Hedge Fund Fraud: What Investors Need to Know
Hedge funds are actively managed investment pools with managers who use a blend of strategies, including non-traditional investments or asset classes, to outstrip the returns offered by ordinary investments. Investors typically pick hedge funds based on the manager’s reputation and supposed financial acumen. Because these are private investments, hedge funds are not required to register with the SEC unless they intend to advertise.
Because hedge funds come with less oversight, unscrupulous investment advisors and stockbrokers may misrepresent hedge funds to line their own pockets with significant fees and commissions. In addition to commissions, hedge fund managers offer very little information on how they intend to invest. This makes it possible for hedge fund managers to misrepresent key components of the hedge fund’s investment strategy.
Hedge fund fraud lawyers work with investors to deconstruct the potential misrepresentations and outright lies behind this complex variety of securities fraud. Hedge fund managers have ample opportunity to perpetrate scams, but investors may also be victims of hedge fund fraud if their broker or financial advisor advised they buy shares of a hedge fund without emphasizing the risks. For instance, hedge fund managers frequently use leverage, or borrowed money, to expose their clients to more of the market and increase the potential for gains. Leverage always amplifies risks and exacerbates any losses.
Each hedge fund is designed to take advantage of specific market opportunities. Wealthy individuals who can afford risk may use a hedge fund to take their wealth to the next level. In some cases, they will earn tremendous gains, although investors must also accept the risk for enormous losses.
What Does a Hedge Fund Manager Do?
Hedge fund managers earn clients based on their stellar reputations in the financial world. They are expected to have a great degree of insight into the market, and investors pay a pretty penny for their services. Hedge fund fees are exceptionally high compared to other types of investments.
Hedge funds often employ a “2 and 20” fee structure. Management fees usually amount to 2% of the fund’s total assets. As a result of this fee setup, managers can continue to enrich themselves despite delivering average returns for their investors. If the hedge fund performs well, investors can expect to pay the manager 20% of the gains. These potentially enormous fees create an incentive for the manager to take huge risks.
What is the Difference Between Hedge Funds and Mutual Funds?
Hedge funds and mutual funds are both pooled investments—at first glance, they may seem like similar investment vehicles. Their different regulation requirements and investing strategies, however, mean that they each have a very different set of risks.
Mutual funds might have a manager or employ a passive investment strategy. Unlike hedge funds, mutual funds must register with the SEC. Mutual funds also trade on the stock exchange, so investors can sell their shares when they wish.
Hedge funds often invest in illiquid, private securities, which may require investors to commit to keeping their money in the hedge fund for a certain amount of time. Mutual funds might choose a riskier strategy or asset class, but they would have to disclose that information to the SEC, making it readily available to investors. Hedge funds do not have to disclose all their holdings, and this lack of transparency is one factor that makes hedge funds so risky.
Hedge Fund Fraud Risk
Hedge funds are more susceptible to fraud because they are less regulated than other investment structures. Because of the major risk, shares of hedge funds generally only take on accredited investors. Accredited investors have a significant amount of assets or an especially high income.
Some managers are not required to register with the SEC and therefore do not need to publicly report their earnings. The lack of oversight allows managers to make claims that they know they cannot deliver.
Why Do Hedge Fund Investors Lose Money?
Hedge funds can lose money simply because the manager believed in a certain strategy that proved incorrect. Many hedge fund managers expressed concern over fraud when retail investors decided to purchase shares of GameStop and AMC en masse, making certain hedge funds’ short positions on those shares lose money. To date, the SEC has not found any evidence of fraudulent practices perpetrated by retail investors who sought to increase the price of GameStop shares.
Investors can also lose money due to outright fraud. Hedge fund fraud is a type of investment fraud and is any act of financial misconduct committed by or for the account of a hedge fund. Common hedge fund frauds include Ponzi schemes, self-dealing investments, and schemes to mislead investors about investment strategies and performance. Managers have also been known to misprice private fund investments, resulting in large personal bonuses, which is a violation of multiple antifraud provisions.
Top Hedge Fund Frauds List
When hedge fund managers engage in fraud, investors often suffer seven-figure losses.
Wealthy hedge fund managers tend to move in powerful circles, occasionally granting them access to non-public information about significant sales and acquisitions. In 2017, billionaire hedge fund manager Leon Cooperman agreed to pay $5 million to settle SEC charges that he purchased shares of Atlas Pipeline Partners based on non-public information regarding the sale of a major asset he had learned from one of APL’s executives. Cooperman allegedly made $4 million from the trades.
“Self-dealing” happens when a hedge fund manager works in their own best interests rather than their investors’. Martin Shkreli, a.k.a., “the pharma bro,” is best known for raising the price of a life-saving drug by 5,000%. Before his business ventures in the pharmaceutical industry, Shkreli ran a disastrous hedge fund that lost all his clients’ money. When he started a second hedge fund called MSMB, he neglected to mention his previous losses. Once again, Shkreli’s strategy led to losses, and Shrekli had his pharmaceutical company, Retrophin, sign lucrative consulting contracts with his defrauded investors to prevent them from pursuing a case with the SEC.
Bernie Madoff authored one of the worst-case scenarios for hedge fund investors–a Ponzi scheme. Madoff was such a well-respected financier that investors chose not to question how he could fulfill his promises of outsized returns. He perpetrated a Ponzi scheme that eventually cost his investors $65 billion. Madoff’s scam took place over the course of at least 17 years, possibly longer. In 2021, Bernie Madoff died 12 years into his 150-year sentence. This is one of the largest hedge fund frauds in history.
Recently, the Department of Justice sentenced 24-year-old cryptocurrency hedge fund manager Stefan He Qin to seven years in prison after his investors discovered that his “[investment] strategies weren’t much more than a disguised means for him to embezzle and make unauthorized investments with client funds.” According to the DOJ, Qin used the embezzled money to pay for a luxurious lifestyle that included a penthouse apartment in New York City. The DOJ further alleged that Qin continually lied to investors about the value and status of their investment capital.
The SEC alleges that former hedge fund manager Bill Hwang attempted to manipulate stock prices by placing losing trades. These trades were meant to drive down the price of certain shares and increase the value of short positions in his hedge fund.
As sophisticated investment professionals, hedge fund managers are uniquely capable of using smoke and mirrors to hide the truth about an investment portfolio. For instance, the SEC charged a portfolio manager in 2019 with mispricing fund investments using complex swap options. These financial instruments artificially inflated the funds and increased the manager’s fees.
Conflicts of Interest
In 2012, the SEC took action against a hedge fund manager who used his investors’ money to invest in an affiliated company, which the hedge fund manager had invested in personally. The hedge fund manager did not disclose this conflict of interest to his investors. Unfortunately for investors, the affiliated company went bankrupt.
Unsuitable Investment Fraud
Huge hedge fund losses are not unusual, even when the hedge fund manager works in earnest to generate a return for his investors. In that case, the investor should consider if they were in the position to take on the risk of a hedge fund. Brokers and financial advisers should understand a hedge fund’s risk before recommending it to their investors. If they do not, they may have violated FINRA Rule 2111, which requires brokers to consider their investors’ risk tolerance and thoroughly understand the investments they recommend.
How Can I Prevent Becoming the Victim of Hedge Fund Fraud?
The SEC has published an Investor Bulletin that offers investors guidance when they choose a hedge fund:
- Always research the backgrounds of hedge fund managers. Investigate their qualifications, and whether they have any disciplinary actions on their FINRA BrokerCheck record or SEC Investment Advisor Public Disclosure record.
- Is the hedge fund using leverage? What about speculative investments? Make sure you understand exactly how much of a gamble the hedge fund manager is willing to take with your money.
- Ask where the fund’s assets will be held and if any independent third parties will verify the existence of the fund’s assets.
- Learn how your hedge fund’s value and performance are calculated. Hedge funds can invest in illiquid securities, and that may make it more difficult to assess a funds’ true value. This is important information since the hedge fund performance determines the manager’s fee.
- Understand fees. Make sure you clearly understand how much the hedge fund investor is making off your investments.
- Although many hedge funds are not required to register with the SEC, remember that they are subject to the same prohibitions against fraud as other market participants. The SEC can and will take action against a hedge fund engaging in fraudulent conduct. In the meantime, contact a securities attorney to begin the process of recovering losses from hedge fund fraud.
Contact a Hedge Fund Fraud Lawyer
Hedge fund fraud lawyers can work with you to recover lost money, no matter how large and powerful the hedge fund may seem. If you are concerned about your hedge fund investments, contact Kurta Law for a free case evaluation.