How to Avoid a Hedge Fund Fraud – Lessons from Bayou Fund

How to Avoid a Hedge Fund Fraud - Lessons from Bayou Fund
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CNBC’s American Greed (which is a great show, in case you haven’t seen it) recently broadcast a piece on Samuel Israel III, the hedge fund manager who ran the Bayou Fund until his hedge fund fraud caught up with him in 2005. Israel was charged with losing more than $400 million from investors in the Bayou Fund and was sentenced to 20 years of prison in 2008. He’s most infamously known for faking his suicide and writing “love is blindness” on the hood of his vehicle before turning himself in several weeks later in Western Massachusetts. He is currently serving a 22 year federal prison sentence at the Butner Federal Correctional Complex in Butner, North Carolina.

Although this is not a new story, Bayou fund is a classic example of some simple, yet important lessons in recognizing and identifying a hedge fund fraud. History continuously repeats itself and this is an important reminder that there are some simple investment manger due diligence checks that anyone can do to potentially avoid a hedge fund fraud, ponzi scheme or investment fraud.

Confirm Work History

Israel reported in marketing materials provided to investors that he was head trader of Omega Advisors, a $4+ billion hedge fund run by former Goldman Sachs partner Leon Cooperman, for nearly four years. The New York Times later reported that Israel only worked at the fund for 18 months and he “executed orders on behalf of senior partners at the firm” and was not the “head trader” that he claimed to be. Promotional materials from Bayou also reported that Israel began his career at F.J. Graber & Company, but the New York Times later found that he was a summer intern and never had a leadership role at the firm.

Some employers have policies not to divulge information without a signed authorization, but in most cases, you can simply contact the former employer and confirm dates of employment and certain “directory” information.  In addition to contacting former employers, at minimum, you should confirm dates of employment and his last title, but in certain situations it may be appropriate to contact former colleagues to gauge the character, responsibilities and pedigree of the individual.

Verify Service Providers

In a desperate attempt to hide mounting loses, Bayou “fired” their independent auditor and created their own accounting firm, founded by Bayou’s own chief financial officer, Dan Marino. Marino, through the new accounting firm, Richmond-Fairfield Associates, continued to perpetrate the fraud by sending investors fraudulent statements. Bayou also claimed that Grant Thornton, a well respected accounting firm, was the firms auditor in 2002, but Grant Thornton hadn’t worked for them since the 1990′s.

A simple telephone call to Grant Thornton or later to Richmond-Fairfield Associates, may have raised a red flag, but reviewing information on Richmond-Fairfield Associates would have shown that it was a newly formed firm that had ties to Bayou’s own chief financial officer. While some investors have made it a point to independently confirm the relationship with the auditor by contacting the auditor, in instances where it is a relatively unknown or small accounting firm you should also confirm the corporate status, verify accounting licenses through state regulators and/or other professional licenses as well as identifying any disciplinary actions against the individual/firm. In addition, it’s a good idea to search for potentially derogatory news or recent lawsuits. Investment frauds also attempt to legitimize themselves by aligning themselves with well known law firms, prime brokers, bankers and outside counsel.

Red Flags in Civil and Criminal History

Israel was arrested in 1999 for driving under the influence of alcohol and criminal possession of a controlled substance. A review of New York State criminal history records through the Office of Court Administration and/or searches of driving records would have come up with both of these cases. It was later uncovered that Israel relied heavily on pain pills.

Additionally, Bayou was the subject of a federal lawsuit in 2003 filed by a former employee and his son alleging that the former employee discovered ”possible violations of the S.E.C. regulations governing the operating of hedge funds.” Although the case went to arbitration and the outcome would have not been publicly available, allegations of S.E.C. violations is a serious matter.

Some of the most sophisticated investors in the world have been caught in investment frauds; Bayou had over $400 million from fund of funds, public pension funds and wealthy investors. Goldman Sachs, who is arguably the most reputable investment bank out there, served as Bayou’s prime broker for years. JP Morgan also marketed the fund to investors.  With high profile clients like these, Israel became better known and Bayou’s assets grew exponentially in the early 2000′s when consulting firms and funds started recommending Bayou to their clients. The perceived value of another investor, prime broker or even your most trusted family member is not a reason to make an investment.

Pedigree

Hedge funds are sophisticated investment vehicles that are run by sophisticated people. While Israel conveyed that  pedigree, Dan Marino worked at a second tier accounting firm and according to the New York Times, lived with his mother in Staten Island during the 1980′s…now of course there is nothing wrong with living with your mother, but would you want that person overseeing $400 million?

These are some simple tried and true lessons; there are plenty more examples of red flags, but Bayou is a classic example of some simple due diligence that any investor can do to protect themselves from a hedge fund fraud.

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