Current Issues
The Bernie Madoff Fraud
As splashed across the cover page of every major newspaper, Bernard Madoff, through Bernard L. Madoff Investment Securities LLC (BMIS), admittedly perpetrated the single largest Ponzi scheme fraud in the history of humanity, with estimates exceeding a truly staggering $50 billion in institutional and individual investor losses. Madoff gathered capital through a worldwide network of feeder funds and promoters, all of whom made millions by touting BMIS. Madoff purported to invest through a market neutral strategy that bought stocks of major companies then hedged those investments by buying options contracts. In reality, however, Madoff simply paid old investors a steady return on their investment with new investors’ capital. The consequences of this sensational story will continue to ripple through the global financial markets for years to come.
Petters Fraud
This $3.5 billion fraud involves Petters Group Worldwide (Petters Group) and other associated operating companies, including such household names as Polaroid and Sun Country Airlines. With about $2.3 billion in revenue in 2007 and 3,200 employees, Petters Group ranked 170th in the Forbes magazine list of the largest private companies. Tom Petters, CEO, and a handful of associates allegedly conducted a decade-long fraud that offered investment opportunities in funds backed by liquidated merchandise that could be sold to national retailers for a profit. However, as is the case in many Ponzi schemes, the purchase and sales orders generated by the funds were fictitious, thereby creating massive losses on behalf of unknowing investors.
Bear Stearns Structured Credit Fund Fraud
In a prelude to the sensational collapse of America’s 5th largest investment bank, Bear Stearns engulfed itself in a multi-billion dollar hedge fund fraud involving improper self-dealing and inflated valuations of collateralized debt obligations (CDOs). Bear Stearns marketed its High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund to investors purporting that the securities in the portfolios would be collateralized by highly rated mortgages and the portfolio would be as liquid as a money market account but would offer a much more attractive yield. Naturally, if it sounds too good to be true, it usually is. As it turns out, the CDOs in the portfolio were unworthy of a high credit rating and the funds’ positions were, contrary to representations, entirely illiquid and intentionally overvalued. As most people are aware, the whole house of cards crumbled, taking investors’ capital and Bear Stearns with it.
Valuation and Transparency Issues
Many hedge funds hold thinly traded and/or unlisted assets that are difficult, but not impossible, to properly value. Sometimes funds use NAV calculation methods that are inconsistent with the technique stated in their operating documents. As such, the method employed by the fund to assess such holdings may raise concerns for investors. Issues arise when the fund uses unseemly or disingenuous procedures and/or does not inform its investors of the altered approach.
Gates
Many hedge funds’ operating documents have provisions allowing them to impose “gates”. If the fund manager imposes a gate, redemptions are halted, presumably so a fund manager is not forced to sell holdings at a time of undesirable valuations and/or great illiquidity. However, questions of valuation and fairness frequently arise when certain investors are permitted to redeem their capital before the gate comes down, while others are prevented from doing so.
Due Diligence Issues
In the post-Madoff world, investors in hedge funds and other private investment vehicles must ensure that their capital is safe. It is no longer sufficient to rely on a manager’s reputation or purported track record. Responsible investors need thorough legal, accounting and operational due diligence to be performed on each of their investments, both retrospectively and prospectively. Many questions that once went unasked, now sit at the core of each investment decision.
Sadis & Goldberg LLP offers the industry's most comprehensive due diligence platform. Our multi-faceted service includes partnerships with marquee service providers throughout the accounting, operations and investigation worlds.
Leverage and Margin Issues
Leverage and its relation to market volatility is a timely concern for investors. When leverage is used through a margin account, buying power is increased. Obviously, such an arrangement can greatly increase returns, but it can result in diametrically opposed consequences as well. For instance, if an improperly leveraged fund receives a margin call, it may have to liquidate its positions in unfavorable market conditions, thereby depleting investors’ capital contributions. Similarly, if an inappropriately leveraged fund finds itself facing unanticipated market conditions, it can quite easily find itself deeply in the negative. The amount of leverage employed by the fund should be a major concern for investors, as the fund may be taking on unacceptable and, more importantly, undisclosed risks.
Auction Rate Securities
Auction Rate Securities (ARS) are debt instruments created for long term borrowing at short term rates. The securities typically are re-priced every 7, 28 or 35 days. In February 2007, the ARS market seized up, thereby halting short term re-pricing. Since the ARS could not be properly priced, holders found themselves unable to find buyers. In an attempt to manipulate the market, at least two of the biggest players in the ARS space, Merrill Lynch and UBS, were submitting bids to create the impression that the market for these instruments was operating efficiently. Consequently, many investors suffered material financial damages, as they were unable to satisfy their short term cash needs during this crisis.