It has not been a good month for the financial industry: JPM's ever growing CDS trading (and apparently mismarking) loss; PFG Best's appreciation for Adobe Photoshop; HSBC's AML deficiencies; and pretty much eveyone's LIBOR manipulation, although only Barclays have - so far - turned up the "thanks for that - let's have some Bolly" emails.
PFG Best displays some key red flags - the CEO was a controlling personality and the only one who could access bank statements. Moreover, the firm was audited by a no name, apparent one person auditor. Thankfully, in a hedge fund context, a normal adminstrator would complete a full, tri partite reconciliation - taking trade information from the manager, booking it into their systems, and then reconciling, daily, to the prime broker. Moreover, technology is the hedge fund investor's friend - the days of daily rec administrators relying on paper PB statements are, thankfully, long gone.
JPM appears to present a different pattern where, once more, traders were in charge of - or at least had undue influence over - pricing of complex securities, despite the fact that their multi million dollar bonuses depended on those very prices. This is not a JPM problem, but is "best practice" throughout the investment banking industry (and, unfortunately, is too frequently used as a justification by hedge funds who have elected to put the front office in charge of the pricing process). We continue to have extreme skepticism that putting traders in charge of marking portfolios, and then paying them large sums of money based on those marks, will lead to a reliable pricing process. We have yet to encounter a trader who was not supremely confident that their marks were correct - especially when they knew they were wrong.
The issue of conflicts of interest, alignment of interest and compensation brings us to an editorial published in the National Post, the more right wing of Canada's two national newspapers. We have included the text in full, as this is one of the best summaries of the state of leadership of the global finance industry we have seen to date.
Dishonesty is the new greed on Wall Street
A high-level executive at Europe’s biggest bank quit on Tuesday. It was big news: a senior corporate leader actually accepting some blame for his actions, while his bank is engulfed in scandal.
In this case the bank is HSBC Holdings PLC and the allegations are just another day at the office for the modern-day finance industry: terrorism, money-laundering, drug-running, sanctions-busting. Not that your local HSBC has been staffing up with drug lords. No, the crimes are at higher levels, up where HSBC corporate bosses make thereally big bucks, and where they acknowledged that, when the opportunities arose, they didn’t do all they could have to avoid dealings with killers, bombers or organized crime in places like Mexico, Saudi Arabia and Iran. Instead the bank offered “a gateway for terrorists to gain access to U.S. dollars and the U.S. financial system,” according to a U.S. Senate report.
Ho hum. “I recognize that there have been some significant areas of failure,” acknowledged David Bagley, who was head of HSBC’s group compliance. “HSBC has fallen short of our own expectations, and the expectations of our regulators.”
Well gee David, no need to get all worked up about it. “Some significant areas of failure” — Is that what they call involvement with international crime bosses these days? Oh well, at least Mr. Bagley is stepping down. Most other corporate titans wouldn’t bother. Anyone know what happened to Jamie Dimon since he admitted J.P. Morgan vaporized somewhere between $5-billion and $8-billion? Oh yeah — he’s still in charge. Like most of the lords of international finance who have been embarrassed by massive cock-ups involving billions or trillions of dollars, he’s clinging to their jobs for all its worth, which as usual is quite a lot.
Sorry if I’m sounding a bit cynical, but really: If you decided to enjoy the summer and skip the business pages, you’re missing a humdinger of a crime story. Just four years after they helped send the global economy into a chasm it has yet to escape, the world’s corporate and financial leaders are back with a sequel. There’s greed on a monumental scale. Cheating and lying. Dishonesty, incompetence and theft. Hubris like you’ve rarely seen. Arrogance, lots of arrogance. Plus fraud, embezzlement, conspiracies and money-grubbing on a monumental scale, by a host of breathtakingly high-paid bankers, financiers and corporate kingpins. There’s even a moral to be learned: no matter how well-educated, well-dressed or well-paid, when an ambitious executive is put in the vicinity of billions of dollars and given an opportunity to pilfer it, all sense of honesty goes out the window.
There’s been so much malfeasance the Wall Street Journal can barely make room for its ritual editorials denouncing government interference in corporate affairs. The Journal views corporate governance much like China treats foreign intrusion in its domestic matters: We don’t care how high the bodies are stacked, that’s our business, not yours. But so abundant is the current supply of kleptocracy that it couldn’t resist. Even a capsule summary can barely contain the main points of all the wrongdoing that’s been going on:
* Russell Wasendorf Sr., a U.S. “business kingpin and philanthropist”, tried(unsuccessfully) to take his own life, after writing a suicide note revealing he’d spent 20 years systematically defrauding customers of Peregrine Financial Group, which he founded 22 years ago and almost immediately began looting. Peregrine is missing $215-million. Mr. Wasendorf’s explanation was straightforward: When his company ran into trouble he decided he could admit the truth, or start stealing. And he was too embarrassed to admit the truth.
* Mr. Dimon, CEO of J.P. Morgan and Chase, dismissed concerns over “trading problems” at the bank as a “complete tempest in a teapot” in April, but now admits it’s a bit worse than that. No, Morgan didn’t blow a measly $250-million as he thought at the time, or even $2-billion like he suggested in May, but more like $5.8-billion. Or maybe it’s $7-billion or $8-billion — who knows, it’s early yet. Numerous agencies are investigating the losses, and there’s talk of criminal inquiries, though there’s plenty of precedence for banks blowing that kind of money with no one ever being held to blame.
* J.P. Morgan’s losses pale next to the big Libor scandal, which involves a group of the world’s top banks deliberately manipulating interest rates to avoid admitting how bad their finances had become during the financial meltdown of 2008 (which was caused, in case you’ve forgotten, by many of these same banks and financiers trying to scam investors with third-rate, high-risk products dressed up to look like safe investment opportunities.) It’s unlikely anyone will ever know how much money Libor involves. The money flow is simply too big and complex, and involved too many organizations in too many countries. The New York Times notes that “up to $800-trillion in financial products are pegged to Libor”, meaning all the bankers in all the world could use all their fingers and all their toes and still never produce a clear idea of how much they scammed from various economies.
But that’s what we’ve come to expect, isn’t it? We already know from the 2008 meltdown that we can’t trust Wall Street as far as we can throw it. We can’t trust ratings agencies, which certified all those high-risk derivatives as completely safe and sound. We can’t trust the regulators, who either can’t spot, or can’t stop, abuses of the financial system. U.S. regulators evidently knew of the Libor problem four years ago, but couldn’t figure out a way to let their British counterparts in on the secret. Mervyn King, head of the Bank of England, claims he only learned what was going on a few weeks ago, even though there have been reports in the papers since at least 2007. The quality of policing when it comes to corporate crime is so hilariously low that Mr. Wasendorf managed to outwit authorities for two decades with the simplest of tricks: He used Photoshop and Excel to forge bank statements, gave auditors a phony address so he could intercept their communications and wouldn’t let anyone else open his mail. Now the same geniuses who missed his criminal activity say Mr. Wasendorf is obviously such a skilled liar they can’t decide whether to believe his confessions
Most of all, we know we can’t trust the men (and a few women) who reign at the top of the financial heap, tasked with making money for shareholders, protecting the investments of clients and staying within the law. Other than Mr. Wasendorf, you’ll have a hard time finding a CEO willing to take the blame for anything untoward, not withstanding the evaporated billions. Forbes magazine is bedazzled by Mr. Dimon, noting, “He hasn’t even stepped down as chairman of the Morgan board of directors or even as a ‘Class A director’ of the Federal Reserve Bank of New York.”
“If Jamie Dimon had been on the Titanic, he’d have jumped in a lifeboat … and then issued a press release describing his heroism,” Forbes notes.
Slightly less adept is Robert Diamond Jr., the high-octane head of Barclay’s Bank, who has been front and centre in the Libor mess but is so unrepentant he had to be driven from his job by the combined forces of the British government. As with other bosses, he’s willing to admit mistakes were made – just not by him. Diamond blames U.K. regulators, and says he only stepped down because of “external pressure.” The point of the gargantuan rewards people like Mr. Dimon and Mr. Diamond pay themselves is purportedly to compensate them for the enormous responsibility they carry in overseeing large and complex organizations that handle huge amounts of money. Yet when deceit, fraud, criminal activity or mammoth losses occur, somehow the buck never quite stops at their desk. Barclays put it about that Mr. Diamond had agreed to give up a $32-million sweetener when he resigned, though a later report suggested he wasn’t due the bonus in any event. It was considered a big deal last week when Ina Drew, J.P. Morgan’s chief investment officer, voluntarily agreed to return two years’ salary – about $30 million – over her involvement in the bank’s losses. And three other traders involved in the losses had part of their pay cheques seized. But is their boss’s neck on the line? Could Mr. Dimon actually be held to account? Fat chance. AsForbes marvels, “He’s unsinkable!”
Because, you see, when these huge losses occur, it’s always other people’s money. Other people’s mortgages are bundled up and sold to unsuspecting suckers. Other people’s investments are pilfered while the regulators are on coffee break. Other people have to cope with the effects of the global downturn while the banks protect themselves by manipulating interest rates and lying to federal authorities. Other people watch their investments shrivel up because some London Whale wants to make a name for himself by launching fantastically risky bets. And other people are supposed to accept that these self-serving egomaniacs deserve to be paid tens, or hundreds, of millions of dollars a year due to their unsurpassed financial acumen and the value they bring to international markets.
So what’s a business prof supposed to tell his class when it comes time to discuss ethics and corporate accountability? Ethics? Honesty? Responsibility? Integrity? What makes you think you’d need to be familiar with those concepts, just because you might find yourself running a public company in which millions of small investors have put their savings, and trust?
Judging by recent history, the key to corporate success is an unshakeable belief in your own superiority, combined with a total lack of responsibility and an overwhelming disregard for the impact of your actions. The goal is to get a job in which you’re able to enrich yourself so mightily that, even when disaster strikes, you’ll still have millions stashed away with which to comfort yourself. Avoid risking your own money, because if you own a private company and it goes belly up, you’re the one on the hook for the losses. Much better to lead a public company where you can help yourself to more than your share of the profits during good times, and wriggle out of blame when things go south. And never question that you deserve every penny.
National Post
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Asset Manager Operational Due Diligence
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The New York Times has added to the mounting criticism of the Cayman "rent a director" model, with an article (including video!) and follow up blog commenting on the large number of directorships held by certain individuals on the island, with a focus on the self described "Goldman Sachs" of the industry, dms.
This article continues other, strongly critical commentary, including a May 2012 leader in the FT, "A Call to Fix Hedge Fund Governance" following on from earlier FT articles in November 2011, "Hedge fund investors urge transparency", and a follow up, "Businessman turns local niche to Global Niche".
Castle Hall's own views on the directorship debtate were set out in our recent white paper - "Redefining Corporate Governance: Towards a New Framework for Hedge Fund Directors". In that paper we outlined the "6 C's of governance", being Competence, Capacity, Composition, Choice, Compensation and Control.
The fact that Cayman corporate governance continues to win column inches in the top tier, global business press makes it clear that this issue will not go away. As such, it has become vital for the offshore directorship industry to address, clearly and unambiguously, the core question of capacity - the maximum number of boards upon which a director can serve with any plausibility.
We would agree that the capacity question has some nuances: should we consider, for example, the number of client relationships or the number of funds (especially when dealing with master / feeders or multi layer fund structures). However, such questions are refinements and do not not distract from the central problem: we have yet to encounter any investor - let's repeat that, ANY investor - who is remotely supportive of the view that an individual serving on 100+ boards meets their expectations as to the standards of care and attention they expect from a board member entrusted with fiduciary oversight over their offshore hedge fund assets.
As a first step, we would call on the Cayman Islands Monetary Authority to step up - given the new standards of transparency set by the SEC, Cayman should offer offshore investors an easily accessible, searchable database of Cayman funds that allows investors to confirm the number of directorships held by each service provider.
Alternatively, perhaps the SEC could do this if Cayman won't - it would only take a quick addendum to the newly enhanced ADV and supporting schedules for managers to be mandated to identify the directors of their offshore funds.
However the information is mandated, the days when directors decline to confirm the number of their Board appointments - and let's face it, there's only one reason why you would want to decline that information - are numbered.
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Hedge Fund Operational Due Diligence
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A recent SEC complaint alleges that a hedge fund manager called Robert Stinson (helpfully described as a "convicted felon and securities fraud recidivist") raised some $16 million from investors from 2006 until he was caught earlier this year. Needless to say, instead of investing that capital in a genuine hedge fund strategy, the SEC claims that Mr. Stinson used the cash "to fund lavish spending involving restaurants, yachts, automobiles, baseball games and travel."
The first red flag - Mr. Stinson had named his hedge fund company "Life's Good." We would rest our case at that point, but apparently not everyone has our aversion to blatantly ridiculous management company names.
Also of interest, the Life's Good STABL Mortgage Fund LLC was, according to a news article, rated by Morningstar, where, surprise surprise, it received the maximum 5 star rating. When the returns are entirely fake, it stands to reason that it is relatively easy to produce a 5 star track record.
In fairness to Morningstar, their rating product is crystal clear with the caveat emptor disclosures that it (i) relies entirely on manager reported data (which could, therefore, be fraudulent) and (ii) that Morningstar has developed four "operational red flag" criteria, with the Life's Good fund, per the news article, violating three of the four during its tenure in the database as a 5 star performer.
A Morningstar paper outlining the four red flag criteria is available here - the four are
(i) recognized auditor (where an auditor acts for at least 5 other funds in the Morningstar database)
(ii) recognized administrator
(ii) registered
(iv) returns do not evidence serial correlation
We're not sure which of the four operational red flags the STABL fund violated, but the most interesting is probably the latter - returns which do not evidence serial correlation.
Our comment here is not to criticize Morningstar, who appear to have been pretty clear as to the quality, scope and limitations of the information they were selling. Rather it is the broader point that focusing on investment returns alone can be entirely unhelpful unless operational analysis is also included. ODD can kick the tires for blatant fraud, and, more subtly, can comment on the quality of reported returns by analyzing the quality of a fund's pricing process.
Let's take the examples of two multi billion distressed debt funds. In one fund, the back office gathers a collection of broker quotes direct from the underlying brokers, removes any outliers, and takes the mathematical average of the remaining bids to determine the price used in the fund's NAV. In the second case, the front office marks the portfolio, and the back office will accept the price as long as the front office mark falls anywhere within the range of the lowest bid to the highest ask from the quotes received. Which one will have the highest measure of serial correlation...but also the highest Sharpe ratio?
In this case, operational due diligence information is critical to help investors make a more informed choice between these two, hypothetical funds. In the real world example of Life's Good, Morningstar's research clearly illustrates the worst case outcome when a fund has a 5 star track record, but a 75% red flag rating.
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Hedge Fund Operational Risk Due Diligence
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Well, Mr. Adoboli isn't quite as good as Mr. Kerviel when it comes to rogue trading, but the financial impact of his unauthorized trades has now increased from the initial estimate of $2 billion to $2.3 billion. Still a strong effort from the 31 year old, who pushes Nick Leeson of Barings fame down to #3 in the rogue trading hall of fame.
Back in January 2008, we commented on the Soc Gen debacle (the post also contains a potted history of just some of the multitude of rogue traders in the investment banking industry). The title of our comment at the time - do we really want hedge funds to aspire to be institutions?
Our point then - which this week's events at UBS support once more - is that most hedge funds have a number of significant, structural advantages over large investment banks when it comes to rogue trading.
At their core, the trading desks of investment banks are self administered - there is no independent oversight over trade capture, reconciliation, valuation and P&L reporting. This is a huge weakness in the investment banking model: ultimately, can you trust the trader paid directly on his or her investment performance without a third party, independent arbiter to check that all is bona fide?
Moreover, as we all know, the back offices of investment banks are very much the junior partner in any discussion with the trading desks - they are a cost centre, while the stars of the trading desk drive profits. There is an obvious chasm between the compensation levels of the back office professionals and the front office traders: you do not need to be an astute observer of behavioural dynamics to predict that a discussion between someone on a $50k bonus as compared to $5m will be an uneven affair.
It is also striking that both Kerviel and Adoboli share the same profile: more modest employees, without family name or Ivy League / Oxbridge credentials, who started in the back office before getting a chance to step onto the lowest rung of the trading desk - the Delta 1, equity index business. Both appear to have used their knowledge of back office procedures to faciliate their frauds. Both also had a first fingertip on the trading desk hierarchy and could see the potential for truly colossal compensation in the far distance, with all the lifestyle benefits that come from multi million bonuses.
How does this impact hedge funds? Thinking of the contrast between alternative asset managers and investment banks, we can identify five factors which impact the potential risk of undetected rogue trading.
1) Organization size
Investment banks are massive organizations. With a reported 15,000 staff on the UBS investment banking payroll (itself just part of the bank's' total 65,000 person headcount), the law of averages creates the risk that there could be at least one outlier employee: someone who could become sufficiently envious, stressed or misguided to start to conceal trades. The organization is then so big, its systems so complex, the number of trades so high - finding a way to exploit some weakness in how data is monitored becomes more conceivable.
A hedge fund, however, is generally a much smaller and far more cohesive entity. While there are a handful of funds with several hundred employees (and less than 5 with more than 1,000) the vast majority of firms have fewer than 50 staff. In reality, it would be hard not to pick up strange behaviour in a hedge fund when there is only a small group of investment professionals, all clustered around the same desk in their daily fight with the markets.
Conversely, risk would seem to rise when funds get larger: once a fund has tens or even hundreds of risk takers, even a hedge fund begins to lose the automatic protection of everyone sitting together and watching each other's behaviour. Risk also increases when traders are spread out amongst multiple locations, especially when the traders are isolated in a preferred location separate from the back office.
2) Systems
Many hedge funds, in house, use a central accounting system such as Advent Geneva. Investment banks, by contrast, rely on a hodge podge of systems, some current, some ancient - with a lot of Excel as a Band Aid. A single, centralized platform for all data is a critical component which underpins any strong control environment, giving many hedge funds a strong controls advantage.
For funds, therefore, best practice is to see a robust, single platform supporting trade capture, reconciliation and accounting. Equally, more complex funds with a mosaic of different systems for different asset types increase the risk that a motivated employee could exploit weaknesses in the systems infrastructure.
3) Authority of the back office
In an effective hedge fund, the CFO and COO are senior members of a firm's management team, with genuine authority to hire, fire and build a robust control environment. Indeed, in our view, the quality of the CFO is likely the single most important control factor in a hedge fund: a capable CFO will have the technical knowledge and experience to get the job done right, but - even more importantly - he or she will have the authority and stature in the organization to set a "tone at the top" which focuses on controls and oversight.
We have completed due diligence on many hedge funds where the CFO and / or COO are exceptional professionals, with genuine governance over their organizations. By contast, investment banks may not be as strong as their facade would suggest - as just one example, we have recently read a number of books about the 2008 financial crisis, all of whom have various stories of how risk management and back office professionals were readily marginalized during the sub prime profit frenzy.
4) External oversight
As we have stated above, investment banks are self administered. The post Madoff, now mandatory appointment of an independent, third party administrator creates a significant control benefit in favor of hedge funds.
We do have some words of caution, however. Firstly - as we have frequently noted in Risk Without Reward - not all administration servicing is created equal. To provide the best protection against rogue trading, an administrator should complete daily accounting, taking trade records from the manager (not the PB) and then completing a daily reconciliation to each prime broker, custodian and counterparty. Weekly or monthly accounting cycles do not provide the same degree of external oversight.
Secondly, the most effective control comes from a parallel system, where the manager's in house back office and the external administrator both complete full accounting and reconciliation procedures daily. We do see risk in the trend to completely outsource accounting and reconciliation: in this model, there is no in house accounting, and the administrator becomes an outsourced back office, moving away from the model of independent watchdog. Both managers and investors should remember than administrators will, for cost reasons, often hire staff a more deeply resourced hedge fund wouldn't: best practice controls, therefore, always balance in house expertise with external independence.
5) Compensation
Finally, one of the key risk factors in any asset management organization is how investment professionals get paid. Investment banks, by and large, operate on the Darwinian principle of "eat what you kill". This compensation model obviously creates an "every man for themselves" culture: it motivates risk taking to boost income, and equally scares poorer performers facing their stop loss limits to find desparate ways to stay in the game. Either - and especially the latter - can drive rogue trading.
Within a hedge fund, it is more common to see a model of discretionary compensation, or at least a hybrid where elements of formulaic, performance based compensation are balanced with discrectionary bonuses or payment based on firm wide performance rather than just individual trading P&L. Hedge funds have also proved flexible to implement a range of effective comp deferral schemes which further mitigates the incentive to rogue trade.
Unfortunately, we do have to remind investors that hedge funds cannot be immune from the risks of rogue trading. As with all types of fraud, a clever trader likely can fool all of the people - at least some of the time. However, on balance, the smaller, more cohesive nature of hedge funds, their more tightly controlled systems, stronger CFOs and better independent oversight materially reduces risk. Most hedge funds are not like investment banks, and that's a good thing, at least when thinking about rogue trading.
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Hedge Fund Operational Risk Due Diligence
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As we all know, Bernie Madoff is currently serving a minimum 150 year sentence at a federal jail in Butner, North Carolina. Other high profile hedge fund fraudsters are also reflecting on their sins from the inside of a US penitentiary, notably Sam Israel of Bayou, "I've faked my suicide" fame.
Against this background, it was surprising to read this past week (see link to FT) that the UK Serious Fraud Office has decided not to pursue any charges against the founder and principal of Weavering Capital, Magnus Peterson. Peterson previously held the high profile role of head of trading at the major Swedish bank SEB - as such, he is another example where apparent hedge fund fraud is conducted by established and senior industry professionals, rather than small time opportunists.
In early 2009, Weavering was unable to meet redemption requests, and it turned out that the fund's primary asset was a private swap transaction with a related party company set up in the British Virgin Islands (see an investigative piece written at the time by the Daily Telegraph). Given that Weavering couldn't pay its investors back yet claimed assets of $639 million, it would appear that the aforementioned swaps were fake. However, according to the SFO, there is now "insufficient evidence to secure convictions".
What is even more surprising is that, just a week ago, Weavering was involved in a landmark judgment against the two directors of its offshore fund (see Fin Alternatives), who conveniently happened to be Peterson's 80 year old father and his brother in law. Much to the delight of the Cayman directorship services industry (given that the two directors involved - probably more by good luck than management - weren't Caymanian), the two individuals were each fined $111 million. Certainly, someone thinks that there was criminal wrongdoing associated with the Weavering case.
According to one commentary, the SFO's decision not to take action against Peterson has "caused investors to raise serious questions about the ability and will of British prosecuting authorities to bring criminal charges in substantial fraud cases, which can only be damaging to the City's position as a center of international finance."
Hmm. And, of course, this isn't the first time this has happened. Despite the UK's efforts to infer that fraud is unlikely in Mayfair given the oversight provided by the FSA, there have been other examples of UK hedge funds blowing up under a cloud of accused wrongdoing. In 2006, the FSA banned Jae Wook Oh, the founder of the hedge fund Regent's Park, from any "controlled function" for three years. Given that no prison time was involved, this can only be described as a wrap across the knuckles.
According to the regulator, "it appears that over a number of months in 2005 there was a difference between the realisable value of certain investments and the valuations provided by Regent's Park." Yes well...while all that happened to Wook Oh was apparently a three year time out from money management, Regent's Park's administrator, GlobeOp, was found liable in a $43 million compensation case - again, someone obviously thought that something had gone severly wrong.
Still, having called out the UK, let's remember that the US also has problems with its prosecution process. In a process which took nearly a decade to get to court, Michael Lauer, the founder of Lancer group, was recently acquitted of stock fraud. According to prosecutors, Lauer bought shares in tiny shell companies and then put in buy orders at the end of each month to provide a temporary bump to the price used in the fund's NAV. However, the jury disagreed and Lauer now expects to return to money management. Due diligence, anyone?
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Hedge Fund Operational Due Diligence
"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc. All rights reserved.
The SEC have just settled a case under which Morgan Keegan, a Tennessee subsidiary of Regions Bank, agreed to pay $200 million (without - of course - admitting or denying any of the findings!) to settle fraud charges related to deliberate mismarking of ABS / subprime positions in a 1940 Act registered mutual fund. The SEC's press release is available here, and the full text of the SEC's order is presented here.
According to the latter document, Morgan Keegan was responsible for valuing securities in its own mutual funds. The first warning sign, therefore, is the absence of a third party administrator or valuation agent. Despite being a highly regulated mutual fund, the funds were still exposed to the unavoidable conflict of the management company marking its own book.
In this case, things went predictably wrong as the sub prime market fell apart in early 2008. According to the SEC, the alleged actions included:
- Morgan Keegan's fund accounting group periodically obtained broker-dealer price confirmations for certain fair valued securities. Unbeknownst to the fund accounting group and the fund's independent auditor, the portfolio manager actively screened and influenced a broker-dealer to change the price confirmations that the fund accounting group and auditor obtained from that broker dealer;
- Morgan Keegan's valuation committee left pricing decisions to lower level employees in the fund accounting who "did not have the training or qualifications to make fair value pricing determinations";
- Fund accounting personnel relied on the portfolio manager's "price adjustments" to determine the prices assigned to portfolio assets. Per the SEC, these adjustments were "arbitrary and did not reflect fair value. The price adjustments were routinely entered upon receipt by the staff accountant in a spreadsheet used to calculate the NAV of the Funds." (They are using a spreadsheet to calculate the NAV of a 40 Act mutual fund??) Further, "Fund accounting and the Funds did not record which securities had been assigned values by the portfolio manager"';
- Fund accounting personnel gave the portfolio manager discretion...to determine which dealer price confirmations to use and which to ignore, without obtaining documentation to support his adjustments;
- The valuation committee and fund accounting did not ensure that the fair value prices assigned to many of the portfolio securities were periodically re-evaluated, allowing them to be carried at stale values for months at a time (months??);
- In some instances, when price confirmations were received that were substantially lower than current portfolio values, Fund Accounting personnel, acting at the discretion of the portfolio manager, lowered values of bonds over a period of days, in a series of pre-planned reductions to values at or closer to, but still above, the price confirmations.
Cherry picking of broker quotes, manipulation of broker dealer information, control of the pricing process by the portfolio manager without challenge from the back office - this one has it all.
For hedge fund investors, this case is yet another reminder that some portfolio managers - either to make more money or to cover up losses - will push pricing issues to the edge. Some will inevitably push beyond into deliberate misvaluation. In this instance, the strongest form of regulated fund structure - a 40 Act mutual fund - made not one bit of difference to prevent the PM cooking the pricing books.
As such, this case is a $200 million reminder that, as always, best practice must be to separate portfolio management from the valuation process, with an independent, third party responsible for pricing portfolio securities in the NAV. After all, even the most honest portfolio manager can make an honest mistake and, inevitably, a handful of portfolio managers will be dishonest.
Equally, Morgan Keegan shows the enormous value that an effective, third party administrator can provide to the hedge fund investor. However, readers of Risk Without Reward will not be surprised with our final comment = investors need (and are prepared to pay for) an administrator who prices the portfolio themselves, not as directed by the manager, and who applies a degree of skill and expertise far beyond the apparent level of the back office employees in this case.
As always, it is the most difficult to price securities which are the most susceptible to deliberate mispricing, so it is these securities where investors need administrators to focus their greatest efforts on independent pricing. Otherwise the next Morgan Keegan could very easily be a hedge fund.
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Hedge Fund Operational Due Diligence
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We don't normally comment on investment related issues, but an article in the Daily Mail, a UK newspaper, caught our eye. In an expose across a range of metrics related to the Greek economy, the Mail noted, for example, that only 5,000 people in this country of 12 million declare a taxable income in excess of GBP90,000. The latest trick from the wealthy Athens socialite set? Buy camouflage netting to disguise your swimming pool from helicopters looking to identify wealthy families who haven't paid taxes.
The big banks in Paris, Frankfurt and London must have very big loans outstanding to Greece to want to save this debacle.
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Hedge Fund Operational Due Diligence
"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc. All rights reserved.
As a follow on to our earlier post on some of the audit implications from the Sino Forest saga (or perhaps our earlier comments were a hoax from the SEC...!!), our attention was drawn to an article in the NY Times which also used this case to consider various issues impacting the audit process. The full article can be accessed here.
Among the Times' comments:
"Investors trying to decide whether to believe the Muddy Waters report, with its detailed assertion that the company's claims are contradicted by Chinese records, would love to know just what Ernst did check. What records did it inspect? Which tree plantations did it visit? Who did the work? Was it people from Ernst's Toronto office, which signed the report, or people from a Chinese affiliate? How many auditors did the work, over what period of time?
Ernst's report does not say, which is no surprise. Virtually every audit opinion in the world says almost the same thing, with no details about the company being audited."
The article continues with more comments as to whether the scope and procedures of the audit should be more transparent - an interesting read.
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Hedge Fund Operational Due DIligence
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In our last post, we provided some background to the Sino-Forest saga, a Canadian quoted company currently rocked with allegations of fraud related to its Chinese forestry assets.
In our post, we commented on an article from the National Post in Canada. We thought it would also be useful to draw attention to some of the other comments in the Post article.
According to the Post, "no matter how you break it down, the past nine days have been a debacle for Canada's capital markets, as an obscure short-seller took down the shares of a 19 year old Canadian Forestry giant in record time.
If Mr. Block turns out to be wrong, then it is shocking that investors took his word above the bankers, analysts and auditors who backed this company for years. It undermines Bay Street institutions and could go down as one of their biggest embarrassments.
If he is correct about Sino-Forest, then it's Armageddon reminiscent of Bre-X. It will take years to figure out how the company was able to raise so much money and fool so many outsiders. Almost nobody will come out of it looking good."
One comment in the article particularly struck us:
"Mr. Block, for his part, has no trouble explaining potential cracks in the financial system. He describes the capital markets as a 'hot potato' where the various groups (auditors, bankers, lawyers etc.) pass the blame to each other when the system suddenly fails." According to Mr. Block, "the gatekeepers whom investors think are providing protection against fraudulent listings don't function as they should."
Is Mr. Block correct, and does his view also translate to hedge funds? Do hedge fund administrators, auditors and lawyers provide sufficient protection against hedge fund fraud and NAV error?
In this case, Sino-Forest's auditors are Ernst & Young Toronto. The firm's 2010 financial statements are available here, and received a clean audit report dated March 14, 2011. As an aside, we're pleased to see that Ernst & Young direct their audit report to the Sino Forest "shareholders" as a body. As we have discussed before, EY has adopted "Cayman GAAP" - whatever that might be - to decide that they have no reporting responsibility to the shareholders in any offshore hedge fund and hence direct their hedge fund audit opinions only to the directors. Shamefully, Deloitte appear to have picked up the same tactic for the 2010 year end, although this is a topic for another post.
If Sino Forest is a complete fraud - which seems possible - or is at least subject to some form of material misstatement - which certainly seems possible - then it will also be a catastrophic audit failure. This leads us to make three comments.
Firstly, it is evidently extremely difficult to obtain clear evidence as to ownership of assets in certain countries. In China, auditors face an obvious language barrier, and a different legal system where ownership and property rights are not documented and enforced following anything like the practices of Western legal systems. It is fair, therefore, to have some sympathy for the auditors and at least recognize the inherent difficulty of unambiguous verification of title for companies operating in these countries. However, at the same time, the starting point of any audit must be to prove that a company actually owns what it says it owns. If the audit can't do that with certainty, then the entire audit is, we hate to say, worthless.
Secondly, we are reminded of a recent email we received from a friend of the firm: "we have seen a growing trend of corporate frauds at overseas companies such as the recent one in Longtop....we have found that one consistent item across some of these is that they were audited by overseas Big 4 auditors who missed big items such as cash."
In the case of Longtop (a Chinese software company), according to Business Insider, "the cash balance on Longtop's balance sheet, it turns out, was fake - a fiction created by the company's managers and helpers....According to an extraordinary letter that Longtop's auditor, Deloitte, sent the company when it quit last week, Longtop's banks sent out fake statements attesting to the company's fake cash balance. It wasn't until Deloitt'e's examiners physically visited the banks, and talked to other employees at the banks, that the fraud was discovered."
Some other examples of similar frauds are Satyam India, the software company with an estimated $2.5 billion of fake cash and other assets (PwC India has recently settled for a $6 million fine) and, of course, Parmalat.
These issues are all combined and lead to our third observation. Once more, investors should recognize the purpose of the audit - as we have discussed before, the financial statements are the responsibility of management, and it is the auditor's responsibility to gather sufficient evidence to determine whether those financial statements are free of material misstatement. In practice, this means that the audit seeks out a baseline of evidence to support management's assertions. The purpose of the audit is not to actively search out information which could disprove management assertions.
This, ultimately, is the question: where on the continuum should an effective audit fall between "innocent until proven guilty" and "guilty until proven innocent"? Should the efforts of the auditors go towards proving what management has told them - or should the auditor work harder to find information which may contradict management's assertions?
Taking the example of a hedge fund, let's think about a fund which owns a hard to value distressed bond. Is it enough for the auditor to circularize the broker the manager used in its year end pricing matrix and confirm the same price of 65; or should the auditor independently contact other brokers, not used by the manager, who may, perhaps, have a lower mark?
As an aside, there is also an interesting extension from this observation. At what point does a major audit firm, auditing multiple funds holding the same security, say that it cannot be materially correct for each client to hold the same security at different prices? While there may be sufficient evidence to prove one manager's mark, does that evidence in turn disprove another manager?
It is obviously unrealistic to expect any seachange in the core framework for the audit process. However, it is a fair point to at least question whether the current audit process is sufficent when a company holds assets which are hard to value or where title is hard to prove. For this type of company - which includes many hedge funds trading hard to price assets - should the auditors dig deeper and look for more independent evidence, outside the sources suggested by management? This approach would make an audit longer and more expensive - probably much more expensive in the case of companies such as Sino Forest. But, against a history of multi billion dollar frauds, it might be better to pay the auditors extra basis points now, rather than lose 10,000 bp later on.
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Hedge Fund Operational Due Diligence
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OK, so we can imagine Ashton Kutcher misplacing his vehicle after a night's heavy partying (hey, if you end up with Demi Moore, we'll allow you room for quite a few transgressions!) However, it's another thing to misplace an entire forest...or if it turns out that all of those trees don't belong to you after all.
The saga of the Canadian quoted Sino-Forest Inc. impacts hedge fund investors in several ways.
According to the National Post, a leading Canadian newspaper, "Sino-Forest was one of the darlings on the TSX over the past five years, rising more than 2,000% since 2002 to a peak valuation in excess of $6 billion." This was, of course, before a damning report written by a short seller, Carson Block, of the firm Muddy Waters.
According to Muddy Waters (full research report available here), "like Madoff, Sino-Forest is one of the rare frauds that is committed by an established institution....The foundation of Sino-Forest's fraud is its convoluted structure whereby it runs most of its revenues through "authorized intermediaries" ("AI"). AI's supposedly process Sino Forest's (symbol: TRE) tax payments, which ensure that TRE leaves its auditors far less of a papertrail. On the other side of its books, TRE massively exaggerates its assets. We present smoking gun evidence that TRE overstated its Yunnan timber investments by approximately $900 million."
The most recent reports from another Canadian newspaper, The Globe and Mail, certainly don't look promising. This weekend, the Globe published a detailed article with the headline "key partner casts doubt on Sino-Forest claim".
"The Globe's investigation raises particularly hard questions about a key agreement in March, 2007, that SIno-Forest says gave it the right to buy timber rights for up to 200,000 hectares of forest in Yunnan for between $700 million and $1.4 billion. The trees were to be bought through a series of agreements with an entity called Gengma Dai and Wa Tribes Autonomous Region Forestry Co, Ltd., also know as Gengma Forestry. The company (i.e. Sino-Forest) says it has fulfilled virtually all of the agreement with Gengma and now owns more than 200,000 hectares in Yunnan. But officials with Gengma Forestry, including the chairman, dispute the company's accounting of the deal, telling the Globe and Mail that the actual numbers are much smaller."
The Globe decided to do due diligence the good ol' fashioned way - put boots on the ground, and physically go to meet the parties involved in China.
"To find Gengma Forestry, SIno-Forest's local partner in the so-called 'Yunnan master agreement" - the 2007 deal said to be worth as much as $1.4 billion - you have to duck down an alleyway behind the drugstore on the main street of this nondescript trading city, then up a dusty cement staircase. On the landing is the litter-strewn office with an open door and a window protected by metal bars. Despite signing a deal with Sino-Forest that should guarantee a windfall, the company has clearly fallen on hard times. 'Our relations with [Sino-Forest] were not totally good. They talked about a lot of things, but in the end it was hard to get money from them,' said Zhang Ling, Gengma Forestry's office manager."
Ooops.
Obviously it remains to be seen what happens with Sino-Forest, but even a generous observer would say that there is plenty of smoke and likely quite a few flames. Among those impacted is, of course, Sino Forest's largest shareholder, the Paulson funds - their 14% holding has lost, according to Business Week, more than $500 million since the Muddy Waters report.
In our next post, we'll consider some more implications from the Sino-Forest saga - particulary with respect to the audit process.
UPDATE: Bloomberg reports that Paulson, referenced above, has now sold his firm's stake in Sino-Forest, leading to a potential loss of up to $720 million.
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Hedge Fund Operational Due Diligence
"Risk Without Reward" is a registered trademark of Entreprise Castle Hall Alternatives Inc. All rights reserved.