Book Excerpt: 'Octopus,' by Guy Lawson

In an excerpt from his new book, Octopus, Guy Lawson explains how a hedge fund fraudster cooked the books
"The 'trick,' if that's what you call it, was really an exercise in misdirection," says Marino Illustration by Kelsey Dake

By the time the Bayou Hedge Fund imploded in 2005, it had grown to $450 million—or so its investors were led to believe. Effectively, the fund was a Ponzi scheme. Bayou’s chief executive officer, Samuel Israel III, was later sentenced to 20 years in jail for orchestrating one of the most unbelievable frauds in Wall Street history, plus two years for faking his suicide. Over the course of countless interviews I conducted with Israel and his chief financial officer, Dan Marino, who is also serving 20 years, Marino revealed how the fraud worked on a day-to-day level. The pair founded Bayou as a legitimate hedge fund in 1996. In its first year, however, it suffered a net loss of $161,417. The fund had less than $1 million invested. A string of bad trades and bad luck meant that Bayou had a negative performance of 14 percent in a year that marked the onset of a historic bull market. The reputable firm of Grant Thornton had been hired to do the fund’s first-ever audit. As soon as the results were released, Marino and Israel knew, Bayou would be dead—and they had staked everything on succeeding this time.

Israel was the scion of one of the most successful commodity trading families in the country. After going bust three times as a trader, he had vowed never to go broke again, no matter what. Dan Marino confronted an even bleaker reality. The socially awkward, heavyset 37-year-old accountant had a hearing disability, thick glasses, and a pronounced lisp, and still lived at home with his mother on Staten Island. If Bayou went out of business, Marino would be fortunate to eke out his days doing taxes in a strip mall.

To give Bayou time to trade its way out of trouble, Marino had to find a way to fudge the numbers. It happened that Bayou consisted of two separate businesses—the hedge fund and a broker-dealer to execute trades on behalf of the fund. The organizational documents said that the broker-dealer “may charge commissions” for the trades it did for the fund. Marino pointed out to Grant Thornton that the word “may” meant Bayou had discretion. Why not forgo the commissions to save the hedge fund’s investors the brokerage fee?

The auditors scratched their heads. It sounded like flimflammery; at the same time, it made sense. The obvious fear with two closely related companies was that the broker-dealer would overcharge the hedge fund. Marino’s suggestion did the opposite. At least that’s how it seemed. “I said that if investors suffered a loss because of our trades, why should they pay brokerage commissions? It was unfair that we earned the commission if we’d accomplished nothing,” Marino recalls. “So why not rebate the commission and call it a day? I told the auditors I could’ve done it without telling them and they’d never have known.”

Brokerage commissions on Bayou’s trades amounted to $400,000, more than enough to compensate for the loss. Unable to grasp the hidden motive, but reassured that the hedge fund’s investors weren’t being ripped off, the auditor agreed to Marino’s proposal, adding that the change didn’t have to be noted in disclosure documents, not even in a footnote. Bayou’s results were thus magically transformed from a double-digit loss into an adjusted gross rate of return of 40 percent—a result certified as authentic by a top-tier accounting firm. Repeated over the years, Marino’s ledger legerdemain formed the basis of Bayou’s business model.

“The ‘trick,’ if that’s what you call it, was really an exercise in misdirection,” Marino says. “People allow themselves to be directed to where you want them to go. Once you understand what they want to see, you develop your strategy around that.”

The CFO’s gambit couldn’t hide Bayou’s dire trading results forever, though, especially not in a bubble economy. In 1998 the Standard & Poor’s 500-stock index rose 30 percent. Bayou went down 18 percent. Even the credulous accountants at Grant Thornton would notice such a disparity.

Marino and Israel came up with a new plan: a fake audit. That same year, Marino invented an accounting firm he called Richmond-Fairfield—the name taken from the counties where he lived and worked, respectively. He designed stationery and a teardrop logo and rented space in an office in Manhattan for the fictitious firm. Then Marino copied verbatim the format from the previous year, changing only the numbers. The results showed that Bayou had grown from $1.6 million to $4.1 million, an impressive feat for a startup. The rate of return was stated as precisely 22.047 percent.

The blatancy of the fraud should terrify any investor whose eyes have glazed over at the sight of columns of numbers as they drift down to the alluring bottom line. Trust and laziness were two human weaknesses Marino exploited ruthlessly. In his Richmond-Fairfield audit of 1998, the Statement of Financial Condition for Bayou hid the fraud in plain sight: The line recording the amount “due from brokers” was $3,105 in Bayou’s first year. The next year, it was $3,761,539. The category was supposed to reflect the amount of money Bayou had on deposit at Spear, Leeds & Kellogg, the fund’s clearinghouse. In actuality, it was a rough representation of the size of the fraud.

“I didn’t discuss this with Sam,” Marino said. “I just told him [the “due from brokers” column] was the best place to conceal it because we wouldn’t have to make up any positions in stocks that could cause an issue in the future. If an investor was smart enough to truly look at the financials, they would’ve asked for an explanation. You could say it was elementary, or you could say it was sophisticated. The bottom line is, it worked. No one looked. Ever.
Adapted from Octopus: Sam Israel, the Secret Market, and Wall Street’s Wildest Con. Copyright 2012 by Guy Lawson. Published July 10 by Crown.

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