Hedge Fund Case Study On Petters
Abstract
Less attention is paid to Thomas Petters thanks to Bernie
Madoff's enormous fraud, he successfully played his own show
over 13 years. His illegitimate asset based lending scheme
seems very simple and the promised returns were too good to
be true. Then, why did so many investors miss his misconduct
for such a long time?
A golden rule to avoid a potential fraud is: there is no free
lunch. But, there are three other critical steps investors could
have taken to avoid the massive losses they suffered.
Case Profile
1.
Fund
Name
Investme
nt
Managers
Portfolio
Managers
Other
Notable
Arrowhead - Arrowhead Capital Finance Ltd.;
Arrowhead Capital Partners II L.P.; Elistone Fund
2.
Lancelot - Lancelot Investors Fund, L.P.; Lancelot
Investors Fund II, L.P.; Lancelot Investors Fund, Ltd.
3.
Palm Beach -Palm Beach Finance Partners, LP; Palm
Beach Finance II, LP; Palm Beach Offshore, Ltd.;
Palm Beach Offshore II, Ltd.
4.
Stewardship - Stewardship Credit Arbitrage Fund,
LLC; Stewardship Credit Arbitrage Fund, Ltd.
1.
Petters Company, Inc.
2.
Petters Group Worldwide, LLC.
3.
Arrowhead Capital Management, LLC / Blue Point
Management Ltd./Integrated Alternative Investment
Limited
4.
Lancelot Investment Management LLC
5.
Palm Beach Capital Management LP / Palm Beach
Capital Management LLC
6.
Stewardship Investment Advisors, LLC / Acorn
Capital Group, LLC
1.
Thomas Petters (Petters)
2.
Arrowhead - James Fry and Michelle Palm
(Arrowhead)
3.
Lancelot - Gregory Bell (Lancelot)
4.
Palm Beach - Bruce Prevost; David Harrold
5.
Stewardship - Marlon Quan (Stewardship)
PC Funding, LLC; Thousand Lakes, LLC; SPF Funding, LLC;
PL Ltd., Inc.; Edge One, LLC; MGC Finance, Inc.; PAC
Parties
Fund, LLC
Investme
nt
Strategy
Asset Based Lending, or Purchase Order Inventory
Financing
Founded
1988
Estimated
AUM
$3.65 billion
Estimated
Losses
Over $3 billion
1.
Major
Misconduc 2.
3.
ts
4.
Background
Conspiracy
Money laundering
Misappropriation of assets
Fraudulent reporting
From as early as 1995 through September 2008, Thomas
Petters ("Petters"), a prominent businessman in Minnesota,
perpetrated a massive Ponzi scheme through the sale of
promissory notes to investors. While Petters' $3.65 billion
fraud dwarfs Bernie Madoff's $65 billion, it is still the third
largest hedge fund fraud case as of today (Jan 2012).
After failing several retail businesses, Petters started a
wholesale brokerage business, which later became Petters Co,
Inc., ("Petters Co") in 1988, and traded closeout, overstock
and bankrupt company merchandises, which were usually
traded with a huge discount. Petters Co and its affiliates
bought those merchandises and sold them to "Big Box"
retailers such as Wal-Mart and Costco, but such transactions
usually took up to 180 days to complete and that the sellers or
manufacturers demanded payment up front while the retailers
did not pay until the merchandise was delivered. In order to
finance this 180-day period ("purchase order inventory
financing"), Petters issued a short-term (up to 180-day)
promissory note with a large coupon payment (from 10 to
18% p.a.) to at least 20 investors.
There were at least four fund operators of feeder funds, which
are set up primarily to purchase secured notes from Petters Co
and its affiliates. Shortly after the arrest of Petters, SEC
accused all four operators, including their principals, for
knowingly supporting the fraud scheme. According to various
court documents, these feeder funds raised more than $4
billion from their investors, including well-known fund of hedge
funds operators.
Fund Operators of Feeder
Funds
Principals
Capital
Raised
Lancelot Investment
Management LLC
Gregory M. Bell
$2,000,000,0
00
Palm Beach Capital
Management LP
Bruce Prevost & David
Harrold
$1,000,000,0
00
Arrowhead Capital
Management, LLC
James Fry & Michelle
Palm
$600,000,000
Stewardship Investment
Advisors LLC
Marlon Quan
$450,000,000
Source: various court documents; figures are rounded
Many feeder funds are structured to purchase the notes from
subsidiaries or affiliates of Petters Co. In order to show
legitimacy of the scheme, Petters Co. established bank lock
box accounts, or "Escrow" account, over which Petters Co has
no control. All payments from the Big Box retailers shall be
paid into the accounts. Each feeder fund had a slightly
different scheme, but the fundamentals are basically the
same. The following diagram is the scheme used by
Stewardship.
(click to enlarge)
Source: SEC vs. Stewardship (2009)
Doug Kelly, a personal lawyer of Petters, became a courtappointed receiver in the Petters' bankruptcy and filed about
200 lawsuits, seeking to recover about $2 billion. As of Dec
2010, he had collected about $200 million.
Problems
Petters fabricated purchase orders from retailers and used
them as collaterals to borrow money through hedge funds. In
reality, paying 10-18% interests on highly secured paper
sounds too good to be true and the scheme crafted by Petters
was relatively simple compared to other Ponzi schemes. So,
why did many investors, who directly purchased the Petters
paper or indirectly invested in the feeder funds, fail to detect
his misconduct?
The reason he could run this $3 billion Ponzi scheme over so
many years was largely due to negligence of investors and
lack of operational due diligence. The stable return stream of
the feeder funds (1.0-1.5% a month with almost no
fluctuation) was, if true, attractive not only for individual
investors, but also institutional investors who obsessively
sought "low volatility, low correlation" opportunities.
The payment scheme with the lock box accounts described
above should have worked well if it were operated and
monitored properly by the direct holders of the notes (i.e.,
feeder funds). But, it was a sham as the feeder fund operators
never conducted due diligence as promised.
Petters and his affiliates indeed knew very well how to
manipulate investors' psychology and many investors thought
they were invested with a legitimate lending practice:
1.
By being informed that all promissory notes were
secured by purchase orders from the Big Box retailers,
investors made themselves believe that Petters should
have not made such obvious lies
2.
Multi-layered schemes, including subsidiaries/affiliates of
Petters Co and feeder funds
3.
The lock box account scheme gave false sense of security
4.
Payments were made on time for over 13 years of its
existence until very late stage of the scheme
5.
No audit was legally required at the level of borrowers
(Petters Co and its affiliates), even though annual audit
for the feeder funds were conducted by reputable audit
firms (they might have missed several key issues during
the audits)
Recommendations
Conduct extensive background checks on all related
parties
1.
2.
This is one of many cases in which background checks
should have helped investors to avoid investing in the
scheme. But, it was important for investors to conduct all
related parties since investors tend to conduct
background checks on principals of feeder funds for
various reasons (mainly due to the high cost to execute
background checks).
For example, on May 22, 2005, a potential investor
emailed one of the feeder fund operators, stating that a
third party "report indicated that Mr. Petters's
background includes a criminal history (fraud or forgery
convictions, possibly with prison time served), along with
significant civil litigation, including a recent $5 million
fraud suit." In fact, Petters had been convicted of several
felonies, including a 1983 conviction for writing a bad
check, a 1989 conviction for forgery (for which he served
time in prison), and a 1990 conviction for theft by check.
3.
New York hedge fund manager Richard Bookbinder of
Bookbinder Capital Management passed on an
investment after he learned that Petters had lied on a
Dun & Bradstreet questionnaire about earning a degree
from St. Cloud State University.
4.
Mr. Bookbinder late said, "Things popped up and we
didn't feel comfortable. When people gave money [to
Petters] they didn't ask, 'Who's this guy? What's his
background?' The question is: This information was out
there in 2002. We looked at it and we're a small firm;
why didn't other people look at it?"
Confirmation on the Big Box retailers and their
payments to the lock box accounts
1.
In 2005, AG Deutsche Zentral-Genossenschaftsbank
Frankfurt Am Main ("DZ Bank"), a German lender,
discovered that the lock box account did not function as
Stewardship represented in its offering materials. DZ
Bank made this discovery in the course of performing
due diligence for a line of credit to Stewardship's
operating company called Acorn Capital Group, LLC.
2.
In 2008, Acorn sought a loan from Fortress Investment
Group LLC ("Fortress"), but Fortress decided not to loan
Acorn money after it learned that the Big Box retailers
did not make payments directly into the lock box
accounts as explained by Acorn.
3.
For an investor of a feeder fund, it could be difficult to
obtain transaction details of the lock box accounts.
However, it is possible to conduct due diligence by calling
some of the Big Box retailers whether they recognize
Petters Co and its affiliates as counterparties of the
transactions and whether they recognize purchase
orders, which many feeder fund operators claimed as
collaterals for the notes they purchased.
Confirmation of registration as a Registered Investment
Advisor
1.
Arrowhead Capital Management LLC ("Arrowhead LLC"),
and Arrowhead Finance told their investors and potential
investors that Arrowhead Corp. (predecessor of
Arrowhead LLC) and, later, Arrowhead LLC were
registered with the SEC as investment commission. While
Arrowhead Corp did registered with the SEC on
November 27, 1995, but terminated its registration on
July 7, 1997 before Arrowhead raised any capital for its
funds. A quick online check at the SEC website should
have revealed that it was not true and investors should
have considered it as a red flag.
Resources
U.S. Securities and Exchange Commission (2009). Litigation
Release No. 21124 / July 10, 2009. SEC Website
U.S. Securities and Exchange Commission v. Thomas J.
Petters, Gregory M. Bell, and Lancelot Investment
Management LLC, and Inna Goldman, Inna Goldman (2009).
U.S. District Court for the District of Minnesota.
U.S. Securities and Exchange Commission v. Marlon Quan,
Acorn Capital Group, LLC and Stewardship Investment
Advisors, LLC, et al (2009). U.S. District Court for the District
of Minnesota
U.S. Securities and Exchange Commission v. Marlon Quan,
Acorn Capital Group, LLC and Stewardship Investment
Advisors, LLC, et al (2009). U.S. District Court for the District
of Minnesota
Ellerbrock Family Trust, LLC; Belmont Strategic Income Fund,
LP, on behalf of themselves and all other similarly situated v.
McGladrey & Pullen, LLP (2009). U.S. District Court for the
District of Minnesota
Lancelot Investors Fund, LP, Lancelot Investment
Management, LP v. Thomas Joseph Petters, Thousand Lakes,
LLC, Petters Company, Inc., Nationwide International
Resources, Inc., Enchanted Family Buying Company, Larry
Reynolds, Michael Catain, Deanna Coleman, & Robert White
(2009). U.S. District Court for the District of Minnesota
Moylan, Martin. "J. P. Morga Chase sued to recover Petters
fraud funds", Minnesota Public Radio website, December 30,
2010
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