The SEC censured and fined an investment adviser for due diligence lapses. Yosemite Capital Management, LLC and its managing director, Paul H. Heckler, got a wrist slap for failing to disclose to clients that they had encountered substantial problems when attempting to perform the due diligence.
The big problem is that Yosemite had made a promise to at least two clients prior to placing his clients into the investment. They had promised to conduct due diligence. We saw a similar action by the SEC against the Hennessee Group for their failure to conduct their promised due diligence.
Yosemite ended up putting their clients’ money into a Ponzi scheme. Yosemite placed $3.25 million of four clients’ funds through a feeder fund, Ashton Investments LLC which was supposed to make bridge loans arranged by Norman Hsu and Next Components, Ltd. Heckler’s clients’ funds became part of a Hsu’s $60 million Ponzi scheme.
Yosemite missed some bright red flags:
The business cards from Ashton’s representatives that listed their position as “Represenative” [sic].
Ashton gave Yosemite a brochure riddled with spelling errors and mostly general, unverified information.
In addition to the business cards and the brochure, the only other written information concerning Ashton and Hsu that Yosemite received were emails, without any identifying information, that summarized a few of the loans.
Heckler was told that he could not contact Hsu’s lawyers or accountants because Hsu was a private person.
Heckler was told that the bridge loans were safer than stocks or bonds.
When Heckler requested a disclaimer in the loan agreement, he was told that it was unnecessary because the investment was not risky.
Because Ashton had no offices, Heckler met the Ashton representatives at local restaurants to discuss the investment.
Heckler and Yosemite willfully violated Section 206(2) of the Advisers Act, which prohibits any investment adviser from engaging in any transaction, practice, or course of business, which operates as a fraud or deceit on any client or prospective client, and Heckler caused Yosemite’s violations of Section 206(2) of the Advisers Act.
The “wrist slap” was a disgorgement of the fee earned ($26,000), prejudgment interest and a $50,000 fine. Heckler invested $275,000 of his own money in the scheme and lost $150,000 of it.
Of the $3.25 million of the clients’ money invested, they lost $1.95 million when Hsu’s Ponzi scheme collapsed.
The fi360 Fiduciary Score is a quantitative evaluation of how well a fund meets a minimum set of due diligence criteria. The score can quickly help identify a list of Mutual Funds and Exchange Traded Funds that are worth further research in your selection process. You can also use the score as part of your ongoing monitoring process since it can highlight funds with potential deficiencies.
If you are an investment adviser, you need to conduct your diligence on the investment choices you distribute. As we saw in the Hennessee Group administrative action, if you promote your diligence program you have to actually follow that program. [Failure to Conduct Diligence Can Lead to SEC Sanctions]
The fi360 scoring system weights a fund’s standing in relation to thresholds in nine areas. The more points, the worse the fund choice. Zero is good and 100 indicates significant shortfalls. The nine areas for scoring:
regulatory oversight;
track record;
assets in the fund;
stability of the organization;
composition consistent with asset class;
style consistency;
expense ratio/fees relative to peers;
risk-adjusted performance relative to peers; and
performance relative to peers.
Fi360 offers investment fiduciary education, practice management, and support. They also offer training and certification for investment fiduciary professionals.
If you advertise that you have due diligence process, you had better follow that process. The Securities and Exchange Commission brought an administrative proceeding against an investment adviser for failing to follow its advertised due diligence program.
The Hennessee Group promoted its process for evaluating and selecting hedge funds as the “Five Level Due Diligence Process.” They represented to clients and prospective clients that they would not recommend investment in hedge funds that did not satisfactorily complete all five levels of its due diligence evaluation. The Hennessee Group routinely touted the excellence and rigor of the process.
According to the SEC’s order, approximately 40 clients invested millions of dollars in the Bayou hedge funds from February 2003 through August 2005 after the Hennessee Group recommended those investments. Most of the money was lost by Bayou’s principals, who defrauded their investors by fabricating Bayou’s performance. The SEC charged the managers of the Bayou hedge funds with fraud in 2005.
“With regard to Bayou, Hennessee Group, at Gradante’s direction, failed to perform two elements of the due diligence evaluation that Hennessee Group had told its clients and prospective clients that it would do: (1) a portfolio/trading analysis; and (2) a verification of Bayou’s relationship with its purported independent auditor. By not conducting the entire due diligence evaluation that it had advertised, and by failing to disclose to clients that its evaluation of Bayou deviated from its prior representations, Hennessee Group and Gradante rendered the prior representations about the due diligence process materially misleading and breached their fiduciary duties to Hennessee Group’s clients.”
To resolve the matter, the Hennesse Group agreed to adopt procedures to ensure proper disclosure of its evaluation processes. They also had to pay $549,000 in disgorgement of its advisory fees related to Bayou, and to pay a civil penalty of $100,000.
These seems like a great example of the consequences for failure to follow your policies and procedures.
Garrity, Graham, Murphy, Garofalo & Flinn and PRMIA (Professional Risk Managers International Association) sponsored a webinar that focused on the signs of fraud and what you can do detect fraud in the context of hedge funds.
The agenda and my notes:
The profile of a fraudster (James Tunkey, I-OnAsia)
The psychology of the gullible investor (Stephen Greenspan Ph.D., Clinical Professor of Psychiatry, University of Colorado)
Current legal and regulatory requirements for hedge funds (Philip Thomas, Esq., Garrity Graham)
A hedge fund insider’s view (Samuel Won and Greg Ivancich, Global Risk Management Advisors, Inc.)
The regulatory future for hedge funds (Philippa Girling, Esq., FRM, Garrity Graham)
James Tunkey of I-OnAsia, started off with The Profile of a Fraudster. He is a certified fraud examiner. His focus was on the incentives, structures and control systems in an organization.
James put forth the proposition that Fear, Greed, and Honor are the three drivers of fraud. In the context of private investment funds, they are driven by the fear and honor of not making investment targets. There is greed trying to make more money for themselves.
Stephen Greenspan focused on the psychology of the gullible investor. (He has a new book out Annals of Gullibility and an article in the Wall Street Journal: Why We Keep Falling For Financial Scams.) Everybody is capable of being scammed (and probably have been). Stephen has also been scammed. He was a Madoff investor. He breaks a foolish action into three different groups: (1) practically foolish act, (2) non-induced socially foolish action, and (3) induced socially foolish action. It is this induced socially foolish that is gullibility.
Stephen pointed out that investor mania is like a Ponzi scheme. The early investors tell others about how wonderful their investments performed. There is a social feedback loop that drives the mania. The scam artists are skilled manipulators at using these factors.
Phillip Thomas looked at some regulations in place and steps you can take as part of the diligence. He pointed out that in today’ s environment, it is not a good time to be cutting back on compliance. He led a discussion through some recent court cases to highlight some of the issues.
Disclosure, potentially manipulative practices, and valuation are three hot regulatory topics. There are several rules in place limiting the sale and reconciliation of securities. As for valuation, you should have a segregation of responsibilities and oversight.
Some tools that don’t work very well.
The due diligence questionnaire. These are probably canned responsibilities and are unlikely to uncover problems
Form ADV. Also have canned answers
Interview of Managers. He thinks this is a good a tactic, at least as a smell test.
References. The problem is that they will only give you good references.
He thinks out that you should run a background investigation of the principals.
He moves on to some best practices for due diligence:
Don’t take anything from the fund manager at face value
Be suspicious of a manager limiting access to information
Consult specialist professionals who will be able to spot irregularities
Pay attention to what industry leaders are saying and doing about best practices.
Samuel Won and Greg Ivancich presented the view from inside a hedge fund. They believe people were too busy chasing returns during the extended bull market to spend time and energy on due diligence. Too many people just did check the box diligence and did not take a close look. Investors did not look at the underlying processes and operations at their investment funds.
They also see a regulatory sea change coming, likely to be draconian and over-reaching. They expect to see changes in requirements from institutional investors. Firms may also use the existence of their risk management and compliance as competitive differentiators. There will also be some new best practices emerging.
They see a need for independence. it is important not just to have an independent audit of financial statements, but also of infrastructure, processes, controls, investment style, valuation, and risk management.
Philippa Girling looked at the global political reaction to the current crisis and how it will affect hedge fund regulation. Germany and France are pushing for deeper regulation that the U.S. IMF is also pushing. (Any country using the term “shadow financing” wants more regulation.) The European Union as a whole is looking to regulate hedge funds.
Establish appropriate protections to meet anticipated regulations and investor demands. (We have already seen the Obama administration putting a short time line on enacting regulatory problems.)
Evaluate risk
Manage compliance
Ensure Anti-Money laundering procedures are in place
Conduct fraud assessments
Review current documents for improvement to current best practices
Be ready for enhanced due diligence visits from potential investors
Some of the more interesting questions from the Q&A sessions:
What are the most important red flags?
A manager not delivering information, instead standing alone on their reputation
Lack of third party administrator/custodian
Will regulation just lead to more avoidance?
SEC registration does not mean there has been an effective review
The UK centralized model takes away the US regulatory arbitrage (different agencies reviewing different types of investment companies)
The Managed Funds Association put together a Model Due Diligence Questionnaire for Hedge Fund Investors (.pdf). This questionnaire was designed to identify the kinds of questions that a potential investor may wish to consider before investing in a Hedge Fund. The questions that may help amplify on or provide additional details to the disclosure in a Hedge Fund’s offering documents.
KPMG Forensic released aurvey of 103 U.S. executives with FCPA duties. The survey found:
only one-third of respondents reported having an adequate due diligence process, and 27% said such compliance was only “minimal.” The survey also found that while 40% of companies include anti-corruption certifications in their normal business dealings, most of those companies apply the certifications only to their own employees. Only 24% reported using the certifications for outside vendors or suppliers and 35% for outside contractors, both of which are often cited by FCPA experts as a leading cause of briberies.
I could not find this survey on the KPMG websites.
