Monday, October 29, 2012

Peering Beneath the Surface: Uncovering A Fraud


Peering Beneath the Surface: Uncovering A Fraud

At one point in my career, my firm was the sponsor of a high yield mutual fund that garnered a highly desirable five-star rating from Morningstar.  Brokers were eager to recommend the fund to their clients, and hundreds of millions of dollars flowed into it.  The fund was a “serene duck.”  Its investment performance was outstanding, and it barely bobbed as the credit market rose and fell.  At first, I thought this was one of those rare circumstances where a money manager had legitimately constructed a high return, low volatility product.  The returns were driven by a series of bets on telecommunications bonds, which were benefitting from the emergence of the Internet.  The serenity appeared to be the result of some fairly mundane credits that were thinly traded or privately placed.  The prices of those bonds didn’t move very much, creating the calm appearance of the portfolio.  My colleagues told me that the portfolio manager was really smart, but they couldn’t describe her investment method in any detail.
High Yield (1999)


As this was a rather unique portfolio, I thought it made sense to get to know the manager better and obtain some insight her methods.  I wanted to understand how she evaluated and monitored her telecomm holdings, and how she conducted due diligence and sourced her private placements.  She’d been invited to our headquarters for a celebration as the fund had reached $500 million in assets.  By the time the celebration occurred a few weeks later, the fund had more than $700 million in assets.   I asked if she’d be willing to meet me for breakfast or lunch.  She didn’t have time.  I asked if she could meet in my office.  She didn’t have time.  A few weeks later, I traveled out to her office to meet with a bunch of her associates who managed a lot of other fixed income products.  Once again, I asked her for a meeting.  Yup, you guessed it: too busy.

Her evasiveness was starting to worry me.  I decided to analyze her portfolio myself.  For three or four evenings, I sat at a Bloomberg terminal and studied each of the portfolios holdings.  The risk and return characteristics of the big telecom holdings and other large positions were readily apparent.  The illiquid securities and private placements only contained a modest amount of information as I expected, and our portfolio accounting unit had suitable and multiple sources for pricing these securities.  However, there were several bonds that did not show up when I entered the bond’s name, security number and CUSIP (a nine digit alphanumeric code assigned to every security).  I wasn’t too concerned, as some small private placements don’t have any information in financial databases such as Bloomberg.

I found a bit of information on the Internet about companies that had the same names as the securities in the portfolio.   I called two of the companies.  They told me that they did not have any debt outstanding.  There was one security for which I couldn’t find any information, so I contacted the Secretary of State’s office, where I thought the company might be incorporated (the company had the state’s name in its name).  Once again, there was no record. 

My concerns were rising.  I asked our portfolio accounting people for the name of the broker that was helping to price the securities.  I figured they might be able to provide me with some research and insight.  When I called the broker, they said someone would get right back to me.  About ten minutes, later the portfolio manager called my boss and said she didn’t want me trying to contact the broker (her language was much more colorful).  There wasn’t much more I could do for the moment as I was headed to Europe for the remainder of the week.  As I was traversing the Pittsburgh airport, I was paged (I was a late adopter of the cell phone).  I found a pay phone, and called the office.  The portfolio manager had come into work, cleaned out her desk, and walked out. 

Our compliance professionals secured her files and discovered that she had colluded with the broker to create a series of fictitious companies.  It turned out she’d originally made legitimate investments in some very risky businesses.  When those businesses began to fail, she didn’t want to recognize the losses, so she conspired with the broker to create “new companies” that would buy the failing securities at par (full price).  For accounting purposes, everything looked fine.  However, the paperwork in her desk told a different story.  It turned out that the serene duck had been paddling furiously beneath the surface and trying very hard to keep anyone from looking beneath the water.

My firm made the investors whole by injecting cash into the mutual fund to cover the losses. The SEC barred the portfolio manager from managing money.  As far as I know, the portfolio manager never received any personal benefit from creating the fraud.  Apparently she wanted to protect her investment track record and five-star reputation.  I don’t think the fund ever again achieved the same level of success or recognition.  It was just another high yield duck.  

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