Fourteen Due Diligence Lessons to Be Derived from the SEC’s Recent Action against a Serial Practitioner of Hedge Fund Fraud

On July 13, 2011, the SEC issued an Order making findings and imposing remedial sanctions against an individual hedge fund manager.  The Order describes a career involving modest and infrequent investment successes, and predominantly characterized by repeated, serial and egregious frauds.  The diversity and audacity of the frauds make for lurid reading, but the relevance of the Order for the Hedge Fund Law Report and our subscribers resides in the due diligence lessons to be derived from the factual findings.  This article details the factual findings in the Order, then extracts 14 distinct due diligence lessons from those facts.  Many of our institutional investor subscribers will read the factual findings and say, “This could never happen to me.”  And they may be right.  But we never cease to be amazed by the level of sophistication of investors caught up in even the most crude and simple frauds.  Perhaps this is because our industry is based on trust, and despite the salience of fraud, fraud remains (fortunately) the exception to the wider rule of ethical conduct.  Perhaps it is because frauds that look simple in retrospect were difficult to discover in the moment.  Regardless of the reason, hedge fund investors of all stripes and sizes can benefit from ongoing refinement of their due diligence practices.  And we continue to believe that the best way to refine due diligence practices is to look at what went wrong in actual cases and to revise your list of questions and techniques accordingly.  Here is a useful test for hedge fund investors: read the facts of this matter, as described in this article, then pause to ask yourself: Would our current due diligence practices have discovered all of these facts and caused us to pass on this investment or to redeem?  If the answer is yes, you can stop reading.  But if the answer is no – that is, if your due diligence practices may have missed any aspect of this fraud – we strongly encourage you to read and incorporate our fourteen lessons.  We would also note that we have undertaken similar exercises with respect to prior SEC actions.  That is, we have reviewed allegations of hedge fund manager fraud and detailed the due diligence steps that may have uncovered such frauds.  All of our thinking on this topic is available in the “Due Diligence” section of our Archive.

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