Asleep At The Audit?

A hedge fund's apparent fraud went undetected for three years

It seemed too good to be true. A twentysomething hedge-fund manager, an Austrian-born college dropout, was regularly beating the pants off seasoned pros. He was reporting gains of up to 27% a year by betting big that tech stocks such as Yahoo! Inc. and Cisco Systems Inc. would tank. Although such stocks were soaring, investors--including sophisticated international banks from Republic National Bank of New York (Suisse) to Bank Austria--didn't seem to notice. They poured $350 million into Michael W. Berger's Manhattan Investment Fund.

Then the roof fell in. On Jan. 18, the Securities & Exchange Commission filed suit against Berger, 28, in U.S. District Court in Manhattan "to stop a massive fraud." Berger's gains, it turned out, were more than extraordinary, they were completely false, according to the SEC. Manhattan lost money every year it was in business, and Berger hid the fact by sending phony numbers to fund administrators and auditors. Within the next two days, fund assets were frozen and the fund put into receivership. Not that there was much left to put on ice: Although the fund claimed assets of $426 million, the real figure was just $28 million by the end of August, 1999.

Now, Berger, who declined to be interviewed on the record for this story, and Manhattan are facing 13 investor lawsuits filed in Bermuda and elsewhere. The fund's auditor, Deloitte & Touche in Bermuda, is named in at least one investor suit for "acting recklessly and with gross negligence." Scotia Nominees, the Channel Islands trust that filed the suit, also blames an affiliate of Ernst & Young in Bermuda for endorsing "grossly overstated" fund values. Neither Deloitte nor Ernst & Young would comment on the suits.

Berger's problem was that he needed to raise lots of new money because he had lost so much--more than $300 million by the end of 1999, according to SEC documents. Besides, many existing investors wanted to cash out. "There was as much as $75 million of redemptions in 1999--more than 20% of the fund's reported assets," says Alex Shogren, President of HedgeFund.Net, an online hedge-fund database. "But I heard rumors from 8 to 10 different people in the summer of 1999 that there were irregularities with the fund's numbers." Berger himself filed a lawsuit in August, alleging that five unnamed companies were spreading vicious rumors about his fund being down 30% in 1999, "when in fact it had improved over 7%," the suit said.

WIDER PROBE. Some observers say wider investigations are sure to follow. Barry P. Barbash, former SEC director of investment management and now a partner at Washington law firm Shearman & Sterling, says he expects the commission to look at the roles of Bear Stearns, Deloitte & Touche, and the Ernst & Young affiliate in the Manhattan Fund debacle. "It's clear as the nose on my face that the SEC will turn around and look at the service providers in terms of how much did they know about what was going on. Should they have known about the fraud sooner? And should they have taken decisive action sooner?" SEC officials say they cannot comment on current investigations. Deloitte and Ernst & Young would not comment on possible SEC investigations, but a Bear Stearns spokesperson said: "Bear Stearns brought this matter to the attention of the SEC and has continued to assist in the investigation of Manhattan Investment."

By his own account, ever since he was a teenager Berger wanted to be in the securities business. While studying economics at the University of Linz, he worked as a financial analyst for one of Austria's biggest savings and loans, Salzburger Sparkasse Bank. At the age of 20, he was publishing a newsletter called SmartMoney, later called Wall Street Notes, about the U.S. stock market. And within a couple of years, he was sharing an apartment in New York's Hell's Kitchen with a roommate and a lot of cockroaches. By 1993, he was working out of a small office on Park Avenue, writing his newsletter and acting as a technical stock consultant for a Columbus (Ohio) broker-dealer called Financial Asset Management.

But all along, his burning ambition was to get into the big leagues and run his own offshore hedge fund. Almost as soon as he achieved that goal, Berger's fund turned sour, and he began operating a straightforward fraud, according to the SEC. The ease with which he did so raises serious questions about the regulation of hedge funds authorized to do business in the U.S.

FADING DREAM. In September, 1996, just five months after he formed the Manhattan Fund--geared to foreign banks that invested on their own behalf and for wealthy European clients, as well as tax-exempt U.S. pension funds and trusts--Berger's dream began to crumble. His strategy of shorting U.S. equities, especially in what he thought was the highly overvalued tech sector, quickly racked up big losses. Based on public information, it is unclear what stocks Berger was long in--if any. The SEC alleges Berger began sending phony statements about the fund's performance to its administrator in Bermuda, an Ernst & Young affiliate called Fund Administration Services. The fake reports, which showed Manhattan making lots of money, were written on the letterhead of Financial Asset Management, the small Columbus outfit for which Berger had worked as a consultant after arriving in the U.S. In reality, FAM was one of many brokers executing trades for Manhattan. "I had no clue of his unauthorized use of our name," says FAM owner James Rader. "Plus, there was no verification by anybody," says Rader, adding that in the three years Berger committed the fraud, neither the auditor nor the administrator ever contacted him to check the accuracy of the statements.

Normally, verification would have started with Ernst & Young's FAS unit, which as administrator was charged with looking out for shareholders' interests and issuing statements of true net asset values. FAS received accurate documents from Bear Stearns, clearly showing that the fund was losing heavily. As its prime broker, Bear was in charge of clearing all of the fund's trades and holding its assets, and so it was in a position to know the truth.

But according to the SEC, Berger instructed the Ernst & Young affiliate to ignore the Bear statements, saying they did not reflect the hedge fund's entire portfolio. Not only were the phony statements made to look like the Bear documents, the two reports even shared the same account number. That was another indication, according to one hedge-fund accounting expert, that something was wrong. The expert, who examined Manhattan Fund documents for Business Week, said: "It is so cut and dried [that] there was something going on here, it's mind-numbing." Ernst & Young says its affiliate's agreement with the fund was to "act in a very limited capacity. It did not provide accounting or auditing services to the fund." It was responsible for making "mechanical NAV calculations" based upon financial information provided to it by Manhattan.

Manhattan's auditors apparently did not spot the fraud, either. Each year, Deloitte & Touche asked Bear and FAM to confirm their numbers. The SEC suit alleges that FAM simply forwarded the information to Berger, at his request. Berger then confirmed the false numbers. Why Deloitte didn't go back to Bear in an effort to reconcile the two statements is hard for some analysts to fathom. "It's very unusual for an auditor not to have carefully studied the records from Bear and used that as authentic information. Any reports that didn't tie into it would raise significant red flags to auditors that something is wrong," says Howard Schilit, head of the Center for Financial Research & Analysis Inc. in Rockville, Md.

Since the SEC suit was filed, Deloitte has said that no further reliance should be placed on the audited statements of the Manhattan Fund for 1996 through 1998. Deloitte executives declined to be interviewed, but the firm's New York headquarters said in a statement: "Clearly, fraud schemes can be created that escape discovery by diligent audits, particularly through the use of carefully scripted, multiparty misrepresentations. That appears to be the situation regarding The Manhattan Fund."

Berger could certainly be convincing and charming when necessary. One South American investor, who asked not to be named, met Berger twice in 1999 and found him to be reserved but down-to-earth. "He gave the impression that he knew what he was talking about," said the investor, who was particularly taken by documentation showing returns for the Manhattan Fund dating back to '92. He was so impressed that he soon increased his investment and recommended the fund to friends. By the time he realized that the chart data began four years before the fund was even launched, he had lost his money.

There's little doubt that Berger was appealing to the greed of his investors. In principle, there's nothing wrong with that. "The attractiveness of our business is that it is not uncommon for a guy to come out of nowhere," says HedgeFund's Shogren. "And if a fund is cranking out phenomenal returns, investors flock to it."

Where the system seems to have broken down is in its failure to capture an apparently very simple fraud. And if the SEC's account is to be believed, it's just too easy for a plausible and ambitious manager to run rings around the watchdogs who are charged with stopping fraud and safeguarding shareholders' interests.

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