FUNDS MANAGEMENT IN AUSTRALIA:

WHERE ARE THE VULNERABILITIES?

N O T H A N D O M A L A B A

( N O R T O N R O S E F U L B R I G H T , M E L B O U R N E )

A N D

D R . P E L M A R A J A P A K S E

( G R I F F I T H U N I V E R S I T Y , B R I S B A N E )

FUNDS MANAGEMENT IN AUSTRALIA:

WHERE ARE THE VULNERABILITIES?

Background to this Research

Australia is one of the world’s largest fund management markets with

the third largest fund pool in Asia. As at 31 March 2014, Australian

managed funds institutions held around $2,3 trillion worth of assets.

Over the past decade, Australians have suffered significant losses as

a result of financial fraud and market misconduct.

It is therefore essential that public confidence in the operation and

regulation of the funds management industry is developed and

maintained.

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Purpose of the Research

To analyse the organisational and regulatory structures of

the funds management industry and their effectiveness in

the prevention of fraud.

The research primarily focused on the funds management

industry in Australia, whilst drawing comparisons with

other developed countries such as the United Kingdom,

the United States and to a lesser extent Canada.

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Structure of the Paper

Part 1: Funds Management and Fraud

• Meaning of ‘fraud’

• The different ways that fraud can occur within the

context of the funds management industry

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Part 2: Structure of the Funds

Management Industry

• Examines the various corporate structures and the role of

responsible entities, custodians and fund managers.

• Considers the allocation of risk and liability between the various

entities within fund management corporate structures.

• Considers the potential for conflicts of interests between entities

within a corporate group.

• Analyses the use of offshore hedge funds to reduce legal liability and

minimise tax liabilities.

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Structure of the Paper

Part 3: Regulation

• Examines regulatory bodies governing the industry: • Australia: ASIC, APRA and the ATO

• United Kingdom: Financial Conduct Authority (previously known as the Financial

Services Authority)

• United States: Securities and Exchange Commission

• Examines the main regulations applicable to the industry: • Australia: Corporations Act 2001 (Cth), Superannuation Industry (Supervision) Act

1993 (Cth), Australian Securities and Investments Commission Act 2001 (Cth) and

the Australian Prudential Regulation Authority Act 1998 (Cth)

• United Kingdom: Financial Services Market Act 2000, Financial Services Act 2012

and Open-Ended Investment Companies Regulations 2001

• United States: Securities Act of 1933, Securities Exchange Act of 1934, Advisers

Act of 1940 and Investment Company Act of 1940

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Part 4: Examples of Fraud

• Examines specific cases of fund management fraud:

• Australia: the Trio Capital fraud

• United States: the Bernie Madoff Investment Securities fraud

• United Kingdom: the Weavering Capital fraud

• Examines how the fraud occurred, how the fraud was uncovered and

the response of the various regulators.

• Considers the effectiveness of the regulatory arrangements in

detecting and sanctioning the specific instances of fraud.

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Australia: Trio Capital Fraud

($176 million)

Background

• Astarra Strategic Fund (ASF) and the ARP Growth Fund (ARP) were two of a

large number of funds managed by Trio Capital.

• ASF was an Australian based hedge fund, whilst ARP was structured as a

registered managed investment scheme that owned a contract held by a

company in the British Virgin Islands.

• A key aspect of the fraud involved the movement of the funds of Australian

investors overseas by Trio Capital.

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Australia: Trio Capital Fraud

($176 million)

How was the Fraud uncovered?

• Neither APRA nor ASIC knew the extent of the fraud until concerns were raised

by a whistle blower.

Factors that led to the occurrence of fraud at Trio Capital

• The compliance framework imposed on Trio Capital was found to be

inadequate and created an abundance of ‘red-tape’ that could be easily

circumvented.

• The fund auditors routinely valued the underlying assets of the funds and

found no deficiencies. They had no way of knowing that the documentation

provided to them by the funds’ administrators were fraudulent.

• x

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• The custodians of the funds did very little to protect the fund assets and acted

on the instructions of the responsible entity.

• AISC is only an oversight and enforcement body that can ‘arrive” at the scene

of the accident” ... to see who caused it’.

• Lack of communication between the two regulatory bodies - APRA failed to

alert ASIC of the discrepancies in the operations of the funds being managed

by Trio Capital.

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United States: Bernard L. Madoff Investment Securities

(BMIS) fraud

(US$65 billion)

Background

• Madoff operated a fund that attracted high net worth clients and large

organisations.

• BMIS acted as a broker and investment manager and custodian over the

funds invested.

• Madoff operated a Ponzi scheme – a pyramid scheme where redemptions

are paid out from the deposits of investors, instead of the underlying

investment returns.

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United States: Bernard L. Madoff Investment Securities

(BMIS) fraud

(US$65 billion)

How was the fraud uncovered?

Fraud came to light through the persistence of a whistle blower who was

repeatedly ignored by the SEC.

How did the Fraud Occur?

• BMIS taking on the dual role of both operations and oversight.

• The lack of communication between various SEC offices.

• The inexperience of the staff and failure to respond to complaints allowed the

fraud to go undetected.

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United Kingdom: Weavering Capital (UK) Ltd

Fraud - (US$600 million)

Background

• Weavering Macro Fixed Income Fund (Macro Fund) was a hedge fund

incorporated in the Cayman Islands, and Weavering Capital (UK) Ltd

(Weavering) acted as the investment manager of the Macro Fund.

• The Macro Fund suffered heavy losses and ultimately collapsed in 2009

amidst allegations of fraud.

• The Macro Fund entered into allegedly fictitious transaction with a related

entity fund established in the British Virgin Islands to mask losses incurred on

the fund's other trading.

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Factors that led to the Macro Fund Fraud

• Poor corporate governance practices – most directors were not fit to hold

their positions and lacked the requisite skill and expertise.

• Misleading public documents which showed glaringly inaccuracies and

omissions on important matters relating to the fund.

• Inconsistent valuations of the assets of the Macro Fund which masked the

true volatility of the underlying assets.

• Operating outside investment guidelines of the Macro Fund.

• The Serious Fraud Office had conducted investigations into alleged fraud by

the Fund, however it failed to follow through with these investigations.

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Part 5: Policy Reform Considerations

• Examines the key policy reform areas with a view to

proposing reforms to the organisational and regulatory

structures of the funds management industry.

• These proposed reforms draw on lessons learnt from the

case studies and examples of successful reforms that

have helped to prevent fraud in other jurisdictions.

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Policy Reform Considerations

Penalties

The penalties imposed on those involved in fraudulent conduct is inadequate

and fails to act as a sufficient deterrent.

• In Trio Capital those responsible for the fraud escaped severe punishment;

whilst others paid fines and were disqualified from managing corporations.

Shawn Richards is the only director who received a jail sentence.

• In the Bernie Madoff case, Madoff was sentenced to 150 years in jail.

Offshore Investments

• Offshore investment disclosure documents must provide details of the nature

of the investment, the structure of the investment vehicle, the particular

jurisdictional risks of investing in the particular country and what measures (if

any) are taken to supplement compliance processes.

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Policy Reform Considerations – cntd.

Gatekeepers

Conducting independent and robust investigations to ensure the integrity of the

compliance role imposed on auditors and custodians.

Custodians should be given a greater oversight role - they should be

conducting basic investigations to highlight any unusual commercial

transactions.

Collaboration between Industry Professionals and Regulators

Complaints by whistle blowers should be given greater weight than what has

been seen in the fraud cases of Trio Capital, Bernie Madoff, and Weavering.

Regulators should be more proactive when they receive complaints of fraud

and commence immediate investigations.

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Policy Reform Considerations – cntd.

The Distinction between Retail and Sophisticated Investors

The re-characterisation of retail and sophisticated investors in the context of

offshore investments by superannuation funds which may result in the

indirect exposure of the public’s retirement savings.

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THANK YOU!

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