Peter J. Turecek
01/01/2004
Hedge fund fraud is making headlines as high-profile investigations by the Securities and Exchange Commission and state law enforcement authorities shine a spotlight on problems in the industry. What can investors do to avoid becoming ensnared in a hedge fund fraud? It helps to know with whom you are dealing—and hiring the best advisors and investigators can save you millions.
| The key is trust, but verify. |
Of the first ilk are John Turant Jr. and Russ Luciano—and their JTI Group Fund—who were sued by the SEC in September 2003 for allegedly defrauding some 100 investors of $4.5 million. The pair allegedly promised they would be day-trading securities and claimed annual returns of 20 percent to 120 percent. Another is Mark Yagalla, a young college dropout who set up his own hedge fund with the money of family and friends. As the fund grew, he started living a lavish lifestyle, indulging in pricey trips, yachts, chauffeured limos, chartered jets and a $1.2 million home in Las Vegas for his Playmate girlfriend.
These types of fund managers often have red flags in their past; conducting a simple investigation can turn up issues that steer investors away, saving them both time and money. For example, investigators might have discovered that Turant claimed security licenses that were either expired or nonexistent. He also was subject to a legal action by the Pennsylvania Securities Commission, which he did not disclose to his investors.
Yagalla’s background also raised a few red flags. One item that would arch an investigator’s eyebrow was his incorporation of a nursing home company, for which he, at the age of 21, was the CEO. Another would be his purchase and sale, within a year, of a $200,000 Delaware condo, followed by his purchase of a $1.25 million luxury home in Las Vegas.
Creative Accounting
The second ilk uses creative accounting or similar strategies—and these are increasingly difficult to identify—to dupe investors. The SEC unearthed one in June 2002 when it accused Von C. Cummings and his fund, Paramount Financial Partners LP, of inducing investors to put $15 million into the hedge fund, which the SEC alleged was nothing more than a Ponzi scheme, paying out early investors with money raised from new investors. The SEC found another when, in November 2002, it sued Beacon Hill Asset Management, alleging the fund had materially overstated its value to investors and the fund’s prime broker.
Unfortunately, even comprehensive due diligence investigations have little hope of uncovering instances of internal fraud involving misallocations, improper valuations or strategies different than those presented to investors. In the secretive world of hedge funds, this information is typically closely guarded by fund managers and not shared with investors, business partners or industry colleagues. While a thorough review of a manager’s reputation may identify sources who are suspicious of a fund manager’s activities, it will rarely be able to offer documentary evidence.
For those contemplating investments in hedge funds, the key is trust, but verify. A few simple questions may help prevent the investor from becoming trapped in a fraud:
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How did the investor meet the hedge fund manager? Did the contact come through a trusted contact, investment advisor or through an acquaintance?
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Does the investment opportunity sound too good to be true? Investors need to ask and trust their gut—if something sounds sketchy, it probably is.
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Similarly, when the investor meets with the hedge fund manager and his or her team, what is the impression of them? Do warning bells go off? Are the managers and team candid and detailed with responses?
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When was the hedge fund started? What are the assets under management? A number of fraudulent hedge funds show that they tend to be recently established funds with small amounts of capital under management.
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Who is the fund’s legal counsel? Accountants? Other professional service providers? Verify the accuracy of these statements with the provider.
 | Peter J. Turecek is a managing director in the New York office of Kroll Inc., a global risk consulting company. He has worked on a variety of multinational investigations and specializes in investigations of hedge fund managers and investors. |