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CHAPTER 1
Recent Hedge Fund Scandals
PALM BEACH, FLORIDA
Palm Beach, Florida, is home to some of the highest net worth individuals in the country. This community has been investing in hedge funds for several decades and unfortunately has also been a target of several scam artists. As Palm Beach has featured in several financial scams and scandals in the press of late, it behooves me to delve a little bit deeper into the makeup of its denizens and the psychology of the society. I believe that it will help in understanding the way people generally approach investing and the overreliance on relationships rather than due diligence.
The island of Palm Beach is an exclusive community that runs about fourteen miles in length, but most of the multimillion-dollar mansions are located in a two-mile stretch along South Ocean Boulevard. It is often confused with West Palm Beach, but once you cross one of the three bridges connecting Palm Beach island to West Palm Beach you quickly realize that there is little in common between Palm Beach and what lies OTB (“over the bridge” in Palm Beach lingo). Palm Beach serves as a summer home for the super-rich Wall Street tycoons, industrialists, recording artists, and European aristocracy. While deserted almost six months of the summer, the height of the hurricane season in Florida, it comes to life from October to April. The lavish and umpteen charitable galas held every year at the Breakers Hotel and Donald Trump’s Mar-a-Lago Club are a must-attend for the socialites of Palm Beach. My girlfriend at the time ran one of these charitable foundations on Palm Beach. As a result, we both frequented these charity balls. Being an outsider, I was often amused and befuddled by my observations. While sipping glasses of Dom Perignon and being entertained by crooners like Wayne Newton, the conversations often covered the latest exotic vacations, yacht acquisitions, and the best-performing investments of the year. The competition to climb the social ladder in Palm Beach and being on the invitation “A” list is second to none. Being feted in the Shiny Sheet, the Palm Beach society newspaper, by a charitable organization is far more important than knowing the destination of one’s philanthropic dollars. Need for social recognition and being a part of an exclusive group or invitation list is a panacea. There is no wonder that in such an environment a hedge fund that advertises superfluous or metronomic returns and admits investors on an invitation-only basis would be highly sought after. As we take a look at the following scandals, we will see that blind greed, a herd mentality to belong to an exclusive club, and lack of proper due diligence has often led to financial ruin.
KL FINANCIAL, MARCH 2005
John Kim, one of the founders of KL Financial, a hedge fund, once said, “I cannot promise one hundred and fifty percent annual returns, but I won’t rule out the possibility.” The story of KL Financial starts in a San Francisco apartment in the late 1990s at the peak of the Internet boom and the day trading fad. John Kim and Mr. Won Sok Lee, two of the three partners of KL Financial, started day trading technology stocks. Neither of them had any formal training or experience prior to this as stock traders. Mr. Lee grew up in Las Vegas and earned a law degree at Tulane University in 1996. He then worked as an associate in the gambling department at a Las Vegas law firm, and, in the late 1990s, in the tax department at a San Diego law firm. John Kim and his brother, the third partner, Yung Kim, grew up in a Virginia suburb of Washington. John Kim often regaled his friends and associates with the story of how upon graduating from George Washington University he had operated a coffee importing business in South Korea, but had it taken away by the despotic government because of its huge success. No record of such a coffee importing business or its usurping by the South Korean government can be found. Mr. Kim also liked to brag about his days as a mergers and acquisition banker at Merrill Lynch, although Merrill Lynch has no record of his ever working there. Furthermore, the NASD, a regulator that licenses securities professionals, says it has no records that any of the firm’s three principals ever applied for the necessary licenses to trade stocks for clients on Wall Street. Despite such a nebulous track record, Mr. Kim and Mr. Lee rode the tech boom and managed to set up a trading operation in Irvine, California, and in 2002 an office in Palm Beach, Florida. They hired a staff of inexperienced, usually fresh college graduates. Mr. Kim acted as the Chief Investment Officer, his brother Yung Kim as the Chief Financial Officer, and Mr. Lee handled back-office duties.
Ritzy Palm Beach Offices: Looking the Part
It is often said that if you want to be successful, you have to look the part. The principals of KL Financial took that to heart: When one is trying to woo the Palm Beach crowd, one has to really impress. They conjured up returns of 70 percent in 2003 and 40 percent in 2004, according to doctored statements given to investors. To complement their outsized returns, they bought outsized lifestyles. They bought flashy cars: Maserati, Porsche 911, and Mercedes SL 500. The firm’s personal masseuse drove a Jaguar X-Type that was provided by KL Financial. End-of-year holiday parties were held in Las Vegas, where Mr. Kim and Mr. Lee were high-rolling VIPs at several casinos. They shopped on Worth Avenue, the equivalent of New York’s Fifth Avenue and made themselves very conspicuous. They befriended the right people, who provided them with access to society functions and thereby introductions to their wealthy clients. To create the right impression, they spent $1.8 million in decorating their office space, which spanned most of the 17th floor of Esperante, a signature tower with bird’s-eye views of KL Financial’s target market: Palm Beach. According to a report by the Palm Beach Post, the $47,000-a-month suite’s private landing had a $15,000 wall-size waterfall, a feng shui ceiling of carved wood and a floor of wenge planks, a dark, black-veined hardwood from Tanzania. The lobby had a rotunda-style coffered ceiling, dark mahogany built-ins, gray plush sofas, pewter-hued suede walls, and Wenge floors. Dakota Jackson custom furniture included Aldabhra conference room chairs of kiln-dried solid mahogany. Opposite a window wall overlooking the waterfront were double-faced wood-trimmed panels of frosted glass filled with reeds of bamboo. John Kim, the chief investment officer and senior principal had a $6,000 Inada black leather Shiatsu massage recliner in his spacious corner office. The large sunlit offices were filled with gorgeous desks designed by Dakota Jackson and a conference table that had to be hoisted seventeen floors through the building’s elevator shaft. The trading floor had large flat-panel televisions scattered throughout. Spread on end tables and John Kim’s credenza were brochures for Palm Beach, America’s International Fine Art & Antique Fair, a book on Korean folk painting, and brochures for the Ritz-Carlton Golf Club, the Bear’s Club, and PGA National Resort and Spa. John Kim’s trading station had eighteen screens hooked up to ten computer towers. Former employees cooperating with the investigation told investigators that Kim’s computers looked at times like rockets at liftoff, with lights blinking and fan motors revving. While KL Financial’s offices were very expensively decorated, there are several hedge funds whose offices are even more stupendous. But the difference is that the principals of KL Financial used money stolen from its clients not earned in the markets.
Ronald Kochman: The Facilitator
Ronald Kochman has been mentioned in several press articles and investigator reports as the person instrumental in introducing the KL Financial principals to the Palm Beach elite. Since the late 1990s, Mr. Kochman had built a lucrative trusts-and-estates practice, counting a number of Palm Beach’s movers and shakers as clients. “Kochman had one of the pre-eminent practices down here,” said Richard Rampell, an accountant who worked with Mr. Kochman on several occasions. “In the last couple of years, he probated two estates that were well into nine or even ten figures. He was the envy of a lot of lawyers.” According to investigators and KL employees, Mr. Kochman became increasingly involved with the firm and formed a close friendship with John Kim, who made Kochman a principal in KL Financial. Mr. Kochman, these people said, believed that there were greater riches to be reaped if KL were sold to a large Wall Street firm, as Mr. Kim indicated it eventually would be. They said Mr. Kochman planned to downsize his trusts-and-estates business in order to play an even bigger role at KL. Trusting his new friends, Mr. Kochman provided introductions to his clients and friends and was responsible for bringing in many of KL’s investors, according to investigators. The aura of success and exclusivity around KL Financial was so strong that investors often begged to be let into its funds, some of which were said to have astounding annualized returns of 125 percent for several years. Among the funds’ over two hundred investors were some of Palm Beach’s elite, including Jerome Fisher, the founder of the Nine West shoe store chain; Carlos Morrison, an heir to the Fisher Body automotive fortune; and golf pros Nick Price and Raymond Floyd, according to people who have seen lists of investors.
The Duping and the Post Mortem
In the fall of 2004, several of KL Financial’s investors started asking for certified audits of the funds. John Kim kept promising to get the audit done but kept delaying it. Investors started to get jittery and decided to redeem their assets. On February 22, 2005, Securities and Exchange Commission (SEC) officials unexpectedly visited KL Financial’s offices and asked to see documents. After the meeting, investigators said, Mr. Lee walked out of the office, leaving a half-eaten bag of cookies on his desk. The next morning he went to the airport and bought a one-way ticket for South Korea, using frequent-flier miles. The day after that, Yung Kim disappeared as well. A few days after the SEC appeared on KL’s doorstep, John Kim invited about thirty employees to his home. As the employees listened in shock, he said that the company was under investigation and that his brother and Mr. Lee were missing. John Kim squarely put the entire blame on his two partners and played the innocent victim.
KL Financial principals ran a Ponzi scheme, i.e., paying out any redemptions to existing investors from funds received from new investors. All the superfluous returns were doctored and $190 million of investors’ money was either lost in the markets through incompetent trading activity or spent in personal pursuits by the principals.
On July 17, 2008, John Kim and his brother Yung Bae Kim were sentenced by the Honorable Kenneth L. Ryskamp in the United States District Court in West Palm Beach, Florida. John Kim was sentenced to 220 months imprisonment followed by three years of supervised release. Yung Bae Kim was sentenced to 75 months imprisonment followed by three years of supervised release. Each defendant was also ordered to pay restitution, which will consist of 50 percent of any income they earn in a Federal Prison Industries job, and following their release, ten percent of their monthly gross earnings. Won Lee, the third principal who is also named as a co-defendant in the indictment, remains a fugitive from justice.
The post mortem of the KL Financial in the presses produced the usual warnings from the various experts that went unheeded. First was the sloppy doctored re-creation of brokerage statements. The brokerage statements did not look professional and should have been spotted by the investors. Second, fingers were pointed at a lack of due diligence on John Kim’s background. The offering memorandum of KL Financial did not give details on John Kim’s professional background. And finally, the third red flag was the lack of audited statements.
These blatant red flags beg the question, How could such smart, successful and savvy investors from Palm Beach be duped by the charlatans of KL Financial? I feel that the answer to the question is twofold—an overreliance on relationships and not enough on due diligence; second and more important, improper due diligence. Many people have blamed greed for high returns as a culprit, which in my opinion is a ridiculous statement. We all have the option of keeping our money in cash or under the mattress.
My friend Steve Malone, a successful businessman, never invests in the stock market, let alone hedge funds. He invests in himself; he identifies businesses that he has a passion for, then he invests not just his money but time as well in these businesses. For those of us who do invest in the capital markets and hedge funds around the world, our main motivation for doing so is because we want higher returns while acknowledging that we are taking higher risks as well. The key is understanding all the risks involved in our investment decisions and then making prudent investment choices. The fault lies not with the desire to invest in high yielding investments but in not reconciling our expectations with the risks associated with them. The reason why the investors in KL Financial got duped was not because they were greedy but because they did not understand or care to find out all the risks involved in their investment.
Ronald Kochman was the estate and trust attorney for a lot of wealthy families on Palm Beach that invested in KL Financial. He was an attorney who was an expert in understanding the tax code, IRS regulations, and drawing up proper legal contracts to fulfill his clients’ tax obligations. He was very good at that job, but how did that qualify him to become an expert on hedge fund trading strategies? What in Ronald Kochman’s resume made his clients feel that he had the expertise to guide them toward a proper investment choice while explaining all the risks involved? Nothing. Ronald Kochman had excellent relationships with his clients built as a result of his work as an attorney for them. He used his relationships to open doors for KL Financial principals and to persuade his clients to invest with them. His clients put blind faith in their relationship with him and performed no due diligence. They should have hired experts who would have examined in great detail John Kim’s trading models, their historical performance history, and the correlation of that performance with market cycles. Then they would have checked his trading background to verify his experience, education, and past performance, and finally they would have insisted on an audited track record. KL Financial would have never passed this rigorous due diligence process, and the investors would have been saved $190 million and Ronald Kochman his relationship with his clients.
AMARANTH ADVISORS, SEPTEMBER 2006
The everlasting red pigment of the Amaranth flower has stood as a symbol of immortality since the time of ancient Greece. Nicholas Maounis, the founder of Amaranth hedge fund picked the famed flower for the name of his hedge fund when he opened the fund in September 2000 with $600 hundred million in assets. Maounis graduated from the University of Connecticut in 1985 with a finance degree, started his career at investment bank LF Rothschild, Unterberg, Towbin and hedge fund Angelo, Gordon & Co., both based in New York. In 1992, he joined Greenwich-based Paloma Partners LLC, a hedge fund, and eventually traded $400 million, the largest amount managed by any individual at the hedge fund. After eight years, Maounis left to form Amaranth with twenty-seven employees. Based in Greenwich, Connecticut, Amaranth started out trading a convertible arbitrage strategy. Convertible bonds are bonds issued by companies that give the bond holder the option to buy the company’s stock at a predetermined price. Convertible arbitrage traders profit from trading the perceived value of that embedded stock option. This strategy was Nick Maounis’s expertise, what he knew best, and his original intention for starting his hedge fund.
Outgrowing Its Core Competency
Amaranth flourished, and the fund was able to attract big money from some of the biggest institutional investors, including funds run by Goldman Sachs Group Inc., Morgan Stanley, Deutsche Bank AG, and Bank of New York Co.’s Ivy Asset Management Corp. Pension funds of 3M Co. of St. Paul, Minnesota, and the San Diego County public employees also signed on. At its peak, according to Amaranth’s marketing materials, it described itself as a global, multi-strategy hedge fund. Amaranth had over 400 employees, including 170 investment professionals, and managed in excess of $9 billion for institutional investors, including corporate and public pension funds, endowments and foundations, insurance companies, banks, family offices, and funds of hedge funds. The basic rule of capitalism is that money will flow where there are the biggest money-making opportunities or inefficiencies. Money will keep flowing until those inefficiencies have been taken out of the market. This is what happened to the convertible arbitrage market in the early 2000s and why Nick Maounis decided to diversify his ever-growing hedge fund into other areas.
Brian Hunter
The area that Nick Maounis picked was energy trading, and the trader he picked to run that area was Brian Hunter, a 26-year-old trader. Hunter, who grew up near Calgary, had earned a master’s degree in mathematics from the University of Alberta before starting to trade natural gas in 1998, according to Amaranth marketing materials. He traded for Calgary-based TransCanada Corp., then joined Deutsche Bank in New York in May 2001. In his first two years, he earned $69 million for the bank, according to a complaint Hunter later filed in New York State court in Manhattan that claims the bank owes him bonus money. By 2003, Hunter was head of the bank’s natural gas desk. In December 2003, Hunter and his colleagues were up $76 million for the year. In the first week of the month, however, the desk lost $51 million after an “unprecedented and unforeseeable run-up in gas prices,” according to Hunter’s lawsuit. Hunter says in the suit that even with the loss, he made $40 million for Deutsche Bank that year and more than $100 million in three years. Hunter left Deutsche Bank in April 2004 and joined Amaranth shortly thereafter. According to former employees, by the end of 2005, Hunter was the highest paid trader at Amaranth. Hunter earned 15 percent of any profit he made, while most traders made an average of 10 percent. In 2005, Hunter took home about $75 million, primarily from his Katrina bet, compared with about $4 million in 2004. At the end of 2005, Maounis let Hunter move his wife and two children back to Calgary and op...
