• Being Diligent

Case 007: Westgate



Abstract:

James Nicholson’s hedge fund dream ended with a diminishing cash balance during the financial crisis. He told his clients Westgate Capital was making money while others were losing, but in fact, he was losing even more money. But, what was his technique to keep running the Ponzi scheme over 10 years?


Case Profile:



Background

James Nicholson (“Nicholson”) had a choppy carrier. After graduating from the State University of New York at Stony Brook, he joined Shearson Lehman Hutton, Inc. in Oct 1988. Within five months, he switched employees twice, from Drexel to Smith Barney, where he spent 2 years and 3 months. Over the next 8 years, he worked at Prudential, Merrill Lynch, First Colonial Securities and The Key Group.


In 1999, Nicholson left The Key Group to establish Westgate Capital Management, LLC (“Westgate”), an unregulated hedge fund management company, in Saddle River, NJ, with Robert Lee, his classmate from SUNY, and began soliciting wealthy individuals to invest in his equity long/short fund. The performance of Nicholson’s first fund, Westgate Growth Fund, was second to none as it generated consistently strong returns regardless the market conditions.


Exhibit 1: Performance Second to None



Nicholson was also a sweet-talk marketer. In December 2008, he solicited investors with a “special” opportunity to earn an 8-10 percent guaranteed return for a one month investment available only to Westgate’s “best clients.” At least one existing investor took advantage of this offer by investing an additional capital with Westgate.


Nicholson’s business seemed to be very successful to prospective investors as he often told Westgate’s AUM is well over $750 million, however, he was running into a big trouble by early 2009.

Problems

On December 13, 2008, a few days after the news of Bernie Madoff’s arrest, Ray Froimowitz (“Froimowitz”), a representative of Carrickmore Property & Development Co., LLC (“Carrickmore”), became concerned with Westgate’s legitimacy and requested Nicholson to provide audited financial statements for Westgate Strategic. Nicholson agreed to provide the documents immediately, but never did. On December 26, 2008, Froimowitz attempted to physically visit the NY office of Havener and Havener (“Havener”), Westgate’s audit firm since its inception – Froimowitz couldn’t believe what he found there. The listed address of Havener, 49 East 41st Street, New York, NY was just an empty small room of a so-called virtual office.


Nicholson stopped paying rent and salary to his employees as early as January 15, 2009 because his cash balance was running short. As the financial crisis deepened and his investors needed cash from their investments in Westgate, Nicholson couldn’t raise enough money to sustain his big lie. Checks he sent to the investors were returned for insufficient funds. On February 25, 2009, the FBI arrested Nicholson while US Attorney’s Office for the Southern District of New York announced the filing of criminal charges of Securities Fraud and Bank Fraud against him. It was the end of his game.


Nicholson later admitted that he failed making money since the beginning. As his losses mounted, he realized it was almost impossible to recoup them. Instead of telling the truth to his investors, he took money from the hedge funds and used for himself. Westgate never managed $750 million, but only raised $218 million before payout to meet redemption requests. Westgate lost 35% of capital through trading, 17% through theft and 6% for other reasons.


Exhibit 2: Westgate’s Gains and Losses


Source: United States of America v. James Nicholson (2009),

Note: Lee Richards, Receiver of Westgate, later recovered $9.99 million from investors who made “fictious profits” in November 2010


Recommendations:

Conduct thorough background checks, including FINRA broker-dealer database and interviews with former employees

  • FINRA BrokerCheck is an important source of background information for managers as many of them have experiences to work as a broker-dealer; according to the record, Nicholson was sanctioned by NASD (now-FINRA) and barred in all capacities as a broker-leader in 2001 for (1) furnishing the NASD with a false/misleading response to a request for information and (2) failing to respond to NASD requests for information made pursuant to NASD rule 8210.


Exhibit 3: Red Flag on the FINRA’s BrokerCheck Result


  • According to the article published on NorthJersey.com, at Prudential Securities in Fort Lee and Merrill Lynch in Bardonia, N.Y., Nicholson faced customer complaints of “unsuitable trading” or “unauthorized trading.” Nicholson had a more serious problem in 1995 when he was fired from Merrill Lynch after he admitted to management that he “exercised discretion” in client’s account and violated firm policy.

  • A group of customers from Nicholson’s time at First Colonial accused him of embezzling money from their accounts, according to the securities records. Nicholson left the firm in March 1999 and got a job at The Key Group Inc., an investment firm in Ramsey. There, he came under internal review for apparent wire transfers from a customer’s account into his personal bank account, according to the securities records, which don’t specify whether the two complaints were related.

  • By 2000, one of Nicholson’s clients, Bob DeBeauvernet, had accused Nicholson of embezzlement during his days at First Colonial. DeBeauvernet accused Nicholson of embezzling the money he and his relatives invested with Nicholson.

Review the legitimacy of an audit firm

  • It is always advisable that potential and existing investors review the legitimacy of an audit firm which conduct an annual audit

  • In the case of Westgate, Nicholson fabricated Havener and Havener to hide losses in his hedge funds. This is very similar to what Sam Israel of Bayou did.

  • Havener and Havener is never known as an audit firm and prospective investors should be concerned with its legitimacy when they saw the name. Find a main number of the office and call them to make sure they have more than one employee. For $750 million hedge funds, its annual audit cannot be handled by one person. Check if the accountant really possess CPA designation via the Office of the Professions website (for NY), http://www.op.nysed.gov/opsearches.htm


Exhibit 4: Verification Search for NY CPA


Review Form 13F on the SEC’s EDGAR system

  • All institutional investors that use the U.S. mail and exercises investment discretion over $100 million or more in Section 13(f) securities (publicly traded US stocks, equity options and warrants, ETF and convertible bonds) are required to report its holdings on Form 13F with the SEC. Form 13F is available for the public through the SEC’s EDGAR System (http://www.sec.gov/edgar/searchedgar/companysearch.html)

  • Although Westgate claimed that it is trading U.S. stocks with over $750 million assets under management, it never filed the Form 13F. This is clearly a serious warning sign for either (1) violation of the Securities Exchange Act or (1) the manager does not exercise investment discretion over $100 million.


Use your common sense…

  • Westgate’s investment performance was too good and too consistent. Exhibit 5 shows that the performance of Westgate is almost flat line with two extremely sharp growth periods. This unreasonably consistent return profile is similar to other well-known fraud cases like Madoff and Petters.


Exhibit 5: Comparison of Returns Since Inception



Source:

What can be salvaged?”, NorthJersey.com, September 13, 2009

’Huge holes’ in oversight, NorthJersey.com, August 16, 2009

U.S. Securities and Exchange Commission v. James M. Nicholson, et al (2009), United States District Court Southern District of New York

Carrickmore Property & Development Co., LLC, a Delaware limited liability company, On Its Own Behalf and On Behalf Of All Others Similarly Situated v. James M. Nicholson, et al (2009), United States District Court Southern District of New York

United States of America v. JamesNicholson (2009), United States District Court Southern District of New York

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