The Importance

of Being Diligent

Graphic Booklet N.1 Bayou

Trust, but Verify

• We know the importance of being diligent, but there usually no clear guidance as to how to be diligent.

• Even the professional lie-detectors – lawyers – can do no better than “just look for something unusual.”

• However, detecting something as “unusual” requires experience, which is more often than not subjective and not easily transportable.

• Therefore, these case studies are my attempt at systematizing my experience based on the following principles.

• As President Reagan said: Trust, but Verify.

N. 1: Bayou

Profile

• Sam Israel started Stamford, CT-based Bayou Management, LLC in 1997

• Short-term Equity Trading

• Managed $450 million at peak and lost $350 million of investors’ capital

Fraud Schemes

• Fake performance

• Fake auditor

• Fake administrator

Fake Performance

Source: SEC v. Bayou Management LLC, et al, Markov Process International, LLC

Sam Israel claimed Bayou’s short-term trading

strategy enabled him to generate his stable returns

Fake Auditor

• Bayou told potential investors that Grant Thornton was its auditor

• But, in reality, it was Richmond-Fairfield Associates, CPA, PLLC which was established by Dan Marino, CFO

• Located at a tiny office at 575 Madison Avenue

575 Madison Ave. Suite 1006

How come an audit firm for a $400 million hedge

fund uses this tiny rental office space?

Marino’s Name

Richmond-Fairfield was

registered under Bayou

CFO’s name…? Why??

Source: New York State Education Department, Office of the Professions

Fraud Administrator

• Initial administrator Admiral resigned since Bayou refused to provide data

• Bayou then purportedly appointed Global Standard Financial Group Ltd.

Resignation Letter

On November 9, 2004, Admiral Administration

resigned and gave this “unusual” explanation…

Source: Report of the Joint Provisional Liquidators of Bayou Offshore Master Fund; Bayou Offshore Fund A,

Ltd; Bayou Offshore Fund B, Ltd; And Bayou Offshore Fund C, Ltd, 15 December 2005

Fake Administrator

Bayou Offshore Funds appointed an

administrator unrecognized by the

Cayman Islands Monetary Authority

on April 1, 2005;

This means that Bayou operated

without an administrator for three

months…?

Source: Report of the Joint Provisional Liquidators of Bayou Offshore Master Fund; Bayou Offshore Fund A,

Ltd; Bayou Offshore Fund B, Ltd; And Bayou Offshore Fund C, Ltd, 15 December 2005

Recommendations

• Read the Fine Prints of the Financial Statements

• Check the Legitimacy and the Independence of the Audit Firm

• Check the Legitimacy and the Independence of the Administrator

To read the case study: http://www.being-diligent.com/case-n-1-bayou/ The Bayou Story: http://www.being-diligent.com/trust-but-verify/the-bayou-story/

Summary

• There are many similarities among hedge fund fraud cases (very stable and too good track records, promissory notes, fake service providers, etc.)

• No matter how clever they are, fraudsters are still human beings and prone to leave traces of their misconducts

• However, you really need to be diligent to find those traces and make informed judgment

For More Information

The Importance of Being Diligent is a blog of hedge fund case studies managed by Sus Volans. Please visit our website and sign up for an e-mail subscription.

http://www.being-diligent.com