Fraud against hedge funds: implications to operational risk and due diligence

Abstract

Purpose

The loss of an amount in excess of $100m cash deposit can be disruptive to the operations, definitely the liquidity of the hedge fund. Should a hedge fund liquidity position deteriorate, its compromised solvency could impact its vendors, most notably creditors and prime brokers. Large successful hedge funds do make basic mistakes. Lawyer Marc Dreier committed the criminal act of selling fraudulent promissory notes to hedge funds and others. Mr Drier’s success in selling fraudulent promissory notes was facilitated by his accomplices who posed as fake representatives of legitimate institutions. Drier and team presented bogus “audited financial statements” and forged developer’s signatures, and even went as far as using the unsuspecting institutions’ premises for meetings to meet potential notes buyers to further falsely legitimize the scheme. He had the notes buyers send their payments to his law firm account, to secure the money. His actions cost his victims, who include 13 hedge fund managers, other investors and entities, $400m in addition to his law firm’s employees who also suffered when his law firm was dissolved. For his actions, he was sentenced 20 years in federal prison for investment fraud. This study aims to direct hedge fund investors and other stakeholders to thoroughly vet the compliance function, especially controls on cash disbursements, even if the hedge fund is sizable (in excess of $1bn). Investors and even other stakeholders also should place a greater focus on what is usually overlooked issue; most notably the credit quality and authenticity of short-term investments bought by their hedge funds.

Design/methodology/approach

A thorough investigation of a fraud committed by a lawyer against a number of hedge funds. Several important lessons are identified to professionals who conduct due diligence on hedge funds.

Findings

The details of the case are very remarkable. This case directs investors’ attention to place greater efforts on certain aspects of operational risk and due diligence on not only hedge funds but also other investment managers. Normally investors conduct operational due diligence on the fund and its operations. Investors also vet fund external parties such as prime brokers, custodians, accountants and fund administrators. Yet, investors normally do not suspect the quality of short-term fund investments. In this case, the short-terms investments were the source of unforeseen yet substantial risk.

Research limitations/implications

Stakeholders in hedge funds need to carefully investigate the issuer of and the quality of short-term investments that a hedge fund invests in. Future research can investigate the association of hedge fund manager failure with a liquidity position of the fund.

Practical implications

Investors must thoroughly the entirety of the fund including short-term securities.

Originality/value

Normally, it is the hedge funds that commit the fraud against investors. In this case, it is the multi-billion hedge funds run by sophisticated fund managers, who are the victims.

Citation

Muhtaseb, M.R. (2020), "Fraud against hedge funds: implications to operational risk and due diligence", Journal of Financial Crime, Vol. 27 No. 1, pp. 67-77. https://doi.org/10.1108/JFC-03-2019-0032