Hedge Fund Fraud Case Study — Bayou

Source: CNBC


How important is it to check the legitimacy of the audit firm? The importance of reviewing financial statements goes without saying. Duly audited financial statements provide the proof for the existence of the assets and for the verification of past performance. No other document provides such vital information. But, it is like oxygen: it is fundamental and critical, and yet the importance of oxygen is often unrecognized and quite ignored because it is tooobvious.

However, the importance is not in the contents of the financial statements. Unlike the 10-Ks and the 10-Q required for listed companies, the financial statements of hedge funds are not comprehensive; thus, analysts only give them a cursory review and check them off from their due diligence lists.

Therefore, it is not the contents, but the legitimacy of these financial statements that is of absolute importance. Many financial statements are distributed in a digital format, with only the electronic signature of the auditor, which is clearly easy to fabricate.

Case Profile


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. According to Marino’s suicide note, Israel and Marino started to manipulate Bayou’s accounting records by steering trading commissions from Bayou Securities, an affiliated broker-dealer, back to Bayou’s funds in 1997.

Bayou’s investment activities continued to generate losses; 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; and Marino could no longer face the mounting pressures when the Arizona attorney general seized $101 million in May 2005, which purportedly belonged to Bayou’s funds.


  • Richmond-Fairfield Associates (“Richmond-Fairfield”), the audit firm of Bayou’s funds, played a critical role in Bayou’s 8-year scam. The accounting firm was established by Marino, Bayou’s CFO, and fabricated the financial statements of all the hedge funds managed by Bayou. In Bayou’s earlier marketing presentations, Grant Thornton was listed as the audit firm, but they in fact had never performed any auditing.
  • Admiral Administration, the original administrator for Bayou’s offshore funds, resigned because it was unable to calculate NAV due to the lack of availability of portfolio data. In its stead, a less-known Global Standard Financial Group Ltd. (“GSFG”) was appointed as the new administrator; however, GSFG was never licensed to operate as a fund administrator in the Cayman Islands.
  • Verifying and checking the legitimacies of the auditor and the administrator would have raised a red flag, even if they are not conclusive by themselves to constitute evidence of fraud.


Read the Fine Prints of the Financial Statements

  • Although most analysts, whether for hedge funds or public securities, spend their time on the quantitative parts of the financial statements, this approach is problematic. The more valuable information is actually found in the qualitative sections, such as the auditor’s statements and footnotes.
  • Read the auditor’s statements carefully, check if the auditor’s name, accounting standards and audit standards are the same as the previous year’s.
  • Cross-check the information in the footnotes with other legal documents (e.g., PPM, sub doc) and marketing documents (e.g., pitchbook, DDQ).
  • In the case of Bayou, quite unusually, the dates on the auditor’s statements were the same from 2001 to 2003. Furthermore, contrary to industry-standard practice, there was only one consolidated financial statements for all the funds managed by Bayou. In 2005, Bayou failed to deliver its offshore financial statements on time without every providing a reasonable explanation for the delay. All of these were signs of a potential problem.

Check the Legitimacy and the Independence of the Audit Firm

  • The first thing to do when conducting an audit firm review on a fund is to verify the existence of the audit firm. This can be quite easily done by calling the audit firm and ask the operator to connect you with the contact person of the fund. If the operator cannot find the name of the fund, it is a red flag. Similarly, if you have the name of the individual auditor, ask to speak to this person. If the operator cannot find the auditor on the list of employees, it is another red flag.
  • After identifying the auditor, ask for a copy of the financial statements. Then check the statements from the auditor against those sent by the investment manager. Needless to say, they should be identical.
  • In the case of Bayou, it was relatively easy to spot the questionable legitimacy of the audit firm. But in reality, almost nobody doubted if it was affiliated with Bayou’s CFO. The word, “audit,” gives off an impression of legitimacy. In fact, the more boldly done, the fewer people will suspect that a reputable hedge fund manager will take such a risk to create a bogus accounting firm.
  • Richmond-Fairfield had a tiny office at 575 Madison Avenue, with only such space as large enough for two desks. Richmond, the alleged auditor, was never there as he was no less than Marino himself (see Appendix 1.1). Although a very few analysts pay attention, Dun & Bradstreet’s database actually listed Marino as the principal of Richmond-Fairfield as well as New York State Education Department website (see Appendix 1.2). These were all alarming signs pointing to the dubitable legitimacy and independence of Richmond-Fairfield.
  • Unfortunately, post-Bayou and Madoff, it is increasingly more difficult to have a conversation with the audit firms and the auditors as they are afraid of the potential legal liabilities. In theory, fund investors should be considered, vicariously, as the audit firm’s clients, as well as the fund, which pays the audit fees, but that is usually not how audit firms or auditors think. As a matter of fact, they very often refuse to speak to the fund investors. If this is the case, contact the investment manager to request a confirmation of audit. Although this is not the best way to confirm the legitimacy of the audit firm, at least, it provides an extra layer of checks. Alternatively, contact the fund administrator and set up a call with to discuss the auditing process. Based on my experience, fund administrators are more open to discussion and can provide a wider range of information. Ask the name of the auditor with whom the fund administrator is working with to prepare the financial statements.

Appendix 1.1: Floor Plan of 575 Madison Ave, 10th Floor

Source: World-wide Business Centres website

Appendix 1.2: Result of Verification Search on New York State Education Department Website

Source: New York State Education Department

Check the Legitimacy and the Independence of the Administrator

  • If a fund is registered in the Cayman Islands, go to the Cayman Islands Monetary Authority’s website and find a list of licensed administrators. If the administrator’s name cannot be found on the list, it cannot legally operate in the Cayman Islands. The Bermuda Monetary Authority has a similar list on its website.
  • Again, call the main number of the administrator and ask to speak to the main contact person of fund. If the operator cannot find the name of the fund, it is a red flag. Similarly, if you have the name of the main contact person provided by the investment manager, ask to be put through to the contact person. If the operator cannot find the contact person on the list of employees, it is another red flag.
  • Conduct a due diligence call with the administrator and review their day-to-day operations with its accounting team. It is also important to check whether an independent data feed system from the funds’ custodians are established, bypassing the investment manager. Similarly, the fund administrator should have established independent valuation guidelines for most of the public securities.
  • In the case of Bayou, Admiral’s resignation could have, or should have, pulled the trigger. However, full service administration was not an industry standard back then. Therefore, although switching to a non-licensed administrator was a clear sign of problem, as it signified that Bayou could not find any legitimate replacement for Admiral, no one had paid much attention.



Shinya Deguchi @ Star Magnolia Capital

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