Kenneth Lipper’s second-in-command at Lipper Holdings LLC, Edward Strafaci, pleaded guilty yesterday in federal court to overstating the value of two hedge funds he managed.

The overstatement resulted in $330 million of investor capital being wiped out and the closing of the hedge funds.

Mr. Strafaci, 45, faces 10 years in prison. In court yesterday, he acknowledged overvaluing the two portfolios he controlled for six years beginning in 1996 until his resignation in January 2002. He was unavailable to comment.

According to the indictment, Mr. Strafaci manually overrode the prices assigned to the portfolio by the fund’s computer programs and Wall Street dealers.

Lipper Holdings announced the portfolio revaluations – sending the portfolios from $722 million in assets to $392 million – in January 2002, and Mr. Strafaci resigned soon afterwards. The remaining $392 million was liquidated at the end of that month.

“The values I assigned to some securities would be higher because I valued them according to my estimate of what they would have been worth in the future,” said Mr. Strafaci, in front of U.S. District Court Judge Laura Taylor Swain, according to Bloomberg News.

“I knowingly and willfully and with intent to defraud made untrue statements of material facts,” he said.

The indictment against Mr. Strafaci said his overvaluation scheme produced annual gross returns of between 12%-21%. The indictment said that once the appropriate valuations were applied to the portfolio, the funds were found to have lost money in those years.

The indictment also said Mr. Strafaci’s income between 1998 and 2001 fluctuated between $1 million and $1.3 million annually.

Mr. Lipper, who was Mayor Koch’s deputy mayor, and who produced the Hollywood drama “City Hall” and the Holocaust documentary “The Last Days,” was unavailable to comment.

The fraud not only cost 20 people their jobs and closed a hedge fund manager that had been open since 1985, it cost Mr. Lipper much of his net worth, said Mr. Lipper’s lawyer, Elkan Abramowitz of Abramowitz, Grand, Iason & Silberberg.

At least two civil suits have been filed against Lipper Holdings as a result of the overvaluation.

“Mr. Lipper was largely wiped out by Mr. Strafaci’s crimes,” said Mr. Abramowitz, declining to specify Mr. Lipper’s losses. “No one wants to touch him now, no one wants to do anything with him, so he is basically ‘on the beach’ until the civil suits are resolved,” Mr. Abramowitz said.

Mr. Abramowitz claims that Mr. Lipper discovered the overvaluation and brought it to the attention of authorities.

He said Mr. Lipper, will likely seek to get back into the money management business once he clears his name.

Mr. Strafaci’s admission of guilt comes at a bad time for the nearly $1 trillion hedge fund industry as it wrestles with a Security and Exchange Commission proposal to require hedge funds with over $15 million to register as investment advisers under the 1940 Investment Company Act.

The move – called a necessary step in monitoring the rapid growth of hedge funds and the assets they manage – is broadly opposed within the industry.

However, the Managed Funds Association, the hedge fund industry’s lobbying and public relations group, in a November 21 reply to the SEC concerning the proposed registration requirement, cited Mr. Strafaci’s indictment as proof that registering hedge funds with the government would likely do little to deter fraud.

“Many of the [SEC’s] enforcement actions were brought against registered investment advisers. [The] MFA believes that the premise that the absence of regulation increases the likelihood of fraud is without foundation,” the MFA wrote.

One Manhattan-based hedge fund manager, T2 Partners’ general partner Whitney Tilson, agreed with the MFA that registration as an investment adviser cannot prevent fraud.

“It will not do much against intentional fraud since hedge fund partnership documents give wide latitude to the fund manager in assigning values to the portfolio,” he said.

What will help deter future incidents, Mr. Tilson said, was “the fact that hedge fund auditors are getting their spines back.”

He cited his own fund’s auditors, Ernst and Young, as an example: “I own mostly stocks and options, but for the small positions that I have that are illiquid, like a few small private placements, I was required to get letters from the issuers certifying the values we assigned.”

Mr. Tilson called stronger auditing “very encouraging for the industry and investors, since the auditors have always been the first and best line of defense.”