An RIA that paid the price for falling for the Bayou scam speaks out

Yesterday, RIABiz posted a column by Pat Huddleston, a former enforcement chief for the SEC, about the increased due diligence that RIAs should undertake to keep fraudulent investments out of their clients’ portfolios. He used as an example the case of New York-based Hennessee Group, a well-known advisor to hedge funds, which was caught up in the 2005 collapse of hedge fund Bayou Management.

In RIAs need to become students of financial fraud so scam artists can’t rent their credibility, Huddleston pointed out that Hennessee paid a price for recommending Bayou, in dollars and in reputation. Just last year, it disgorged $800,000 back to its clients to settle a negligence charge brought by the SEC against the firm.

After the column was posted, we got a call from Lee Hennessee. She and her husband Charles Gradante are principals of the firm, well known for its Hennessee Hedge Fund Index that is cited by publications from the smaller trade magazines up to the Economist. It now has about $300 million of AUM, considerably less than it did before the scandal.

The damndest liar

She talked about what it was like to be sucked in by Sam Israel, who was later sentenced to 22 years in prison for defrauding investors of hundreds of millions of dollars. “He was the damndest liar,” she says. And she freely admits that she learned plenty from the experience.

“My ignorance was that I didn’t think somebody would lie to you in writing,” she said, noting that Bayou provided a plethora of phony documents.

She said none of the firm’s clients had more than 5% of their portfolios in Bayou, which limited their losses. Still, Bayou’s collapse put Hennessee through years of legal battles.

But both Hennesee and Gradante take issue with the main point of Huddleston’s column, which is a question of huge concern for RIAs. Huddleston argues that RIAs need to increase their due diligence so that they can uncover fraud. Gradante says that in the hedge fund world, where hedge funds typically do not offer basic access to investors, that is well-nigh impossible.

“RIAs are really not qualified and are not hired to uncover fraud,” he says, likening RIAs’ role to that of a stockpicker.

In 2007, Judge Colleen McMahon, in an opinion dismissing a case by one of Hennessee’s clients against it, seems to put RIAs’ level of accountability at a level no greater than that of other elements of the investment community, writing that, “The Complaint alleges that Bayou concealed the fraud from investors, the public, investment advisors, other industry professionals and regulators – including the SEC – for nine years. Given that Israel … managed to deceive the entire investing community for nearly a decade, South Cherry’s allegation that Hennessee Group would necessarily have uncovered the fraud had it conducted the due diligence it promised is far from compelling.”

Though the court dismissed the case, the SEC filed charges just after the Madoff case broke. See also: SEC details new. Hennessee said the firm, out millions of dollars of legal fees by this time, decided the best course of action was not to fight with the SEC. The $800,000, she said, represents the same amount as the fees that clients paid Hennessee over the years for the Bayou advice.

One takeaway for advisors, she says: “You can win in court but that doesn’t mean the SEC won’t have its way with you.”

Who has the accountability?

So if an RIA doesn’t have responsibility for the level of due diligence it takes to uncover a well-constructed fraud, who does? That remains an open question.

Gradante argues that the SEC could issue new regulations that would add safeguards through lawyers and accountants who serve hedge funds and their investors. The regulations could, for instance, require audits of hedge funds. Attorneys could be responsible for vetting the resumes of those involved in hedge funds.

Some clients who lost money are trying to hold Goldman Sachs, Bayou’s clearing firm, accountable. Goldman Sachs was ordered to pay $20.6 million in an arbitration hearing because it did not uncover the fraud, according to a New York Times article. In July, the Times reports, Goldman moved to vacate the decision.

“The award was a watershed,” wrote Times writer Susanne Craig in late October. “If the federal courts uphold the arbitration decision, it could have ramifications across Wall Street. Wall Street firms, which handled billions of dollars in trades, say that their job is to clear the trade, not police the clients.”

One part of the financial system that’s not being held accountable: the regulators. FINRA regularly audited Bayou.

See also: Why advisors see FINRA as the devil.

This story was changed on Nov. 18 to clarify Hennessee’s payment to clients in response to SEC charge, and to clarify the mention of FINRA’s audits.