The Hedge-Fund Confidence Game

With so little oversight, the business is attracting crooks

To the investors who entrusted him with millions over 18 months, Donald C. O'Neill of the Orca Funds was a hotshot money man promising to earn big returns from a stock market that was in free fall. He even pledged to usher in "a new era of transparency" in the secretive hedge-fund world.

Some transparency. The few statements that he did send to his investors chronicled nothing but phony trades made with a nonexistent brokerage firm. Even his traders were duped -- the computer trading system on which they made their foreign-exchange deals was bogus. "They went into the ether," says Susan B. Bovee of the Commodity Futures Trading Commission's Enforcement Div. Last September, the CFTC charged O'Neill with a "wastrel lifestyle" and fraudulently raising at least $13 million from 29 investors. In court documents, the agency said the money paid for call girls, a $3 million estate in Lighthouse Point, Fla., and $800,000 in gambling debts. The CFTC is suing O'Neill on behalf of investors; he denied the charges last October, but his present whereabouts are unknown.

Like latter-day Willie Suttons, impostors such as O'Neill are heading where the money is. Already, the 6,000 hedge funds that make up the lightly regulated industry have nearly $600 billion under management; in a decade, that is expected to triple, to $1.7 trillion. Says Ron S. Geffner, partner of Sadis & Goldberg LLC and a former Securities & Exchange Commission enforcement lawyer: "People of questionable character are drawn to where there's money to be made hand over fist."

Even a few longtime managers with once-pristine records and a long line of celebrity clients are coming to grief. Last year, investors lost a combined $4.5 billion when New York-based Lipper & Co. and Summit (N.J.)'s Beacon Hill Asset Management went belly-up after allegedly mispricing securities in their portfolios. The SEC is investigating both firms.

Most hedge funds are honest operations. Although statistics are hard to come by, the worst cases of abuse seem to come from a fringe element that is sullying an industry that has enjoyed four relatively scandal-free decades. Lately, however, there has been a sharp uptick in actions by regulators against hedge funds. The SEC has brought 26 enforcement actions since 1998 -- almost half of them since mid-2002, after Paul F. Roye, director of the SEC's Investment Management Div., had earlier warned that the hedge-fund craze was luring "Ponzi-scheme operators and swindlers."

The trend prompted the SEC to take a hard look at hedge-fund practices. It held a public roundtable on the issue on May 14-15 in Washington. SEC Chairman William H. Donaldson told a packed meeting that the agency's probe of 650 funds managing $162 billion had highlighted worries about "potential conflicts of interest, questionable marketing tactics, valuation concerns, and the market impact of hedge-fund strategies." The SEC is mulling steps ranging from forcing the funds to disclose more about holdings and trading practices to stripping managers of their ability to operate in secrecy.

By law, hedge funds can be sold only to sophisticated investors who are reckoned to be savvy enough to tell a scam from a legitimate investment. At a minimum, buyers are supposed to have $1 million in assets or have earned more than $200,000 for two successive years. Even so, it can take months for experienced hands to sniff out problems. Most funds have so-called lockups, strict limits preventing investors from cashing out in a hurry. Typically, it takes another six months to get out. "By then, nothing's left," says Jon Lukomnik, a senior consultant at Sinclair Capital, an adviser to institutional investors.

Just ask Morgan Stanley (MWD ). Earlier this year, after failing to obtain statements it requested over months, it wrote off a $15.6 million investment in the troubled Lancer Partners of New York's Park Avenue. Morgan Stanley and other investors are suing manager Michael Lauer, who once managed at least $1 billion. Lauer's attorneys declined to comment. Lancer filed for Chapter 11 bankruptcy protection in Connecticut on Apr. 16 to "avoid a fire sale of assets following adverse publicity of the fund," says the fund's bankruptcy attorney, James Berman of Zeisler & Zeisler in Bridgeport, Conn.

Whether or not the SEC changes the rules, would-be fraudsters are likely to ignore them just as they do today. Investigators regularly unearth managers with rap sheets almost as long as their lists of blindsided investors. Says Thomas Fedorek, senior investigator at Citigate Global Intelligence & Security, a New York corporate private eye: "They have the backgrounds and felony convictions that would make it impossible to work elsewhere in financial services."

The short, butterfly lives of many legitimate hedge funds provides plenty of cover for the con artists. About one in five hedge funds closes each year, often after losing money through poor investment decisions. "Funds die off silently," says Glen Beigel, principal at Cogent Alternative Strategies Inc., which raises capital for hedge funds.

Still, in its January review of 140 of the largest hedge-fund blowups over the last 20 years, Capco, a global financial-services consulting firm, found that problems aren't limited to bad investments: 15% of the failures it studied stemmed from "good old-fashioned fraud," says Chris Kundro, the co-head of Capco who oversaw the study.

Because managers are regally rewarded for performance -- a 20% cut of profits is standard -- the temptation to exaggerate investment returns is enormous. Capco found that 21% of the blow-ups had put false or misleading valuations on their portfolios. That's what investors suing in Manhattan federal court and the SEC claim Beacon Hill did after making the wrong call on the direction of interest rates. The firm allegedly stood to collect a $26.4 million bonus if it hit its performance target, or forfeit $7.1 million if it missed.

What's more, as Beacon Hill was headed toward the cliff, its assets were shifted to rival hedge fund Ellington Management Group LLC. Problem is, Ellington investors had suffered similar losses earlier when managers bought mortgage debt and hedged it with an offsetting short-sale of U.S. Treasuries just before interest rates fell -- cutting the value of both positions.

Some rogues hide behind elaborate facades. In classic pyramid style, they pay off existing investors with money raised from new ones. Others doctor client statements to make it look as though they are making money. Michael T. Higgins of San Anselmo, Calif., pleaded guilty in 2001 in the U.S. District Court for the Northern District of California to defrauding clients of $7.6 million in the late 1990s by lying about the performance of his Ballybunion Capital Partners fund. Higgins, who made bad market calls and lost the money, reported assets as much as 10 times greater than the $750,000 he actually had and told investors he was earning profits when he had lost all but $11,000. The SEC has barred him from associating with any investment adviser.

Often, investors are lured into hedge funds with big talk. Todd Eberhard of Manhattan's Eberhard Investment Associates Inc. had a swanky midtown Manhattan address and a penchant for name dropping. Ubiquitous TV appearances on CNNfn and other financial news broadcasts added to his mystique. "It gave him all kinds of credibility," says one burned investor in Eberhard's Stone House Capital Partners hedge fund. "I trusted him." In a lawsuit filed in U.S. District Court for the Southern District of New York in February, the SEC charged Eberhard with issuing phony customer statements and looting some 2,278 accounts worth $77 million. A document citing five counts of criminal activity by Eberhard was filed in New York on Feb. 4 by the Assistant U.S. Attorney, the day before Eberhard was arrested at his office. He entered a not-guilty plea on May 6.

Dishonest managers commonly embellish their résumés by hyping their investment experience or academic credentials. Clemson University doesn't offer the business degree that Orca Funds' O'Neill claimed to have received, and the school says O'Neill was never a student there. Some just invent themselves from scratch: David M. Mobley of the Maricopa Investment Fund advertised in brochures that he was a child prodigy who performed at New York's Carnegie Hall and had followed the markets since he was 13. In reality, he was a blue-collar worker from Toledo who recast himself as a jet-setter from tony Naples, on Florida's Gulf Coast. An FBI agent tipped off the CFTC that Mobley's claimed $450 million hedge fund, which was actually about $124 million, was making suspicious claims about returns. Mobley spent the money on, among other things, a home in Vail, Colo., a Jaguar and a Porsche, and a $40,000 diamond ring. He pleaded guilty to money laundering and fraud in U.S. District Court in Fort Myers, Fla., and in July, 2001, he was ordered to pay $77.6 million in restitution to some 360 investors and given a 17 1/2-year prison sentence.

Often, there's good reason for a hedge-fund manager to hide his past. How would you like to know that your big-deal manager filed for personal bankruptcy? Paul J. House of House Asset Management LLC in Mt. Zion, Ill., had. According to an SEC civil complaint, that didn't stop him from telling about 60 investors, largely from rural Illinois, that he and his partner, Brandon R. Moore, had generated returns of up to 148%. In fact, their fund had lost at least $850,000 in barely two years. The SEC said in court documents that the duo, who are now permanently banned as investment advisers, defrauded investors of at least $2.9 million. "For some investors, this was a big part of their life savings," says SEC lawyer John J. Sikora Jr. The SEC hasn't yet decided on a fine. Moore did not return phone calls, and House could not be reached for comment.

Even when law enforcers catch up with fraudsters, they sometimes manage to slip away. Michael Berger admitted, then recanted last year, that he lied to 280 investors about returns in the $300 million-plus Manhattan Investment Fund he ran, according to court documents. The SEC found Berger liable for securities fraud, fined him more than $20 million, and banned him from the securities industry permanently. He skipped sentencing on a criminal case scheduled in Manhattan federal court on Mar. 1, 2002, and remains a fugitive. According to hedge-fund news service Mar/Hedge, he is hiding in Dominica -- a Caribbean island with no extradition treaty with the U.S.

No matter what technique they use, many of the rogue managers use their ill-gotten gains to fund a lavish lifestyle. For example, Peter W. Chabot, after a brief stint on Goldman, Sachs & Co.'s arbitrage desk, lied both about his age and trading experience to collect more than $1.2 million from 14 investors starting in 1999 for his Synergy Fund, according to court documents. The 26-year-old spent the money on Armani suits, personal-fitness trainers, and tickets to New York Knicks games. A chronic drug abuser, according to a criminal complaint, he was caught on the run in Mississippi, allegedly on his way to Mexico in November, 2001. He pleaded guilty in U.S. District Court in New York to two felonies: using manipulative and deceptive devices and fraud. In March, 2002, he was sentenced to 27 months in prison and ordered to pay $1.3 million in restitution and to undergo drug rehab treatment.

Investors tend to focus on the high returns that the best hedge funds produce. They've always had to weigh whether they were comfortable with the risks their managers take to earn them. Now, they need to worry about who their managers are. Although they appear to be few in number, the outright fraudsters are causing billions in losses.

By Mara Der Hovanesian, with Susann Rutledge, in New York

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