Dec 2009-Jan 2010

LEGAL EASE: FSA should probe harder for fraud

It is worrying that but for the current economic climate, the Bernie Madoff and Stanford frauds may not have been discovered. Jacqui Hatfield (pictured) and Gil Gohen comment...
hatfield.jpgThe global economic crisis has coincided with a steep rise in fraud investigations. Whilst Bernie Madoff enjoys the start of his 150 year sentence in a US federal prison for his orchestration of a $65bn (€44.4bn) Ponzi scheme, Sir Allen Stanford has been accused of a $7bn investment fraud through the Antigua-based Stanford International Bank.

The UK has also seen its fair share of fraudulent activity in recent months, with the investment fund industry being rocked in particular. In June, the (up to that point) highly successful structured product distributor and administrator, Keydata Investment Services, was forced into administration by the Financial Services Authority following the discovery of a £5bn (€5.5bn) tax liability. Only once PwC had attempted to trace the assets backing Keydata’s products was it discovered that the £103m worth of underlying investments had been liquidated and the proceeds misappropriated.

The FSA began investigating Keydata for its aggressive and potentially misleading marketing of its Secure Income Bonds. It was only through this investigation that it was discovered that the investments were ineligible for tax efficient ISAs as they were not listed on an Inland Revenue-recognised stock exchange.

The policies’ manager, Luxembourg-based SLS Capital, had made no income payments since October 2008, yet Keydata continued to pay investors income and returning cash to those who wanted to sell by using its own corporate funds.

An environment of declining asset prices and increased redemption requests has made the discovery of black holes in managers’ balance sheets all the easier. It is worrying that but for the current economic climate, the Bernie Madoff and Stanford frauds may not have been discovered.  In addition, had the products been properly set up for ISA purposes and the tax liability had not been discovered, Keydata could have continued making payments using its own funds without raising suspicion.

The Keydata scandal raises some issues for the FSA and for Keydata’s auditors. The FSA was already investigating Keydata, albeit for misleading marketing rather than for fraud.

Should the FSA have investigated further and if it had done so, would it have spotted the fraud?  It is also difficult to see how the auditors of Keydata failed to spot the discrepancies regarding payments when auditing the company. This could put them at risk of a potential negligence claim.

As the economy recovers the FSA’s ability to discover frauds of this nature will once again become difficult.  Certain changes if implemented may go someway to ensuring that frauds are discovered.

For example, schemes such as the Protean Fraud Appraisal Certification process, which combines internal due diligence and external background checks with an underwriter risk review to assess the overall risk of a hedge fund, could be useful if made compulsory in the UK in bringing to light the risk of fraudulent activities within a particular fund.

Auditors should always ensure that they review where payments are being made when auditing a company or fund and should investigate further where potential issues come to light.

The FSA should be more alert to potential frauds and better at spotting them. They should be prepared to probe more widely when investigating other behaviour of a regulated entity, such as misleading marketing in Keydata’s case, to ascertain whether there is potentially a wider issue. The FSA should ensure that they follow up any complaint by an investor, auditor, service provider to or employee of a FSA regulated entity, which raises suspicions that there may be fraudulent activity.  In addition the fines in the UK imposed by the FSA for fraudulent activity need to be significant enough to act as a disincentive to others.

Alongside this, investors should be encouraged to look on the FSA register when they appoint a financial advisor, manager or broker to see whether the company is appropriately authorised and to review their disciplinary records. 

Investors should also query the extent of customer complaints, training, experience and remuneration structures of their proposed financial advisor, manager or broker before they appoint them, so that they can make an informed decision in relation to them.

•  Jacqui Hatfield is a partner and Gil Cohen is an associate in the financial services group at Reed Smith

©2009 Funds Europe

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