The SEC settled enforcement proceedings under the anti-fraud provisions of Section 206(2) of the Investment Advisers Act of 1940 against a registered investment adviser (the “Adviser”) and its principal (together with the Adviser, the “Respondents”) for failing to review and analyze a recommended family of hedge funds (the “Hedge Funds”) pursuant to due diligence procedures that the Respondents represented they would follow when evaluating, selecting and monitoring hedge fund investments (the “Procedures”). In addition, the SEC found that the Respondents subsequently failed to adequately respond to information suggesting that (a) the identity of the outside auditor to the Hedge Funds was in doubt and (b) there existed a conflict of interest between a principal of the Hedge Funds’ investment adviser and the purported outside auditor. In a separate proceeding, the SEC had already found the Hedge Funds to be fraudulent investment schemes and found the audited financial statements and the auditor opinion letters on behalf of the Hedge Funds to be falsified, costing the Respondents’ clients more than $56 million.
Failure to Follow Advertised Procedures: From 2002 to 2005, the Adviser promoted its Procedures as the “Five Level Due Diligence Process” and routinely touted the excellence and rigor of these Procedures for assessing investments in marketing materials, its website, and in oral and written presentations. In evaluating the Hedge Funds, however, the Adviser at the principal’s direction did not perform two core elements of the Procedures: (1) a portfolio and trading analysis; and (2) a verification of the relationship between the Hedge Funds’ investment adviser and auditor.
The promotional materials circulated by the Adviser indicated that it conducted portfolio and trading analyses based on prime brokerage reports to evaluate quantitative information about a fund’s portfolio characteristics, investment and trading strategies and risk disciplines. Nevertheless, when the Hedge Funds refused to provide such information to the Adviser, the Respondents continued with their positive recommendations of the funds relying entirely on the uncorroborated representations and purported rates of return received from the Hedge Funds and their investment adviser and without disclosing to clients that Respondents had not conducted the advertised portfolio and trading analysis.
Similarly, the Adviser advertised that it verified a fund’s relationship with its independent auditor and ensured that the auditor actually performed audits of the financial statements. While the Hedge Funds’ investment adviser provided the Adviser with audited financial statements from one accounting firm and told the Adviser that more recent financial statements were to be audited by a different accounting firm, the Adviser took no steps during its initial evaluation to confirm that either accounting firm had an audit relationship with the Hedge Funds. The SEC emphasized the need for auditor verification under such circumstances where the Adviser had no previous relationship with either named auditor and none of the many other hedge funds that the Adviser recommended had used either auditor.
Accordingly, the SEC found that the Respondents breached their fiduciary duty by misrepresenting the services that they were providing and without fully disclosing material departures from the Procedures to clients.
Inadequate Response to Red Flags: The SEC found that the Adviser subsequently failed to properly follow up on inconsistent information it received concerning the Hedge Funds’ outside auditing firm. First, while the Adviser was told that a new auditing firm was hired to conduct audits in 2002 and received marketing materials to that effect, audited financial statements from 2002-2004 were signed by and on the letterhead of the Hedge Funds’ previous auditing firm. The Adviser failed to act on this information or disclose it to clients.
Second, the Adviser, through its principal, failed to adequately follow up on rumors it received that the chief operating officer/chief financial officer of the Hedge Funds’ investment adviser had an economic interest in the previous auditing firm. Instead, the Adviser relied on written representations from that individual that he had severed all ties with the previous auditing firm. Despite contradictory information in its own files, the Adviser took no steps to further investigate the rumors, such as contacting the previous audit firm or conducting research on the internet or through public records. By failing to adequately respond to conflicting information that it had received, the SEC found that the Respondents had breached their fiduciary duties to their advisory clients.
Sanctions: In addition to censure and cease and desist sanctions, the Respondents were jointly and severally required to disgorge nearly $715,000 (including interest) and pay a civil monetary penalty of $100,000. Each Respondent also undertook to (A) adopt written policies and procedures to ensure adequate disclosures to clients and prospective clients regarding the Adviser’s process for evaluating, selecting and monitoring hedge funds, and (B) mail copies of the SEC order to their existing clients and provide a copy to any new client during the succeeding two years.