Investment Fraud and the Role of Trust

This article entitled “Investment Fraud and the Role of Trust” by Dr. Susan Mangiero was originally published on April 19, 2017 in The Fraud Examiner, a publication of the Association of Certified Fraud Examiners that is distributed to some 65,000 fraud professionals.

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Investment fraud can happen to anyone, and unfortunately, there is no shortage of investment fraud possibilities. Affinity fraud, pyramid schemes, pump-and-dump security trading, high-return or risk-free investments, and pre-IPO scams are only a few of a long-list of schemes that could separate investors from their hard-earned money. 

Investors can find themselves the victims of fraud when they don’t do enough due diligence or put too much faith in the people selling or managing a fund. Investors around the world would be wise to grasp fundamentals of the financial services industry, especially since results from a 2016 survey conducted by the National Association of Retirement Plan Participants show that only one in 10 persons express confidence in financial institutions. Financial advisers are similarly viewed with doubt. This is problematic.

Due in part to these concerns, very few people are adequately saving for retirement and those with money frequently invest in riskier assets in hopes of high returns. Following the 2008 credit crisis, people are changing the kinds of assets allocated in their pension plans and foundation portfolios. Taking more risks isn’t necessarily bad as long as investors sufficiently understand what is being offered to them and have assurances that sufficient safeguards are in place. Moreover, savers urgently need reliable help. Fragile confidence in the intentions of financial service providers creates a friction that can discourage investors from getting the input they need.

But investment fraud isn’t just a problem for individuals. When it occurs, it taints the financial services industry and the professionals who operate with high integrity and put customers first. Low trust of an entire industry can invite additional regulation. The net effect can be unfair penalties that diligent investment stewards must pay for the trespasses of fraudsters.

Increasing Investor Confidence

Although there is no such thing as a risk-free investment, investors can take action to detect red flags and hopefully avoid problems. With the Madoff Ponzi scheme, there were some who seriously questioned whether the touted strategy was legitimate, let alone viable, and did not invest. Regarding Enron, some investors looked askance at the energy company’s reliance on a complex web of special purpose vehicles. One lesson learned from the Bayou hedge fund scandal is to verify whether auditors are independent and well respected.

In its guide for seniors, the U.S. Securities and Exchange Commission urges the use of publicly available databases to check the disciplinary history of brokers and advisors, warning that investors should “never judge a person’s integrity by how he or she sounds.” The guide also says to avoid those who use fear tactics and to thoroughly review documents. The Financial Industry Regulatory Authority cautions investors not to be pressured or to believe that a “once in a lifetime” opportunity will be lost without immediate action.

To help combat investment fraud, the North American Securities Administrators Association teamed up with the Canadian Securities Administrators to create an online quiz that anyone can take to enhance awareness of what to avoid.

Although there are organizations that formally grade companies on their trustworthiness, investors should not rely on a single metric alone. Instead they should study whether a financial service provider has a good reputation in the marketplace and what the company is doing to manage its economic and operational risks.

Financial service companies likewise have responsibilities to be trustworthy and ensure that adequate protections are put in place. Some of these critical action steps include:

  • Setting up controls to prevent rogue trading
  • Appropriately compensating salespersons to minimize conflicts
  • Providing existing and potential customers with clear and understandable investment documents
  • Regularly communicating what the organization does well to lower risks for its customers
  • Calling out questionable activities of its competitors and working with industry organizations to improve risk management and fraud prevention techniques.

Disclaimer: The information provided by this article should not be construed as financial or legal advice. The reader should consult with his or her own advisors.

Interview With Susan Mangiero, PhD About Fraud Prevention

As a forensic economist, I have worked on multiple matters relating to the quality of fiduciary practices provided by investment stewards. Sometimes, fraud is involved. Unfortunately, the statistics about fraud are not good. According to the 2014 Report to the Nations, published by the Association of Certified Fraud Examiners ("ACFE"), "the typical organization loses 5% of revenues each year to fraud" or about $3.7 trillion - roughly "22 days worth of trading on the New York Stock Exchange."

Last fall, I pursued and earned the designation of Certified Fraud Examiner. I had to meet an experiential requirement and successfully complete a series of rigorous exams. Click to read the press release and learn about the designation.

A few weeks ago, to my delight, I was asked for an interview by the ACFE. The result is a just-published Question and Answer profile entitled "Susan Mangiero: Take Pride in Curiosity." During the interview, I talked about trust and the value of maintaining a good reputation. Specifically, I described a situation that involved a trader who had backtracked on several deals. After news got out, few persons understandably wanted to deal with him.

Having a good reputation in business, especially financial services, is still important. In recent years, I have been asked to quantify the economic relationship between reputation and the ability for a firm to generate revenue based on the trust factor. Feeling comfortable with an advisor, consultant, banker or asset manager is paramount for an institutional investor who is obliged to carefully select and monitor a third party service provider.

Coincidentally, the CFA Institute just released its study entitled "From Trust to Loyalty: A Global Survey of What Investors Want." In its "Key Insights" section, the point is made that performance and ethical conduct are both important, with investment managers needing to demonstrate that they have gone beyond "adherence to mandatory codes of conduct." This makes sense. Governance is seldom a "check off the box" exercise. (As an aside, I am proud to say that I am a CFA® charterholder."

With the investment community abuzz about the U.S. Department of Labor's proposed Conflict of Interest Rule and its international regulatory equivalents, transparency, ethics and performance issues will no doubt remain high priorities for investors.

Dr. Susan Mangiero Earns Certified Fraud Examiner (CFE) Credential at a Time When Global Fraud is Estimated at $3.7 Trillion Per Year

Dr. Susan Mangiero, financial expert and author, has earned the Certified Fraud Examiner (CFE) credential from the Association of Certified Fraud Examiners (ACFE), having successfully met the ACFE’s character, experience and education requirements for the CFE credential, and having demonstrated knowledge in four areas critical to the fight against fraud: Fraudulent Financial Transactions, Fraud Prevention and Deterrence, Legal Elements of Fraud and Fraud Investigation. Dr. Susan Mangiero joins the ranks of business and government professionals worldwide who have also earned the CFE certification.

According to its recent comprehensive study, the ACFE estimates that the average organization loses roughly five percent of revenues each year to fraud. This translates into an estimated worldwide loss of $3.7 trillion every twelve months. CFEs on six continents have investigated more than 1 million suspected cases of civil and criminal fraud.

Dr. Mangiero is currently a Managing Director of Fiduciary Leadership, LLC and lead contributor to Pension Risk Matters and Good Risk Governance Pays. Dr. Mangiero has served as a testifying expert and behind-the-scenes forensic economist on multiple investment and financial valuation and risk assessment matters. She is a CFA® charterholder and holds the Financial Risk Manager (FRM®) designation. In addition, Dr. Mangiero has earned the Accredited Investment Fiduciary Analyst™ professional designation from Fiduciary360. She has received formal training in investment fiduciary responsibility and is certified to conduct investment fiduciary assessments.

About the ACFE

The ACFE is the world’s largest anti-fraud organization and premier provider of anti-fraud training and education. Together with more than 75,000 members, the ACFE is reducing business fraud world-wide and inspiring public confidence in the integrity and objectivity within the profession. Identified as “the premier financial sleuthing organization” by The Wall Street Journal, the ACFE has captured national and international media attention. For more information about the ACFE visit

About Fiduciary Leadership, LLC

Fiduciary Leadership, LLC is an investment risk governance and forensic economic analysis consulting company. Clients include asset managers, transactional attorneys, litigation attorneys, regulators and institutional investors.

Foreign Corrupt Practices Act and Implications for Institutional Investors

For those who don't know, I am the lead contributor to an investment compliance blog known as Good Risk Governance Pays. I created this second blog as a way to showcase investment issues that had a wider reach than just the pension fund community. While I strive to publish different education-focused analyses on each blog, sometimes there are topics that I believe would be of interest to both sets of readers. A recent article that I co-wrote is one example. Entitled "Avoiding FCPA Liability by Tightening Internal Controls: Considerations for Institutional Investors and Corporate Counsel" (The Corporate Counselor, September 2014), Mr. H. David Kotz and Dr. Susan Mangiero explain the basics of the Foreign Corrupt Practice Act. Examples and links to reference materials are included, along with a discussion as to why this topic should be of critical importance to pension funds and other types of institutional investors. Click to download a text version of "Avoiding FCPA Liability by Tightening Internal Controls: Considerations for Institutional Investors and Corporate Counsel."

Vendor Contracts and Risk Assessment: Lessons Learned from Fraud Convictions

Dr. Susan Mangiero, CFA, certified Financial Risk Manager and Accredited Investment Fiduciary AnalystTM is pleased to address service provider due diligence and investment manager risk mitigation as part of the upcoming 2012 Governance, Risk and Control conference. Sponsored by the Institute of Internal Auditors, this event is part of a multiple day examination of ways to improve internal controls. Join us in Palm Beach from 8:30 am to 9:45 am on August 22, 2012 for a discussion of “Vendor Contracts and Risk Assessment: Lessons Learned from Fraud Convictions.”

The panel will be moderated by Mr. Frank Lazzara, Managing Director with FTI Consulting. Co-panelists include Dr. Susan Mangiero, Managing Director with FTI Consulting, Ms. Annie Dugas, CA, DIFA, CFE, Director - Investigative & Forensic Services with Raymond Chabot Grant Thornton Consulting Inc. and Paul E. Zikmund, MBA, MAcc, MBEC, CFE, CFD and Director - Global Integrity and Forensic Audit with Bunge, Ltd.

The program will include the following:

  • Discussion of best practices for selecting and monitoring service providers within an enterprise risk management framework;
  • How to vet related party transaction disclosures to prevent problems;
  • How to identify and mitigate conflicts of interest such as when a customer has an equity stake in a vendor;
  • When to use independent experts to conduct investigative due diligence on the vendor and key persons;
  • Understanding bribery and anti-money laundering issues when dealing with non-US vendors;
  • Discussion of lessons learned from prominent fraud convictions that involved service providers and what internal auditors should do as a result.

What Every Fiduciary Needs to Know About How to Mitigate Investment Fraud Risk

Economic growth may be anemic but fraud continues to find a life of its own. According to the Financial Fraud Research Center, at least 30 million people are impacted by fraud each year with an annual cost of $100 billion for retail fraud alone.  In a 2011 speech, the head of the U.S. Securities and Exchange Commission discussed how key offices and divisions are working together in all areas of its anti-fraud efforts and how the SEC is collaborating more frequently with state regulators, criminal prosecutors or local nonprofits in an effort to weave these initiatives into an increasingly fine-meshed net that is focused on fighting fraud. While the U.S. Department of Labor is not exclusively focused on fraud, enforcement teams have been busy with a closure of nearly 3,500 civil cases and 302 criminal cases, monetary results of $1.39 billion and 129 indictments.

Surprisingly, there is little information available to institutional and individual investors alike as to how to mitigate the risk of losing money to fraudsters. The goal of this webcast is to empower investors to better protect themselves with knowledge of situations to avoid whenever possible. Attendees will hear experts talk about:

  • Common causes of investment fraud;
  • Enforcement and litigation trends relating to investment misdeeds;
  • Lessons learned from financial scandals of the last decade;
  • Role of the investment fiduciary in vetting service providers;
  • Red flags to detect poor internal controls that could lead to fraud; and
  • Regulatory action to stem financial fraud and preserve the integrity of the capital markets.

Speakers for this 75-minute event include:

  • Dr. Susan Mangiero, CFA, FRM – Managing Director, FTI Consulting
  • Jonathan Morris, Esq. – Day Pitney LLP / former General Counsel of Barclays Wealth
  • Brian Ong – Senior Managing Director, FTI Consulting
  • Karen Tyler, North Dakota Securities Commissioner and former president of the North American Securities

To attend this webcast scheduled for Wednesday, June 13, at 1 pm Eastern and sponsored by FTI Consulting, please visit the investment fraud webinar page at

The Oops Factor and a Crackdown on Retirement Plan Advisors

In recent discussions with asset managers, pension trustees and consultants, investment fraud continues to attract attention. It is no surprise that people want to know more about what constitutes bad practice versus crossing the line, especially in the aftermath of a devastating few years of economic losses. New disclosure regulations are another catalyst for learning more about how to avoid trouble. Email your request if you want more information about what can be done to detect fraud and/or would like to receive research and thought leadership on the topic of investment fraud.

Impending changes to fiduciary standards and allegations of fiduciary breach likewise continue to create a stir.

In "The EBSA Cracks Down on Retirement Plan Advisors," AdvisorOne's Melanie Waddell (March 26, 2012) describes a material increase in enforcement actions brought by the U.S. Department of Labor ("DOL"), Employee Benefits Security Administration ("EBSA"). Besides effecting nearly 3,500 civil cases in 2011, EBSA closed 302 criminal cases with "129 individuals being indicted," "75 cases being closed with guilty pleas or convictions" and an excess of $1.3 billion in monetary damages collected. Quoting Andy Larson with the Retirement Learning Center, the article mentions fiduciary negligence as a key concern of regulation and a driving force behind a proposed expansion of ERISA fiduciary duties to numerous professionals who work with retirement plans in an advisory capacity.

ERISA Attorney David Pickle points out that fraud and embezzlement of 401(k) plan money have been investigated for years by the DOL and U.S. Department of Justice ("DOJ") but recent investigations are being done now as part of the formal Contributory Plans Criminal Project ("CPCP"). He observes that "the DOL is conducting an increasing number of investigations of financial service providers, including registered advisers, banks and trust companies (both as trustees or custodians but also as asset managers), and consultants. For other insights about ERISA pain points, read "An Excerpt From: K&L Global Government Solutions (R) 2012: Annual Outlook."

According to the ERISA enforcement manual, civil violations include:

  • Failure to operate a plan prudently and for the exclusive benefit of participants
  • Use of plan assets to benefit the plan administrator, sponsor and other related parties
  • Failure to properly value plan assets at the current fair market value
  • Failure to adhere to the terms of a plan (assuming that those terms are compatible with ERISA)
  • Failure to properly select and monitor service providers
  • Unlawfully taking action against a plan participant who seeks to exercise his or her rights.

Criminal violations include:

  • Embezzlement of monies
  • Accepting kickbacks
  • Making false statements.

The "oops - I didn't know" strategy is unlikely to serve those who work with or for pension plans. The spotlight continues to focus on ways to improve the management of $17+ trillion U.S. retirement system and rightly so. There is so much at stake for millions of people.

George Washington said that "In executing the duties of my present important station, I can promise nothing but purity of intentions, and, in carrying these into effect, fidelity and diligence.

ERISA and public pension trustees are likewise tasked to be faithful and diligent, among other things. For those who choose a different path, the outcome can be dire indeed. Jail time and stiff penalties as well as legal costs are a few of the potential costs associated with a fraud conviction, not to mention shame and the loss of income.

ERISA Pension Plans: Due Diligence for Hedge Funds and Private Equity Funds


Join me on May 1, 2012 for a timely and interesting program about alternative investment fund due diligence and other considerations for ERISA plan sponsors, their counsel and consultants. Click here for more information.

This CLE webinar will provide ERISA and asset management counsel with a review of effective due diligence practices by institutional investors. Best practices will be offered to mitigate government scrutiny and suits by plan participants.


With the DOL's and SEC's new disclosure rules and heightened concerns about compliance and valuation, corporate pension plans that invest in alternatives must focus on properly vetting asset managers more than ever before or risk being sued for poor governance and excessive risk-taking.

The urgencies are real. The use of private funds by asset managers is crucial for 401(k) and defined benefit plan decision makers. Understanding the obligations of private funds is essential to any retirement funds with limited partnership interests.

In addition, suits and enforcement actions against asset managers make it incumbent on counsel to hedge fund and private equity fund managers to fully grasp and advise on full compliance with the duties of ERISA fiduciaries to plan participants.

Listen as our ERISA-experienced panel provides a guide to the legal and investment landmines that can destroy portfolio values and expose institutional investors and fund managers to liability risks. The panel will outline best practices for implementing effective due diligence procedures.


  • ERISA fiduciary duties for institutional investors
    1. Hedge funds and private equity funds compared to traditional investments
  • Regulatory developments
    1. Disclosure
    2. Compliance
    3. Valuation
  • Developments in private litigation involving pension plan fiduciaries and alternative fund managers
  • Best practices for developing due diligence plans



The panel will review these and other key questions:

Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.

  • Regulatory developments
    1. Disclosure
    2. Compliance
    3. Valuation
  • Developments in private litigation involving pension plan fiduciaries and alternative fund managers
  • Best practices for developing due diligence plans
  • What are the regulatory concerns for ERISA pension plans that allocate assets to hedge funds and private equity funds?
  • What are the potential consequences for service providers that fail to comply with new fee, valuation and service provider due diligence regulations?
  • What can counsel to pension plans and asset managers learn from recent private fund suits relating to collateral, risk-taking, pricing, insider trading and much more?
  • How should ERISA plans and asset managers prepare to comply with expanded fiduciary standards?


Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.


Susan Mangiero, Managing Director
FTI Consulting, New York

She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors as well as offered expert testimony and behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary for various investment governance, investment performance, fiduciary breach, prudence, risk and valuation matters.

Alexandra Poe, Partner
Reed Smith, New York

She has over 25 years of experience in investment management practice counseling managers of hedge funds, private equity funds, institutional accounts, mutual funds and broker-dealer advised programs. She counsels hedge and private equity fund advisers in all stages of their business and due diligence matters.



Pensions and Washington Mutual Class Action Lawsuit

According to "Washington Mutual settles class-action suit for $208.5 million," Associated Press, July 1, 2011, pension plans that include the Ontario Teachers' Pension Plan Board (as lead) will benefit as shareholders of the failed bank (if and once the Bankruptcy Court approves the terms).

On a related note, Judge Mary F. Walrath of the U.S. Bankruptcy Court for the District of Delaware tells certain Washington Mutual ("WaMu") employees that they are "entitled only to general unsecured claims because they do not have a right to the funds that is superior to the rights of the other general unsecured creditors." She added that "Because the plans were unfunded, and the funds were identified as property of WaMu," it was not possible to "impose a constructive trust because the money allegedly owed to the participants can no longer be clearly traced to funds or property in their possession." See "WaMu wins bankruptcy fight over employee retirement funds," Thomson Reuters News & Insight, June 20, 2011.

The two articles caught this blogger's attention as a timely example that financial distress can impact multiple constituencies in completely different ways.

Is $88 Million Missing and If So, On Whose Watch?

According to TechCrunch ("Canopy Financial Turns Into Sad, Comical Game of Hot Potato" by Michael Arrington), nearly $90 million in venture capital money may have done little to thwart alleged fraud at Canopy Financial. If true that this company has been reporting incorrect numbers, why has it taken so long to uncover?

Here is what I've been able to uncover from a quick search of the web (with no guarantees that these website links will remain live much longer, if they even exist now):

  • Canopy Financial was listed #12 on Inc. Magazine's 2009 list of fast-growing companies with reported growth of nearly 8,000%, 84 employees and 2008 revenue of $19.8 million. Click to read more.
  • Important website links for Canopy Financial except for a single Contact Us page (About Canopy, Learning Center, Solutions, Press Releases, Clients) are broken.
  • Red Herring reported that Canopy Financial raised $15 million in a "funding round led by Granite Global Ventures," allowing this health insurance-related service company to "develop and market some of its new products and services." Read "Canopy Financial Banks $15M" by Cassimir Medford (January 10, 2008).
  • Healthcare Finance News reported on an acquisition by Canopy Financial about a year ago. See "Canopy Financial buys CareGain" (October 20, 2008).
  • PE Hub writes that Canopy Financial's CEO claims "no prior knowledge whatsoever of any fraud..." Click to read "Statement from Canopy Financial's Ex-CEO" by Dan Primack (November 24, 2009).
  • The link to Perkins Coie is likewise broken though Google shows text that reads "Represented Canopy Financial in its Series A and Series B Preferred stock financings."
  • lists financing for Canopy Financial in the amounts of $15 million Series A funding (January 2008), $8 million Series B funding (August 2008), $4 million in debt funding (2009) and $62.5 million in Series C funding (October 2009). Click to read more.
  • Health Care IT News reports a partnership between Canopy Financial and Wolters Kluwer Financial Services to "make Canopy's healthcare banking platform available to all banks and credit unions." See "Financial providers integrate HSAs for banks" by Molly Merrill (February 14, 2008).
  • Canopy Financial reports the release of its "Mobile Consumer Directed Healthcare (CDH) Software Application." Read the May 13, 2009 press release.
  • Canopy Financial sought to recruit a product analyst as recently as November 9, 2009.
  • Canopy Financial's November 3, 2009 press release describes a partnership witih A.D.A.M., a "leading provider of healthcare information technology." Click to read more.
  • Canopy Financial sends out a March 2009 press release that lauds its successful completion of the "Statement on Auditing Standards No. 70 (SAS 70) Type II audit, which assesses the operational effectiveness of internal controls within service organizations." Read "Canopy Financial Achieves SAS 70 Type II Certification."

The list continues. If true, yet another fraud perpetuated on investors would be shocking. Questions abound, some of which are listed below.

  • Who was conducting the due diligence for each funding round?
  • What due diligence was done on Canopy as relates to several acquisitions and partnerships?
  • What was the role of the auditor?
  • What questions were asked of the management team by the Canopy Financial board of directors? 
  • Did institutional investor limited partners utilize finder firms or contract with the venture capital general partners directly?
  • Did any of the investors review the SAS 70 audit report and find it wanting?

Until more facts are uncovered, everyone deserves their day in court and we can't make hasty judgments.

On a general note, the hope is that lessons are learned along the way about who is tasked to do what, on what basis and with what rigor. While I truly believe that there are many, many good players who do their work thoroughly and with high integrity, one is compelled to reflect on why the stigma and shame of dishonesty is discarded by those who rightfully deserve a place in the Financial Hall of Ignominy.

PBS Frontline Documentary About Madoff


If you haven't watched the 55 minute PBS Frontline documentary about the Madoff fraud (originally aired on May 12, 2009), click here. As I watched the video, I kept asking myself. How could this happen? Why were so many individuals willing to trust without verification? Hopefully (as they become available) court case transcripts will shed some light on the due diligence role of intermediaries. If financial market participants can learn lessons to better mitigate risks, we'll have at least one silver lining from this massive debacle.


Financial Forensics and Made-Off Scandal

Several readers have offered comments about signals they deem could have and should have been indicators of trouble. Adding to our January 13, 2009 list ("Madoff Red Flags" How Many Can You Count?"), the tally now includes:

  • Regularity of returns despite market volatility
  • Complex strategy
  • Poor transparency about performance reporting standards
  • Unknown audit firm
  • Seemingly limited due diligence by some parties
  • Unclear assignment of investigation-related duties (knowing who does what)
  • Questionable diversification
  • Few questions asked about risks
  • Limited internal controls, if any
  • Lure of "movie star" reputation
  • Limited attention paid to hedging efficacy
  • Limited knowledge of rebalancing techniques
  • Limited knowledge of trading limits and stop loss points
  • Limited knowledge of collateral risk
  • Unclear understanding as to who played the role of fiduciary
  • Limited knowledge about asset valuations and related valuation process
  • Absence of an independent custodian to safe keep assets
  • Analysis of option open interest and trading volume activity that would have shown "bad math" (reality versus alleged activity on the part of Madoff affiliates).

According to "Risk test study of Madoff claims" by Anuj Gangahar (Financial Times, January 21, 2009), a bias ratio computation could have likewise shed light on what is now accepted by most as the largest financial scandal in modern times. Believed to be akin to a test for randomness, the bias ratio is "a mathematical technique that identifies abnormalities in the distribution of investment returns." (I wrote about the bias ratio in "Hedge Fund Returns - Illusion or Fact?" on July 15, 2007. Riskdata is releasing a study today on their findings.)

Gangahar likewise mentions something called Benford's Law, a comparable method that is used by forensic specialists to detect accounting fraud. According to "I've Got Your Number" by Mark J. Nigrini (Journal of Accountancy, May 1999), a physicist named Benford discovered that "numbers with low first digits occurred more frequently in the world." Applied to Madoff, observations made by this 1920's GE employee could infer that sustained steady growth would have been highly improbable. (Paul Kedrosky, author of "Infectious Greed" seems to debunk the value of Benford's Law as applied to Madoff returns. See "Bernie vs. Benford's Law: Madoff Wasn't That Dumb," December 19, 2008.)

Editor's Note: Keep in mind that underlying assumptions for any mathematical technique that is used to detect fraud and/or lack of randomness must comport with reality. In the Madoff situation, an option strategy referred to as a "split strike conversion" was heavily relied upon. It would be helpful to know if any Madoff-related risk analyses took into account the asymmetry of historical statistical returns for this option collar technique.

CT Town Swears Out Madoff Arrest Warrant for Alleged Pension Fraud

According to the Wall Street Journal video "Connecticut Town Loses Millions With Madoff" (January 14, 2009), Fairfield is the first municipality to "go after" Madoff. In an attempt to recover $42 million or 15% of the this Connecticut town's pension plan, an arrest warrant has been issued for Mr. Madoff. The town is pursuing civil action as well. Click to watch the video.

What would be interesting is if Fairfield law officials succeed in jailing Madoff after several failed attempts by the U.S. government to do the same.

Editor's Note: In 2006, Money Magazine ranked Fairfield, CT as #9 on its list of "Best Places to Live."

Madoff Red Flags: How Many Can You Count?


With losses estimated at $50 billion, “l’affaire Madoff” is deemed the largest financial fraud in world history. Not since Charles Ponzi scammed millions from investors in the 1920’s have world financial markets seen such a systemic breakdown of what should have and could have been done to prevent fraud. Institutions and individuals alike bear the pain, forcing some organizations to shut their doors, declare bankruptcy, withdraw charitable donations, offer fewer scholarships or go back to work, long after retiring. Litigators and regulators are busy filing lawsuits and enforcement actions that could take years to settle. Questions abound. Who was responsible for due diligence? What could have been done before the fact to preempt financial ruin? What can be done now to avoid subsequent losses?

Based on research of publicly available information, I count well over a dozen red flags, including but not limited to the following:

  • Regularity of returns despite market volatility
  • Complex strategy
  • Poor transparency about performance reporting standards
  • Unknown audit firm
  • Seemingly limited due diligence by some parties
  • Unclear assigment of investigation-related duties (knowing who does what)
  • Questionable diversification
  • Few questions asked about risks
  • Limited internal controls, if any
  • Lure of "movie star" reputation
  • Limited attention paid to hedging efficacy
  • Limited knowledge of rebalancing techniques
  • Limited knowledge of trading limits and stop loss points
  • Limited knowledge of collateral risk
  • Unclear understanding as to who played the role of fiduciary
  • Limited knowledge about asset valuations and related valuation process.

It goes without saying that much remains to be learned about the Madoff situation. The good news is that more attention, at least for some organizations, will now be paid to due diligence and prudent process.

What did I leave off the list that should be added? Email me and let me know.

Funds of Funds - What Comes Next?

According to John Gapper, funds of funds ("FOFs") are significant players, accounting for nearly one-half of all hedge fund assets. This Financial Times chief business commentator connects growing institutional interest to a rise in demand for intermediaries who offer due diligence services. Post-Madoff, he paints a grim picture for the industry unless good players are able to differentiate themselves from those who are now being scrutinized.

Whether certain organizations could have detected fraud is unknown at this time though Grabber suggests that "funds of funds need to work harder and show that they actually contribute something valuable." I am quoted as saying “It is not as if this stuff is really complicated. A lot of the risk of fraud can be mitigated by measures that are low-cost and not very time-intensive.”

I certainly agree with Gapper that there is a "role for the good funds of funds." I'd go further to say that it is unfortunate indeed for those funds of funds that exercised care and discipline in researching  financial and operational risks on behalf of pensions, foundations and endowments. They are unfairly being painted with a dirty brush.

For institutional investors, a key question remain. Will pensions, endowments and foundations continue to reach out to funds of funds or decide instead to hire in-house experts? If they have already hired one of the funds of funds that turns out to be tied to large Madoff-related losses, to what extent might investment fiduciaries be asked to explain their FOF choice and subsequent oversight of said FOF? These are important questions, yet to be answered.

Click to read "Funds of funds have to work harder," Financial Times, January 7, 2009. (Access may be limited to subscribers only.)

Editor's Note: Click to read "Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds," published by the U.S. Securities and Exchange Commission. Click to read "Report on Funds of Hedge Funds," published by the International Organization of Securities Commissions, June 2008.

FBI Hiring Spree - More Financial Fraud Expected?

In a January 5, 2009 press release, the Federal Bureau of Investigation ("FBI") announces its intent to hire "over 2,100 professional staff employees and 850 special agents" in "one of the largest hiring blitzes" in the agency's 100-year history. Mathematicians and computer scientists are in demand, along with finance and accounting experts who can assist with investigations of corporate malfeasance. See "Wanted by the FBI: Talented Professionals to Serve the Nation."

Is this a harbinger of more financial fraud to come or a way to address cases already being investigated?


Congress and Hedge Fund Regulation

Many financial market participants seem resigned to an onslaught of new regulations. For them, it is no longer a question of "if" but "when," with the unknown being the form of eventual rule-making. One area that is likely to receive more than a passing glance is the role of the service provider to pensions, endowments and foundations. Always important, the Madoff scandal has pushed the issue front and center as institutional investors, reeling from reported losses, ask their advisors for clarity about their exposure to the now defunct Bernard L. Madoff Investment Securities LLC. According to "Crackdown on hedge funds after Madoff affair" (December 29, 2008), Financial Times reporters Deborah Brewster and Joanna Chung suggest that funds of funds may be especially feeling the pinch, with an anticipated change in how due diligence is conducted.

Next week's Congressional hearing should be telling. Convened by U.S. Congressman Paul Kanjorski (Democrat - Pennsylvania), this investigative meeting may be "standing room only" as members of the Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises seek to understand what went awry before being able to "craft a strong, effective, modern regulatory system for the financial services industry." 

Though best left to legal experts, one wonders if a likely inquiry will center on the allocation of fiduciary duties across investors and advisors. Under what circumstances might an advisor or consultant be seen as encouraging an "unsuitable" investment? This of course begs the question as to what is deemed "appropriate" for a particular buyer and on what basis should an investment be assessed for a particular pension, endowment or foundation? We've heard that some financial professionals are responding to l'affaire Madoff by imposing more stringent, and arguably prudent, literacy requirements BEFORE accepting client money.

Corporate Fraud - FBI Speaks Out

In a recent speech, Federal Bureau of Investigation ("FBI") Director Robert S. Mueller, III, warns white collar criminals that agents are busy at work. Citing an alarming increase in fraud (up by "more than 80 percent since 2003"), Mueller provided some interesting facts to attendees of the American Bar Association, Litigation Section Annual Conference.

  • The FBI has nearly 2,000 agents working on almost 17,000 white collar cases, "from public corruption and financial fraud to health care and mortgage fraud."
  • The FBI has successfully prosecuted more than "490 corporate and securities fraud convictions in 2007" with more than 30 insider trading indictments affecting employees of at least four major banks.
  • The FBI is investigating in excess of 1,300 mortgage fraud incidents and has identified "19 corporate fraud matters related to the subprime lending crisis."
  • The FBI has its sights on "accounting fraud, insider trading, and deceptive sales practices."

Urging reform to protect shareholders and other relevant parties, this lead G man cites the need for independent (and arguably competent and objective) auditors, outside counsel and independent directors. Conflicts of interest remain a concern.

Click to read the full text of Director Mueller's speech.


Co-Founder of Defunct Hedge Fund Gets 20 Year Sentence

Bayou Group leader, Samuel Israel III, age 48, receives a sentence of 20 years for his part in handing a $400 million loss to investors. (He pled guilty to conspiracy and fraud in late 2005.) A shorter than 30 year sentence reflects his co-operation with the authorities. U.S. Districut Judge Colleen McMahon is quoted as rejecting leniency and instead chastising this hedge fund "mastermind" as a "career criminal" who "ruined lives." In what appears to be a sea change in sentiment towards financial fraudsters, Reuters cites Judge McMahon's upset, referring to white-collar crimes as "every bit as heinous as every other type of crime."

Click to read "Bayou co-founder sentenced to 20 years in prison" (Reuters - April 14, 2008).

New York Pension Probe

According to State Editor Jay Jochnowitz for, Attorney General Andrew Cuomo is investigating "alleged abuses of the state pension fund" at school district, town and village levels. External contractors may be costing Empire State taxpayers a bundle in the form of "undeserved" retirement benefits. (See "Cuomo expanding pension probe," April 14, 2008.)

Not surprisingly (and assuming facts bear out the presence of fraud), folks are in a major huff. To read a few takes on the fast-changing situation, check out these items.

Hourly Hyberbole - Beefing Up the Pension Payout

In what must be an amazing "way to go" moment for any journalist, Milwaukee Journal Sentinel reporter Dave Umhoefer earns the Pulitzer Prize for his detective-like reporting about pension trickery in Milwaukee County. According to "Pension investigation earns reporter Pulitzer: Umhoefer scoured county data for 6 months," Bill Glauber writes that privileged workers were allowed to buoy their benefits by purchasing "service time for seasonal and part-time jobs held decades ago" (Milkwaukee Journal Sentinel, April 7, 2008). Certainly novel, this form of back-dating is said to violate county and IRS rules galore. Congratulations to Mr. Umhoefer for bringing fraud to light on behalf of honest plan participants.

In "Buybacks may figure in pension lawsuit" (Milkwaukee Journal Sentinel, April 12, 2008), reporters Steve Schultze and John Diedrich write that legal documents have the county claiming that "its full costs of the '01 pension perks will reach in excess of $600 million." Alleging failure to give "adequate warning of the potentially steep costs of the lump-sum provision and related benefits while they were under consideration in 2000," the county seeks redress from defendant Mercer Co. The pension consulting firm counters that the county is "seeking to pass the buck for its own failings."

On the topic of fraud, infamous rogue trader Nick Leeson (remember the sale of Barings Bank to ING for a nominal sum?) warns of a "black hole in some markets unless risk-management systems" catch up with the "sophistication of trading desks." Now a "been there, done that" luminary on the speakers' circuit, Leeson apparently corroborates the intended defense of Jerome Kerviel in Rogue Trader v. French Bank. In "Leeson warns of fraud 'black hole' in markets," Financial Times reporter Jeremy Grant (April 9, 2008) writes that corporate negligence will take the stand as Kerviel shouts "J'accuse" and ponders how his jumbo trading could go unchecked for so long.

If HBO found entertainment value in L'Affaire Leeson ("Rogue Trader" starring Ewan McGregor, 1998), can a french film version be too far behind? With so much real-life intrigue, Hollywood writers have little need to imagine.


SEC Warns Pension Plans on Matters of Fraud

As a result of its investigation of the Retirement System of Alabama ("RSA"), the U.S. Securities & Exchange Commission, Division of Enforcement, issued a March 6, 2008 report "to emphasize the responsibilities of all investment professionals, including large public retirement systems and other public entities, under the federal securities laws and to highlight the risks they undertake when they operate without a compliance program."

At the heart of the matter was an allegation of improper trading of shares in The Liberty Corporation, prior to the public announcement of its acquisition by Raycom Media, Inc. ("Raycom"). While this state agency, with over $30 billion in assets under management, is described as having cooperated with the SEC, pre-event, it had no "program, policy, practice or training to ensure that its investment staff understood and complied with the federal securities laws in general or insider trading laws in particular. RSA also did not have a compliance officer, and the responsibilities of its general counsel did not include oversight of RSA's investment activities."

According to this official report, RSA founded Raycom in 1996 and was its "primary financing source." (Enforcement investigation aside, this begs an interesting question. Why was the Retirement System of Alabama in the business of creating a private business?) A disturbing excerpt from the SEC report is shown below.

<<RSA's purchases of Liberty stock were unusual in at least two respects. First, RSA's CEO directed the trades even though he normally was not involved in equity trading decisions. Second, Liberty's market capitalization at the time was less than $1 billion and did not satisfy the $5 billion market capitalization guidelines RSA generally used for the two funds that purchased the shares.>>

While state pension plans are not subject to the Investment Company Act of 1940 and the Investment Advisers Act, public plans and their employees are subject to anti-fraud provisions of the "federal securities laws and Commission rules thereunder."

The Commission concluded that bad acts could have been avoided if the state pension plan "had adequate policies and procedures to assure compliance with the federal securities laws." The SEC took into account the following - (a) RSA's cooperation (b) remedial action and (c) the fact that no individual gained from said trades.

Click here to read "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The Retirement Systems of Alabama.".

Fraud in France - Time to Take Our Webinar on Trading Controls?

The news broke on January 24, 2008 that a rogue trader at Societe Generale was allegedly responsible for nearly US $7 billion (4.9 billion euros) in fraudulent transactions. Hours later, Bank of France governor, Christian Noyer, tried to allay fears. Refuting any connection between sub-prime exposure and the situation at hand, Reuters reports Noyer as saying that "nobody could have foreseen the loss" but acknowledged that risk controls should have been a barrier. "Today we have seen there was a glitch in the system that was exploited by someone who I think got around five successive risk control systems." See "Bank of France head reassures after SocGen fraud" (January 24, 2008).

When contacted for comments by, Mr. Tony Turner, principal with Financial Tracking, LLC asks - "Who was watching the store and who was watching the watchers? This highlights the need for automated and consistent monitoring and alerting."

What's interesting (at least based on preliminary public information) is that the identified bad player was supposedly an expert in operations and able to use that knowledge to his advantage. Many questions arise. 

  • How should back office, middle office and front office controls change to avoid a repeat occurrence?
  • What role do humans play with respect to monitoring computer systems thought to be otherwise safe from attack?
  • Who should ultimately bear responsibility for le rogue trader?
  • Is this type of fraud a "black swan" event or can we expect more trouble?
  • What can pension fund decision-makers do to better vet their banks' risk controls?

This will not be the last time we read about fraud and its potentially devastasting impact on related parties.

Should Pensions Care About Valuation Fraud?

According to "Bonds' Pricing Is Questioned In Email Trail, Former Trader at RBC Alleges Mismarking Of Plain-Vanilla Issues " (October 26, 2007) Wall Street Journal reporter Susan Pulliam describes alleged fraud at one of the large Canadian banks. Whether government and corporate bonds were incorrectly valued to hide losses remains to be seen. However, if true, this is serious stuff.

Pension fiduciaries should be regularly asking external managers about their trading checks and balances. However, in light of recent negative headlines, one wonders (a) whether sufficiently tough questions are being asked (b) who is doing the investigation and (c) whether risk management and valuation best practices are more myth than reality at some organizations.

ERISA and state pension laws make it clear that fiduciaries have a solemn obligation to properly select and review external money mangers. Are breach of duty complaints likely to ensue for those plan sponsors who have selected "troubled" money managers and cannot provide evidence of a disciplined and comprehensive review of their risk management and valuation policies? 

Our forthcoming November 6, 2007 webinar will look at trading controls and the selection and review of external money monagers. Click here for more information.

'Til Jail Do Us Part? How Much Do You Know About Your Money Manager?

A recent news article chronicles another insider trading scam that highlights a dangerous variation of pillow talk. According to a May 11 article, "A husband and wife were arrested and charged yesterday after allegedly netting nearly $600,000 (£300,000) of illicit profits from shares they bought in a takeover target." journalist Steve Hawkes writes that this joint arrest follows quickly on the heels of another couple's guilty plea for providing material non-public information about pending mergers and acquisitions. Click here to read more.

Does nuptial bliss mean scandal? Prison is now a known commodity to Mr. and Mrs. Fastow of Enron fame. Similar allegations were recently launched against a husband and wife team who worked at a hedge fund and investment bank, respectively, and engaged in questionable "chatting."

Fraud is not uniquely committed by power couples with privileged access. Sometimes it's a family act.  A former New York University student pled guilty last year to bank and wire fraud. His mother "was sentenced in March to two years in prison after she pleaded guilty last year to conspiracy to commit wire fraud in the scheme. The two lived in Pound Ridge before they were arrested in June 2005." Click here to read more.

These cases are yet another reminder that risk comes in many forms. It's simply not enough to look at risk-adjusted return performance (historical, current and projected). Pension fiduciaries must carefully vet money managers (regardless of asset class) on a comprehensive basis. This includes a rigorous assessment of their internal controls that relate to trading, how valuable information is protected and the ethical requirements for anyone on the "production line."

Compensation CFO Gets Jail in Coin Gate

According to Business Insurance, the former Chief Financial Officer of the Ohio Bureau of Workers' Compensation gets sixty-four months in jail. Involved in a rare coin investment scandal dubbed "Coin Gate,"  he pled guilty to "violating the federal Racketeer Influenced and Corrupt Organizations statute." (See "Former Ohio comp bureau CFO sentenced" by Roberto Ceniceros , May 11, 2007.)

The current Statement of Investment Policy and Guidelines prohibits investments in coins. Click here to access the document.

Paris Hilton Syndrome in Pension Land?

The latest news on Hilton heiress Paris is not good. Sentenced to forty-five days time for violating probation over a suspended license, she must report to jail on June 5. Click here for the story.

Ordinarily we wouldn't include a story about Paris Hilton except that it gives one pause for the following reason. In the last week, we've been busily focused on gathering news about litigation, enforcement and general stories about fraud in the financial world for and

Our conclusion? There are a lot of Paris Hilton wannabes out there if you think of her as a role model for "let them eat cake."

One can barely keep up with allegations of wrong doing - securities fraud, option backdating, imprudence of investment selection, lack of oversight, accounting "flexibility," incorrect valuations, conflicts of interest, absence of prudence, excess this, excess that. Many of the cases being filed allege fiduciary breach on the part of pension decision-makers or directors and officers or both.

To be VERY clear, allegations mean little until due process takes place and individuals have their day in court to argue their case. Additionally, we recognize that it's easy to hang our hat on the most egregious events, letting them taint everyone in the business. This too is an injustice for those folks who work diligently to execute best practices.

That said, however, the sheer number of news stories, allegations and complaints about financial bad acts is daunting to say the least. There are some who predict more to come, especially with so many millions of dollars at stake and increased exposure to complex securities and strategies.

We'd like to emphasize the importance of applauding the "good guys and gals." Let's learn lessons from demonstrated bad acts (for the sake of improvement).

For those who find it hard to resist temptation, keep in mind - The "pass the buck" mentality is unseemly and dangerous, especially when innocent bystanders stand to lose.

Economics, the SEC and Amnesia

According to the SEC website, a complaint has been launched against an economics professor and several funds he controlled. In "SEC v. Albert E. Parish, Jr., Parish Economics LLC and Summerville Hard Assets LLC, Civil Action No. 2:07-cv-00919-DCN" (D. S. C., April 5, 2007), the SEC charges fraud.

Shortly after the filing, in a somewhat sad turn of events, news outlets report a claim of amnesia. See "Fund Manager Offers Memorable Response to SEC's Fraud Charges" by Suzanne M. Schafer (Associated Press), April 7, 2007. Click here to read the article (one of many).

What's ironic is that the professor, apparently oft-cited as an economic forecasting expert, was quoted in May 2006 as happy with the Enron verdict. "It certainly provides a boost of faith." Click here to read the text of "Local businessman, economists pleased by Enron verdict," The Sun News, May 26, 2006.

Everyone should have their proper day in court but it does seem odd that $134 million is allegedly missing and a "smart" man suffers forgetfulness.

Nevertheless, in the spirit of lessons learned, plan sponsors can be reminded (for that matter, all investors should pay heed) that background checks of key players is desirable, nay essential.