. Messages choked the firm's voice-mail system.
Israel, whose father and grandfather had made their fortunes trading commodities, repaired to a Tudor mansion in Mount Kisco, New York, which he rented from Donald Trump for $32,000 a month. He refused to speak to clients or reporters. Marino, a 250-pound (113-kilogram) man with a severe hearing disability and, by his own account, a volatile temper, holed up in his $2.9 million McMansion in Westport, Connecticut, his blue 2004 Bentley in the garage.
Marino didn't follow through with his suicide threat that August day, and on Sept. 29, he and Israel finally came clean about what really had happened at Bayou. It was even worse than investors had feared.
Sham Audits
Israel and Marino had duped investors almost from the start, the men confessed. They had used sham audits to hide trading losses, inflate reported returns and pocket tens of millions of dollars in fees on phantom profits. In the federal courthouse in White Plains, New York, Israel and Marino, both 46, pleaded guilty to conspiracy to commit fraud, mail fraud and investment adviser fraud. Released on $500,000 bail apiece, pending sentencing on Jan. 9, each faces as much as 20 years in federal prison. Neither they nor their lawyers responded to telephone calls requesting interviews for this story.
Marino's letter, along with hundreds of pages of other court documents, police records and interviews with former colleagues and clients, tells a tale of lies, drugs and violence. During his years at Bayou, Israel had become addicted to painkillers, Marino wrote. At times, Israel would beat Marino, and at one point, he even threatened him with a gun.
On many days, Israel never showed up at Bayou's offices, leaving Marino to terrorize the staff, according to two people who worked for Bayou and asked to remain anonymous, saying they feared being drawn into the scandal.
Soccer Coach
When Israel did appear, he would often recline on the floor to soothe his bad back or hunch before an array of computer screens, including one showing streaming video from NASA's Kennedy Space Center in Florida. He rarely, if ever, turned a profit on his trades.
The revelations have shocked people who know Israel. He grew up in a house overlooking the Westchester Country Club in affluent Rye, New York; coached his daughter's soccer team; and boasted that trading was in his blood.
Israel came across as a charming and affable jokester whose only interest seemed to be investing, says Jack O'Halloran, an ex-prizefighter and former Hollywood actor who ran a company on the Isle of Man that Israel and Marino invested in. ``Sam's a nice guy,'' O'Halloran says. Jeffrey Fotta, a former hedge fund manager who did research for Bayou, summed up Israel this way: ``To know Sam was to love Sam.''
As Israel and Marino confront prison, Bayou clients face their own harsh reality: Most of their money may be gone. In mid- October, the U.S. Securities and Exchange Commission was in the process of appointing a receiver who will try to figure out how much money clients might recover.
Assets Seized
The state of Arizona has seized $100 million of Bayou's assets, leaving more than $300 million as yet unaccounted for. Much of that fortune was lost long ago as Israel tried to trade his way out of bad bets on the markets, according to Marino's letter, a copy of which was obtained by Bloomberg News.
Whatever money is left may not be easy to find. The assets seized by Arizona authorities had already been whisked through bank accounts in Germany, the U.K. and Hong Kong. As much as $40 million may have disappeared into a second investment firm called IM Partners, according to two people who helped Israel and Marino make the investments. IM Partners -- IM, as in Israel-Marino -- sank money into small, private companies ranging from Vectrix Corp., a Newport, Rhode Island-based maker of electric scooters, to CiteVision, a cable television company based in Amiens, France. IM also invested in a film production in Puerto Rico as well as companies incorporated on the Isle of Man and Cayman Islands, both offshore tax havens. The wrangling over Bayou's remains has only just begun.
Red Flags
Lulled by financial statements showing annual returns of as much as 33 percent, many investors missed red flags at Bayou. Rather than use a separate brokerage to execute trades, for example, Bayou established its own in-house broker-dealer, Bayou Securities, to skim commissions for Bayou Management.
Rather than employ a reputable accounting firm, Israel and Marino told investors that a firm called Richmond-Fairfield Associates was auditing the hedge fund. According to registration documents on file with the state of New York, Richmond- Fairfield's sole accountant was none other than Marino, Bayou's chief financial officer. His fake accounting firm produced false audits.
Israel and Marino seduced not only wealthy individuals, who invested a minimum of $250,000 in the hedge fund, but also money managers such as Seattle-based Silver Creek Capital Management LLC; New York-based Multi-Dimension Fund LP; 168-year-old DePauw University in Greencastle, Indiana; and the Jewish Federation of Metropolitan Chicago.
Lawsuits
Multi-Dimension and the Jewish charity have sued Israel and Marino, saying the men defrauded them. Silver Creek partner Eric Dillon, who discovered Marino's suicide letter in August, declined to discuss the fiasco.
Bayou didn't lure investors all by itself. Israel and Marino also used hedge fund consultants, such as New York-based Hennessee Group LLC and Memphis, Tennessee-based Consulting Services Group LLC, to drum up business. Such firms advise clients on where to make hedge fund investments and get paid for steering money into funds, either by their clients, the funds or both.
Consulting Services began recommending Bayou to investors in 2001, according to a due-diligence document Bayou circulated to potential investors. By then, Bayou had been ripping off investors for four years. Consulting Services told investors in 2004 to pull their money out, says Joe Meals, that company's compliance officer. Meals declines to say why or to comment further.
`I Will Drag Everyone Down'
At least two Bayou employees suspected years ago that something was wrong. One, Paul Westervelt, told Israel in 2003 that he thought the firm might have violated securities regulations, according to a breach of contract lawsuit Westervelt filed against Bayou, in which he said he was misled when he was recruited. Another, Greg Lopak, called Bayou in 2002 and threatened to blow the whistle on Israel.
``I will fucking crucify him,'' Lopak warned a Bayou employee, according to an incident report filed with the Stamford Police Department on Feb. 1 of that year. ``I will drag everyone down and call the feds.'' Lopak never followed through with his threat. Neither he nor Westervelt could be reached for comment.
From the start, Israel and Marino made an unlikely duo. They were born within three months of each other, in 1959, into different worlds.
Southern Money
Israel came from Southern money. His grandfather and father ran a century-old commodities trading firm, originally called Leon Israel & Bros., in New Orleans. In the Crescent City, the Israels were people to know and generous patrons of charitable and civic causes. Sam's father, Lawrence, served on the President's Council of his alma mater, Tulane University, near the city's Audubon Zoo. The campus is home to the Merryl and Sam Israel Jr. Environmental Sciences Building, named for Israel's grandparents.
Like his father, young Sam attended Tulane. Unlike his dad, he never graduated. Israel dropped out a few months shy of commencement, he told U.S. Magistrate Judge George Yanthis on Sept. 29. If Israel had hopes of inheriting the family business, he was soon disappointed. The Israels sold their firm to Donaldson Lufkin & Jenrette Inc. for $44 million in 1981. A year later, the family patriarch, Samuel Israel Jr., Sam's grandfather and namesake, died at the age of 72. The New Orleans Times- Picayune newspaper ran the obituary on the front page.
``I always tried to think of the `other fellow,''' Samuel Israel Jr. wrote in a letter he left to his family that was quoted in the Times-Picayune.
Staten Island
Dan Marino didn't come from money. He grew up on Staten Island, home to New York's 2,200-acre (890-hectare) Fresh Kills garbage dump. His Manhattan-born father, Elias, practiced law out of the family's two-story brick home on Whitaker Place. He was a member of the local Italian-American club.
Dan's mother, a Greek immigrant and one-time flamenco dancer named Daisy, attended City College of New York, founded in 1847 to provide higher education to the children of the city's working class. Daisy worked as an assistant in Elias's office.
The Marinos wanted to send young Dan, who was born partially deaf and has difficulty speaking, to a school for the hearing impaired, Marino once told a colleague. Dan, the second of four children, refused to go. Growing up, Dan and his three siblings, Marcus, Elizabeth and Matthew, came across as quiet and studious, says a neighbor, Susan Somma. The kids often did chores around the house, she says.
Tragedy Struck
The Marinos' hard work paid off. Marcus, now 48, became an architect; Elizabeth, 44, a doctor; and Matthew, 42, a lawyer. And Dan became an accountant. In 1981, he graduated from Wagner College, about two miles from his home. That year, tragedy struck the Marino household: Elias Marino died of a heart attack at the age of 55.
When Daisy Marino died in 2000, at the age of 73, Dan's older brother, Marcus, eulogized her in an obituary published in the Staten Island Advance.
``She was a devoted parent who stressed honesty and being a good citizen to her children,'' Marcus Marino said. ``She always tried to encourage us to read as much as possible and learn as much about the world as possible and to treat every single person equally.''
As Israel and Marino celebrated their 22nd birthdays in 1981 -- Israel on July 20 and Marino on Sept. 7 -- they embarked on the careers that would eventually draw them together.
Coopers & Lybrand
Marino put his college degree to work as an auditor at New York-based Coopers & Lybrand LLP, then one of the Big Eight U.S. accounting firms, according to Bayou marketing documents. Israel headed for Wall Street. In 1982, he joined F.J. Graber & Co., where his father kept an office, according to a former Graber associate.
Israel executed trades at Graber. It was there that he met James Marquez, who would later introduce Israel to Marino and, according to Marino's letter, help hatch the scheme at Bayou. Stanley Twardy, a partner at law firm Day, Berry & Howard LLP, who is representing Marquez, declined to comment other than to say that his client has discussed Bayou with the U.S. Attorney's Office in New York.
Israel left Graber in late 1988 and spent the next two years bouncing from one small firm to the next. First, he joined Midwood Securities Inc., then Gerard Klauer Mattison & Co. and finally Gruntal & Co. He soon ran into trouble at Gruntal. After making a trade that resulted in a ``substantial loss,'' Israel stopped showing up for work, according to his employment record on file with the National Association of Securities Dealers. Israel left Gruntal in March 1991.
Patchy Resume
By now, Israel had spent almost a decade on Wall Street and had little more than a patchy resume to show for it. Marino's career had stalled too. He left Coopers and joined Spicer & Oppenheim, a smaller firm, according to Bayou marketing documents. In April 1991, Israel hooked up with Marquez, his acquaintance from the Graber office, who had opened a hedge fund firm called JGM Management Co. on Park Avenue. Marino eventually landed there, too, as JGM's chief financial officer.
JGM turned out to be a disaster. In 1992, a year in which the Standard & Poor's 500 Index rose 4.46 percent, JGM hemorrhaged 40 percent of its assets, according to a person with knowledge of the fund's performance. The next year, the fund plunged 25 percent.
As the losses mounted, Marino often flew into fits of rage, firing people and rehiring them the next day, according to a former JGM employee who later invested in Bayou. Marino's former colleague asked to remain anonymous because he says he withdrew his money before Bayou collapsed and fears the fund's other investors might lay claim to his money.
Israel Bailed
Israel soon bailed and joined Omega Advisors Inc., the New York money management firm run by Leon Cooperman. Marino eventually quit, too, and Marquez shut JGM Management in 1995.
At Omega, Israel was an order taker, Cooperman says. ``Israel was not a fundamental stock picker, and he had no trading authority at Omega,'' Cooperman says. Israel left in 1995, according to his NASD employment record, and, according to a former colleague, spent the next few months trying to develop computer trading models.
When that project sputtered, Israel moved on once more. In March 1996, he opened his own hedge fund in Stamford, Connecticut. The name he chose harkened back to his roots in New Orleans: Bayou. To help him, he recruited his old colleagues from the failed JGM, Marino and Marquez.
Like JGM, Bayou stumbled from the beginning. Israel managed to cobble together just $1.2 million for his fund from friends and former colleagues. Even as the U.S. stock market ignited, sending the S&P 500 soaring 20 percent in 1996 and then 31 percent in 1997, Bayou lost money. The firm's first audit, conducted by Chicago-based Grant Thornton LLP, shows a 12 percent loss for the first year.
Sleight of Hand
With a debut like that, Bayou would never lure new investors. So Israel tried some sleight of hand. He changed the date of inception of his fund, effectively erasing his debut losses, according to Bayou marketing documents.
Israel also had a plan to generate fat fees for his newly christened fund. Hedge funds typically charge customers an annual management fee of about 2 percent and take a 20 percent cut of any profits. In Bayou's marketing documents, Israel said his fund would beat the market with rapid-fire day trading. He waived the standard 2 percent management fee and established an affiliate, Bayou Securities, to execute his trades. The more Israel traded, the more Bayou would pocket in trading commissions. It wouldn't matter if the trades were profitable or not.
Fatal Flaw
Israel, however, had a fatal flaw for a money manager. He couldn't make money investing. As stocks soared in 1997, Bayou lost money and hid the damage by steering Bayou Securities' trading commissions back to Israel's fund. Marino says in his letter that he convinced Grant Thornton not to disclose that arrangement in detail. Grant Thornton spokesman John Vita declines to comment.
Marino's relationship with Israel and Marquez began to fray, according to Marino's version of the events. Israel tried to trade his way out of trouble, but it was no use: his losses kept mounting. Israel and Marquez, however, kept telling Bayou investors that the fund was making money, Marino wrote. ``They were lying to their clients all year long,'' his letter says.
On the last trading day of December 1998, Israel summoned Marquez and Marino and told them the situation was desperate.
The Russian government had defaulted on $40 billion of debt that August, roiling world markets. Long-Term Capital Management LP, the hedge fund firm run by John Meriwether in nearby Greenwich, Connecticut, had collapsed.
Bogus Audit
Marino says in his letter that Israel and Marquez suggested that he concoct a bogus audit to hide Bayou's losses. The charade would buy time to make new, profitable trades, the men argued. Bayou Securities, meantime, would keep generating trading commissions. And Bayou would persuade new investors to pump money into the ailing fund.
Marino faked the audit. To cover his tracks, he sent the audit letters to investors on stationery bearing the name Richmond-Fairfield Associates. The name reflected his daily commute from Staten Island, in Richmond County, New York, to Stamford, in Fairfield County, Connecticut. Bayou investors had no idea that he worked for the hedge fund, Marino wrote.
Not even the phony audit was enough to rescue Bayou. The hedge fund kept losing money. Marino wrote he was diagnosed with Hodgkin's disease in 1999 and spent much of that year caring for himself and his ailing mother in Staten Island. Tempers flared. ``The arguments among Jim, Sam and I were constant,'' Marino wrote. ``When I think back now, it's all a daze.''
Out of Control
In late 2000, Israel decided that Marquez had to go so Bayou could raise money from still newer investors. Marquez left in mid-2001, Marino wrote. ``I wondered whether Sam could truly trade and handle the pressure himself,'' he wrote.
Soon, Bayou began to spiral out of control. Israel became addicted to the painkillers he was taking for back pain, and the hedge fund sank deeper into the red, Marino wrote. Israel started abusing Marino verbally and sometimes physically. ``He would slap me around at night at my apartment,'' Marino wrote. Once, Israel even brandished a gun, according to Marino's account.
Israel started skipping work. Left on his own, Marino bullied Bayou's staff, former colleagues say. Marino himself wrote that he ``browbeat'' the employees. In 2003, Israel's wife, Janice, filed for divorce.
Hedge Fund Marketers
By mid-2003, Israel and Marino were in dire straits. To help maintain its charade, Bayou had reached out to consultants and hedge fund marketers such as Hennessee, run by husband and wife team Charles Gradante and Lee Hennessee. Hennessee began recommending Bayou to investors in 2003 and never suspected anything was wrong.
``We've never had a situation like this in our history,'' Lee Hennessee says. ``We did an outside background check and spoke to former employers and employees who worked alongside Sam.'' DePauw University sued Hennessee Group in federal court in the Southern District of Indiana earlier this month for breaching its fiduciary duty by allegedly failing to conduct thorough due diligence.
Another firm, Altegris Investments, based in La Jolla, California, also steered investors to Bayou. Altegris Chief Investment Officer Matthew Osborne says his firm told investors to quit the fund in 2004. He declines to say why.
Bayou's plan worked, at least for a while. The firm raked in $125 million of fresh cash in 2003, according to a civil complaint the SEC filed against Israel and Marino on Sept. 29. That was enough to temporarily paper over Bayou's losses.
Didn't Fool Everyone
Israel and Marino didn't fool everyone. J. Ira Harris, a former partner at Lazard Freres & Co., says that when he read the marketing documents that Bayou was circulating, which included a resume for Israel, he called Cooperman at Omega. Israel had claimed he was a general partner at Cooperman's firm.
Cooperman told Harris that everyone at the firm was a partner. ``He told me Israel had no trading authority,'' says Harris, 67, and now chairman of J.I. Harris & Associates, a consulting firm based in Palm Beach, Florida. Harris says he didn't invest in Bayou. Cooperman, 62, says he didn't either.
As Bayou melted down, Israel and Marino were living large. The firm had collected $23.3 million in bogus fees on the phantom profits it reported from 2000 to 2004, according to a suit filed against Bayou, Richmond-Fairfield, Israel and Marino by the U.S. Commodities Futures Trading Commission. His marriage on the rocks, Israel rented Trump's house in Mount Kisco. Marino bought a six-bedroom home with a pool on Bayberry Lane in Westport. He then surrounded it with a 4-foot (1.2-meter) stone wall topped with a white-picket fence.
`The House of Mystery'
``Around here, we call it the house of mystery,'' says Stan Englebardt, who lives across the street. Until news of the fraud broke, Englebardt says he thought his neighbor was the Miami Dolphins quarterback named Dan Marino. Marino also bought three cars -- a Bentley, a Ferrari and an Audi -- which together cost more than $350,000, according to town tax records.
It was about this time that Israel and Marino began hunting for places to invest their ill-gotten gains. They established their separate firm, IM Partners, to buy stakes in companies in the U.S. and Europe. Among their first investments was a startup called Kycos Ltd., which was based on the Isle of Man and had offices in the Caymans. The company, which helped offshore banks comply with anti-money-laundering laws, was co-founded by John Bourbon, formerly head of supervision at the Isle of Man's Financial Services Authority and an ex-managing director of the Cayman Islands Monetary Authority.
Bourbon says he met Marino and Israel several times at Bayou's Connecticut office. ``We didn't see much of Israel,'' Bourbon, 49, says. ``He was usually behind his desk with lots of screens, doing all his trading.'' IM Partners eventually invested $10 million in Kycos.
`King Kong'
To scope out Kycos, Marino flew to the Isle of Man in October 2003. There, he met the former boxer, O'Halloran, who is 62 and lives on the island. O'Halloran's acting credits include supporting roles in the 1976 remake of ``King Kong,'' with Jessica Lange, and ``Superman II,'' the 1980 movie starring the late Christopher Reeve.
O'Halloran says he suggested IM Partners consider another startup, Debit Direct Ltd., which planned to provide money transfer services to offshore financial institutions. IM Partners sank $2 million into that company.
Kycos has since gone into liquidation. IM Partners sued Debit Direct in October 2004, claiming Debit Direct and its officers used its $2 million investment to benefit other companies controlled by its officers and directors.
O'Halloran says Marino had a short fuse. ``Marino used to rage at meetings,`` O'Halloran says. ``Marino was a $35,000 accountant who suddenly started wearing silk ties and Armani suits and driving sports cars.''
Offshore Misadventures
At this point, Israel and Marino's offshore misadventures get even stranger. O'Halloran says that in 2004, he introduced Israel to Robert Nichols, a self-described weapons expert who played a bit part in the 1992 action flick ``Under Siege,'' which stars Steven Seagal.
Israel returned to Connecticut and told Marino that Nichols was a former secret agent --- and that he had told Israel of a clandestine government investment program capable of generating returns of 100 percent a week, according to Marino's letter. Nichols, who testified in a 1993 civil lawsuit that he had worked for the CIA for almost 20 years, couldn't be reached for comment.
``I found this to be all insane, but Sam wanted to pursue it,'' Marino wrote. Israel said that if they invested $100 million in this secret scheme, Bayou's troubles would be over.
Last Big Trade
And so Israel and Marino embarked on their last big trade. In April 2004, they wired Bayou's remaining assets -- about $150 million -- to a U.S. account at Citibank Inc., according to the SEC's Sept. 29 complaint. From there, Israel wired the money to Deutsche PostBank, in Saarbruecken, Germany. After winging through another German bank and a London brokerage firm, the money landed in a Wachovia Bank account in Hong Kong in April 2005.
Finally, $100 million, the last remnants of Bayou, turned up in an account at a Wachovia Bank branch in Avondale, Pennsylvania, under the name of Karl Johnson and Majestic Capital Management. Johnson, who works out of his home in Flemington, New Jersey, says Bayou hired him to manage the money. He declines to comment further.
The barrage of bank transfers aroused suspicion at the Arizona Attorney General's Office, which froze the Wachovia account in May. The game was over.
`Disappearing Act'
Arizona Assistant Attorney General Cameron Holmes says he has two theories about Israel's secret government investment scheme. The first is that Israel had fallen for some sort of bank fraud. The second: ``He was creating a disappearing act with the money.''
As he'd always done, Israel tried to charm his way out of trouble. He borrowed $3 million on June 14 from Steven Starker, a former Goldman, Sachs & Co. partner, purportedly to settle his divorce.
It's unclear how the men knew each other; Starker, 40, didn't return telephone calls seeing comment. E-mails that Israel sent to Starker, disclosed in a lawsuit that Starker filed against Israel on Sept. 8, show Bayou's founder lying to the very end.
``I hope my credibility has not suffered too much as I am sure it has, but you did me a major favor and I would never screw you nor anyone else for that matter,`` Israel wrote to Starker on July 23. ``I have had a situation that can only be described as disastrous occur,'' Israel wrote him on Aug. 6.
On Aug. 12, four days before Marino's suicide note was discovered at Bayou, Israel himself delivered two personal checks to Starker at his home in Rye. One was for $3 million; the other, for $150,000. Both were decorated with characters from the television cartoon SpongeBob SquarePants, a freewheeling, undersea adventure full of surreal twists.
The checks bounced.
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