Kupersmith Admitted to Free-Riding Scam Several traders, including an individual named Scott Kupersmith, employing a scam known as free-riding, recently admitted his guilt. Free riding effectively employs a scheme where through manipulation, a customer buys or sells securities in a brokerage account without having the money or securities to pay for them. According to the SEC, Kupersmith and his compatriots, used various aliases and stories to fraudulently opening brokerage accounts. These included using corporations owned by Kupersmith to disguise his identity. Mr. Kupersmith, using a family member’s identity, also claimed to be a money manager for hedge funds. On other occasions he even claimed that he ran a small hedge fund with approximately $50 million in assets under management. An interesting aspect of this case is that effectively Mr. Kupersmith, and his cohorts, fooled broker dealers and executing brokers into opening accounts with them and then letting them trade, under the false belief that custodial accounts at other financial institutions held securities which could cover those trades. When an investor is evaluating a hedge fund or private equity fund, one of the key operational aspects reviewed involves a fund’s service providers. For administrators and brokers in particular, it is often useful for investors to inquire as to the due diligence a service provider performs on new clients before opening an account on their behalf. Outside of basic regulatory checks such as anti-money laundering checks, does the service provider do anything more? One reason why this is important to evaluate is because the fund manager is effectively exposed to, at a minimum, reputational risks associated with a prime broker for example. In this case, if a hedge fund traded with one of the time brokers which opened an account for Mr. Kupersmith, it may raise questions among investors as to how diligently a hedge fund examined the service providers new account opening procedures. Similarly, if the prime broker is on the hook for any losses due to frauds such as those orchestrated by Kupersmith, and fund assets are commingled, then there is a potential for financial loss to the hedge fund as well. It is also advisable that similar questions should also be asked of the fund manager in both evaluating potential new subscription capital as well as in adding new service providers. Some key questions investors should consider asking when evaluating the robustness of a fund manager’s new counterparty addition include:
Does the fund manager have a formal process for evaluating new counterparty additions? What due diligence does the fund manager perform on new counterparties? Are conflict checks performed to ensure for example that no employee of the firm is related to the owners of any counterparties (i.e. – brokerage firms) utilized? Are counterparties balance sheets reviewed?
© 2012 Corgentum Consulting, LLC
By taking steps during the operational due diligence process to thoroughly vet the process by which both a fund’s service providers and the funds themselves are exposed to new clients and counterparties, investors can make significant headway in reducing potential losses due to fraud from counterparty risk. Visit www.corgentum.com for more information.
Š 2012 Corgentum Consulting, LLC