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Hedge funds on the verge of making critical decisions should have a corporate investigator on speed dial to get them the information they need to increase the likelihood that they will make a good investment decision.

A famous proverb among Wall Street investors warns that once information is available to the public, investors have already missed the boat. Over the years, many hedge funds have heeded this wise proverb and created internal research departments designed with the specific intent of digging up the best and most relevant information to use for their deal…before the information becomes public.

But, what about those hedge funds who are less progressive? Or don’t have the bandwidth to maintain an internal research group? Instead, what if they utilized the services of a corporate investigator to legally obtain critical information before it hits the public domain?

Whether a corporate investigator can dig up publicly available information from open-source records or rely upon non-public information, through legal means [emphasis added], the information we get you can make or break your deal.

Of course, stay away from the investigator who takes your request to the extreme and gets you information through illegal channels. A good investigator knows the boundaries and sticks to them…if an investigator promises bank account information, wire tapping or insider information, run.

Here’s what a good corporate investigator might dig up…

In Civil Litigation:

Corporations are often hit with lawsuits from partners, suppliers or investors that are typically not reported in the press and in public SEC filings for months. A professional corporate investigator can help you identify relevant litigation and gather pertinent facts relating to the lawsuit before the information goes public.  Going a step further, review of litigation documents and interviews with relevant parties to determine additional facts and disclosures can also identify additional information to understand significance of the potential damages.

About New Executive Leadership:

New executive leadership in a publicly-held company may be unfamiliar to the investment community or a new executive may have been put into a role that does not fit their skill sets. This new executive may be critical to the future success or direction of the company.  A comprehensive background investigation on the new executive may identify past issues pertinent to an investor. For example, interviews with former colleagues or business associates may identify issues about their leadership capabilities, financial acumen or questionable business practices.

Verifying Company Claims:

Any publically-held company can make bold claims about sales of a newly released product, explosive growth or value of certain assets (see Spongetech).  A review of publicly filed documents, interviews with former employees or site visits to worldwide offices or assets (e.g. mines, property, factories, etc.) can provide a glimpse into whether the company is being forthcoming in public claims.

Getting to the Bottom of Explosive Allegations:

Explosive allegations disclosed in news publications, blogs or on financial message boards can provide a glimpse into potential or standing issues of concern, but often these claims must be taken with a grain of salt.  A corporate investigator can initiate a hunt to determine the source of the information and verify these claims can provide additional perspective into the issues or potentially confirm that the issue is not particularly relevant.

What is the “Health” of the Company:

In today’s Internet age, companies have a lot more ways to get information out and even manipulate what is said about them in the press and the investing community, but does this really give you a glimpse into what’s really going on behind the scenes?  An investigator can help get to the bottom of what is really the health of a company. For example, interviews with former employees can give you a better sense into employee morale, financial state of the company, issues with the completion, effectiveness of leadership and overall strategy.

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Conducting an investigation into an alleged Ponzi Scheme has become all too common of an occurrence these days, but you are not the only one.

“Hedge Fund Manager Charged with Running Multi-Million Dollar Ponzi Scheme!”

Does this headline sound familiar…it has become a recurring headline as of late. In 2009 alone, according to research by the Associated Press 150 ponzi schemes collapsed; many of these are names that you have all heard of, but many others, most people have not. The details and aftermath of these frauds all sound the same from its victims…“If I only would have known!”

We live in an age where we have become more intrigued on getting to the bottom of celebrity scandals, versus learning more about who or what we are entrusting with our money and businesses. Like any successful investment scheme, it takes planning, financing and most importantly, word of mouth advertisement from its earliest investors. Most individuals are susceptible to being pulled into these investment schemes by those people they most trust (family and friends), many of whom have unfortunately not done their homework themselves.

How About those Guaranteed Returns?

The idea of conducting an investigation relating to a potential investment to find out the facts behind the “guaranteed returns” used to be considered an unnecessary waste of time and money. Today’s investors are thankfully becoming more aware of their surroundings and are beginning to realize that all investments have risks; knowing the facts of who or what you are planning to align yourself with beforehand can help you avoid being part of the headline.

Do You Need to Hire a Private Investigator to Perform Additional Due Diligence?

Unfortunately even today, some individuals still believe that they can avoid hiring a professional investigator and get everything they need to know about an individual or investment model by reading a subject’s website, “googling” the person, reading blogs or even talking to other investors. Now this is a step in the right direction and every situation may not call on hiring an expert. The SEC outlines several ways to avoid being part of an investment fraud, “pump and dump” scheme or pyramid scheme, but a professional investigator is trained to navigate the Internet and public records, get behind the information readily available to everyone else and to obtain relevant facts to help investors make “informed” decisions.

Conclusion

Word of mouth advertising has succeeded with keeping the investment scheme pool filled. Hopefully now, someone will seek out the facts and consider the consequences before jumping in.

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CNBC’s American Greed (which is a great show, in case you haven’t seen it) recently broadcast a piece on Samuel Israel III, the hedge fund manager who ran the Bayou Fund until his hedge fund fraud caught up with him in 2005. Israel was charged with losing more than $400 million from investors in the Bayou Fund and was sentenced to 20 years of prison in 2008. He’s most infamously known for faking his suicide and writing “love is blindness” on the hood of his vehicle before turning himself in several weeks later in Western Massachusetts. He is currently serving a 22 year federal prison sentence at the Butner Federal Correctional Complex in Butner, North Carolina.

Although this is not a new story, Bayou fund is a classic example of some simple, yet important lessons in recognizing and identifying a hedge fund fraud. History continuously repeats itself and this is an important reminder that there are some simple investment manger due diligence checks that anyone can do to potentially avoid a hedge fund fraud, ponzi scheme or investment fraud.

Confirm Work History

Israel reported in marketing materials provided to investors that he was head trader of Omega Advisors, a $4+ billion hedge fund run by former Goldman Sachs partner Leon Cooperman, for nearly four years. The New York Times later reported that Israel only worked at the fund for 18 months and he “executed orders on behalf of senior partners at the firm” and was not the “head trader” that he claimed to be. Promotional materials from Bayou also reported that Israel began his career at F.J. Graber & Company, but the New York Times later found that he was a summer intern and never had a leadership role at the firm.

Some employers have policies not to divulge information without a signed authorization, but in most cases, you can simply contact the former employer and confirm dates of employment and certain “directory” information.  In addition to contacting former employers, at minimum, you should confirm dates of employment and his last title, but in certain situations it may be appropriate to contact former colleagues to gauge the character, responsibilities and pedigree of the individual.

Verify Service Providers

In a desperate attempt to hide mounting loses, Bayou “fired” their independent auditor and created their own accounting firm, founded by Bayou’s own chief financial officer, Dan Marino. Marino, through the new accounting firm, Richmond-Fairfield Associates, continued to perpetrate the fraud by sending investors fraudulent statements. Bayou also claimed that Grant Thornton, a well respected accounting firm, was the firms auditor in 2002, but Grant Thornton hadn’t worked for them since the 1990’s.

A simple telephone call to Grant Thornton or later to Richmond-Fairfield Associates, may have raised a red flag, but reviewing information on Richmond-Fairfield Associates would have shown that it was a newly formed firm that had ties to Bayou’s own chief financial officer. While some investors have made it a point to independently confirm the relationship with the auditor by contacting the auditor, in instances where it is a relatively unknown or small accounting firm you should also confirm the corporate status, verify accounting licenses through state regulators and/or other professional licenses as well as identifying any disciplinary actions against the individual/firm. In addition, it’s a good idea to search for potentially derogatory news or recent lawsuits. Investment frauds also attempt to legitimize themselves by aligning themselves with well known law firms, prime brokers, bankers and outside counsel.

Red Flags in Civil and Criminal History

Israel was arrested in 1999 for driving under the influence of alcohol and criminal possession of a controlled substance. A review of New York State criminal history records through the Office of Court Administration and/or searches of driving records would have come up with both of these cases. It was later uncovered that Israel relied heavily on pain pills.

Additionally, Bayou was the subject of a federal lawsuit in 2003 filed by a former employee and his son alleging that the former employee discovered ”possible violations of the S.E.C. regulations governing the operating of hedge funds.” Although the case went to arbitration and the outcome would have not been publicly available, allegations of S.E.C. violations is a serious matter.

Some of the most sophisticated investors in the world have been caught in investment frauds; Bayou had over $400 million from fund of funds, public pension funds and wealthy investors. Goldman Sachs, who is arguably the most reputable investment bank out there, served as Bayou’s prime broker for years. JP Morgan also marketed the fund to investors.  With high profile clients like these, Israel became better known and Bayou’s assets grew exponentially in the early 2000’s when consulting firms and funds started recommending Bayou to their clients. The perceived value of another investor, prime broker or even your most trusted family member is not a reason to make an investment.

Pedigree

Hedge funds are sophisticated investment vehicles that are run by sophisticated people. While Israel conveyed that  pedigree, Dan Marino worked at a second tier accounting firm and according to the New York Times, lived with his mother in Staten Island during the 1980’s…now of course there is nothing wrong with living with your mother, but would you want that person overseeing $400 million?

These are some simple tried and true lessons; there are plenty more examples of red flags, but Bayou is a classic example of some simple due diligence that any investor can do to protect themselves from a hedge fund fraud.

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