From the July 2009 issue of Boomer Market Advisor • Subscribe!

Bernie, Bayou and a mighty big fine

Before Bernie it was Bayou; Bayou Fund and its principal, Samuel Israel - that is. Israel was the poster child for hedge fund fraud before Bernie took the mantel.

In fact, the fortunate investors in Madoff who received distributions and breathed some relief at their mitigation of losses shuddered at one of the lessons of Bayou. In the Bayou bankruptcy case, the court held that redemptions by investors may be fraudulent conveyances and, as such, must be returned to the bankruptcy estate. Now comes another lesson from Bayou, this one for the advisor: recommend without due diligence and do so at your own peril.

Hennessee Group and its flag bearer, Charles Gradante, recommended its approximately 40 clients invest in Bayou. Hennessee, a registered investment advisor, promoted its "Five Level Due Diligence Process" for evaluating and selecting hedge funds. The firm also represented that it would not recommend investments in hedge funds that did not completely satisfy all five levels of its due diligence. Well, its investors lost much of their $56 million investments, and the SEC said that Hennessee Group and Gradante willfully violated the anti-fraud provision of section 206(2) of the Investment Advisers Act of 1940.

Specifically, the SEC found that Hennessee Group and Gradante, "in their capacities as investment advisors, owed fiduciary duties to their clients to not misrepresent the services that they were providing and to disclose all material departures from the representations that they made to their clients."

The five diligence steps that Hennessee claimed it took were 1. Requesting general information and data on historical returns, 2. Interviewing the fund manager about such matters as its risk management principles, 3. Conducting a detailed review and analysis of the fund's investment portfolio, trade practices and risk management discipline, 4. Making an on-site visit to the fund to interview key personnel, and 5. Performing a thorough background and reference check on the fund's manager. All the diligence steps are logical; but, Hennessee failed to perform two of the five.

Right now it likely matters not to regulators, or for that matter investors, which due diligence elements are not performed. Rather, if you say that you are going to do due diligence, you must actually do it. Hennessee maintained but did not follow its own detailed procedures as to how it would perform the thorough due diligence. When Hennessee Group could not obtain the prime brokerage reports from the funds, it did not tell its clients that it had not conducted the portfolio/trading analysis. In fact, Hennessee Group "relied entirely on Bayou's uncorroborated representations and purported rater of return that Bayou had provided during its initial information-gathering process." Also, Hennessee Group disregarded certain red flags and did not respond adequately to information that it had received suggesting that the identity of Bayou's auditor was in doubt. The cost to Hennessee Group and Gradante was an SEC censure, compliance undertakings, a cease-and-desist order against future violations and $815,568 in disgorgement, interest and monetary penalties.

But it is the first undertaking in the SEC Order that is the lesson for all.

"Adopt policies and procedures to ensure adequate oral and written disclosures to clients and prospective clients regarding [the] process for evaluating, selecting, and monitoring hedge funds, and maintain a written manual setting forth such policies and procedures."

Jacob S. Frenkel is a partner in the law firm Shulman, Rogers, Gandal, Pordy & Ecker, P.A. in Rockville, Md. He is a former SEC Enforcement lawyer and former federal prosecutor who chairs his law firm's Securities Enforcement and White-Collar Criminal Practice Group.

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