The Bayou Story
On August 16, 2005, police sergeant, Gary Perna, found a suicide note of Marino at his office with a confession of his misconduct. Both SEC and FBI began investigation on the same day and later filed a securities fraud lawsuit against Bayou Management, LLC (“Bayou”), Samuel Israel, III (“Israel”) and Dan Marino (“Marino”). The case was one of the largest hedge fund fraud schemes at the time.
Bayou was founded by Israel and two other co-founders in 1997 and attracted both wealthy individuals and institutions for its continuous stream of stable returns, based on Israel’s proprietary investment strategy. However, Bayou quickly ran into trouble at a very early stage and continued to generate losses over the next 7 years; however, the investors were kept in the dark by the seemingly profitable monthly NAV statements and year-end financial statements. In the end, the money was running out more quickly than Bayou could cover it up.
The firm I was working for at the time (the “Firm”) had been an investor of Bayou’s funds when I joined. The atmosphere of the Firm was far from open; no one seemed keen enough to interfere in the matter of hedge fund due diligence with the Director of Research, including Bayou. Therefore, when he asked me to assist in requesting the financial statements from Bayou, it was almost the first time for me to open Bayou’s due diligence files.
1. The Beginning of the End
In the May of 2005, I was beginning to get nervous because Bayou’s financial statements were late by about a month. Cayman-based hedge funds are usually required to submit financial statements with the Cayman Islands Monetary Authority (“CIMA”) by June 30 (Box 1); however, Bayou’s offshore funds in Cayman Islands had previously submitted their financial statements in April, I skeptically dialed the phone number of Bayou’s investor relations:
Author: We haven’t received the financial statements of your offshore funds. It’s already late May and we want to get the statements as soon as possible. Can you at least tell me when you expect to release the statements?
Bayou’s IR: Oh, I’m sorry. Yes, it’s been delayed this year. I don’t know when exactly we’ll release the statements, but I will check again with our CFO. Perhaps, we can set up a call with him sometime in the next two weeks.
Since the IR person never contacted me to set up the call, I had to call back after a few days. In 2005, the hedge fund industry was much less transparent and less investor-friendly. The analysts were required to be aggressive (and yet ever so tactful without upsetting the investment managers), if they wanted to get information timely.
2. “Too Much” Consistency in the Financial Statements
The financial statements of Bayou’s funds were quite different from those issued by other hedge funds. Despite the fact that Bayou’s funds were not formed as a master-feeder structure, there was only one set of financial statements for all of Bayou’s “Family of Funds.” When I inquired as to the reason for this aberration, Bayou’s investor relations could not provide a clear explanation as to why the financial statements were structured as such.
The lack of explanation made me nervous. Therefore, I decided to take a closer look at Bayou’s financial statements. I had three years of Bayou’s financial statements in front of me, from 2001 to 2003, all of them had the same format and were audited by the same audit firm, Richmond-Fairfield Associates (“Richmond-Fairfield”), a firm that I had never heard of before. Then, suddenly, something caught my eyes: the auditor’s statement. In the financial statements, the auditor’s statement address whether the auditor has found any material concern during the audit. Interestingly, the dates on the cover sheet entitled “Financial Statements and Report of Independent Certified Accountants” for all those three years were identical in month and day. I thought that I smelled something fishy.
3. Disappearance of Administrator
On May 1, 2005, a few weeks before reviewing the aforementioned financial statements, the Firm received a letter from Bayou, stating that Admiral Administration (“Admiral”) resigned as the fund administrator of Bayou’s offshore funds, and that Global Standard Financial Group Ltd. (“GSFG”) assumed the role as of April 1, 2005. A conference call with Admiral was scheduled to discuss the transition.
Author: We have just received a letter from Bayou that you had terminated your administrative services for the offshore funds. Can you tell me what is happening?
Admiral: We regret to tell you this, but we couldn’t perform the appropriate administrative services to the funds because Bayou didn’t send us any portfolio information. We couldn’t calculate or verify the NAV.
Author: That’s strange. We have actually received the monthly NAV statements from your firm directly. How was it possible?
Admiral: We simply used the figures provided by Bayou. But, we were not supposed to do that. So, we decided to resign. I’m sorry, but I cannot answer your questions anymore. If you have any further question, please contact Bayou or its new administrator.
Subsequently, we also learned that Admiral had in fact resigned as of Dec 31, 2004, five months before we received the letter from Bayou. This meant that the funds were operating without a licensed administrator for more than 120 days. Technically speaking, however, unless registered as mutual funds, a Cayman-based fund is not required to have an administrator. Nonetheless, it was against the industry standard not to have engaged a new administrator immediately after the resignation.
Following the call with Admiral, I sent several emails to Ms. Marsha Smith (“Smith”), the contact person at GFSG as listed in the Bayou letter without getting a single reply. Therefore, I called her office in the Cayman Islands. After several failed attempts, she finally managed to call me a few weeks later. She was apologetic and confirmed that her company was indeed the new fund administrator of Bayou’s funds.
I asked Smith to send me private placement memoranda (“PPM”), subscription documents and other key legal documents for the Bayou funds since I couldn’t find these documents in the Firm’s due diligence files, which the Director of Research handed to me. Her answer was quite disconcerting, to say the least: she said that the funds did not have any PPM because the funds had, instead, the funds’ operating agreements and subscription documents, which included all the necessary information, such as the minimum investment amount and the redemption terms. Contrary to her explanation or the lack thereof, it was not the norm for a legitimate hedge fund not to have a complete set of legal documents. To my even greater surprise, however, it seemed that no other investors in the funds had raised this issue until then.
Right after the call with Smith, I decided to check upon GFSG on the CIMA website against the list of licensed administrators who could operate business in the Cayman Islands (Box 2). Not surprisingly, I couldn’t find the name of GFSG on the list.
4. 575 Madison Avenue, Suite 1006
Scheduling a call with the CFO at Bayou was proving to be difficult; so I decided to contact Richmond-Fairfield, the fund’s audit firm to speak with Mr. Richmond, CPA, to inquire as to when the 2004 statements were expected to arrive.
Author: Hi. Can I speak to Mr. Richmond? I’m an investor of a fund to which he provides audit services.
Operator: Unfortunately, Mr. Richmond is out of the office today. Would you like to leave a message?
Author: Yes, please. By the way, do you know if he’s in the office tomorrow?
Operator: I’m sorry. I don’t know his schedule because I’m only an operator.
Author: What do you mean? Aren’t you working for him?
Operator: Yes, I do. But, I am only an operator and don’t know his schedule. Do you still want to leave a message for Mr. Richmond?
I had to repeat the same frustrating conversation with the operator several more times as this Mr. Richmond never called me back. I started to contemplate paying a visit to this elusive Mr. Richmond at his office at 575 Madison Avenue, Suite 1006, New York, NY 10022, as listed on Bayou’s financial statements.
I managed to find a floor plan of the 575 Madison Avenue building of the floor which Richmond-Fairfield’s single office was supposed to be located on (Exhibit 1). According to the floor plan, Suite 1006 (room #6 on the 10th floor) was located right in front of a small “Reading Area” and appeared to be only large enough for a few desks. For an audit firm for a $450 million hedge fund and its affiliated broker-dealer, the space seemed too small to conduct any serious auditing.
Exhibit 1: Tenth Floor Plan at 575 Madison Avenue
I left a message for Mr. Richmond that I was planning to visit his office in the next few weeks and asked about his availability. However, before Mr. Richmond got back to me, I received a call from Bayou’s investor relations to finally set up a conference call with Mr. Dan Marino (“Marino”), the CFO of Bayou. The call took place a few days later.
Author: Hi, Mr. Marino. Thank you very much for your time.
Marino: No problem. Sorry about the delay for the financial statements. We are working on it with our auditor* and should be done in the next few days.
Author: OK. Do you know if there is any issue or concern raised by your auditor?
Marino: What? I can’t hear you. Can you repeat that?
Author: Of course. I just said ‘Do you know if there is any issue or concern raised by your auditor?
Marino: What? Can you say that again?
*Italicized to show that it was exactly as the word as used by Marino. Of course, we later learned that the alleged auditor was owned by Marino himself.
I later learned that Marino was suffering from a serious hearing problem. For an obvious reason, the call produced nothing but frustration, and he hanged up as he got another “important” call.
A few days later, I received a call, from Mr. Richmond, whose voice was almost inaudible due to the poor quality of connection. He told me that the audit on the onshore funds was completed and the investors of the onshore funds had received the financial statements, and the offshore financial statements should be finished in the next few days. I asked him why the offshore financial statements were separated from the onshore’s this year, changed from their previous practice, but he provided no answer to my question. I also asked why the months and days on the statements were all identical. He said that it had just happened by accident. I discussed my conversation with the team and decided to wait for a few more days for the offshore’s financial statements.
The offshore financial statements were never delivered. I requested the investor relations to at least send me the onshore financial statements for the year 2004, but the person wasn’t even aware of them being completed. Discrepancies and inconsistencies were everywhere.
6. Connecting Dots
Before the deadline for the redemption request on June 30, 2005, I prepared a due diligence memo regarding my findings and recommendations to reassess the legitimacy of Bayou’s funds to the Director of Research. Unfortunately, he was on vacation and he never checked his email. Thus, the Firm could take no action for the June 30 deadline but it subsequently submitted the redemption requests for July 31st.
Soon after submitting the redemption requests, the president of the Firm discussed this issue with his friend, who was also an investor in the Bayou funds. The friend was so upset that he walked into Bayou’s office in Stamford and accused Israel of fraud. Then, on July 27th, a letter from Israel arrived regarding the returning of the capital to investors (Exhibit 2).
Exhibit 2: July 27, 2005 Letter from Israel
The redemption proceeds never arrived. A few weeks after the receipt of the letter above, it was reported that Marino disappeared after leaving a suicide note in his office. Marino never committed suicide and was subsequently arrested. The Arizona attorney general announced on August 30, 2005 that it had seized $101 million earlier in May, which belonged to Bayou and Bayou’s funds. It was also revealed that Richmond-Fairfield was a bogus accounting firm established by Marino. I then realized that Mr. Richmond, with whom I spoke, had been Marino himself.
There were a number of yellow and red flags concerning Bayou’s business, which would have alerted the investors if they were known in advance. Regrettably, the Firm’s due diligence process was not stringent enough and the money was gone along with the Firm’s reputation. However, as a young novice in the hedge fund world, it taught me the Importance of Being Diligent.