Volatile markets may tempt hedge-fund fraud

By Svea Herbst-Bayliss - Analysis

BOSTON (Reuters) - While fraud can happen any time, the loosely regulated $1.7 trillion hedge-fund industry looks especially vulnerable following record losses.

Losses of roughly 15 percent this year and a growing sense of panic as hedge-fund clients exit worldwide are creating ripe conditions for a small number of the estimated 9,000 hedge-fund managers to break the law, according to forensic accountants, private investigators and former prosecutors.

"In volatile markets there is a greater likelihood that a manager might want to try and cover up his tracks by issuing bogus reports or making false valuations of securities if the market has turned against him," said Walter Pagano, a former Internal Revenue Service agent who now heads the Litigation Consulting & Forensic Accounting Services Group at Eisner LLP.

Whether managers fabricate returns to salvage ailing funds or spend clients' cash on fast cars or famous paintings for themselves, industry experts said fraud is often accompanied by warning signs.

"There usually isn't one big red flag," said Peter Turecek, a managing director at Kroll Inc, a risk consultancy owned by Marsh & McLennan Cos Inc (MMC.N), the world's largest insurance broker. "But often there is a pattern of little red flags."

These include returns that look too good to be true, accountants said. Investors should ask secretive hedge-fund managers to show more than top-line numbers and to provide details on how they make money.

Investors should also keep an eye out for sudden and unexplained expenses or news of big purchases of yachts or planes, the experts said, noting that the manager of a $2 million fund should not be flying around in a private jet.

If staff suddenly leave a hedge fund, investors should pay attention. "If anything improper is going on, the person most likely to know is someone who just left," said Randy Shain, a private investigator who works with hedge funds at First Advantage Investigative Services.

Unlike mutual funds, hedge funds are allowed to use trading techniques like selling stocks short and using borrowed money and regulators do not require them to make their performance or other details public.

'DESPERATE PEOPLE'

All communication with hedge funds is especially important during turbulent markets. If investment letters arrive late or not at all, it is time to probe further, the experts said.

Several experts said they have seen situations where managers sold off the office furniture and computers and left behind only a receptionist to answer the phones.

"We are experiencing some of the most difficult times ever, and difficult times create desperate people who may do desperate things," said Richard DelBello, senior partner at hedge-fund service provider Conifer Securities.

Some of the hedge-fund industry's most egregious fraud cases made headlines just a few months ago.

Samuel Israel, whose collapsed hedge fund Bayou Group stole $450 million from clients with the help of a phony accounting firm, staged his own suicide in June in a failed bid to avoid jail after he was sentenced in April to 20 years in prison.