Anatomy of a hedge fund fraud (not the one you’re thinking of)

Does regulation prevent fraud? Who knows? But according to this colorful and detailed account of one famous case, the SEC should think again if it expects to stamp out fraud using new regulatory powers. The case is Manhattan Capital and the chronicler is Chidem Kurdas, one of the world’s most experienced and articulate hedge fund journalists. Kurdas’ account of the Manhattan case in the Winter 2009 edition of The Independent Review is well worth the read – particularly as we move into an era of greater hedge fund oversight.

Kurdas points out that “regulatory frenzy occurs every time another fiasco occurs.” And when it does, it’s often ineffective unless an interested party complains after the fact – that is, when the damage is done.”

Kurdas says that “at least one aspect of the Manhattan Fund vividly demonstrates regulations failure to deter fraud.” But it’s clear that this case study (written before the Madoff Affair) may provide some important lessons. In a nutshell, here’s what happened…

Michael Berger, described by Kurdas in this blog post as a “restless” 22 year old Austrian immigrant, launched Manhattan in 1996 with a decidedly bearish view of equities. According to Kurdas’ account, he raised $600 million over 4 years from investors who, like him, wanted to take out a sort of “insurance” against a market downturn. The problem, of course, was that this market downturn didn’t come soon enough for Berger and his investors.

Although Manhattan was later described as a Ponzi scheme, Kurda’s explains that it was actually a “real investment operation”. But as losses mounted, Berger began to cook the books by submitting fake holdings data to his administrator. That administrator trusted Berger’s data since it purportedly came directly from the fund’s introducing broker – a small Ohio firm that in turn used Bear Stearns as its prime broker.

The problem was, Manhattan accounted for a significant portion of the introducing broker’s revenue – leading some to believe that it was too quick to acquiesce to Berger’s demands. One of the those demands was that the firm send holdings information directly to him, not to the administrator. Well, you can guess what happened. Berger re-cast those numbers before passing them off to the administrator. When people asked about any discrepancies, he told then that the fund actually used several prime brokers – meaning only he had the full picture.

Eventually, Bear Stearns saw the red flags and alerted the SEC about the discrepancies between their data and Berger’s reports. Berger eventually fled the country and was picked up several years later by US authorities. Ironically, writes Kurdas, the only law suit that exists to this day involves Bear Stearns – the whistle blower, but also, unfortunatley, the firm with the deepest pockets.

The SEC initially blamed a lack of regulation for the fiasco. But it’s far from certain that the regulation eventually proposed for hedge funds would have helped in this case. As Kurdas points out:

“The long-established regulatory regime from brokerages did not deter the [introducing broker’s] executives, but instead gave them the status to assist Berger’s cover up…The aura of being supervised by the U.S. government almost certainly helped [the broker] play that role.”

“The case of Manhattan Capital’s Ohio broker is just one of many examples in which government supervision was already extensive and yet ineffective in preventing malfeasance. Decade after decade, illegal schemes crop up in closely regulated regulated industries.”

But what if Manhattan itself was registered with the SEC and had been examined by the commission? Kurdas questions whether it would have actually uncovered the scam. After all, she says, “If there had been a chance of an SEC examination, he [Berger] would have prepared for it.”

Kurdas goes on to explore the psychological and behavioral aspects of the case, saying that Berger’s “…confidence and audacity helped convince people. He wouldn’t dare tell barefaced lies [about the fund], would he? His explanation had to be true.” (sound familiar?)



As you read this story, you will quickly see the parallels to more recent fiascoes. But what is truly ironic about this captivating tale is that Berger acted as both fraudster and whistle blower. His investment strategy was based on a belief that companies like Enron and Worldcom were themselves cooking the books. But his complaints to the SEC fell on deaf ears. Writes Kurdas:

“At the time, however, attempts to bring up the issue were futile. Regulators showed no interest, even though Berger’s repeated warnings suggested that anyone willing to look could see the sleight of hand.”