1)   Chesapeake’s $3 Billion Lifeline Heaps Pressure on McClendon (Update 2) ow.ly/aTt1z

2)    Flags Said to Go Unheeded by Bosses at JPMorgan – Are you ignoring similar red flags during #duediligence? ow.ly/aV1pC

3)   Watchdogs ‘too slow’ to expose Trio #fraud ow.ly/aWRQD

4)   JP Morgan unit has $100bn of risky bonds, Credit hedge funds benefit, equity funds may lose on JPMorgan… ow.ly/aZQJO

5)   #SEC charges fund manager Mark Spangler with #fraud http://ow.ly/aZQyk

According to the SEC, Kupersmith and his compatriots, used various aliases and stories to fraudulently opening brokerage accounts. These included using corporations owned by Kupersmith to disguise his identity. Mr. Kupersmith, using a family member’s identity, also claimed to be a money manager for hedge funds. On other occasions he even claimed that he ran a small hedge fund with approximately $50 million in assets under management.

An interesting aspect of this case is that effectively Mr. Kupersmith, and his cohorts, fooled broker dealers and executing brokers into opening accounts with them and then letting them trade, under the false belief that custodial accounts at other financial institutions held securities which could cover those trades.

When an investor is evaluating a hedge fund or private equity fund, one of the key operational aspects reviewed involves a fund’s service providers. For administrators and brokers in particular, it is often useful for investors to inquire as to the due diligence a service provider performs on new clients before opening an account on their behalf. Outside of basic regulatory checks such as anti-money laundering checks, does the service provider do anything more? One reason why this is important to evaluate is because the fund manager is effectively exposed to, at a minimum, reputational risks associated with a prime broker for example. In this case, if a hedge fund traded with one of the time brokers which opened an account for Mr. Kupersmith, it may raise questions among investors as to how diligently a hedge fund examined the service providers new account opening procedures. Similarly, if the prime broker is on the hook for any losses due to frauds such as those orchestrated by Kupersmith, and fund assets are commingled, then there is a potential for financial loss to the hedge fund as well.

It is also advisable that similar questions should also be asked of the fund manager in both evaluating potential new subscription capital as well as in adding new service providers. Some key questions investors should consider asking when evaluating the robustness of a fund manager’s new counterparty addition include:

• Does the fund manager have a formal process for evaluating new counterparty additions?
• What due diligence does the fund manager perform on new counterparties?
• Are conflict checks performed to ensure for example that no employee of the firm is related to the owners of any counterparties (i.e. – brokerage firms) utilized?
• Are counterparties balance sheets reviewed?

By taking steps during the operational due diligence process to thoroughly vet the process by which both a fund’s service providers and the funds themselves are exposed to new clients and counterparties, investors can make significant headway in reducing potential losses due to fraud from counterparty risk.

1)      #Wall St. does not know how to value #privateequity according to Forbes article -    reason for discount at Carlyle IPO? ow.ly/aKylB

2)      #fraud alert – Dimitry Vishnevetsky #hedge fund and Oxford Capital charged with commodity pool fraud by #CFTC ow.ly/aMA8L

3)      Private Equity Alert: Centro Agrees to Record $202 Million Lawsuit Settlement ow.ly/aNuOt

4)      Millionaire financier Chris Ruffle under investigation over £5m #fraud http://ow.ly/aQzMG

5)      Millionaire financier Chris Ruffle under investigation over £5m #fraud http://ow.ly/aQzMG

One of the more recent items of note are the allegations brought against commodity pool operator Dimitry Vishnevetsky and his Hodges Trading and Oxford Capital. It has been alleged that this scheme has been perpetrated since September of 2006 and has caused almost $2 million in losses.

In a complaint against Vishnevetsky et. al. , the CFTC alleged that he obtained money through a variety of fraudulent schemes focused around a commodities fund that he allegedly told investors that he traded in. The problem, the CFTC alleges, is that no trading actually occurred. The CFTC complaint further alleges that Vishnevetsky:

• Misappropriated a portion of investors money and issued false account statements to them
• Defrauded customers by failing to open and fund commodity trading accounts for them
• Misrepresented that Hodges issued Libor Notes and invested in commodity futures contracts to enhance the value of the purported Libor Notes

The CFTC further alleges that Vishnevetsky even went as far as to allegedly create an entirely false performance overview document, which he distributed to investors.

Schemes such those alleged to be undertaken by  Vishnevetsky, outline the continued importance of operational due diligence in detecting and avoiding fraudulent activities. In Vishnevetsky case, based on the CFTC complaint it seems that a number of less than best practices were in place. It is likely that an operational due diligence review would have at a minimum raised many questions about the firm’s operational practices. These questions would have merited further investigation during the due diligence process.

By asking additional questions and performing a detailed operational due diligence review, yellow flag items would likely have been raised in this case.  Specifically, it has been alleged that Vishnevetsky did not actually conduct any trades. During a detailed operational due diligence review an investor will generally look into a fund’s service providers and counterparty relationships. In this case, as was the case with other Ponzi schemes such as Madoff, an investor who contacted service providers might have learned that Vishnevetsky’s firms may have had no relationship with these counterparties at all.

Additionally, outside of confirming basic counterparty trading relationships investors can also attempt to conduct independent asset verifications of a fund manager’s asset levels with counterparties. In this case, investors may have learned that the purported asset levels that Vishnevetsky was supposed to maintain at these funds did not comport with what he had told investors.

It is also worth nothing that if an investor had conducted a cursory review of the trading procedures in place at Vishnevetsky’s firms, assuming there was actually a description of the trading procedures, they might not have noticed any red flag items. A simple description of a trading procedure may be fraudulent or inaccurate on its face. This scenario is a good example of the need to going beyond simply taking the manager’s word for certain procedures, and attempting to both observe and independently verify the implementation of procedures with counterparties.

The combination of each of these operational risks might have made investors leery of investing capital with Vishnevetsky. As outlined above, these risk factors allegedly included a fund that is alleged to have had questionable counterparty relationships, false documentation, and supposedly did not actually conduct trades in certain instances. A thorough, consistent multi-disciplinary operational due diligence review can help investors raise flags concerning questionable practices and increase the likelihood that investors can avoid exposure to frauds. Without such due diligence, investors may be left attempting to reclaim lost capital from alleged Ponzi schemers such as Vishnevetsky.

1)      SEC Fines Adviser Over Ties To Hedge Fund Accused Of #Fraud ow.ly/aC3NK

2)      According to a recent article in Pensions & Investments, #Hedgefunds need more accountability… ow.ly/aC3Xy

3)      Special Report: Inside Chesapeake, CEO ran $200 million #hedgefund ow.ly/aElhZ

4)      Regulations, investor demands put pressure on #hedgefunds ow.ly/aEBBt

5)      Feds sue Utah #hedgefund owner ow.ly/aFTZH

This class is geared toward hedge fund managers to advise them on how they can best prepare for an operational due diligence review. This class will give them insight into what due diligence consultants are looking for when they begin a review of a hedge fund.

To read the full blog post, visit the Bull Run Blog.

Also, if you would like to register for “Surviving a Hedge Fund Operational Due Diligence Audit”, click here.

The Firefighters’ Retirement System of Louisiana, the Municipal Employees’ Retirement System of Louisiana and the New Orleans Firefighters’ Pension and Relief Fund invested $100 million in Fletcher Asset Management in 2008 and were suing to get approximately $145 million back in accrued earnings.

These pension funds invested with Fletcher after they were promised a 12% yearly return. The first signs of trouble arose when two of the pension funds requested a $32 million redemption. Fletcher did not return the money in cash, but instead, gave the pension funds IOUs.

A fund’s offering memorandum outlines the general rules for the payments of redemptions. There are a number of specific guidelines that investors can evaluate during the operational due diligence process with respect to redemptions by evaluating documents including a fund’s offering memorandum. These can include:

• when redemption requests can be submitted by investors
• when a fund will generally pay them
• in what form (i.e. – in case, in-kind) a fund will pay them
• how much the fund will pay immediately
• if the fund has the ability to not pay any portion of an investor’s redemption request until after the completion of the audits – (this is sometimes referred to as an audit holdback)
• the ability of the manager to invoke gates
• specifics concerning prohibitions on early redemption (i.e. – hard lockups) or penalties for early redemptions (i.e.- soft lockups)

If an investor further takes the time to fully read a fund’s legal documentation, such as the offering memorandum, they will effectively learn that all of these rules can effectively be changed at the whim of the General Partner (for onshore funds ) or Board of Directors (for offshore funds). While, some legal documents may contain language which places limits on these rule changes (i.e. – changes which “materially affect” an investor require majority consent), others may not.

Returning to the case of Mr. Fletcher, a manager replying to redemptions requests with an IOU is bizarre to say the least.  While there may be nothing technically illegal or theoretically wrong  with an IOU in this case on face value, it certainly raises the obligation of investor’s to perform further due diligence.  Yellow flags lead to red flags and in this case, the IOU was a bright yellow flag which should have been investigated further in part by a detailed operational due diligence review of Fletcher’s firm.

A representative from Fletcher said that the returns could not be guaranteed and are looking toward an appeal in the case.

This is a perfect example of the importance of operational due diligence. It may have been beneficial to the pension funds to perform some sort of operational due diligence before investing with this hedge fund. Potentially, a review of cash management policies may have signaled yellow flags to investors. Between questionable cash management policies and the IOUs, unmitigated and undetected operational risks clearly played a part in contributing to losses. Although operational due diligence does not always uncover something as serious as outright fraud, operational problems can still abound in honest organizations. Detailed operational due diligence reviews coupled with an ongoing monitoring program can help funds stay out of court attempting to recoup losses and avoid Fletcher type funds.

1)      This report outlines the risks of Asian based #fund managers ignoring #FACTA ow.ly/asb13 #compliance #risk

2)      Father and son #hedgefund team (GMB) who fed #Madoff settle with #SEC over false strategy statements ow.ly/asbfb #fraud

3)      Louisiana Pensions could benefit from #operational #duediligence news.hedgefund.net/default.aspx?s…

4)      Hedge fund accused of unlicensed trading…It’s always important to use #operational #duediligence ow.ly/ax5up

5)      Bawag Bankers Who Lost Billions Begin Austrian Retrial http://ow.ly/ayzcg

1)      NJ (James Turner) Hedge Fund Executive Sentenced To 1 Year In Insider Scheme ow.ly/ajF1Z

2)      #Galleon probe fallout continues – Gupta (ex #Goldman director) faces new insider trading claim ow.ly/akHkD pic.twitter.com/1XOiCux5

3)      Four Questions to Consider BEFORE Investing in Hedge Funds from Forbes… ow.ly/akHFS

4)      #UBS Delta One rogue trader Adoboli jail complaints – wants better access to data for defense ow.ly/anUth pic.twitter.com/SS99mAck

5)      Rajaratnam Case Shows Outmanned, Outgunned SEC on a Roll… ow.ly/apoIe

1)      #hedgefund Vincent McCrudden Manager Gets Jail Time for Death Threats ow.ly/aarGf

2)      Harbinger #hedgefund reportedly to enter in settlement talks with #SEC ow.ly/1Ko8AM

3)      #SEC says new #hedgefund disclosures will better police #fraud – why is the #SEC putting faith in HF self reporting? ow.ly/1Ko8R1

4)      #hedgefund manager Robert Stinson Jr. who ran $17+ Mil. #Ponzi get 33 years – falsely claimed he went to #MIT ow.ly/1Ko99H

5)      Hedge Funds Pleased With Some Parts of Dodd-Frank, a Study Finds ow.ly/ag1N8