The Bayou Hedge Fund Group (the "Bayou Funds"), which collapsed in 2005, was at the center of one of the largest hedge fund scandals prior to Bernie Madoff’s scheme.
Samuel Israel III and Daniel E. Marino were the Chief Executive Officer and Chief Financial Officer, respectively, of a group of hedge funds known as the Bayou Funds, founded in 1996 by Israel and based in Stamford, Connecticut. Bayou was started legitimately but quickly began losing money through poor trading. Rather than admit to the losses or adjust their strategies, Israel and Marino turned the funds into a fraud almost from the start. By 1998, Marino was creating fake financial statements, which attracted new investors whose money was used to pay redemptions for earlier clients. In this way, the Bayou Funds had become a classic Ponzi scheme.
The US Securities and Exchange Commission (SEC) alleged in its complaint that from 1996 through 2005, investors deposited over US$450 million into the Bayou Funds and a predecessor fund. During that period, Israel and Marino defrauded current investors, and attracted new investors, by grossly exaggerating the funds’ performance to make them appear to be profitable and attractive investments, when in fact they had never posted a year-end profit. The SEC’s complaint further alleged that Israel and Marino concocted and disseminated to the funds’ investors periodic account statements and performance summaries containing fictitious profit and loss figures, and forged audited financial statements in order to conceal multimillion-dollar trading losses. Among other things, the complaint alleged:
Israel, Marino, and Bayou management overstated Bayou’s 2003 performance by claiming a US$43 million profit in the four hedge funds, while trading records show that Bayou Funds actually lost US$49 million.
In 1999, Marino created a sham accounting firm, Richmond-Fairfield Associates, which he used to fabricate annual “independent” audits of the Bayou Funds and to attest to the fake results that he and Israel had assigned to the funds.
Israel and Marino stole investor money by annually withdrawing from the funds “incentive fees” they were not entitled to receive because the funds never returned a year-end profit.
By mid-2004, Israel and Marino had largely suspended trading securities on behalf of the funds and transferred all remaining fund assets, consisting of approximately US$150 million, to Israel and other non-Bayou-related entities, for investment in prime bank note trading programs and venture capital investments in non-public startup companies. In a twist of irony, the prime bank note programs turned out to be fraudulent, and Israel was one of the victims. An investigation by the Federal Bureau of Investigation was triggered when Israel wired the US$150 million (essentially, all of Bayou’s remaining money) to the unidentified con man.
Despite having abandoned their hedge fund strategy in 2004, Bayou management continued to send periodic statements and financial statements to investors describing purportedly profitable hedge fund trading activities through mid-2005.
The collapse came in mid-2005.
On July 27, 2005, Israel sent a surprise letter to investors, announcing that the Bayou Funds were closing (citing a desire for more family time) and promising redemptions. But Bayou had no money.
When a redemption check bounced and an investor investigated, they discovered an empty office.
Marino left a “confession/suicide note” (he didn’t follow through on suicide) admitting the fraud.
The scheme was exposed in August 2005.
Was justice served?
The SEC filed charges in September 2005 against Israel, Marino, Bayou management, and the funds for fraud and misappropriation.
Both Israel and Marino pleaded guilty to the charges, which included conspiracy, mail fraud, and investment advisor fraud.
On April 14, 2008, U.S. District Judge Colleen McMahon, who presided over the underlying fraud case, sentenced Israel to 20 years in prison (he was to surrender to begin serving his sentence on June 9, 2008) and ordered him to forfeit US$300 million.
In the days leading up to his surrender date, Israel obtained false identification and obtained a recreational vehicle (RV), which he outfitted with a television, mattress, and scooter. On June 9, Israel abandoned his GMC Envoy car at the Bear Mountain Bridge, in the vicinity of Cortlandt, New York, in an apparent attempt to stage his own suicide. Scrawled into the dirt on the abandoned SUV’s hood were the words “Suicide is Painless.” Israel then had an associate drive him to a rest area near the intersection of Interstates 684 and 84, where the RV was waiting. He then fled and remained a fugitive until July 2, 2008, when he surrendered to police.
On July 15, 2009, U.S. District Judge Kenneth M. Karas sentenced Israel to two further years in prison, for failing to surrender to serve the 20-year prison sentence and for faking his own death in the failed escape attempt.
Marino received a 20-year prison sentence.
The Bayou Funds filed for Chapter 11 bankruptcy in 2006. Authorities seized funds, with some restitution to victims, although recovery was incomplete. On February 1 and April 14, 2008, US$108,759,689.16 in fraud proceeds were forfeited to the United States as part of the sentences of Israel and Marino. The net proceeds of that forfeiture, plus interest, were applied towards the partial satisfaction of the restitution orders entered against the defendants. The restored funds were distributed in accordance with Distribution Orders signed by Judge McMahon on April 14, 2008 and May 5, 2008 (In re Bayou Group LLC, et al., 06-22306 (ASH)).
The Bayou case highlighted again the risks for hedge fund investors of fake statements and audits, and the dangers of unverified performance claims.
Sources:
Federal Bureau of Investigation (2009), “Samuel Israel, III Sentenced to Two Years in Prison for Failing to Surrender,” Press Release, July 15: https://archives.fbi.gov/archives/newyork/press-releases/2009/nyfo071509.htm
No author listed (2010), “The Fall of Samuel Israel III,” CNBC, January 27: https://www.cnbc.com/2010/01/27/Suicide-is-Painless:-The-Fall-of-Samuel-Israel-III.html
U.S. Attorney’s Office, Southern District of New York (2008), “U.S. to Restore $115.6 Million of Forfeited Funds to Bayou Hedge Fund Fraud Victims,” Press Release, July 2:
https://www.justice.gov/archive/usao/nys/pressreleases/July08/bayourestoration.pdf
U.S. Securities and Exchange Commission (2005), “SEC Charges Samuel Israel III, Daniel E. Marino, Bayou Management, and Bayou Funds for Defrauding Hedge Fund Investors and Misappropriating Investor Assets,” Press Release, September 29: https://www.sec.gov/news/press/2005-139.htm
U.S. Securities and Exchange Commission (2006), Litigation Release No. 19692: “Samuel Israel III and Daniel E. Marino,” May 9:
https://www.sec.gov/enforcement-litigation/litigation-releases/lr-19692