Hedge Funds Could Face Increased Regulation

The Jewish Federation of Metropolitan Chicago prides itself on international philanthropy and how efficiently and effectively it spends money.

But these days the federation is fighting to recover more than $4 million invested in a hedge fund operated by Stamford-based Bayou Securities. Federal authorities say the fund was a fraud.

The federation’s attorney and leaders declined to comment on its lawsuit. Bayou executives, who have not been charged, did not return telephone calls seeking comment.

Bayou would be the latest in what regulators say is a growing number of frauds involving hedge funds, which are largely unregulated and traditionally serve institutions and wealthy investors. Hedge funds profit by using unconventional techniques, such as short-selling -- betting that a stock’s price will decline. Hedge funds typically are active traders and can use techniques that are off limits to mutual funds.

In the last five years, the Securities and Exchange Commission brought 51 cases charging hedge fund managers with defrauding investors of more than $1 billion. According to the agency, there are about 7,000 hedge funds managing $870 billion in assets, a 260% jump from five years ago.

“The growth in hedge funds has been accompanied by a substantial and troubling growth in the number of our hedge fund fraud enforcement cases,” the SEC said in a report last year.

Regulators say they are particularly concerned about the fraud because of the growing exposure of smaller investors, pensioners and charitable organizations to hedge funds in recent years.

Hedge funds require much higher minimum investments than mutual funds do. But to attract smaller investors, some funds have been lowering their entry requirements. Ordinary investors also passively participate in hedge funds through their pension and 401(k) plans, which are putting billions into hedge funds.

The SEC has mandated new oversight for hedge funds, saying the move could help identify fraud earlier in some cases and deter it in others. The new regulation will open the funds’ books to SEC examiners starting in February and make them subject to accounting and disclosure requirements.

Those who oppose regulating hedge funds have long argued that sophisticated investors are well equipped to detect fraud. They say hedge funds have not been disproportionately involved in frauds and the government should focus its limited resources on mutual funds that serve far more investors of modest means.

“You’re dealing with people who understand the risks involved,” said David Friedland, director of the Hedge Fund Assn. and president of a fund in Florida.

But even sophisticated investors have fallen victim to hedge fund frauds.

In Greenwich, a wealthy Connecticut suburb where hedge funds have concentrated in recent years, a New York University student and his mother were indicted in June on charges that they ran a $7.4-million scam.

Prosecutors say Hakan Yalincak, 21, and his mother, Ayferafet Yalincak, 50, created the illusion of wealth to persuade investors to sink millions of dollars into a sham hedge fund. Prosecutors say they spent investors’ money on a Porsche and a $1.25-million donation to New York University, then used those trappings to lure more investors. A trial is scheduled for November.

Bayou investors who lost millions called the fund a massive fraud that operated like a classic Ponzi scheme. Lawsuits filed in New York and Connecticut claim that Bayou executives hid massive investment losses by raising new money to pay withdrawing investors and to pay themselves fees and commissions they had not earned.

Bayou executives sent false statements and newsletters to investors, consistently overstating the fund’s value and performance, according to the lawsuits. Bayou also falsely claimed that it had an independent auditor, one lawsuit alleges.

Stamford police say one of the investors recently found a suicide note written by Daniel Marino, Bayou’s chief financial officer, alluding to fraud at the company. Marino was briefly hospitalized but has since been released.

Some Bayou investors lost retirement money, said Ross Intelisano, an attorney who represents nine Bayou investors. “For some, it’s a significant amount of their net worth,” Intelisano said.

In Connecticut, home to a large number of hedge funds, state officials are forming a task force to recommend reforms that could crack down on conflicts of interest and ensure that funds have independent audits.

That move has some in the industry worried that more regulations are on the way, possibly jeopardizing the flexibility of hedge funds to respond rapidly to changing market conditions.

The Managed Funds Assn., a group of hedge fund managers that claims about 1,000 members, favors an alternative approach of raising the net worth required for an individual to invest in hedge funds, said John Gaine, president of the association.

“We will be very vigilant in ensuring no unnecessary or unjustified regulations are put in place,” he said.