(NOTE: This is one of my many investigative exposés on commercial crimes during my newsroom days. It involved the first hedge fund manager sent to prison in Asia.)
Daniel Hilken and Vanson Soo
Saturday, February 19, 2005
“This is by far the most difficult e-mail that I have ever had to write.”
So began the message that Brian MacDougall, then marketing chief of Charles Schmitt & Associates, sent to more than 1,000 of the company’s investors on June 16.
“Last week my colleague, Jennifer Carver, and I came across some internal documents that led us to suspect irregularities in the CSA Absolute Return Fund,” MacDougall continued.
After sharing some of the depressing details, he concluded: “There is nothing I can possibly say to express how sorry we are.”
A scenario like this is every investor’s worst nightmare: your trusted adviser has been accused of fraud and you may not be getting your money back.
For some 1,300 investors in the hedge fund, managed by a collapsed Hong Kong advisory firm, the nightmare has become a reality that doesn’t end when the sun comes up.
The founder and owner of the firm, Charles Schmitt, 59, a United States citizen residing in Discovery Bay, was charged by Hong Kong police in June with stealing US$930,000 (HK$7.25 million) from the CSA Absolute Return Fund.
Nearly US$200 million was invested in the fund, but up to US$50 million may never be recovered, partly because of losses related to the need to close out positions early.
Schmitt, who is free on bail, could face further charges. His next scheduled court appearance is March 1.
To recover what remains of their money, the investors face a trawl through the murky world of offshore funds and a tedious legal wrangle in Hong Kong.
It is one more cautionary tale about hedge funds, those virtually unregulated, deliberately opaque, high-risk, high-reward vehicles that are considered even by financial sophisticates as being for “consenting adults” only.
Regulators tend to give hedge funds a wide berth, not only because their investment strategies are generally byzantine, but because the products are seen as intended for rich people with money to lose, in the case of the CSA Absolute Return Fund, up to US$100,000, the minimum investment.
The CSA product was a “fund of funds” that ostensibly invested in other hedge funds. But these, it is alleged, were fakes.
Schmitt was alledgedly involved in setting up bogus funds and bogus bank accounts to siphon off money from the fund.
Like many a protagonist in previous financial scandals, Schmitt had hardly anyone looking over his shoulder.
According to Carver, the former chief operating officer of the advisory firm, she and Schmitt comprised the investment committee, which met monthly to discuss asset allocation. After each meeting, Schmitt would place the orders for the Absolute Return Fund while Carver did the same for the two other funds run by her boss’ companies.
“I had no influence on the Absolute Return Fund,” she said.
The fund’s custodian bank, Bermuda Trust, accepted only orders placed by Schmitt himself. Carver had no signing authority for the Absolute Return Fund, or for any bank accounts.
“The bank accounts’ part especially bothered me,” she said. “I asked him to accept me as a signatory but he just dragged the matter.
“Now I understand why.”
Carver was not the only one who missed the alleged scam. So did the custodian, the auditor of the Absolute Return Fund, Ernst & Young, and Hong Kong’s financial services regulator, the Securities and Futures Commission (SFC).
Bermuda Trust acted as overall administrator of the 10 hedge funds in which the Absolute Return Fund purported to invest. Each of the 10 in turn had its own administrator, who would supply information, including the value of the assets, to Bermuda Trust, which would then channel appropriate investment amounts to each fund.
In all, US$192.8 million of investor money was transferred from Bank of Bermuda, the trust company’s parent, according to an investigation by PricewaterhouseCoopers (PwC).
The accounting firm, which was appointed by the High Court to liquidate Charles Schmitt & Associates and the Absolute Return Fund, intially concluded that some 20 percent of this money was missing after being shifted among more than 20 banks and brokerage accounts.
Investors were told at a meeting in Hong Kong Thursday that the amount still unaccounted for could be almost twice as high as that.
At Schmitt & Associates, Carver said, the filings for fund orders went into binders. Both she and marketing head MacDougall had assumed that nothing was amiss because the orders seemed to be placed through the proper channels.
However, Carver was shaken out of her complacency on June 5 when she returned to her office on a Saturday and found some misplaced documents that aroused her suspicions. She showed them to MacDougall, who was about to leave on a business trip. “We thought we knew what was going on, but still couldn’t believe it,” she said.
MacDougall declined to be interviewed for this article.
Carver declined to reveal the details of her discovery, other than to say that among the documents figured the name of an administrator she did not recognize. That, plus an indication that the funds in which the Absolute Return Fund invested had their own bank accounts in Hong Kong, which seemed to make no sense.
She spent the next few days searching for answers. When MacDougall returned, they contacted a lawyer and reported to the SFC the same morning.
Schmitt was charged on June 15 and the Absolute Return Fund was frozen.
The allegations against Schmitt have yet to be tested at trial, but the long and complicated process of recovering and distributing the remaining assets of the fund is well under way. It’s a thankless task. At a meeting between the liquidator and investor representatives in October, PwC said it had found over 8,000 documents, 3,000 transactions and 60 accounts for the Absolute Return Fund alone. And mingled in with them, apparently, were transactions of four other hedge funds and some private client funds.
The liquidator is still coming to grips with the difficult task of demonstrating that Absolute Return Fund money was used to acquire assets through third parties, and that these assets were held in trust or beneficially for Schmitt & Associates. Both the firm and the Absolute Return Fund were ordered wound up on January 10, but investigations continue in Hong Kong and in the British Virgin Islands, where the fund was incorporated.
Assigning priority to the claims of different investors is proving to be a headache.
For example, those who subscribed for shares but never received certificates might legally be classified as creditors and therefore have a claim on the assets ahead of other investors.
To resolve the whole issue, PwC asked the court for the power to set up a “scheme of arrangement” that would allow it to share out the recovered proceeds as it saw fit. At a November court hearing into the application, some investors complained that the recovery process was opaque and inefficient.
They said PwC had not informed them of its bid to decide the reimbursement policy by itself, and both they and the government’s Official Receiver’s Office identified an overlap between PwC’s functions and those of the administrator appointed by the SFC, John Lees & Associates. The scheme of arrangement issue remains unresolved but an informal investors’ committee has been set up to facilitate communication among the parties.
Some investors fear the process is taking so long that the value of the recoverable assets is being steadily depleted. The professionals appointed by the court to clear up the mess are not directly accountable to investors, yet their fees come out of the fund’s assets.
With HK$20 million in service fees already racked up, it is no wonder that already distressed investors are furious. Many have come around to the view that to avoid delays and expense, a scheme of arrangement is the best solution.
Said Jeff Stryer, a Singapore investor with US$275,000 in the fund: “I am frustrated by the pace of the proceedings and support ongoing efforts to persuade the court to avoid the expense of an extended process. It appears most of the money has been located and identified so I believe the return of funds to the investors can be expedited.”
Jan Blaauw, a partner in PwC’s business recovery services, said: “We have issued eight reports to investors since July 2004 to explain our progress and issues encountered. At investors meetings held [Thursday], our appointment as liquidators was unanimous.”
While investor lawsuits against various banks and auditors are under consideration, it appears the victims could receive a first payment out of the recovered assets in three or four months.
Meanwhile, Carver and MacDougall continue to manage other funds previously run by Schmitt’s companies. Carver said the two funds she managed herself, the CSA Plus Fund, which came under Charles Schmitt & Associates, and the CSA Dublin Fund under CSA Management, were untainted by the scandal.
The two funds, which had total assets of US$114 million, offered little opportunity for fraud, she said.
The Plus Fund deals only with Societe Generale and Royal Bank of Canada leveraged products, which are tightly monitored, while the custodian for the Dublin Fund, Citco, uses a tamper-proof electronic trading platform. After conducting a limited audit, the SFC allowed both funds to remain active.
Now most of the assets are managed by a new advisory firm set up by Carver and MacDougall, Oria Capital.
“The SFC fast-tracked our licenses so that we could continue to manage the funds that were still active, so as to stem any further damage to investors,” Carver said.
Oria Capital was appointed manager of the Dublin Fund by external directors in July, while shareholders of the Plus Fund voted it in as manager in August.
Most investors and independent financial advisers believe that Carver and MacDougall emerged from the whole affair with their honor intact.
“It is my belief that the discovery of the alleged fraud was due purely to the honesty and courage of MacDougall and Carver and not a result of the takeover [last year] of Bermuda Trust by HSBC,” investor Stryer said.
“What they did took intelligence and guts, and they deserve respect.”
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