The Importance

of Being Diligent

Graphic Booklet N.3 Petters

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. 3: Petters

Profile

• Tom Petters set up Petters Group Worldwide, LLC (“Petters”) in 1988

• Asset Based Lending/Purchase Order Inventory Financing

• Petters and its feeder funds raised over $3.65 billion and lost $3 billion

Fraud Schemes

• Feeder Funds/Complex Scheme

• Fake Performance

• False Sense of Security

Feeder Funds

Fund Operators of Feeder Funds Principals Capital Raised

Lancelot Investment Management LLC Gregory M. Bell $2,000,000,000

Palm Beach Capital Management LP Bruce Prevost & David Harrold $1,000,000,000

Arrowhead Capital Management, LLC James Fry & Michelle Palm $600,000,000

Stewardship Investment Advisors LLC Marlon Quan $450,000,000

• Feeder funds are structured to purchase the notes from subsidiaries or

affiliates of Petters Co. In order to show legitimacy of the scheme, Petters

Co. established bank lock box accounts, or “Escrow” account, over

which Petters Co has no control.

• All payments from the Big Box retailers shall be paid into the accounts.

Each feeder fund had a slightly different scheme, but the fundamentals

are basically the same. The following diagram is the scheme used by

Stewardship.

Layers of Cover-ups

Source: Lancelot Bankruptcy Status Report

Fake Performance

Lancelot Investors Fund, LP August estimated net return rate: 1.16%, YTD: 9.65%

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec YTD CUM.

2001 2.54% 2.54% 2.54%

2002 2.42% 2.51% 2.60% 2.33% 2.24% 2.16% 1.98% 1.92% 2.22% 2.98% 2.14% 2.03% 31.28% 34.61%

2003 2.86% 2.15% 2.10% 2.02% 1.87% 1.72% 1.95% 1.86% 1.42% 1.40% 1.20% 1.26% 24.11% 67.07%

2004 1.19% 1.11% 1.10% 1.08% 1.10% 1.10% 1.30% 1.15% 1.17% 1.26% 1.08% 1.07% 14.60% 91.47%

2005 1.08% 1.16% 1.20% 1.27% 1.16% 1.15% 1.11% 1.16% 1.13% 1.20% 1.20% 1.14% 14.89% 119.98%

2006 1.09% 1.10% 1.09% 1.11% 1.03% 1.05% 1.05% 1.08% 1.06% 1.05% 1.08% 1.15% 13.74% 150.20%

2007 1.30% 1.31% 1.39% 1.16% 1.04% 1.09% 1.22% 1.18% 1.04% 1.07% 1.10% 1.09% 14.92% 187.53%

2008 1.19% 1.10% 1.05% 1.25% 1.34% 1.13% 1.05% 1.16% 9.65% 215.29%

Sharpe

ratio: 9.57

Source: Lancelot Bankruptcy Status Report

Lancelot’s track record shows no negative month over 81 months.

Promissory Note

Source: Lancelot Bankruptcy Status Report

In order to finance this 180-day

period (“purchase order inventory

financing”), Petters issued a short-

term (up to 180-day) promissory

note with a large coupon

payment (from 10 to 18% p.a.) to

at least 20 investors.

This $31 million promissory note

pays 80% p.a. interest (or at legal

max.) over 3 months (from Feb 1

to May 1, 2008), 100% secured by

the capital stock of Polaroid

Holding Company, LLC

False Sense of Security

A Bank Lock

Box gave

investors a

false sense

of security

Source: SEC v. Stewardship (2009)

Ineffective Administrator

Swiss Financial

Services could not

identify the fraud

Source: Lancelot Bankruptcy Status Report

Recommendations

• Conduct extensive background checks on all related parties

• Confirmation on the Big Box retailers and their payments to the lock box accounts

• Confirmation of registration as a Registered Investment Advisor

To read the case study: http://www.being-diligent.com/case-n-3-petters/

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.

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