FRAUD AND MISMANAGEMENT

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FRAUD AND MISMANAGEMENT As pension fund managers seek higher returns in the current low interest rate environment, they have turned increasingly to investing in hedge funds. But this can be a double-edged sword. They promise higher overall returns that have a low correlation with the market, but their opacity creates concerns for pension fund managers who need to fulfill their fiduciary duty to investors and who fear the headline risk connected with hedge fund fraud. The fear of hedge fund fraud has led investors to look at a hedge fund s brand as a proof of their quality, rather than their performance. The tragedy of this is that the most attractive funds from this calculation (the top 100 hedge funds that have above $10 billion AUM and have been around for over 10 years) often have the weakest returns. ComplianceGuard s revolutionary new technology can quickly detect and thus largely prevent nearly all forms of hedge fund fraud, making smaller, higher performing hedge funds safe vehicles for pension fund asset allocation. To understand how this is possible, consider the following forms of hedge fund fraud and mismanagement. FIVE TYPES OF FRAUD AND MISMANAGEMENT THAT CREATE HEADLINE RISK Headline risk is the risk of damage to a pension fund manager s reputation from having selected a hedge fund that is later accused of regulatory violations. No one wants to see their star trader indicted for, say, insider trading, with the lurid headlines that brings. According to Tracy Wills-Zapata, managing director at Campbell & Co., Pension investors live in mortal fear of headline risk and the negative impact it could have on their careers. Although it is hard to quantify reputational damage, it is crystal clear to anyone who has held fiduciary and executive positions and responsibilities that reputational damage can be even more detrimental than financial damage. Pension fund managers are held personally accountable for the compliance breach when a hedge fund they have invested in turns out to have engaged in fraud. Each of the following forms of fraud can result in financial and reputational damage to pension fund managers who invested in the fund. Each of them is also easily detected and is therefore largely preventable with ComplianceGuard. 2 FIVE FORMS OF HEDGE FUND FRAUD

1 CHANGES IN A FUND S TERMS/STRUCTURE New Stream Capital was a $750 million hedge fund based in Connecticut. 1 In 2007, during the financial crisis, New Stream decided to close a fund in Bermuda and move existing investors assets into a new fund in the Cayman Islands. Gottex Fund Management, it s largest investor, threatened to withdraw its investment. In an effort to avoid a redemption by Gottex, New Stream agreed to secretly keep its Bermuda fund open for Gottex alone and to give the Bermuda fund priority over other funds. The other investors that were moved into the Cayman fund, as well as new investors, were not told of these changed arrangements. When New Stream finally closed its funds in 2011, investors had been defrauded out of $46 million. 2 PONZI SCHEMES In his famous Ponzi scheme, Bernard Madoff targeted charities that were unlikely to make withdrawals. 2 Madoff had a long and storied career on Wall Street that made him a trusted manager. The fraud he engaged in, however, was very simple. In his guilty plea he acknowledged that he hadn t actually traded since the early 1990s and all his returns since then had been fabricated. He simply took money from new investors and paid returns to old investors from the new money coming into the fund. Madoff was aided by auditors Friehling & Horowitz, who asserted that they performed legitimate audits when they had not. Friehling & Horowitz were charged by the SEC for securities fraud in 2009 for their work with Madoff. Overall, investors lost some $65 billion. A number of philanthropies that invested with Madoff were forced to close their doors. 1 http://www.fa-mag.com/news/jailed-hedge-fund-managers-sanctioned-by-sec-24407.html http://www.justice.gov/usao-ct/pr/fairfield-county-hedge-fund-executive-sentenced-33-months-federal-prison-fraud-scheme https://www.sec.gov/litigation/complaints/2013/comp-pr2013-28.pdf 2 https://en.wikipedia.org/wiki/madoff_investment_scandal https://www.sec.gov/news/press/2009/2009-60.htm Copyright 2017 CGBlockchain 3

3 STYLE DRIFT Prestige Wealth Management held itself out to investors as a hedge fund with a low-risk growth strategy whose proprietary trading algorithms included stop-loss features to reduce risk to investors. 3 In fact, the Chief Investment Officer had complete discretion over trading and was not at all constrained by the trading algorithms. Rather than adopting the low-risk growth strategy that he advertised to investors, he adopted an extremely speculative strategy that resulted in the firm losing 80% of its assets in December 2012. 4 STEALING The Chief Compliance Officer of Trident Partners did not engage in sophisticated fraud. 4 He simply stole investor funds. According to the SEC, Quigley was involved in a scheme to solicit investors to buy stock in wellknown companies, or supposed start-ups on the verge of going public, but the securities were never actually purchased for them. Instead, after investors wired their funds to bank and brokerage accounts that Quigley set up and controlled, the money was quickly wired to a bank account in the Philippines or withdrawn in small increments from ATM machines in the vicinity of Quigley s home and office. 3 https://stockbrokerfraud.com/ny-securities-brokers-fraudulent-scheme/ 4 http://www.hedgeco.net/news/05/2015/sec-catches-a-fox-in-the-henhouse-compliance-officer-stealing-from-his-own-hedge-fund.html 4 FIVE FORMS OF HEDGE FUND FRAUD

5 CONFLICT OF INTEREST The highly respected BlackRock Advisors is the world s largest investment firm, with some $4.6 trillion under management as of December 31, 2015. 5 But even blue chip advisors like these run into compliance problems. In 2015, the firm agreed to a $12 million settlement with the SEC for failing to disclose to investors a conflict of interest between one of their investment professionals, Daniel Rice, and clients of the firm whose funds BlackRock managed. The SEC found that Rice had properly disclosed the conflict of interest to the firm but that BlackRock s Chief Compliance Officer had failed to report the matter to the board. THE RED THREAD IN ALL CASES OF FRAUD The common element to all of the above examples of fraud and mismanagement in addition to the obvious ethical malfeasance and criminal intent on the part of the fund s representative is a problem with the audit process. In each case, the audit came too late to be of help or the audit process itself was corrupted. Malefactors either cheat or delay the audit process. A solution to all of these problems of fraud, then, will have to address the audit process and particularly matters of delay or corruption. 5 http://www.hedgeco.net/news/04/2015/hedge-fund-advisor-blackrock-settles-with-sec-for-12-million.html https://www.blackrock.com/corporate/en-us/about-us Copyright 2017 CGBlockchain 5

THE BLOCKCHAIN SOLUTION: AN INSTANT, INCORRUPTIBLE AUDIT What if you could get an instant, incorruptible audit? With ComplianceGuard s blockchain technology you can. Blockchain provides pension fund managers with the assurance that Deloitte has real-time access to fully authenticated numbers from hedge funds using the application. This enables real-time, systemic compliance auditing of hedge funds. The reason ComplainceGuard is incorruptible is that in a blockchain, all transactions are recorded in a virtual block of data. That block is assigned a hash, which acts like a virtual fingerprint that represents the data. If any data is changed in that block, the hash will no longer line up with the data. When a new block of data is entered into the system, the hash of the previous block is added to the new block. In this way, each block is linked to all the previous blocks in an unalterable chain. ComplianceGuard s blockchain technology is also self-authenticating. That means that as every transaction is entered, it s also authenticated as to the correctness of the transaction s entry. 6 Therefore there is no need for an auditor to come in later to confirm that the numbers are correct. Using this verified data, which flows continuously from any active user of ComplianceGuard s blockchain, application-based intelligent algorithms kick in to analyze the transactions for required style and structure, inside trading, conflict of interest, or simple misappropriation. The analysis instantaneously flags an incident or an appearance of an incident that can then be acted upon immediately by the hedge fund executives. ComplianceGuard s blockchain technology is a potentially game-changing risk management technology. It enables investors to know that their hedge funds transactions at every moment are adhering to investment agreements and formal promises. This prevents hedge fund fraud at its bud. Because of it s capacity to eliminate fraud, ComplianceGuard is critical for the future of pension fund managers. 6 http://bitsonblocks.net/2015/09/09/a-gentle-introduction-to-blockchain-technology/ 6 FIVE FORMS OF HEDGE FUND FRAUD

ABOUT CG BLOCKCHAIN INC. CGBlockchain s ComplianceGuard is for pension funds, endowments and other institutional investors in hedge funds who wish to be proactive in their approach to risk. Our team works together to research, explore and implement new technologies and standards that increase transparency and reduce risks in hedge fund investing. For more information visit cgblockchain.com Copyright 2017 CGBlockchain. All rights reserved. Copyright 2017 CGBlockchain 7