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Identifying Hedge Fund Fraud - Lessons From Madoff

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A detailed analysis to show a simple way for Hedge Funds to prove that they are not the next "Madoff"

A detailed analysis to show a simple way for Hedge Funds to prove that they are not the next "Madoff"

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Identifying Hedge Fund Fraud - Lessons From Madoff Identifying Hedge Fund Fraud - Lessons From Madoff Presentation Transcript

  • Identifying Hedge Fund Fraud Lessons from “Madoff” Presented to Bank of New York Mellon Paul F. Dowding Daedalus Oversight of Putney Bridge Enterprises, LLC © 2009 Putney Bridge Enterprises, LLC September, 2009.
  • © 2009 Putney Bridge Enterprises, LLC Sources: September, 2009. EDHEC Business School Research Paper: "Madoff: A Riot of Red Flags" Authors : Greg N. Gregoriou Professor of Finance, SUNY Plattsburgh François-Serge Lhabitant Associate Professor of Finance at EDHEC Business School Capital Markets Risk Advisors (CMRA) - Risk Insights Financial Times Articles by Greg Farrell & Brook Masters PBS – Frontline On-line reporting
  • What is the succinct answer to the question from a Hedge Fund? © 2009 Putney Bridge Enterprises, LLC Challenge: “ How do I convince my investors that I am not the next ‘Madoff’? ” September, 2009. View slide
    • Background:
    • A Technical Review of “Madoff”
    • Fundamentals:
    • A Less Technical Review of Investment Management
    • Back to Basics:
    • Articulating the Issues for Hedge Funds and Investors
    • Perspective:
    • Investment Challenges and Services Summary
    © 2009 Putney Bridge Enterprises, LLC Agenda: September, 2009. View slide
    • Created Bernard Madoff Investment Securities (BMIS) in the 1960’s
    • Initially Pure Brokerage - Pink Sheets and OTC transactions
    • Rule 390 allowed him to trade NYSE stocks away from the floor
    • Used Cincinnati Stock Exchange to change execution practices
    • One of five broker dealers involved in the formation of NASDAQ
    • Spreads were thin and began an investment advisory firm
    • Suffered reversals and paid current investors with new money...
    © 2009 Putney Bridge Enterprises, LLC Background: Madoff’s Story: … the rest is history! September, 2009.
  • © 2009 Putney Bridge Enterprises, LLC Split Strike Conversion - “ Shoulda-Woulda-Coulda ” September, 2009. Profit / Loss Analysis Profit Loss Call Strike Price It is relatively easy to generate profitable trades… … retroactively Background: Lower Price Higher Price
      • Madoff could retroactively create profitable “transactions”
      • Madoff wasn't a Fund - he was an Investment Advisor
      • He was not registered until 2006
      • As of 2008, he only declared that he had 23 Accounts
      • Most accounts were opened with BMIS via Fund of Funds or
      • participated via Fund of Funds with no mention of Madoff
      • The Feeder Funds were audited by top accounting firms
      • His accountant was the little known "Friehling & Horowitz"
      • Madoff claimed to use BMIS for all the "trades"
      • When asked for counterparty records:
        • Madoff gave US regulators European banks and
        • European Regulators US Counterparties
      • He could Trade, Clear, Settle, Report & Account for everything
      • He didn’t need to trade to create the illusion
    © 2009 Putney Bridge Enterprises, LLC Background: How did he get away with it? September, 2009.
    • S&P100 options vs S&P500
    • Trade flows > S&P100 Options Market
    • Style Analysis showed reverse strategy
    • 13F filings showed limited holdings
    • Claimed to return to cash most months
    • Claimed Large cash positions
    • No visible affect to money markets
    • Used renamed Money Market Fund
    • No relationship with Money Market Co.
    • Money Mkt Fund closed in 2006
    • No Segregation between service providers
    • No evolution of strategy
    © 2009 Putney Bridge Enterprises, LLC Background: What, with hindsight, were the red flags? September, 2009.
    • Never charged fees
    • Used small, unknown auditor
    • Was originally unregistered
    • Registered only in 2006
    • Resisted due diligence inquiries
    • Employed only five staff
    • Claimed to manage $17Bn
    • Issued Paper-only statements
    • Sent un-time-stamped trade tickets
    • Reported Low volatility of returns
    • Declared only 5/215 down months
    • Limited trading activity in BMIS
  • This all makes sense to industry participants… © 2009 Putney Bridge Enterprises, LLC Background … but it is hard to explain! September, 2009. Especially when it wasn’t caught! Summary:
  • A less technical review of Investment Management © 2009 Putney Bridge Enterprises, LLC Fundamentals: September, 2009 slightly ^
  • Consider a simplified model of the Investment/Brokerage Process vs. The Accounting Process © 2009 Putney Bridge Enterprises, LLC Fundamentals: September, 2009.
  • Financing: Prime Brokerage Perspective Equity LMV Margin Balance SMV Short Proceeds © 2009 Putney Bridge Enterprises, LLC September, 2009.
  • Financing: Investor Funds Accounting Perspective ASSETS LIABILITIES EQUITY Margin Balance LMV SMV (borrow) Short Proceeds (collateral) © 2009 Putney Bridge Enterprises, LLC September, 2009.
  • Can we link the Investment/Brokerage Process and the The Accounting Process and distance ourselves from Ponzi schemes? © 2009 Putney Bridge Enterprises, LLC Fundamentals: September, 2009.
  • © 2009 Putney Bridge Enterprises, LLC Fundamentals: September, 2009 Fraudster
    • Investor
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    The Pyramid represents what the fund should be – not what it is! The structure will ultimately collapse Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account Investor Account
  • Any “Ponzi” scheme, including Madoff, fails because it can not manage its Assets vs Liabilities… © 2009 Putney Bridge Enterprises, LLC Fundamentals: … and its cashflow September, 2009. This is true for any investment fund or company.
    • An investment fund is a company
    • Companies are represented by financial reports
          • Balance Sheet
          • Income Statement
          • Statement of Cash Flows
    • An Industrial Company uses equity & loans to fund assets
    • The assets are used to make and sell products at a profit
    • A dividend is paid to the equity investors
    • A Hedge Fund uses equity & loans to fund assets
    • The return on the assets (investments) generates a profit
    • A return (dividend) is paid to the equity investors
    © 2009 Putney Bridge Enterprises, LLC Fundamentals: September, 2009.
  • © 2009 Putney Bridge Enterprises, LLC Fundamentals: September, 2009. Linking Investment & Accounting Investor Fund Manager Contributions Withdrawals & Dividends Cash Securities Financing Execution Positions & Transactions Valuation Administrator Custodian Broker Statement of Cash Flows Balance Sheet Assets Liabilities Equity Retained Earnings Income Statement Partnership Accounting Reconciliation Control Reconciliation Control Reconciliation Control Reconciliation Control Reconciliation Control Reconciliation Control
  • © 2009 Putney Bridge Enterprises, LLC Back to Basics: September, 2009. Articulating the issues for Hedge Funds and Investors
    • Emphasize:
    • A "fund" is a company
      • The investor should be
      • able to review the "books"
      • or review a reputable audit
      • of the company
    • Other Points:
    • Demonstrate segregation of functions
    • with controls
    • Show where and how clients
    • can obtain independent audits;
    • Audits of Fund of Funds, Funds,
    • Brokers, Custodians, Administrators
    • Remember, performance is no
    • guarantee of integrity
    • Madoff Differences:
    • He was not a fund
    • He was separated from Investors
    • He controlled every process
    • He used only paper statements
    • He obstructed reviews
    • He managed Brokerage Accounts
    • He provided no Financial Reports
    • He was: “To good to be true”
  • Two summaries: Investment Management Challenges Investment Services Spectrum © 2009 Putney Bridge Enterprises, LLC Perspective: September, 2009.
  • Challenges Critical process issues for Investment Funds: © 2008 Putney Bridge Enterprises, LLC
    • Multiple
    • Client Types
    • Service Providers
    • Solutions
    • Products
    • Practices
    • Fund Types
    • Fund Locations
    • Fund Jurisdictions
    Consistent, accurate and flexible processes, technology & data September, 2009.
  • Investor Services Spectrum (1) © 2008 Putney Bridge Enterprises, LLC (1) September, 2009.
  • Biography: Paul Dowding Paul has over 20 years experience in industry and the financial services. Paul graduated from Chase Manhattan Bank’s Operations Management Program, having previously worked as a manufacturing engineer for Ford Motor Co.   Paul has worked in Global Custody, Securities Lending, Private Wealth Management, Prime Brokerage, Equity Finance and supported other trading and investment management businesses. His roles have spanned Operations, Client Service, Project and Product Management working for Chase Manhattan Bank, Morgan Stanley, Goldman Sachs and Bank of America. He has lived and worked in London, New York, Singapore and Sydney. Paul has successfully run his own “business-process” consulting and creative licensing company Putney Bridge Enterprises, LLC (PBE) since 2001. Daedalus Oversight is a Division of PBE. Paul Dowding is also affiliated with the broker, Meridian Equity Partners as Managing Director, Business Development and Prime Services.   Paul holds a BSc. (Hons) Aeronautics & Astronautics, from the University of Southampton, UK and is an Associate Member of the Institute of Mechanical Engineers, UK. Paul holds his Series 7, 63 & 24. September, 2009.
  • Contact Details: Paul Dowding 203 770 6043 [email_address] Daedalus Oversight is a Division of Putney Bridge Enterprises, LLC September, 2009.