The Weavering fraud case in the Cayman Island is an object lesson in the mistakes people can make in exposing themselves to loss and fraud. This article goes through the kind of checks investors - and their advisors - should make.

Chris Hamblin, editor of Offshore Red and Compliance Matters, two sister news services to this one, writes about one of the most important legal cases involving the Cayman Islands to have taken place in several years. Whenever large crimes are unearthed it inevitably prompts soul-searching among industry practitioners, not to mention wounded clients, of how they managed to miss the fraud and what must be done to prevent such larceny happening again. 


It was in January this year that Magnus Peterson, 51, the head of Weavering Capital, one of the most popular hedge funds in London, was convicted on several counts of forgery and fraud. How did he deceive his investors (a mixture of ultra high net worth individuals, pension funds and funds-of-funds) and what could analysts have found out before it was too late?

The Weavering Macro Fixed Income Fund (incorporated in the Cayman Islands) had total assets under management of $640 million some time before it went into administration in March 2009. Before fraud was uncovered, it had been trading for some time and had been doing relatively well. Eventually, under the helm of Peterson, it was involved in theft, or at least an abusive form of fraud or misrepresentation that cheated investors and ultimately caused the fund to be valued wrongly. Eventually, it had to close and the investors suffered.

What was Peterson actually doing? A recent briefing from Laven Partners, the compliance experts and consultants for funds and investors, looked at the case from the point of view of an investment analyst. Laven's fund analysts thought that some tell-tale signs would have been discernible at the time to anyone who had known what to look for.

Step one: begin with the name
According to the experts, the first step towards an understanding of what a fund does is to start with its propaganda - what it says it does. Weavering used words such as “macro” and “fixed income.” The former typically refers to all forms of economic influences that might lead the fund manager to invest, while the latter typically puts one in mind of bonds, or at least some form of derivatives of bonds and so forth. This is, at first sight and judging from the name, is what a family office, private bank or sophisticated investor might have expected Peterson to be doing as a manager.

Step two: check the financial statements
The next step is to investigate the fund's financial statements, i.e. to look at what that fund is actually buying. This particular fund was investing largely in futures. There is nothing out of the ordinary about this in the macro world; macro funds often deal in futures. “Fixed income,” however, might seem to be something of a misnomer. Futures are not fixed income; such instruments are, instead, likely to be much more volatile and risky to trade. Risky investments are by no means bad in and of themselves, but even at this stage an analyst might have concluded that there was a difference between what the fund was purporting to do and what it actually was doing. “Fixed income” tends to suggest a regularity of return and a low risk.

Step three: look at service-providers and capacity
Weaknesses appear when one looks at other things. A look into the independence of the service providers reveals some conflicts of interest. Capacity (the total amount of money that can be put to work with a given manager or strategy without deteriorating the fund's performance) seems to have been suspiciously low for this type of fund – Laven Partners put it around the $200 million mark, commenting that this figure was not common for a fixed income fund that trades globally.

Step four: look at “margin to equity”
The act of comparing a manager’s margin levels with his total accounts can give investors a sense of how much risk that manager is undertaking. The fund sought to limit the “margin to equity” ratio (which indicates what percentage, on average, of a commodity trading advisor's managed account is posted as margin) to 25-40 per cent, which would imply very high levels of leverage for the type of investments being managed. The due diligence questionnaire that Peterson provided was very poor and was only 10 pages long.

Step five: look at the human resources
A look at the distribution of personnel at Weavering Capital reveals another “red flag”: strong overall control by members of Magnus Peterson's family. This is something that comes up time and time again in frauds, because family members trust and help each other. The only way in which an analyst or compliance officer can set his mind at rest here is to verify the independence of each family member.

High local expenditure was apparent from the management company accounts. The acquisition of plush accoutrements for an office is another sign that things might not be quite right, as a solid business of this type did not need to spend large sums in that way.

Lastly, the chief operating officer of the firm was also the marketing manager and was rarely in office. This, too, should have been a cause of alarm to investors because the job of COO is a very important one and nobody who has to spend several days a month on the road selling the fund can do it well. Investors should have at least asked Weavering Capital what controls were in place for those days when the COO was not there.

On the other side of the ledger, Peterson did not lead the lavish lifestyle of the archetypal hedge fund fraudster. When investigators looked at his house they found no plush furnishings and it was valued at £1 million. He did, however, remunerate himself very generously to the value of £7 million throughout the life of the fund.

The actual fraud
For years, no actual wrongdoing was apparent. Things finally went wrong when the main fund in which high net worth individuals had invested bought a swap (a form of security/investment) which another company had issued. Weavering Capital Fund Ltd (domiciled in the British Virgin Islands) was wholly owned by the Weavering Macro Fixed Income Fund and had issued the swap to the fund. The court heard that WCF had almost no assets, no independent accounts and no auditors. In 2011, a Cayman Civil Court ruled that his relatives, who were on the board of both WCF and the main fund, were in dereliction of their duties, although nobody subsequently sought to prosecute them for any crime. One of those relatives had even forgotten about WCF's existence.

There now began a cycle of conflicts. The main fund had bought an instrument from a company that it owned. This in itself, apart from the issues of corporate governance and conflicts of interest, is not necessarily wrong in the eyes of investors. As a next step, however, the swap had to be valued somehow. The issuer valued it, but of course the issuer belonged to the fund.

There was much doubt among investigators about the enforceability of the swap contracts. On top of this, WCF did not possess enough in the way of assets to honour its swap obligations. Peterson said at one point that it had $77 million in assets, but this was illusory.

Because of the lack of corporate governance and proper risk management, some people in Peterson's business were undoubtedly subject to influence - a process that caused the value of the swap to be increased. By the time everybody realised this and alarm bells were ringing, it was too late to save the fund because many investors were by then trying to pull out. Many more were, of course, trying to remove their money as a result of the credit crunch of 2008. 

Under stress, people who have too much influence over each other may lead each other to fraud and this is what happened at Weavering Capital. No one thing that was available to the scrutiny of investors stood out as totally bad, but the warning signs were there for anyone eager to carry out a proper investment appraisal.