Andrew Cuomo, the New York attorney general, yesterday filed civil fraud charges against the hedge fund manager Ezra Merkin, alleging he secretly channeled more than $2.4bn to Bernard Madoff's Ponzi scheme in exchange for lucrative fees.
The move is the second regulatory action in two weeks against one of the big so-called "feeder" funds that sent billions of dollars to Mr Madoff, who pleaded guilty to one of history's biggest investment frauds.
Mr Cuomo accused Mr Merkin, a leading figure in the New York charity community and former chairman of financing company GMAC, of steering money from charities, universities and non-profit organisations to Mr Madoff without their permission and reaping about $470m in fees for his three funds.
"Merkin duped individual investors, non-profits and charities into believing he was responsibly managing their investments, when in actuality he was dumping them into history's largest Ponzi scheme,'' Mr Cuomo claimed yesterday.
Operational Risk professionals in these hedge funds and other alternative investment firms are getting prepared. These organizations will continue to be under the regulatory spotlight for years to come. Fraud and the fear of fraud will make their potential clients even more diligent in their understanding of where their funds are being invested. The federal watchdogs, oversight mechanisms and civil law suits will require firms to have their risk management "Act" together.
When it comes time to prove the truth, whether innocent or guilty, it will come down to information. The likelihood that this information is housed in a database, e-mail system or off-site disaster recovery repository is almost certain. Digital information that is part of any inquiry for civil or criminal action is subject to the "Rules of Evidence" and the "Federal Rules of Civil Procedure." This is where most of the alternative investment firms have their greatest exposure and vulnerability today. Call it the "Readiness Factor".
In a groundbreaking case from the past year, Qualcomm Inc. v. Broadcom Corp., No. 05CV1958, 2008 WL 638108 (S.D. Calif. March 5, 2008), the court found the plaintiffs to have committed "monumental and intentional" discovery violations for failing to produce thousands of documents requested in discovery. The court cited the "impressive education and extensive experience" of Qualcomm's attorneys to justify significant sanctions for failure to produce relevant e-mails, including reporting to the State Bar of California.
The "Readiness Factor" goes far beyond the process or procedures for preserving evidence. It starts with the creation of information inside the organization. How is it classified, where is it stored and who has access to it? These are fundamental Information Technology and Records Management 101 questions that any prudent organization has already answered. Where most firms find themselves with their backs up against the "legal wall" has to do with relevance, authenticity, and admissibility of information.
The "Alternative Investment" industry is quickly learning that their own IT professionals are going to end up on the witness stand and in early depositions. They are going to be hearing questions such as:
- What policies or procedures do you manage in your department/organization?
- What training do you have on the collection and preservation of "Electronically Stored Information"?
- Explain your responsibility or supervision of access controls, folder management, indexing, purging controls and metadata?
- Describe the procedures your firm utilizes to identify the places, people (custodians) and quality of the data that has been preserved for this case?
The list continues and the IT professionals better be ready. Adversarial counsel will be digging deep to get after the key components of authenticity and spoilation issues. The unfavorable outcomes from a lack of readiness can produce an "Economic Factor" that far exceeds the cost of just finding and producing the information for e-Discovery.
The economic impact of proving the truth in any case can be significant. If you were a savvy and smart prosecuter, the cases that would filter to the top for scrutiny may very well be those firms that display the most "IT Immaturity." Getting some wins under your belt with some relevant case law could determine how fast future cases are settled far in advance of ever getting to trial.
For those "Alternative Investment" firms that are behind the 8 Ball, here is a good place to start your own discovery of the total cost of proving the truth. The E-Discovery Road Map.