The First Rule of Due Diligence – Trust But Verify

Kingscliff, New South Wales, is a small town that many people would likely struggle to find on a map of Australia. One group who could place it with pinpoint accuracy, however, is the Enforcement Division of the Securities & Exchange Commission in New York, who extended their extraterritorial reach to find an alleged fraud at an Australian fund manager operating half way around the world.

Readers of Ocean Road Magazine, the lifestyle guide to the North Coast of NSW, would have been highly familiar with Goldsky Asset Management LLC and mastermind Kenneth Grace, who ran the transcontinental hedge fund business from the local high street, alongside the coffee shop and what is purported to be a very nice gelato place.

At first glance, Goldsky looks to have little relevance for institutional investors. However, Mr. Grace was savvy enough to involve Citco and Northern Trust (named as fake service providers according to the SEC): these names could easily have been chosen to fool more sophisticated investors. Also, the Manhattan address and the 212 phone number referred to by the SEC indicated Grace had bigger plans for his enterprise. A recent press release indicated the fund was opening in Singapore and Hong Kong too.

And, of course, Goldsky elected to register with the SEC and file a form ADV – which is how the firm first came onto the US regulator’s radar (Castle Hall’s “DiligenceExpress” report on Goldsky, which presents ADV information on all US registered managers in the format of a structured diligence document, is available here).

According to the SEC, Goldsky's performance data, assets under management and service provider directory were all entirely fraudulent. Per the regulator, the Goldsky Fund had boasted “19.45% annual returns and 70.33% monthly returns since inception, all calculated in conformance with accepted accounting principles ("GAAP")”[!] After their investigative work the SEC Enforcement team concluded that the Goldsky Fund had engaged in “no investment activity at all and had not achieved any investment returns”.

GoldSky reminds us of the first principle of due diligence – Trust But Verify.

"Trust but verify" comes from a quote from Ronald Reagan, who used it when discussing the USSR during 1980s disarmament negotiations. The principle certainly rings true when dealing with investment manager due diligence.

In Castle Hall’s due diligence process, our Trust But Verify procedures encompass two key areas:

• Desk procedures to verify all external relationships claimed by the asset manager, at both the firm and the fund level.
• Onsite due diligence verification of internal documents to evidence that procedures operate as described.

We will return to the second topic in our next blog entry. However, to set the scene, when completing onsite due diligence on an asset manager / fund, if a control, procedure or committee is not documented / minuted - with documents and minutes available for investor inspection - then the asset manager cannot prove that the control / procedure or committee exists. Plenty to discuss in this area!

On the first topic, verification of external manager and fund relationships is a fundamental anti-fraud check. Every investor should be able to demonstrate that they have independently verified all key relationships claimed by an investment manager: if they fail to do so and beneficiary capital is then lost, an investor’s diligence process could clearly be criticized as being negligent.

Mandatory diligence checks include:

• Confirmation of appointment of the administrator (email verification)
• Confirmation of appointment of the custodian (email verification)
• Confirmation of appointment of the prime broker(s) / FCM / ISDA counterparties (email verification)
• Confirmation that the stated directors are actually members of the board (email verification)
• Confirmation of assets under management (typically achieved via confirmation with the administrator) (email verification)
• Confirmation of stated track record (reconcile the stated performance to the audited financial statements)
• Confirmation that net assets per the audited financial statements match the assets reported in the year end administrator transparency report (if available)
• Confirmation of the appointment of onshore counsel email verification)
• Confirmation of the appointment of offshore counsel (email verification)
• Confirmation of the appointment of the compliance consultant (email verification)
• Confirmation of the appointment of the IT consultant (email verification)
• Confirmation of registration with the SEC and all other stated international regulators to appropriate websites
• Confirmation of incorporation of the fund to local jurisdiction website (e.g. Cayman, Delaware)
• Confirmation of membership of stated professional bodies (e.g. AIMA, SBAI etc – it is always interesting when a manager who is not a member of AIMA is using the AIMA standard DDQ, for example).

The above procedures are time consuming and often administrative, as investors check “A” to “B”, “B” to “C”, “C” to “D” and “D” back to “A”. However, any inaccuracy is an immediate red flag. What happens if a manager claims to have a relationship with a well-known compliance firm, but it turns out that the manager only hired them once, on an ad hoc basis, 18 months ago? What happens if the stated performance does not tie to the financial statements due to a difference in inception date (e.g. financial statements show commencement of operations on June 16, but track record starts July 1 – with losses actually incurred in the first two weeks of trading, which are conveniently excluded from the track record presented to investors?)

For more information on Castle Hall’s due diligence coverage in Australia, please contact Alex Wise, Head of Australia, at awise@castlehalldiligence.com.