Hedge Funds Are Facing a U.S. Criminal Probe Over Bond Valuations

U.S. prosecutors are investigating one of Wall Street’s darkest markets, focusing on hedge funds suspected of inflating the value of debt securities in their portfolios to juice the fees they collect.

Having prosecuted traders who lied to customers about bond prices, the government is now scrutinizing hedge funds that allegedly solicited bogus price quotes from brokers, according to three people familiar with the matter who asked not to be identified.

Such a practice would have enabled the funds to pump up the value of illiquid securities on their books.

The incentive to manipulate valuations has become more pronounced as investors have abandoned hedge funds because of poor returns and high fees.

Assets managed by hedge funds declined last year for the first time since the financial crisis, with investors yanking more than $70 billion, according to Hedge Fund Research Inc.

The opacity of certain parts of the debt market, with illiquid, sometimes distressed securities, had made it a prime target for deception because of the difficulty of determining prices.

It’s unclear how many funds are under scrutiny by federal prosecutors in New York for possibly seeking bogus quotes from brokers.

But a witness testifying for the government this week in an unrelated trial of three former Nomura Holdings Inc. traders in Connecticut may have shed light on the investigation.

The witness, a former broker named Frank DiNucci Jr., said under oath that he provided bogus quotes to a trader at a mortgage bond fund, Premium Point Investments LP.

DiNucci agreed to plead guilty last month in Manhattan federal court to conspiracy and fraud and says he has been cooperating with a criminal probe by New York prosecutors into Premium Point.

“I would extend marks to make them seem like they were my own,” DiNucci told the federal jury in Hartford.

The goal was to “increase the number of trades we would do with this particular client,” he said.

Steven Bruce, a spokesman for Premium Point, which managed almost $2B at its peak and is now closing, declined to comment on DiNucci’s testimony or on whether the fund is under investigation.

Nicholas Biase also declined to comment.

A focus on bond funds would signal a new direction in enforcement. In recent years, prosecutors have brought dozens of high-profile, insider-trading cases against portfolio managers at equity hedge funds, securing more than 80 convictions.


Their target now appears to be the debt side.

The Department of Justice charged at least seven bank bond traders since 2013 with lying to customers about prices before shifting to the buy-side of the market.

The probes began at the SEC’s complex financial instruments group, according to the people familiar, who declined to comment publicly on the confidential investigation. The SEC declined to comment.

Mismarking fraud was at the center of a case against fund managers at Visium Asset Management LP.

Jurors returned a guilty verdict this year against one of its portfolio managers in just 90 minutes. Prosecutors have also brought charges over another scheme: lying to investors about bond prices.

Former Jefferies LLC trader Jesse Litvak was convicted at a trial in January, and three former Nomura Holdings traders are now on trial in Connecticut, where DiNucci testified.

For more on the Visium case, click here

Some securities, including pools of mortgages, can be especially difficult to price.

The debt can go months without trading. Without recent pricing data, funds rely on estimates of brokers and quotes from third parties to value the debt.

By carrying securities on their books at artificially inflated prices, hedge funds can show better performance.

They can collect more in management and performance fees — or hide poor performance for certain holdings.

DiNucci has been testifying against his former colleagues at Nomura, who he said lied to clients about bond prices.

They deny wrongdoing. Under cross-examination by defense lawyers, DiNucci was asked about the mismarking of bonds.

He said he worked at brokerages Auriga USA LLC and AOC Securities LLC after leaving Nomura. While there, he said he would provide fake quotes to traders including Jeremy Shor, formerly of Premium Point. Shor on Wednesday declined to comment.

Alex Hendrickson, a co-president at Auriga, declined to comment and referred questions to a lawyer, Jeffrey Plotkin, who also declined to comment. A person who answered the phone at AOC said its chief executive, Ronaldo Gonzalez, wasn’t available for comment.

Plea Agreement

As part of an agreement to cooperate in the “Premium Point investigation,” DiNucci said he told prosecutors in New York that there was “a lot more than that.”

He did not elaborate.

A copy of his April 6 plea agreement with New York prosecutors was entered into evidence at the Connecticut trial.

DiNucci’s lawyer, Daniel Zinman, declined to comment.

A Nomura representative didn’t immediately return a request for comment.

Before the financial crisis, regulators had a hands-off policy in monitoring the securitized debt market in part because participants were considered sophisticated buyers and sellers.

That assumption came undone when the market cratered following rising mortgage delinquencies.

To deal with the fallout, the SEC created a specialized unit to examine the market.

The unit got a tip from AllianceBernstein after a spreadsheet was sent to an asset manager revealing that Litvak, then at Jefferies, had lied about the price paid for securities he sold, prosecutors said.

Litvak was sentenced last month to two years in prison for securities fraud.


More Articles