The Securities and Exchange Commission indicted Edward J. Strafaci, a former manager of a prominent convertible arbitrage hedge fund with Lipper & Co., with two counts of securities fraud and two counts of investment advisory fraud. In total, they carry a maximum prison term of 30 years and $2.5 million in fines. The firm is one and the same company where founder Kenneth Lipper lost millions of dollars running a hedge fund for the rich and famous, including Julia Roberts, Liam Neeson and former Federal Reserve Chairman Paul Volcker.

Noting that during the period in question, from 1998 through 2002, Strafaci earned $3.9 million in bonuses as a result of overstating the performance and capital holdings of four funds by as much as much as 49%, the SEC also ordered Strafaci, 45, to return all of his "ill-gotten gains."

Strafaci’s alleged overstatement of the convertible bonds and preferred stock in the hedge funds came to light shortly after he and another principal left in January 2002 to start their own firm. After their departure, the firm wrote down the value of the funds, now in liquidation, between 8% and 40%.

The suit also notes that Lipper & Co. traders called Strafaci on his valuations, but he ignored them. As a result, investments and withdrawals that investors made in the funds were inflated, along with the tens of millions in performance and management fees that Strafaci and the firm received, according to the complaint.

In an analysis of this case, Hewitt Investment Group noted that there are inherent risks to hedge fund valuations, as many invest in illiquid over-the-counter markets. "While most hedge funds have controls in place to mitigate the risks of abusive practices, the wide discretion that hedge fund managers possess means that the potential for impropriety remains," according to Hewitt.

Strafaci reportedly pleaded not guilty in a brief court hearing Wednesday and was released on a $250,000 bond. A class action suit against Lipper Convertibles, L.P. is still pending.

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