The chief financial officer and two managing partners of a U.S. hedge fund firm have been sentenced to prison for defrauding investors of more than US$46 million, WTNH-TV in New Haven, Conn.
reports. Their firm, New Stream Capital LLC, launched two feeder funds in November 2007, based in the U.S. and the Cayman Islands, and announced that its Bermuda Fund would close and its investments would move to the Cayman Fund, according to court documents and testimony. When the Bermuda Fund's largest investor decided to redeem its investment in March 2008, prosecutors say the defendants secretly kept the Bermuda Fund open and prioritized investors who stayed in the fund. The firm did not inform other existing and prospective investors that the Bermuda Fund was still open and would be a priority. Each of the defendants pleaded guilty to conspiracy to commit wire fraud in 2014.
When it comes to offshore hedge funds, the Cayman Islands is the world leader, with estimates ranging from 45 percent to 85 percent of global market share and as much as US$1.4 trillion in assets and liabilities. Included in these funds are institutional investments, such as pension funds.
To tackle criminal and fraudulent behavior, such as in this story, we need to look beyond the individual circumstances of the case and address systemic problems from two different directions: governance/regulatory and investor awareness. Internal auditors can help with both.
Governance/regulatory. Some economists consider the relative lack of oversight of the hedge fund industry by Cayman Island authorities to be a significant threat to the global economy. The Cayman Islands Monetary Authority (CIMA) is responsible for regulating and supervising financial services. It says officials on its board of directors can have contractual relationships with entities they are charged with regulating, creating inevitable conflict of interest possibilities. More independence between these two roles would help protect investors.
Cayman Islands-based hedge funds are not directly subject to U.S. Securities and Exchange Commission (SEC) regulation. However, in 2012, the SEC established a cooperation arrangement with CIMA as part of the commission's long-term plan to improve oversight of regulated entities that operate internationally. This type of cooperation arrangement "generally establishes mechanisms for continuous and ongoing consultation, cooperation, and the exchange of supervisory information … to monitor risk concentrations, identify emerging systemic risks, and better understand a globally active regulated entity's compliance culture," according to an SEC press release. In addition, such memorandums of understanding enable the SEC and regulators in other nations to conduct on-site examinations of registered entities located abroad. Results of these on-site examinations should be reviewed closely for further governance improvements.
A 2012 analysis of thousands of U.S. securities filings by
The New York Times also showed that many directors sit on the boards of 24 or more funds based in the Caymans, which "individually are supposed to be overseeing tens of billions of dollars in assets." Some of these individuals hold more than 100 directorships, and one director sits on the boards of about 260 hedge funds. Notably, this data does not include boards of hedge funds with non-U.S. ownership. Greater disclosure of how many boards directors serve on is obviously needed. And, allowing for some flexibility, limits should be placed on the number of board positions that one director can take on in the interests of investors, fiduciary responsibility, due diligence, and professionalism. A
2013 CIMA survey (PDF) of hedge fund corporate governance stakeholders points to these same needed changes.
Investor awareness. As a general rule, investors must take responsibility for the oversight of funds in which they invest. That includes educating themselves on the nature and risks of hedge funds and offshore banking and investing. They also should apply scrutiny to drive up standards by careful and informed selection of service providers and directors, either directly or through the use of due diligence professionals, including auditors. Where red flags are noticed with regard to lapses in due diligence, class action and other forms of legal redress are likely to be pursued.