Academic journal article Fordham Journal of Corporate & Financial Law

Independent Fund Administrators as a Solution for Hedge Fund Fraud

Academic journal article Fordham Journal of Corporate & Financial Law

Independent Fund Administrators as a Solution for Hedge Fund Fraud

Article excerpt

INTRODUCTION

There is approximately $1.33 trillion invested in hedge funds worldwide.1 Most of this money is invested in legitimate hedge funds,2 with honest managers. In the last decade, however, some significant frauds have been uncovered. Unscrupulous hedge fund managers such as Samuel Israel, Michael Lauer, Paul Greenwood, Kirk Wright, James Nicholson and others have defrauded investors of billions of dollars.3 These frauds, coupled with the current financial crisis, have brought intense scrutiny to the hedge fund industry.4 Legislators have responded by introducing three bills in Congress that would generally compel hedge funds to register with the U.S. Securities and Exchange Commission (the "SEC").5 These bills would also impose new disclosure and recordkeeping requirements on hedge funds.6 Similarly, in June 2009, President Obama released his Administration's proposal to reform the regulation of the financial industry, which includes a provision for fund advisers to register with the SEC under the Investment Adviser Act, and also subject hedge funds to extensive recordkeeping and disclosure requirements.7 The politicians that introduced these proposals claim that registration and the attending disclosures of hedge funds will protect investors and deter fraud.8

This Note will discuss some of the non-market risks that hedge fund investors are exposed to, explore some current hedge fund frauds, and discuss whether disclosure9 is really the most effective way to deter fraud in the hedge fund industry. The Note will conclude by proposing that third party custody of hedge fund assets would be the most effective deterrent against hedge fund fraud.

I. NON-MARKET RISKS FOR HEDGE FUND INVESTORS

Investors generally expect investments in hedge funds to be riskier10 than investment in mutual funds or similar registered investment companies, and thus, deliver superior performance. ' ' That is presumeably why hedge fund investors typically agree to pay a fee based on assets under management (1 to 2%), and to a performance fee (usually 20%) based on the hedge fund's annual returns.12 In addition, hedge fund investors agree to commit their funds for an extended period, in some cases as long as two years.13 However, most investors do not expect to be exposed to several types of non-market risk stemming from the fraudulent conduct of hedge fund managers. These include fictitious performance disclosure, looting, inflated asset valuation, and conflicts of interests.14

A. Fictitious Fund Performance Disclosure

Fund managers provide frequent disclosure documents to their investors: monthly newsletters, account statements, quarterly performance reports, investor calls and annual financial statements.15 Prospective hedge fund investors are usually given marketing materials that detail the hedge fund's strategy and include data such as fund performance on a monthly, annual and since-inception basis.16 Most hedge funds hire an independent accountant to audit this fund performance data. n

Unscrupulous hedge fund managers engage in fictitious disclosure statements to investors to hide trading losses, cover-up looting, or as part of a Ponzi scheme. 18 For example, a hedge fund manager can enter nonexistent profitable trades in his trading software (or enhance real trades),19 aggregate these trades with real unprofitable trades (or in some cases no trades),20 and thereby create the illusion of a profitable monthly trading performance. This fictitious superior performance would then be disclosed to current and prospective investors in order to attract new investors,21 prevent current investors from making an informed decision (i.e. to stay in the fund or withdraw),22 and enable the hedge fund manager to pay himself a hefty performance bonus at year's end.23

Managers who want to show investors audited financiáis have another hurdle to clear when trying to release fictitious trading performance data, but they can still engage in a variety of fraudulent schemes. …

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