Risk Without Reward

A 5 star fund, anyone?

A recent SEC complaint alleges that a hedge fund manager called Robert Stinson (helpfully described as a "convicted felon and securities fraud recidivist") raised some $16 million from investors from 2006 until he was caught earlier this year.  Needless to say, instead of investing that capital in a genuine hedge fund strategy, the SEC claims that Mr. Stinson used the cash "to fund lavish spending involving restaurants, yachts, automobiles, baseball games and travel."

The first red flag - Mr. Stinson had named his hedge fund company "Life's Good."  We would rest our case at that point, but apparently not everyone has our aversion to blatantly ridiculous management company names.

Also of interest, the Life's Good STABL Mortgage Fund LLC was, according to a news article, rated by Morningstar, where, surprise surprise, it received the maximum 5 star rating.  When the returns are entirely fake, it stands to reason that it is relatively easy to produce a 5 star track record.

In fairness to Morningstar, their rating product is crystal clear with the caveat emptor disclosures that it (i) relies entirely on manager reported data (which could, therefore, be fraudulent) and (ii) that Morningstar has developed four "operational red flag" criteria, with the Life's Good fund, per the news article, violating three of the four during its tenure in the database as a 5 star performer.

A Morningstar paper outlining the four red flag criteria is available here - the four are

(i) recognized auditor (where an auditor acts for at least 5 other funds in the Morningstar database)

(ii) recognized administrator

(ii) registered

(iv) returns do not evidence serial correlation 

We're not sure which of the four operational red flags the STABL fund violated, but the most interesting is probably the latter - returns which do not evidence serial correlation.

Our comment here is not to criticize Morningstar, who appear to have been pretty clear as to the quality, scope and limitations of the information they were selling.  Rather it is the broader point that focusing on investment returns alone can be entirely unhelpful unless operational analysis is also included.  ODD can kick the tires for blatant fraud, and, more subtly, can comment on the quality of reported returns by analyzing the quality of a fund's pricing process.

Let's take the examples of two multi billion distressed debt funds.  In one fund, the back office gathers a collection of broker quotes direct from the underlying brokers, removes any outliers, and takes the mathematical average of the remaining bids to determine the price used in the fund's NAV.  In the second case, the front office marks the portfolio, and the back office will accept the price as long as the front office mark falls anywhere within the range of the lowest bid to the highest ask from the quotes received. Which one will have the highest measure of serial correlation...but also the highest Sharpe ratio? 

In this case, operational due diligence information is critical to help investors make a more informed choice between these two, hypothetical funds.  In the real world example of Life's Good, Morningstar's research clearly illustrates the worst case outcome when a fund has a 5 star track record, but a 75% red flag rating.

 

www.castlehallalternatives.com

Hedge Fund Operational Risk Due Diligence

"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved.

Lessons from UBS: 5 reasons why (most) hedge funds are well protected against rogue trading

Well, Mr. Adoboli isn't quite as good as Mr. Kerviel when it comes to rogue trading, but the financial impact of his unauthorized trades has now increased from the initial estimate of $2 billion to $2.3 billion.  Still a strong effort from the 31 year old, who pushes Nick Leeson of Barings fame down to #3 in the rogue trading hall of fame.

Back in January 2008, we commented on the Soc Gen debacle (the post also contains a potted history of just some of the multitude of rogue traders in the investment banking industry).  The title of our comment at the time - do we really want hedge funds to aspire to be institutions?

Our point then - which this week's events at UBS support once more - is that most hedge funds have a number of significant, structural advantages over large investment banks when it comes to rogue trading.

At their core, the trading desks of investment banks are self administered - there is no independent oversight over trade capture, reconciliation, valuation and P&L reporting.  This is a huge weakness in the investment banking model: ultimately, can you trust the trader paid directly on his or her investment performance without a third party, independent arbiter to check that all is bona fide?

Moreover, as we all know, the back offices of investment banks are very much the junior partner in any discussion with the trading desks - they are a cost centre, while the stars of the trading desk drive profits.  There is an obvious chasm between the compensation levels of the back office professionals and the front office traders: you do not need to be an astute observer of behavioural dynamics to predict that a discussion between someone on a $50k bonus as compared to $5m will be an uneven affair.  

It is also striking that both Kerviel and Adoboli share the same profile: more modest employees, without family name or Ivy League / Oxbridge credentials, who started in the back office before getting a chance to step onto the lowest rung of the trading desk - the Delta 1, equity index business.  Both appear to have used their knowledge of back office procedures to faciliate their frauds.  Both also had a first fingertip on the trading desk hierarchy and could see the potential for truly colossal compensation in the far distance, with all the lifestyle benefits that come from multi million bonuses. 

How does this impact hedge funds?  Thinking of the contrast between alternative asset managers and investment banks, we can identify five factors which impact the potential risk of undetected rogue trading.

 

1) Organization size

Investment banks are massive organizations.  With a reported 15,000 staff on the UBS investment banking payroll (itself just part of the bank's' total 65,000 person headcount), the law of averages creates the risk that there could be at least one outlier employee: someone who could become sufficiently envious, stressed or misguided to start to conceal trades.  The organization is then so big, its systems so complex, the number of trades so high - finding a way to exploit some weakness in how data is monitored becomes more conceivable.

A hedge fund, however, is generally a much smaller and far more cohesive entity.  While there are a handful of funds with several hundred employees (and less than 5 with more than 1,000) the vast majority of firms have fewer than 50 staff.  In reality, it would be hard not to pick up strange behaviour in a hedge fund when there is only a small group of investment professionals, all clustered around the same desk in their daily fight with the markets.

Conversely, risk would seem to rise when funds get larger: once a fund has tens or even hundreds of risk takers, even a hedge fund begins to lose the automatic protection of everyone sitting together and watching each other's behaviour.  Risk also increases when traders are spread out amongst multiple locations, especially when the traders are isolated in a preferred location separate from the back office.

 

2) Systems

Many hedge funds, in house, use a central accounting system such as Advent Geneva.  Investment banks, by contrast, rely on a hodge podge of systems, some current, some ancient - with a lot of Excel as a Band Aid.  A single, centralized platform for all data is a critical component which underpins any strong control environment, giving many hedge funds a strong controls advantage.  

For funds, therefore, best practice is to see a robust, single platform supporting trade capture, reconciliation and accounting.  Equally, more complex funds with a mosaic of different systems for different asset types increase the risk that a motivated employee could exploit weaknesses in the systems infrastructure.

 

3) Authority of the back office

In an effective hedge fund, the CFO and COO are senior members of a firm's management team, with genuine authority to hire, fire and build a robust control environment.  Indeed, in our view, the quality of the CFO is likely the single most important control factor in a hedge fund: a capable CFO will have the technical knowledge and experience to get the job done right, but - even more importantly - he or she will have the authority and stature in the organization to set a "tone at the top" which focuses on controls and oversight.  

We have completed due diligence on many hedge funds where the CFO and / or COO are exceptional professionals, with genuine governance over their organizations.  By contast, investment banks may not be as strong as their facade would suggest - as just one example, we have recently read a number of books about the 2008 financial crisis, all of whom have various stories of how risk management and back office professionals were readily marginalized during the sub prime profit frenzy.  

 

4) External oversight

As we have stated above, investment banks are self administered. The post Madoff, now mandatory appointment of an independent, third party administrator creates a significant control benefit in favor of hedge funds.  

We do have some words of caution, however.  Firstly - as we have frequently noted in Risk Without Reward - not all administration servicing is created equal.  To provide the best protection against rogue trading, an administrator should complete daily accounting, taking trade records from the manager (not the PB) and then completing a daily reconciliation to each prime broker, custodian and counterparty.  Weekly or monthly accounting cycles do not provide the same degree of external oversight.

Secondly, the most effective control comes from a parallel system, where the manager's in house back office and the external administrator both complete full accounting and reconciliation procedures daily. We do see risk in the trend to completely outsource accounting and reconciliation: in this model, there is no in house accounting, and the administrator becomes an outsourced back office, moving away from the model of independent watchdog.  Both managers and investors should remember than administrators will, for cost reasons, often hire staff a more deeply resourced hedge fund wouldn't: best practice controls, therefore, always balance in house expertise with external independence.

 

5) Compensation

Finally, one of the key risk factors in any asset management organization is how investment professionals get paid.  Investment banks, by and large, operate on the Darwinian principle of "eat what you kill".  This compensation model obviously creates an "every man for themselves" culture: it motivates risk taking to boost income, and equally scares poorer performers facing their stop loss limits to find desparate ways to stay in the game.  Either - and especially the latter - can drive rogue trading.

Within a hedge fund, it is more common to see a model of discretionary compensation, or at least a hybrid where elements of formulaic, performance based compensation are balanced with discrectionary bonuses or payment based on firm wide performance rather than just individual trading P&L.  Hedge funds have also proved flexible to implement a range of effective comp deferral schemes which further mitigates the incentive to rogue trade.  

 

Unfortunately, we do have to remind investors that hedge funds cannot be immune from the risks of rogue trading.  As with all types of fraud, a clever trader likely can fool all of the people - at least some of the time.  However, on balance, the smaller, more cohesive nature of hedge funds, their more tightly controlled systems, stronger CFOs and better independent oversight materially reduces risk.  Most hedge funds are not like investment banks, and that's a good thing, at least when thinking about rogue trading.

 

www.castlehallalternatives.com

Hedge Fund Operational Risk Due Diligence

"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc.  All Rights Reserved.  

Can the UK authorities catch up with fraudsters?

As we all know, Bernie Madoff is currently serving a minimum 150 year sentence at a federal jail in Butner, North Carolina.  Other high profile hedge fund fraudsters are also reflecting on their sins from the inside of a US penitentiary, notably Sam Israel of Bayou, "I've faked my suicide" fame.

Against this background, it was surprising to read this past week (see link to FT) that the UK Serious Fraud Office has decided not to pursue any charges against the founder and principal of Weavering Capital, Magnus Peterson.  Peterson previously held the high profile role of head of trading at the major Swedish bank SEB - as such, he is another example where apparent hedge fund fraud is conducted by established and senior industry professionals, rather than small time opportunists.

In early 2009, Weavering was unable to meet redemption requests, and it turned out that the fund's primary asset was a private swap transaction with a related party company set up in the British Virgin Islands (see an investigative piece written at the time by the Daily Telegraph).  Given that Weavering couldn't pay its investors back yet claimed assets of $639 million, it would appear that the aforementioned swaps were fake.  However, according to the SFO, there is now "insufficient evidence to secure convictions".

What is even more surprising is that, just a week ago, Weavering was involved in a landmark judgment against the two directors of its offshore fund (see Fin Alternatives), who conveniently happened to be Peterson's 80 year old father and his brother in law.  Much to the delight of the Cayman directorship services industry (given that the two directors involved - probably more by good luck than management - weren't Caymanian), the two individuals were each fined $111 million.  Certainly, someone thinks that there was criminal wrongdoing associated with the Weavering case.

According to one commentary, the SFO's decision not to take action against Peterson has "caused investors to raise serious questions about the ability and will of British prosecuting authorities to bring criminal charges in substantial fraud cases, which can only be damaging to the City's position as a center of international finance."  

Hmm.  And, of course, this isn't the first time this has happened.  Despite the UK's efforts to infer that fraud is unlikely in Mayfair given the oversight provided by the FSA, there have been other examples of UK hedge funds blowing up under a cloud of accused wrongdoing.  In 2006, the FSA banned Jae Wook Oh, the founder of the hedge fund Regent's Park, from any "controlled function" for three years. Given that no prison time was involved, this can only be described as a wrap across the knuckles.

According to the regulator, "it appears that over a number of months in 2005 there was a difference between the realisable value of certain investments and the valuations provided by Regent's Park."  Yes well...while all that happened to Wook Oh was apparently a three year time out from money management, Regent's Park's administrator, GlobeOp, was found liable in a $43 million compensation case - again, someone obviously thought that something had gone severly wrong.

Still, having called out the UK, let's remember that the US also has problems with its prosecution process.  In a process which took nearly a decade to get to court, Michael Lauer, the founder of Lancer group, was recently acquitted of stock fraud.  According to prosecutors, Lauer bought shares in tiny shell companies and then put in buy orders at the end of each month to provide a temporary bump to the price used in the fund's NAV.  However, the jury disagreed and Lauer now expects to return to money management.  Due diligence, anyone?

 

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Hedge Fund Operational Due Diligence

"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved. 

 

And how much is that ABS worth again?

The SEC have just settled a case under which Morgan Keegan, a Tennessee subsidiary of Regions Bank, agreed to pay $200 million (without - of course - admitting or denying any of the findings!) to settle fraud charges related to deliberate mismarking of ABS / subprime positions in a 1940 Act registered mutual fund.  The SEC's press release is available here, and the full text of the SEC's order is presented here.

According to the latter document, Morgan Keegan was responsible for valuing securities in its own mutual funds.  The first warning sign, therefore, is the absence of a third party administrator or valuation agent.  Despite being a highly regulated mutual fund, the funds were still exposed to the unavoidable conflict of the management company marking its own book.

In this case, things went predictably wrong as the sub prime market fell apart in early 2008.  According to the SEC, the alleged actions included:

- Morgan Keegan's fund accounting group periodically obtained broker-dealer price confirmations for certain fair valued securities.  Unbeknownst to the fund accounting group and the fund's independent auditor, the portfolio manager actively screened and influenced a broker-dealer to change the price confirmations that the fund accounting group and auditor obtained from that broker dealer;

- Morgan Keegan's valuation committee left pricing decisions to lower level employees in the fund accounting who "did not have the training or qualifications to make fair value pricing determinations";

- Fund accounting personnel relied on the portfolio manager's "price adjustments" to determine the prices assigned to portfolio assets.  Per the SEC, these adjustments were "arbitrary and did not reflect fair value.  The price adjustments were routinely entered upon receipt by the staff accountant in a spreadsheet used to calculate the NAV of the Funds."  (They are using a spreadsheet to calculate the NAV of a 40 Act mutual fund??) Further, "Fund accounting and the Funds did not record which securities had been assigned values by the portfolio manager"';

- Fund accounting personnel gave the portfolio manager discretion...to determine which dealer price confirmations to use and which to ignore, without obtaining documentation to support his adjustments;

- The valuation committee and fund accounting did not ensure that the fair value prices assigned to many of the portfolio securities were periodically re-evaluated, allowing them to be carried at stale values for months at a time (months??);

- In some instances, when price confirmations were received that were substantially lower than current portfolio values, Fund Accounting personnel, acting at the discretion of the portfolio manager, lowered values of bonds over a period of days, in a series of pre-planned reductions to values at or closer to, but still above, the price confirmations.

Cherry picking of broker quotes, manipulation of broker dealer information, control of the pricing process by the portfolio manager without challenge from the back office - this one has it all.  

For hedge fund investors, this case is yet another reminder that some portfolio managers - either to make more money or to cover up losses - will push pricing issues to the edge.  Some will inevitably push beyond into deliberate misvaluation.  In this instance, the strongest form of regulated fund structure - a 40 Act mutual fund - made not one bit of difference to prevent the PM cooking the pricing books.

As such, this case is a $200 million reminder that, as always, best practice must be to separate portfolio management from the valuation process, with an independent, third party responsible for pricing portfolio securities in the NAV.  After all, even the most honest portfolio manager can make an honest mistake and, inevitably, a handful of portfolio managers will be dishonest.  

Equally, Morgan Keegan shows the enormous value that an effective, third party administrator can provide to the hedge fund investor.  However, readers of Risk Without Reward will not be surprised with our final comment = investors need (and are prepared to pay for) an administrator who prices the portfolio themselves, not as directed by the manager, and who applies a degree of skill and expertise far beyond the apparent level of the back office employees in this case.  

As always, it is the most difficult to price securities which are the most susceptible to deliberate mispricing, so it is these securities where investors need administrators to focus their greatest efforts on independent pricing.  Otherwise the next Morgan Keegan could very easily be a hedge fund.

 

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved. 

 

NY Times on the audit process

As a follow on to our earlier post on some of the audit implications from the Sino Forest saga (or perhaps our earlier comments were a hoax from the SEC...!!), our attention was drawn to an article in the NY Times which also used this case to consider various issues impacting the audit process.  The full article can be accessed here.  

Among the Times' comments:

"Investors trying to decide whether to believe the Muddy Waters report, with its detailed assertion that the company's claims are contradicted by Chinese records, would love to know just what Ernst did check.  What records did it inspect?  Which tree plantations did it visit?  Who did the work?  Was it people from Ernst's Toronto office, which signed the report, or people from a Chinese affiliate?  How many auditors did the work, over what period of time?

Ernst's report does not say, which is no surprise.  Virtually every audit opinion in the world says almost the same thing, with no details about the company being audited."

The article continues with more comments as to whether the scope and procedures of the audit should be more transparent - an interesting read.

 

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Hedge Fund Operational Due DIligence

"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved.

Dude...where's my forest?

OK, so we can imagine Ashton Kutcher misplacing his vehicle after a night's heavy partying (hey, if you end up with Demi Moore, we'll allow you room for quite a few transgressions!)  However, it's another thing to misplace an entire forest...or if it turns out that all of those trees don't belong to you after all.

The saga of the Canadian quoted Sino-Forest Inc. impacts hedge fund investors in several ways. 

According to the National Post, a leading Canadian newspaper, "Sino-Forest was one of the darlings on the TSX over the past five years, rising more than 2,000% since 2002 to a peak valuation in excess of $6 billion."  This was, of course, before a damning report written by a short seller, Carson Block, of the firm Muddy Waters. 

According to Muddy Waters (full research report available here), "like Madoff, Sino-Forest is one of the rare frauds that is committed by an established institution....The foundation of Sino-Forest's fraud is its convoluted structure whereby it runs most of its revenues through "authorized intermediaries" ("AI").  AI's supposedly process Sino Forest's (symbol: TRE) tax payments, which ensure that TRE leaves its auditors far less of a papertrail.  On the other side of its books, TRE massively exaggerates its assets.  We present smoking gun evidence that TRE overstated its Yunnan timber investments by approximately $900 million."

The most recent reports from another Canadian newspaper, The Globe and Mail, certainly don't look promising.  This weekend, the Globe published a detailed article with the headline "key partner casts doubt on Sino-Forest claim".

"The Globe's investigation raises particularly hard questions about a key agreement in March, 2007, that SIno-Forest says gave it the right to buy timber rights for up to 200,000 hectares of forest in Yunnan for between $700 million and $1.4 billion.  The trees were to be bought through a series of agreements with an entity called Gengma Dai and Wa Tribes Autonomous Region Forestry Co, Ltd., also know as Gengma Forestry.  The company (i.e. Sino-Forest) says it has fulfilled virtually all of the agreement with Gengma and now owns more than 200,000 hectares in Yunnan.  But officials with Gengma Forestry, including the chairman, dispute the company's accounting of the deal, telling the Globe and Mail that the actual numbers are much smaller."

The Globe decided to do due diligence the good ol' fashioned way - put boots on the ground, and physically go to meet the parties involved in China.

"To find Gengma Forestry, SIno-Forest's local partner in the so-called 'Yunnan master agreement" - the 2007 deal said to be worth as much as $1.4 billion - you have to duck down an alleyway behind the drugstore on the main street of this nondescript trading city, then up a dusty cement staircase.  On the landing is the litter-strewn office with an open door and a window protected by metal bars.  Despite signing a deal with Sino-Forest that should guarantee a windfall, the company has clearly fallen on hard times. 'Our relations with [Sino-Forest] were not totally good.  They talked about a lot of things, but in the end it was hard to get money from them,' said Zhang Ling, Gengma Forestry's office manager." 

Ooops.

Obviously it remains to be seen what happens with Sino-Forest, but even a generous observer would say that there is plenty of smoke and likely quite a few flames.  Among those impacted is, of course, Sino Forest's largest shareholder, the Paulson funds - their 14% holding has lost, according to Business Week, more than $500 million since the Muddy Waters report.

In our next post, we'll consider some more implications from the Sino-Forest saga - particulary with respect to the audit process.

UPDATE: Bloomberg reports that Paulson, referenced above, has now sold his firm's stake in Sino-Forest, leading to a potential loss of up to $720 million.

 

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Hedge Fund Operational Due Diligence

"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved.

Broker quotes...or what happens when the trader doesn't like third party prices

In mid 2008 we commented on the London branch of the Toronto Dominion bank in London, where a "senior male trader" had "incorrectly priced credit derivatives" resulting in a loss of nearly $100 million.  At the time, we emphasized the lesson that this mispricing was not the work of a junior, green employee, but the senior head of a bank's trading desk.

The wheels of justice can move slowly, but an industry friend (to whom we express our thanks) forwarded some updated information.  The FSA have just published a final notice on the case:

This notice is issued to Nabeel Naqui as a result of his conduct during the period July 2006 to June 2008 (the "Relevant Period"), during which he was employed by Toronto Dominion as Head of the Credit Products Group (“CPG”), Europe and Asia Pacific desk. During this period, Mr Naqui deliberately:

(1) mismarked his trading book; and

(2) subverted the independent process by which Toronto Dominion checked the valuation of its trading positions at the end of each month. Mr Naqui altered prices he had obtained from independent dealers to correspond to the prices at which he had marked positions in his book. Mr Naqui then provided these altered price runs to those responsible for conducting the independent valuation process, knowing that they would be used as the basis of their valuation.

As our industry friend noted, the first question is obvious: exactly how can pricing runs provided by the trader be helpful for those "conducting the independent valuation process"?  

The FSA, helpfully, gives some more information:

"The CPG [Credit Products Group] Europe and Asia Pacific desk was run from London and headed by Nabeel Naqui, a Managing Director. As well as being Head of Desk and responsible for other traders, Mr Naqui was also responsible for trading credit default index and tranche products (“the Products”)....

All CPG trading positions were subject to a month end Independent Price Verification (“IPV”) process in Toronto Dominion during the Relevant Period. The IPV process required the Global Middle Office (“GMO”) to revalue all positions held by the firm’s traders at month end on the basis of independently sourced market price information. The objective of the IPV process was to reveal any error or bias in pricing so that this could be corrected and inaccurate marks eliminated.

OK, fair enough.  But let's learn a little more about the "revaluation" conducted based on "independently sourced market price information":

Mr Naqui was aware that in order to conduct the IPV, GMO used series of market price quotes, known as runs, which he provided to them every month, rather than sourcing these independently from dealers. Mr Naqui was regularly asked by GMO to provide particular runs for use in the IPV process. Mr Naqui obtained runs in electronic messages from independent dealers, and then forwarded them to the relevant individual within GMO.

Yep - the trader was the one who gave the back office the "independent" broker runs.  And guess what happened next...

Before Mr Naqui sent the runs on to GMO, however, he altered particular prices within the runs to correspond to the prices at which he had mismarked his front office positions. He did not alter all prices in which he held positions on his trading book. Mr Naqui did not mark or highlight the altered figures, or provide any indication within the message that some of the figures it contained were not figures supplied by the independent dealer. As a result of this method of circumvention Mr Naqui’s mismarking remained undetected for a period of approximately two years, until after he was informed that Toronto Dominion proposed to make him redundant.

Well, predictable stuff so far (and sound like any administrators we know?)  We do, however, like Mr. Naqui's response:

Mr Naqui asserted that he had amended the quotes for a number of valid reasons. Mr Naqui claimed that one of the principal reasons why he had been obliged to amend the forwarded quotes was so that he was able to negate the impact of what he characterised as systems issues. Mr Naqui explained that there were flaws within the systems used by Toronto Dominion and that these resulted in inaccurate valuations. Mr Naqui relied on evidence which tended to show that he had raised these issues with others within the bank; however Mr Naqui complained that he had not received a satisfactory response to the document he had drafted. Mr Naqui claimed that thereafter he had only ever escalated his concerns about the systems difficulties during the course of face to face meetings with his immediate superior. Mr Naqui accepted that there was no record of any of these attempts to complain about the systems issues, though he did complain that his immediate superior was not a credible witness. Therefore and notwithstanding his reservations about the systems Mr Naqui had been obliged to forward quotes to GMO and thus he had decided to amend certain quotes.

The conclusion of the FSA:

It is clear from the foregoing that the FSA finds that ‘systems issues’ do not excuse or explain Mr Naqui’s conduct. The FSA does not accept the criticisms made by Mr Naqui of both the reports produced for Toronto Dominion. In particular the FSA finds that the recent expert report rebuts Mr Naqui’s contention that he was obliged to amend particular quotes to negate the effects of systemic problems. The FSA finds that Mr Naqui selectively amended quotes only where it was necessary to disguise losses in his book. The FSA finds that were Mr Naqui to have been seeking to cater for systemic issues then it would have been more appropriate for Mr Naqui to have amended all of the quotes that he forwarded to GMO. The FSA finds that whilst there may have been some problems within the systems these did not excuse his decision to amend quotes and nor did they explain the extent of the losses created by his mismarking. The FSA also rejects Mr Naqui’s claim that, having attempted to highlight the systems issues to senior management through a paper on the topic, he then only ever escalated this to his immediate superior in the course of face to face discussions.

One of favorite maxims is this: we have yet to meet a trader who is not supremely confident that his marks are correct, especially when he or she knows that they are wrong...

 

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Hedge Fund Operational Due Diligence

"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc.  All Rights Reserved.

And a couple of fraudsters....

 

We thought that a recent story about a drunk trader who enthusiastically moved the crude oil market while under the influence was one of the more bizarre stories we have heard on our due diligence travels.

However, just to prove that there is an exception to every rule, an investor recently sent us information on one Tara Bryson, erstwhile head of investor relations at New Stream Capital in Connecticut.  According to Forbes, Ms. Bryson and her boyfriend had been engaged in running a "complex marijuana cultivation operation" from their home.  While there was no public comment from Ms. Bryson, her boyfriend did helpfully note that the charges were "bogus", largely on the ground that "we didn't have that many plants"!

As a separate insight into the mind of a hedge fund fraudster, another investor (to whom we express our sincere thanks) provided a link to a recent 60 Minutes interview with Marc Drier.  This is very interesting and, once more, illustrates how an initial fake transaction can grow and overwhelm the perpetrator.

 

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Hedge Fund Operational Due Diligence.

"Risk Without Reward" is a trademark of Entreprise Castle Hall Alternatives, Inc.  All rights reserved.

 

And an unbelievable rogue trader...

According to Britain's Daily Telegraph, a 34 year old broker (nonetheless described as "senior and longstanding") with a small, London based oil trader managed to trade more than $500 million of oil futures in the middle of the night, moving prices by nearly $2 to an eight month high.  The problem - he was drunk.

The events have recently been revealed following an FSA investigation:

According to the regulator, Mr Perkins first started trading irregularly the day before the enormous price spike. He had been drinking heavily over the weekend at a PVM golf event and was returning to a day off work.

As a broker, Mr Perkins was only allowed to place trades on behalf of his clients – not using any of PVM's own money. And records show that he placed a legitimate order for a client at 1.34pm through his broking desk by telephone. This was quickly followed by seven more orders with a value of $8m using PVM's cash.

Mr Perkins' trading stopped for a few hours, but in the early hours of the morning, he returned to the oil market via his laptop. He placed an incredible $520m in orders through ICE Futures Europe, where traders can buy or sell crude oil for future delivery and bet on whether prices will go up or down. The first trade was at 1.22am was at $71.40 per barrel and the last trade at $3.41am was at $73.05. During this period, Mr Perkins gradually edged up the price by bidding higher each time, until he was responsible for 69pc of the global market volume.

By 6.30am, the broker appeared to have realised what he'd done. He sent a text message to the managing director claiming an unwell relative meant he would not be coming in to work and started disposing of the oil futures. When PVM challenged his story, the broker confessed and later co-operated fully with the FSA inquiry.

Mr Perkins told investigators that he has "limited recollection" of the entire episode, claiming he had placed the trades during a drink-induced stupor.

What can you say?!

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Hedge Fund Operational Due Diligence.

"Risk Without Reward" is a trademark of Entreprise Castle Hall Alternatives Inc.  All rights reserved.

Front Running

As one further follow up to our recent post on misvaluation in an investment bank, we were also interested to read of an episode in Australia whereby a trader with Macquarie is alleged to have deliberately traded ahead of large orders to be placed by the bank for his personal account, generating profits of some AUS$3 million.  The twists and turns of the story (and there are quite a few!) can be found here. 

  

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Hedge Fund Operational Due Diligence

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