Fraud against hedge funds:
implications to operational risk
and due diligence
Majed R. Muhtaseb
Department of Finance, Real Estate and Law and Member on Board of Directors
CPP Philanthropic Foundation, California State Polytechnic University,
Pomona, California, USA
Purpose –The loss of an amount in excess of $100m cash deposit can be disruptive to the operations,
deﬁnitely the liquidity of the hedge fund. Should a hedge fund liquidity position deteriorate, its compromised
solvency could impact its vendors, most notably creditors and prime brokers. Large successful hedge funds do
make basic mistakes. Lawyer Marc Dreier committed the criminal act of selling fraudulent promissory notes to
hedge funds and others. Mr Drier’s success in selling fraudulent promissory notes was facilitated by his
accomplices who posed as fake representatives of legitimate institutions. Drier and team presented bogus
“audited ﬁnancial statements”and forged developer’s signatures, and even went as far as usingthe unsuspecting
institutions’premises for meetings to meet potential notes buyers to further falsely legitimize the scheme. He had
the notes buyers send their payments to his law ﬁrm account, to secure the money. His actions cost his victims,
who include 13 hedge fund managers, other investors and entities, $400m in addition to his law ﬁrm’semployees
who also suffered when his law ﬁrm was dissolved. For his actions, he was sentenced 20years in federal prison
for investment fraud. This study aims to direct hedge fund investors and other stakeholders to thoroughly vet the
compliance function, especially controls on cash disbursements, even if the hedge fund is sizable (in excess of
$1bn). Investors and even other stakeholders also should place a greater focus on what is usually overlooked
issue; most notably the credit quality and authenticity of short-term investments bought by their hedge funds.
Design/methodology/approach –A thorough investigationof a fraud committed by a lawyer against a
number of hedge funds. Several importantlessons are identiﬁed to professionals who conduct due diligence
on hedge funds.
Findings –The details of the case are very remarkable. This case directs investors’attention to place
greater efforts on certainaspects of operational risk and due diligence on not onlyhedge funds but also other
investment managers. Normally investors conduct operational due diligence on the fund and its operations.
Investors also vet fund external parties such as prime brokers, custodians, accountants and fund
administrators. Yet, investors normally do not suspect the quality of short-term fund investments. In this
case, the short-termsinvestments were the source of unforeseen yet substantialrisk.
Research limitations/implications –Stakeholders in hedge funds need to carefully investigate the
issuer of and the quality of short-term investments that a hedge fund invests in. Future research can
investigatethe association of hedge fund manager failurewith a liquidity position of the fund.
Practical implications –Investors must thoroughly the entirety of the fund including short-term securities.
Originality/value –Normally, it is the hedge fundsthat commit the fraud against investors. In this case, it
is the multi-billionhedge funds run by sophisticated fund managers, who are the victims.
Keywords Fraud, Hedge fund, Operational risk, Due diligence
Paper type Research paper
Hedge fund investors conduct signiﬁcant due diligence on the hedge funds they invest in.
Usually, they focus their effortson the hedge fund and its operations. The due diligence may
Journalof Financial Crime
Vol.27 No. 1, 2020
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